THE LIBRARY OF THE UNIVERSITY OF CALIFORNIA RIVERSIDE GIFT OF Dr. Gordon Vatkins t/3 U "c5 *-> 4 C w 3 O rt ^ "rt 52 b/j r^ bjo c/3 C r4 * H O '-| o o ^ a, a, C - ^ ~ ro 8 C cd *~ _ . ' W ^ u M 1 ^ I'D 6 HH < H 1 1 > - > . S^ ^ I II III IV V VI VII VIII I 20 2 2 .1 I 2 2O 3 6 (0 4 3 2 4 3 2O 4 16 (2) 10 .8 4 10 4 20 5 35 (4) 19 1-7 7 19 5 2O 6 84 (7) 49 4-2 M 49 6 2O 7 126 (14) 42 6-3 18 42 7 20 8 156 (18) 30 7-8 19-5 30 8 2O 9 179 (19-5) 23 8.9 19.8 23 9 2O 10 200 (19.8) 21 10 20 21 10 20 12 236 (40) 36 11.8 19.7 18 11 20 14 266 (39) 30 13.3 19 15 12 2O 16 290 (38) 24 14.5 18.1 12 13 20 18 312 (36) 22 15.6 17.3 11 14 20 20 330 (34) 18 16.5 16.5 9 15 20 22.2 346 (36) 16 17.3 15.6 7.2 16 2O 25 362 ' (43) 16 . 18.1 14.5 5.7 17 20 28.5 380 (50) 18 19 13.3 5 18 20 33-3 393 (63) 13 19.6 11.8 2.6 19 2O 40 400 (78) 7 20 10 1.1 20 2O 44-4 398 (44) 19.9 8.9 e/5 21 2O 50 393 (50) CO 19.6 7.8 22 2O 57-i 360 (56) in rt 18 6-3 R 3 23 20 66.6 280 (60) u 14 4.2 a 24 2O 80 140 (56) P 7 i-7 w 25 2O IOO 80 (35) ~ 4 .8 B 26 2O 133-3 40 (26) ^ 2 3 s 27 2O 200 20 (20) I .1 ^ /?///* column. These are intended to show what the increase in out- put would have been if it had been just proportional to the increase in the number of L's. But a proportional increase means one which 128 PRINCIPLES OF ECONOMICS [IX just maintains the average of the last preceding combination. Thus, the average for the fourth combination is 7 units for each L, and hence, if the L of the fifth combination is to maintain the average, it must bring in seven units. Accordingly, the figure in this column for the fifth combination is 7. The figures in this fifth column which are not in parenthesis represent the actual increase in output, and are, of course, obtained for any particular combination by subtracting from the total of that combination the total of the combination next preceding. Thus from the 312 output of the thirteenth combination, we subtract the 290 of the twelfth and get 22, the actual increase for the former combina- tion, and this figure, therefore, appears in the fifth column outside the parenthesis. The figures in the sixth column give the average total output for the corresponding combination measured in N's. Thus the figure 14.5 in this column for combination 12 means that the average output for each of the 20 N's in this combination is 14.5. That figure is of course obtained by dividing 290, the total output for this combi- nation, by 20, the number of N's used. The figures of the seventh column similarly show the average total output measured in Us. Thus the 1 8. i appearing in this column under this same combination means that the average output for each L is 18.1, a figure obtained by divid- ing the total output, 290, by 16, the number of L's in this combina- tion. Finally, we have in the eighth column, the addition to output which follows upon 4 the addition of one units of L's. Thus the 12 appear- ing in this column under the twelfth combination means that for each new L appearing in this combination, 12 more units of product appear in the output. This figure is of course obtained by dividing 24, the total amount added, by 2, the number of L's added. In the first 8 combinations the figures for this column are the same as those which appear in column 5 outside parentheses, because in each case there is but one L added, and so division by the number of L's does not alter the figure of the addition. 4 This must not be understood to mean that this addition is produced solely by the unit of L's in question. IX] OUTPUT AND RATE OF PRODUCTION 129 A brief inspection of our table will show that it represents symbolically the phenomena which were set forth above as present in real life. No actual combinations of factors behave in precisely the way indicated in this table ; but the general course of things is strictly regarded. We have but to follow the figures given in the fifth column to see that, for the first 9 combinations, output increases more than proportionally ; that, for the next 10 combinations, it increases less than proportionally; and that, for the last 8 combinations, it absolutely diminishes. In short, it passes through the 3 stages through which real combinations pass. Accordingly, we can safely use the figures of this table to bring out in definite and precise form the points directly or indirectly involved in our principle. ILLUSTRATIVE PROBLEMS 1. Assume that the total output for the twelfth combination is 294 units instead of 290, and compute the figures which would result from this new assumption in the part of the fifth column not in parenthesis, and in the sixth, seventh, and eighth columns. 2. If you had at your disposal 10 N's and 8 L's, what combination would you naturally use? What one, if you had 40 N's and 32 L's? If you had 5 N's and 4 L's ? 60 N's and 75 L's ? 3. If you had at your disposal 60 N's and 48 L's, how much product would you naturally be getting? How much would you naturally get, if you were to put in 6 more L's? How much, if you added another 6 L's? Ill Changes Caused in Averages as Measured in Each of the Two Factors Average Measured in L's. The next point to be remarked concerns the changes caused in the average output as measured in one or the other of the factors. This is, indeed, only another way of looking at the facts already presented, but it is a way of much interest and importance. How, then, does the average measured in L's be- have? The seventh column of our table shows that it increases up to the ninth combination, then diminishes to the end. Moreover, the table shows a perfectly definite reason why this must be so. The average output for any combination, measured in L's, is, of course, 130 PRINCIPLES OF ECONOMICS [IX equal to the total output for that combination divided by the number of L's used in the combination. But, if for any series of combina- tions the total output is increasing more rapidly than the number of L's, (as it is for the first 9 combinations), the quotient obtained, that is, the average, must be increasing. On the other hand, if for any series of combinations the total output is increasing less rapidly (as it is for the 10 combinations after the ninth) than the number of L's, the quotient, and so the average, must be diminishing. Finally, if output is diminishing absolutely while the number of L's is still increasing, the average must of course be diminishing. The average, 1 2 3 4 6 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 N \ \ \ Averages in L's and N's measured in L's, therefore, first increases up to the ninth combina- tion, then diminishes to the end. Average Measured in N's. The behavior of the average measured in N's, as represented in the sixth column, is necessarily somewhat different. Since the total output is increasing up to, and including, the nineteenth combination, while all the time the number of N's used remains constant, that is, since the dividend increases while the divisor remains constant the average, measured in N's, must increase throughout this series. On the other hand, since the total diminishes after the nineteenth combination while the number of N's remains constant, the average, measured in N's, must diminish after the nineteenth to the end. Summary. Summarizing the points made above and the most immediate inferences therefrom, we have the following: First, IX] OUTPUT AND RATE OF PRODUCTION 131 each average rises during a series of combinations ; reaches a maxi- mum in one particular combination; then diminishes for the re- mainder. Secondly, the maximum average combination is differ- ent for the two averages, being an early one for the L-average, a late one for the N-average, a proposition which plainly follows from the conditions. In the third place, the average measured in cither factor is bound to be an increasing one for every combina- tion prior to the tenth ; that average measured in either factor will be a diminishing one for every combination after the nineteenth; and, for the intervening combinations, the average will be a dimin- ishing one, measured in L's, but an increasing one, measured in N's. These points are brought out graphically in the accompanying dia- gram, in which the continuous curve represents the averages measured in L's, while the dotted curve represents the averages measured in N's. IV Changes in Additions or Marginal Products Another effect of attempting to increase output by increasing one of the factors concerns the changes caused in the addition to output as measured in the addition to the changing factor. Thus the thir- teenth combination shows an increase over the preceding one of 22 units of output, while the number of L's added to make this combination was 2; and, dividing 22 by 2, we have u, which is the number of units of product added for each of the L's added. With some show of reason, this quantity is frequently designated the marginal product 5 of the L's that is, of the increasing factor. Anyhow, the course which it takes as we increase the quantity of L's used is of considerable importance. That course is indicated in the last column of our table. It begins at 4 in the second com- bination ; increases to 49 in the fifth ; from thence grows smaller and smaller to the nineteenth ; after which it remains less than o. These results are inevitable so long as the relation between the increase in output and the increase in the number of L's is the exact relation assumed in our table. The addition to output for each "' See Note 2, Appendix. 132 PRINCIPLES OF ECONOMICS [IX added L is just what it is because the relation between the increase in the total output and the increase in the total number of L's is just what it is. We must not infer, however, that the precise course taken by the marginal additions in our table is the only one which they could take under the general conditions assumed, namely, the conditions that output increased more than proportionally up to the ninth combination inclusive, then less than proportionally to the nine- teenth, and then diminished. The precise course taken by the marginal addition or product as a result of a change in the propor- tion between output and the number of L's, depends, not only on the direction of that change, but also on its degree. Thus, if the proportional increase in output had been less rapid during the earlier combinations or had fallen off less sharply in the later ones, the change from an increasing to a diminishing marginal product would have come later. Other possible variations in the behavior of the marginal product from that indicated in our table could easily be worked out arithmetically. Nevertheless, if we assume that the course taken by the output in our imaginary experiment was fairly typical, and I think we may properly do so, the course taken by the marginal product would correspond in a general way to that which it takes in our table: that is, marginal product would increase up to a maximum coming somewhat earlier than the com- bination at which the increase in output became less than propor- tional, then diminish to the end. Before leaving this topic, we must emphasize one aspect of the matter just commented upon, the fact that the point where marginal product begins to diminish does not correspond with the point where the increase in output changes from a more than proportional to a less than proportional one, the latter being at the tenth combination, the former at the sixth. As already noted, this precise location of the point at which the marginal product begins to decline is not neces- sary for every possible case in which the increase begins to be less than proportional at the tenth combination. In other words, our experiment does not prove that a locating of the change in marginal product at a point earlier than that at which the change in propor- tionality takes place is inevitable; it does prove, however, that this is possible, if not probable, It follows that we cannot properly IX) OUTPUT AND RATE OF PRODUCTION 133 treat the two phenomena as identical. The principle that the mar- ginal product first increases, then diminishes, is not the same as the principle that output increases more than proportionally to the changing factor, then less than proportionally. 6 It should be added, however, that, generally speaking, we have no interest in marginal products prior to the ninth combination. These marginal product figures are useful chiefly in showing us whether or not it would pay to add further to the number of L's in the combination. 7 But it goes without saying that such is the case anyhow up to the ninth combination. For up to that point we are raising both averages by each addition of L's; and, as long as this is true, it is a matter of indifference whether or not each L adds as much as its predecessor. V Factor L Constant, Factor N Changing In our imaginary experiment as embodied in the table, the quan- tity of N's was supposed to be constant while that of L's increased. What, now, would be the result were this situation to be reversed with the L's constant and the N's increasing ? It would be precisely similar to that already brought out, with the places of N's and L's reversed. Output would increase at first more rapidly than the N's, then less rapidly, then actually decrease ; the average measured in N's would increase up to some early combination, then diminish to the end, while the average measured in L's would in- crease up to some later combination, then diminish to the end ; and, finally, the marginal additions, the marginal product of N's, would increase up to some combination prior to the ninth, then diminish to the end. And note that the acceptance of these statements does not depend on a new induction. // the points made with respect to the results which follow when N's are kept constant and L's increased are true, the analogous statements with respect to the fc This comment seems necessary on account of occasional carelessness of statement on this point in the literature of our subject. 7 Many economists hold that the marginal product is also very useful in guiding us as to the importance or significance to the producer of the factor in question. 134 PRINCIPLES OF ECONOMICS [IX results which follow when L's are kept constant and N's increased must be true. A table reversing the relations of L's and N's, in respect to both conditions and results, is directly dcducible from the table already given. Accordingly, in so far as the doctrines set forth in the preceding discussion apply to any particular combina- tion, they are true without regard to which of the factors is kept constant and which is increased. If they are true of a combination of land and labor in which the land is constant, they are equally true of one in which the labor is constant. The point just made, that the principles laid down with respect to the effect of increasing one of the factors of a combination while the other remains constant are true whichever one of the factors is increased, must not be understood as implying that it is of no prac- tical importance which factor is taken as the constant one. Some natural factors in production and many produced ones necessarily appear in large, indivisible units. They must be utilized as a whole or not at all. For example, the group of great lakes beginning with Superior and ending with Ontario a very important factor in transportation cannot be made smaller or larger. We must use the system as it is. So a plant for lighting a great city or supplying it with water cannot be changed ever week or month or year. If we have to increase or diminish the amount of service obtained from factors of this type, we must for a time if possible do so by increasing the quantity of auxiliary factors used. Such increasing of the auxiliary factors is usually possible, because those factors are to be had in small or easily divisible units. While we cannot increase the size of the lakes, we can change in no great length of time the number of boats navigating those lakes. While we cannot at frequent in- tervals enlarge the whole lighting plant, we can readily increase the amount of labor employed or the quantity of coal consumed. The importance of the principles brought out in this chapter grows out of their application to cases like these in which one of the combining factors is naturally or necessarily kept constant for a shorter or longer period, while any or all of the others may be changed. IX] OUTPUT AND RATE OF PRODUCTION I35 VI Output from Groups of Factors We have noted the effect on output of increasing one of the factors of a combination when we are dealing with single factors. We have to add that the same phenomena appear when we are dealing with groups of factors over against one or more auxiliary factors. , Thus, when trying to ascertain the effect on output from the aggregation of land, buildings, machinery, etc., which we call a plant, of increasing the amount of auxiliary factors, raw mate- rials, fuel, labor, etc., we have the same general experience as before. For a time, the output increases more rapidly than the auxiliary factors, then less rapidly, then absolutely diminishes. The same statement would of course apply to a business unit as a whole, that is, a partnership or a corporation operating one or many plants. This would be so, partly because the plants operated by the corporation would exhibit the phenomena in question and partly because the organization side of the business would inde- pendently exhibit these phenomena. While parts of the organization remained constant for example, the higher officials, one president, one secretary, and one general manager, other elements would be increased, and this increase would at some stages result in a more than proportional increase in output and at others in a less than pro- portional one. In general, then, it is scarcely to be doubted that we have here a principle or set of principles of very wide application. In practically all cases, we may alter the proportions in which factors are combined without destroying their power to produce ; but we cannot help changing their effectiveness or productivity, making them produce, proportionally, more or less. And this fact will be of importance whenever the circumstances are such that some one factor or group of factors, is absolutely fixed, or, for a longer or shorter period, is fixed by special circumstances. CHAPTER X ATTEMPTS TO INCREASE OUTPUT AND SOME ECONOMIC CONSEQUENCES In the last chapter we explained the more immediate and chiefly technical consequences resulting when we attempt to increase the output from a factor of production by increasing the amount of the auxiliary factors employed. We must now remark on some remoter consequences, especially some of an economic character. I Limits of the Productive Capacity of Individual Instruments As noted in introducing our last chapter, one of the most im- portant economic problems connected with the matter we are now studying concerns the limits of our productive capacity. In so far as this inquiry has to do with the individual instrument, the most valuable conclusions of our study are these two: (i) There is an absolute limit to the amount obtainable from any instrument, and (2) before that absolute limit is reached, there is a stage during which the increase in output is less than proportional to the increase in the quantity of auxiliary factors. On account of its great im- portance, the second of these ought, perhaps, to be given the em- phasis derivable from its statement as a formal principle. This principle is commonly known as the Law of Diminishing Returns. Principle The Law of Diminishing Returns. // attempts are made to increase indefinitely the output of any factor of production by increasing the quantity of auxiliary factors used, a time zvill come, before the absolute limit is reached, when, though there continues to be an increase in output, that increase is less than proportional to the increase in the quantity of assisting factors added. X] INCREASE IN OUTPUT: CONSEQUENCES 137 We must now add a word about certain technical phrases used in connection with the principle just stated: When the utilization of any instrument of production has been carried up to the com- bination which will yield only a smaller proportional return, it is said to have been worked or utilized to "the point of diminish- ing returns." A step further takes it beyond the point of dimin- ishing returns or into the stage of diminishing returns. As the utilization of any instrument is carried further and further into the stage of diminishing returns, it is said to be worked (culti- vated in the case of land) "intensively" or "more intensively." Another method of expressing the same idea is to say that "the margin of cultivation (utilization) is lowered" or "pushed down." The discussion leading up to the above statement of the prin- ciple of diminishing returns has, perhaps, insured its correct inter- pretation. In view, however, of numerous misunderstandings which have appeared in economic controversy, it seems best to indicate specifically certain misinterpretations which need to be guarded against. First, the "returns" referred to in the designation "diminish- ing returns" are physical returns, product, not money or profits. The principle means that by increasing the amount of labor we can increase, though less than proportionally, the potatoes raised on a given piece of ground, or the heat given out by a furnace, or the freight carried by a railway, and so on. In order to emphasize this point, I like to call our principle the Law of Diminishing Output, thus avoiding the ambiguity attaching to the word "returns." Another misunderstanding confuses the principle now under discussion with one which says that there comes a stage in the pro duction of goods when product can be increased only at increasing cost. This statement is without doubt true ; but, as will be brought out in the next chapter, the condition indicated is not identical with the one meant when we say that we have reached the stage of diminishing returns. Another troublesome misunderstanding interprets our principle to mean that output could never be increased at a proportional rate whatever might happen, however much improvement in the productive arts might take place. This, of course, is a quite illegiti- 138 PRINCIPLES OF ECONOMICS [X mate interpretation. A natural law in Economics, just as in Chemistry or Physics or Biology, assumes the continuity of condi- tions other than the one or more which the principle itself represents as changing. Doubtless any person is at liberty to affirm a principle analogous to the one here considered in a dynamic sense, as we sometimes say, that is, as certain to prove true despite changing conditions. But most prudent people will hesitate to do so; and anyhow, unless this is expressly indicated, the affirmation is always made subject to the condition that no changes are to take place except the one specified in the principle itself, namely, an increase in.the quantity of the changing factor. ILLUSTRATIVE PROBLEM "Malthus was quite wrong when he tried to show that at life's ban- quet there was room for only a limited number of guests. The guests are also cooks, contributing their share of the banquet." Dr. Bertillon in a lecture in Paris in 1913. Criticize this statement of Bertillon on the basis of the law of dimin- ishing returns. II Elasticity of the Limit Set by the Lav/ of Diminishing Returns In our formulation of the Law of Diminishing Returns, and too often in our interpretation of that law, all emphasis is laid on the fact that it acts as a check on output, sets a limit to output. Only a very little thought makes it clear that this principle has another side. It is true that output does not increase proportionally to the increase in auxiliary factors ; but then output does increase. If we have reached the stage of diminishing returns in the utilization of any instrument of production, we cannot get any more product out of it at the same rate as before; but we can get some more. In fact, our principle might with very good reason be named the Principle of Output Increasable at a Diminishing Rate. Such a designation recognizes equally the fact that output can be increased and the fact, also, that the increase will be less than propor- tional. X] INCREASE IN OUTPUT: CONSEQUENCES 139 ILLUSTRATIVE PROBLEM The law of diminishing returns is a reason why the price of wheat is lower than it might be, and, at the same time, is a reason why the price of wheat is higher than it might be. Explain the seeming contradic- tion. Ill All Divisible Factors Usually Being Worked in the Stage of Diminishing Returns We have seen that most economic factors are subject to the law of diminishing returns in the sense that, in trying to utilize them more and more fully, a time will come when such attempts will increase product, but increase it less than proportionally. We now have to add that, under normal conditions, the utilisation of any divisible factor must have been carried into this stage, producers must be working it in some combination beyond the point of diminish- ing returns. In terms of our table, any such instrument will at all times be working in some combination later than the ninth and earlier than the nineteenth. The general argument on which the above statement is based is as follows : All combinations earlier or later than those indicated are ex- cluded as being for one reason or another illegitimate. First, all combinations coming after the nineteenth must be excluded, since the additions to the changing factor which make up these combina- tions reduce the total, a result which can be avoided by the simple expedient of not making those additions. Secondly, all combina- tions from the first to the eighth inclusive must be excluded ; since, under our hypothesis that the factor under consideration is divisible, we could transform any one of these early combinations into the ninth by the simple expedient of discarding some of the N's, and, in doing this, would increase our total. Thus, the seventh combination, 20 N's with 8 L's, could be transformed into the ninth by discarding 4 of the N's, making the combination 16 N's with 8 L's, the same 2 to i ratio as that of the ninth. But this combination would give I 4 PRINCIPLES OF ECONOMICS (X us 8 times 20 or 160 units of product, whereas the original com- bination of 20 N's with 8 L's would give us only 156 units. We have seen that, under normal conditions, no divisible factor would be used in any combination later than the nineteenth nor earlier than the ninth. That is, the actual, effective working of any factor would be limited to some one of the n combinations from the ninth to the nineteenth inclusive. But we must narrow still further the range of reasonable, and so actual, combinations. Another element necessarily comes in to determine what ones are possible, namely, cost of production. If N's could be had in un- limited abundance for nothing, while L's had a price however small, the ninth combination would plainly be the most desirable, since it gives the highest average measured in L's, and so, when the price of the L's constituted the only cost, the cost in this combination would be lowest. 1 On the other hand, if N's had a price, but L's none, the nine- teenth combination would be the cheapest, and, so, the most desir- able of all. But, in real life, both N's and L's will have some cost, else they would not be economic factors at all. Further, there will not often be such a difference between their costs that either is negligible in the total cost. It follows that, if both factors are divisible, the truly legitimate combination will normally be one which comes later than the ninth and earlier than the nine- teenth. Assuming reasonable conduct on the part of producers, they will be using any factor in some one of the combinations indi- cated, the combinations lying between the ninth and the nineteenth. But any one of these is bound to be a diminishing-returns combina- tion, that is, one holding such a position that, if we try to increase output by increasing the quantity of auxiliary factors, we shall effect some increase but an increase which is less than proportional to the increase in auxiliary factors. We conclude, then, that, in actual life, we should expect to find any divisible factor being worked in the condition of diminishing returns. 1 This would be true even if N's had a price, but one which was insignificant as compared with that of L's. X] INCREASE IN OUTPUT: CONSEQUENCES 141 IV Indivisible Factors May Be Working in the Stage of Increasing Returns We have just seen that divisible factors will normally be used in the condition of diminishing returns, because on account of the divisibility of the factor which was kept constant in our experi- ments, we could always change to a later combination, and would do so if this was desirable. But, when we come to deal with indi- visible or large-unit factors, the problem is greatly altered. Just because the given factor is indivisible, we cannot adapt it promptly to every change in the need for product. Thus, it is plain that we cannot change our furnace every time the weather changes, substi- tuting a larger one if more heat is needed or a smaller one if less heat is needed. What we have to do is to run the one we have harder or easier, put in coal oftener or less often. An obvious result of this situation is that, if the weather gets warmer, we may be obliged to run the furnace so low that it is being worked in some stage prior to the ninth, say the seventh or the fourth. This of course is uneconomical : we get much less heat per pound of coal than we might if our plant were adapted to just the need of the moment. But we have no choice. We must install a furnace large enough to meet the need of really cold weather ; and yet, on a moderate day, we must not work it hard enough to make the house uninhabitable. It follows, then, that we may find any indivisible factor being used in the stage of increasing returns, output increas- able at an increasing rate. What we have just said of the furnace applies as well to any large natural factor, for example, the lake system used for illustra- tion on page 134. Such a factor may be working in the condition of increasing returns or in that of diminishing returns. Which it will be depends entirely on the existing need for the services of the factor. We have no choice in the matter. We have to use it as it is whether the need be great or small. For a long period while population was small, this vast system of waterways could be utilized only in some inferior combination, some one earlier than I 4 2 PRINCIPLES OF ECONOMICS [X our ninth. With the increase of population during the last fifty years, it probably has passed into some combination later than the ninth. The case of indivisible, large-unit factors of the producible sort is, naturally enough, different. We have some control of the situa- tion in that, when. constructing such instruments, we can adapt them to a particular output, make them of the proper size to supply this output most cheaply. But, as a matter of course, they will be called on to supply different volumes of output at different times. Naturally, the volume for which they will be planned will be that one which is expected to be normal. They will, therefore, be built on a scale which enables them to supply this normal output when working in the combination showing least cost. 2 It follows that, under normal conditions, such indivisible producible factors will be working in that particular combination lying between the ninth and the nineteenth which shows least cost. If, however, the demand is abnormally large, they will be pushed into some later combination ; while, on the other hand, if it is abnormally small, they will be brought back into some combination lying between the least-cost one and the ninth, or, even, into one earlier than the ninth. ILLUSTRATIVE PROBLEM In what stage, as respects returns, would you expect to find an auto- mobile plant working during an industrial depression? After business had revived? When a boom was on? V The Diminishing Marginal Significance of Factors One more important fact which in part anyhow grows out of our effort to increase output by increasing the quantity of the auxiliary factor used, is suggested by the title of this section : "The Diminish- ing Marginal Significance of Factors." In general the different units of any particular kind of factor can be put to uses having * They will probably be built on a little larger scale than this in anticipa- tion of increasing need. X] INCREASE IN OUTPUT: CONSEQUENCES 143 different degrees of importance or significance. When such uses are wholly distinct, this proposition is evident enough. Thus, in time of war, the food supplied to the soldiers in the field plays a more important role than that destined for the ordinary civilian; and the steel used in making ammunition is more significant than that devoted to making pleasure cars. Even if the different uses have to do with one product, the case is scarcely less plain. Thus, the steel used in the corn farmer's plow is more important than that used in his spring-toothed harrow ; without the former he could scarcely farm at all, the latter he might dispense with rather easily. Finally, different uses of the same factor differ in importance or significance even when the factor is operating in just the same way. Thus, if, under similar conditions, a cultivator goes over a cornfield several times, the importance of the service it renders will be smaller as the number of times increases. This, manifestly, is merely a special application of the principle of diminishing marginal produc- tivity brought out in the preceding chapter. But, not only may the different uses to which a given factor is put vary greatly in importance or significance, among these different significances there is one which plays a much more important role than the rest. That one is the smallest or least of them all. Thus, if we have steel enough so that we can afford to use it for both the plow and the spring-toothed harrow, the significance of the steel used in the harrow will play a more important part than will the significance of the steel used in the plow. The former rather than the latter will determine the estimate we put on the importance of the amount of steel necessary to make a plow or a harrow. 3 The reason is not far to seek. Our estimate of the importance of anything in this case the quantity of steel necessary to make either a plow or a harrow depends on how much loss we should experience if we had to give it up. But, if we had to give up either the plow or the harrow, the one chosen for the sacrifice would, of course, be the harrow, the less important of the two. The significance lost to us, therefore, would be the lesser significance ; and, hence, the "As we shall learn later, this estimate will have a part in determining the value or price of steel. I44 PRINCIPLES OF ECONOMICS [X estimate which we make of the importance of steel would be deter- mined by the lesser significance. Broadening the statement so as to cover the whole stock of steel, we say that the estimate we make of the importance of steel would be determined by its significance in the least important use, its least significance. This least significance of any factor which is of much importance in economics, we designate its marginal significance. The designa- tion signifies that this particular significance is located at the boundary line separating the significances which are realised from those which are not. We have seen that the differ ent significances of any factor are quite unequal, and that one of these, the marginal significance, is of great moment in economic matters. We must now add a proposi- tion which we will call the Law of Diminishing Marginal Sig- nificance. Principle The Law of Diminishing Marginal Signi- ficance. Generally speaking, the marginal significance of any factor tends to diminish as the quantity of that factor available increases. The marginal significance of a particular kind of land will be much smaller if there are millions of acres of such land available than it would be if there were only hundreds. As between different kinds of land, the marginal significance of the kind of which there are only hundreds of acres will very likely be greater than the marginal significance of a kind of which there are millions of acres, even though the generic significance of the latter kind is much greater. That things are bound to work in a way to make the above proposition true is easily seen. Assuming the general rationality of business conduct, the uses to which any factor has not as yet been put will be less significant than those to which it has been put. It follows that, if new supplies of that factor are forthcoming, they can be utilized only by assigning them to uses which have less sig- nificance than those already provided for. Hence the principle. X] INCREASE IN OUTPUT: CONSEQUENCES 145 ILLUSTRATIVE PROBLEM Assuming that laborers of any class tend to get a price for their services wages representing substantially the marginal importance of their type of service, show that you would naturally expect restrictions on immigration to raise wages in the United States. CHAPTER XI INCREASE IN OUTPUT AND COST OF PRODUCTION A very important topic closely connected with the one which has occupied the last two chapters is the effect on cost of production caused by attempts to increase the volume of output. This problem really breaks into two parts : ( i ) what will be the effect on cost of trying to increase output from a particular instrument or group of instruments fixed in amount, and (2) what will be the effect on cost of trying to increase the output from a particular industry as a whole, with no restriction on the quantity of any instrument or factor. We begin with the former of these problems. The Effect on Cost of Trying to Increase Output from a Partic- ular Instrument or Set of Instruments Fixed in Amount Interpreted as asking what will be the effect on cost of trying to increase output from a single instrument or set of instruments fixed in amount, our new problem is very close to that treated in Chapter IX. In fact, if we mean by cost only the expenditure for the factor which increases, the two problems are one, looked at from slightly different points of view. Under the conditions named, to say that a plant or a business is in the condition of diminishing returns would amount to the same thing as to say that it is in the condition of increasing cost. But, in actual business, we have usually no interest in particular factors unless they are economic ones, that is, unless they are factors having prices. We have, therefore, to remember that in the real world we shall have to pay for N's as well as for L's. The total cost, therefore, will not change merely with the change in output as measured in L's; it is bound to be influenced by the changes in output as measured in N's also. 146 XI] OUTPUT AND COST 147 But, though different, the two problems are very closely connected ; and the solution of the one treated in Chapter IX plays a large part in the solution of the new one. Our first task is to consider the effect on cost of trying to in- crease output from simple combinations like those made up of our N's and L's. The solution is not difficult, though the explanation must be followed with some care. First, the cost per unit of product for any particular combination must equal the cost per unit measured in N's plus the cost per unit measured in L's. For example, if in a given combination the average output measured in N's is 10 units and each N costs $i, so that the cost of each unit measured in N's is $i over 10 or 10 cents, and, if that same output measured in L's gives 20 units per each L while each L costs $i, so that the cost of each unit of product measured in L's is $i over 20 or 5 cents, then, the total cost of each unit of product must be 10 cents plus 5 cents, or 15 cents. Secondly, the cost per unit measured in either N's or L's must increase as the average output measured in that factor diminishes, and must diminish as the average measured in that factor increases. For example, if the average output in N's increases from 10 to 20 units, when each N costs $i, then the cost per unit, measured in N's, falls from 10 cents to 5 cents. On the other hand, if the average measured in N's diminishes from 20 to 10, the cost of each N being $i, the average cost, measured in N's, rises from 5 cents to 10 cents. Cost Measured in Each Factor.- Again, since the average measured in N's is increasing from the second combination to the nineteenth, while that average diminishes from the twentieth on, the cost, measured in N's, must decline from the second to the nine- teenth combination and must increase from the twentieth on. On the other hand, since the average, measured in L's, increases up to the ninth combination and then diminishes to the end, the cost, measured in L's, must diminish up to the ninth combination and thereafter increase to the end. Further, since the increase in the average measured in N's is rapid during the first few combinations after the ninth, and becomes slow as we approach combination 19, the cost in N's declines rapidly during the earlier combinations after I4 g PRINCIPLES OF ECONOMICS [XI the ninth and slowly during the later ones. In like manner, the cost in L's, though increasing up to the nineteenth combination, does this slowly during the earlier combinations after 9, speeding up as we approach the turning point at 19. Cost Measured in Both Factors. The last two paragraphs have shown us the course followed by the cost of production as measured in one or the other of the factors taken separately. It is now easy to see how the total cost per unit, that is, the cost measured in both factors must behave. Since cost, measured in either factor, diminishes up to the ninth combination, the average of the total cost must diminish up to that same combination. Again, since the average cost, measured in either factor, increases after the nineteenth, the average of the total cost must increase after the nineteenth. This statement disposes of the first and last 8 combinations. What, now, is to be said with respect to the remaining 1 1 ? First, in so far as the cost for any one of these is influenced by the cost measured in N's, that cost will tend to diminish clear up to the nineteenth com- bination, since the cost measured in N's diminishes up to that com- bination. On the other hand, in so far as the average of the total cost is being influenced by the cost measured in L's, it will tend to increase from the ninth combination on, since the cost measured in L's increases from that point. That is, we have here two opposing tendencies, a downward one due to the influence of N's and an upward one due to that of L's. But, again, the opposing pulls of N's and L's are not uniform throughout their course. 1 Instead, the upward pull on costs exer- cised by L's is relatively small in the earlier combinations after 9, but rapidly increases as we approach 19. So likewise, the down- ward pull of N's is great in the earlier combinations after 9 but weakens as we approach combination 19. From these facts it follows that the general trend of the total average is downward during the earlier combinations, upward during the later ones. But, 1 If they were, the resultant tendency might be a constant cost between the ninth and nineteenth combinations, or it might be a least cost at the ninth or a least cost at the nineteenth. XI] OUTPUT AND COST 149 since there must be a turning-point between these two opposite trends, one or at most two 2 of the combinations must show a lower cost than the others, a least cost. In short, for any particular pair of prices for N's and L's, we are bound to have results like this : ( i ) during a shorter or longer series of combinations, cost will de- cline; then (2) a least-cost combination 3 will appear; and (3) dur- ing a longer or shorter series, cost will increase. The Least-Cost Combination. What, now, is to be said with respect to the location of the least-cost combination? In general, this must depend on the relative prices of N's and L's. As we have already seen, the influence of N's must tend to lower cost with every movement toward combination 19, while the influence of L's must tend to lower cost with every movement from 19 toward 9. It follows that the least-cost point will tend to move toward 19 under the influence of N's and toward 9 under the influence of L's. Which of these opposing forces will outweigh the other depends upon their relative magnitude, that is, the relative magnitude of the prices which the producer has to pay for N's and L's. If N's are very costly, this will tend to push the least-cost point toward the nineteenth combination, and vice versa. If, for example, N's cost $i each and L's 40 cents each, the seventeenth combination will be the cheapest; while, if N's cost 20 cents and L's $i, the eleventh combination will occupy this place. Least Cost and Diminishing Returns. The foregoing dis- cussion would seem to clear up pretty fully the problem of cost as affected by changes in combining proportions. Before going on, however, we ought, perhaps, to contrast this problem of changing costs with that of changes in output as affected by changes in com- bining proportions. As we have seen, the principle that output tends 2 When, through the falling of the price of L's, the point of least cost is about to pass from one combination to the next lower, one particular price for L's will make cost in the two combinations just the same, though a slight decline in that price would move that point into the later combina- tion and a slight advance would put it back into the earlier one. 3 Or pair of combinations. ! 5 o PRINCIPLES OF ECONOMICS [XI to increase less than proportionally is the same as the proposition that cost tends to increase, only on condition that we are measuring cost in the changing factor. This point, brought out more sharply now that we are clear as to the hehavior of total cost, means that the turning-point from the preceding stage to the one under con- sideration occurs in a different combination in the two cases. For example, in our series of supposed combinations, the output is in- creasing more than proportionally up to combination 9, after which it increases as far as combination 19 less than proportionally; that is, for output, the ninth combination is the turning-point. As we have just seen, however, the turning-point for cost is practically always a combination later than the ninth. If we suppose the price of each of the factors to be just $i, the turning-point, the least-cost combination, proves to be combination 14. Further, as was fully explained, this turning-point varies with every considerable change in the relative prices of the two factors. In short, instead of being at the same combination as the one at which diminishing returns sets in, it almost never occupies this place, and it may theoretically be in any one of the n combinations from the ninth to the nine- teenth, inclusive. This point needs some emphasis, because not a few writers have carelessly identified the principle that, after a certain point, the proportional returns diminish, with the principle that, after a certain combination is reached, cost of production begins to increase. We may add, as an application of the distinction between these two principles that in any particular case of the utilization of a factor of production, we may have passed the point of diminishing returns and yet not have reached the point of increasing cost. For example, if our N's represent a furnace used in the heating of a house, and if the combination which gave out the largest amount of heat per unit of cost was the I3th, then, if we were actually using the furnace in the nth, we should be using it in a stage earlier than the least- cost stage, but not earlier than the diminishing-return stage. If, however, the day was very mild and we were using the furnace in the seventh combination, we should, be working it in a stage which was earlier than the diminishing-return one as well as earlier than the least-cost one. XI] OUTPUT AND COST 151 ILLUSTRATIVE PROBLEM It is possible to be using a railroad plant in such a condition that, if we could increase the traffic a certain amount, we could increase the re- turn per unit of the assisting factors, and so diminish the cost. But we might also be working that plant under such conditions that, though we could no longer increase the return per unit by increasing traffic, we could, after all, diminish the cost of production. Explain how this could be. Least Cost Seldom Realized. One other point needs a moment's comment before leaving this matter of least cost. At first thought we might suppose that, in using any group of factors, we should always put them together in the proportions giving the least- cost combination. 'As a matter of fact, however, we should rather seldom be able to do this. In almost all situations we have a body of factors which are relatively fixed over against a set which are constantly changing in quantity, the former being designated fixed capital, the latter circulating capital. 4 Now, in the nature of things, the former cannot be nicely adjusted to every change in the volume of output. Any plant will naturally be planned and built on such a scale that, when supplying its normal output, it will be working in the least-cost combination. 5 But when a volume of output smaller or greater than this is temporarily called for, it will become neces- sary to work the plant in a combination earlier or later than the least-cost one. That is, it may be necessary and proper, much of the time, to be working a plant in the diminishing-cost stage or the in- creasing-cost stage, rather than in the least-cost stage. This of course requires that the price of the product should be high enough to justify the producer in using a combination more expensive than the least-cost one. * Costs growing out of fixed capital are often called overhead costs, those connected with circulating capital are called prime or out-of-pocket costs. 6 This statement needs qualification because of the fact that it will usually be thought best to plan for future groivth of demand ; so that the plant will more usually be built on such a scale that, for a time, it will normally be working in a stage somewhat earlier than the least-cost stage. I5 2 PRINCIPLES OF ECONOMICS [XI What has been said of a plant can with equal truth be said of a business unit as a whole. Here, as before, the plant or group of plants run by the concern will sometimes be working in a stage earlier than the least-cost combination, or just at that combination, or later, in the first case, being in the condition of diminishing cost, in the second and third cases being in the condition of increasing cost. In addition, similar statements may be true with respect to the organization side of the business unit or company. The force of general officers, and of departmental superintendents, may be work- ing in a condition of diminishing cost or one of increasing cost. [ Finally, it would seem that the propositions which have been laid down with respect to single instruments, plants, and business units, may be affirmed with respect to social groups, districts, coun- tries, even the world. Broadly speaking, any one of these totalities may at any moment be in such a condition that an effort -to increase the aggregate of economic goods in order to satisfy the needs of a larger population would result in a diminishing expenditure of human effort and natural resources, or just the reverse. In the former case, the community under consideration would not have carried the utilization of its outfit of natural resources to the least- cost combination, though it might have carried that utilization be- yond the point of diminishing returns. And an increase in popula- tion calling for a larger output of products and furnishing a larger supply of human productive power would enable the community to carry the utilization of its natural resources into a less costly and so more desirable stage. If, however, the community had already reached or even passed beyond the least-cost stage, the in- crease in population could only result in driving the industry into, or further into, the stage of increasing cost, and so, from our present point of view, could only result in harm. ILLUSTRATIVE PROBLEMS i. If the demand for a certain manufactured commodity is very small indeed, the cost per unit is likely to be larger than it might be. If the demand for that commodity becomes enormously great, the cost is again likely to be larger than it might be. Explain how both these state- ments can be true. XI] OUTPUT AND COST 153 2. "I am disposed to think that, up to 1900 anyhow, the United States was under- rather than over-populated.'' Explain how. this could be. II The Effect on Cost of Trying to Increase the Output from an Industry as a Whole, There Being No Restriction on the Quantity of Any Instrument Used We now pass to the second phase of our problem the effect on cost of trying to increase the output from an industry as a whole. What will happen to cost, if we try to get more copper from the copper industry, or more wheat from the wheat industry, or more automobiles from the automobile industry? Will the cost per unit remain the same as before or become larger or smaller than before? This question, like our original one, breaks into two. (i) What will be the immediate effect on cost in a given case? In other words, in what stage is an industry at this moment, diminishing cost, constant cost, or increasing cost? (2) What will normally be the effect in a given industry? What effect is characteristic of that industry? In which of the three stages is that industry likely to be most of the time? Theory of Cost Variation. In order to answer these ques- tions even briefly, we need to have in mind the principal causes which tend to affect the cost of production as output is increased. Of these there are three. The first cause to be considered is the condition of the durable instruments already being used in the in- dustry in question. Are those instruments being worked in the stage of diminishing cost, or minimum cost, or increasing cost? Their condition in this respect, in so far as they are able to influence the matter at all, will obviously tend to establish a like condition for the industry as a whole. A second cause affecting cost is the degree of difficulty experienced in duplicating the instruments em- ployed in an industry. Will the new machines, the new labor, and the new land needed to expand output cost the same as, or more or less than, our present stock cost us? The third cause is the degree I54 PRINCIPLES OF ECONOMICS [XI to which the industry is able to realize the advantages of large-scale production set forth in an earlier chapter. The possibility of using large-scale methods must of course tend to put the industry into the condition of diminishing cost ; and the extent to which these methods can be used must determine largely how potent they will prove. Now, when we ask concerning the immediate condition of an in- dustry, the potency of these three causes above enumerated depends chiefly on two considerations: (i) the state of industry in general, and (2) the nature of the particular industry involved. First, to begin with the former of these two considerations, any particular industry is likely to be in the condition of diminishing cost when business is depressed, in that of increasing cost when business is booming, and in that of constant cost when business is in a state lying between these extremes. The reasons are evident. The de- pression means that demand for products is small and prices are low. In consequence, an attempt to increase output in response to increas- ing demand would find the situation advantageous in respect to each of the three causes enumerated above. First, the fixed capital of the industry would be working in a condition of low efficiency or high cost, and the expansion of output would enable producers to utilize that fixed capital in a more efficient, less costly stage. Again, the low prices of a period of depression would make the factors necessary for expansion more than ordinarily cheap. Finally, the increase in out- put would open the way for a fuller utilization of large-scale methods. All this would obviously be reversed at the height of a boom. Fixed capital would be working beyond the point of highest efficiency; the cost of factors would be very high ; the advantages of large-scale methods would already have been utilized to the full. Finally, in the period between these extremes, these opposing tendencies would come to something like an equilibrium in which expansion of output brought neither less nor greater but the same cost. But, again, the effects produced by our three causes would be in- fluenced by the nature of the industry in question. The influence of the possibility of getting more services out of fixed capital, of carry- ing that capital forward to the point of minimum cost, would signify little in the case of an industry which used little of this type of capital, say retail trade but much in an industry such as mines and steel XI] OUTPUT AND COST 155 mills, which used a great deal. Similar differences would show in the influence exerted by the cost of the factors necessary to expan- sion. The industries utilizing a large amount of fixed capital and a relatively small amount of new factors would naturally be less affected by the increase in cost of the latter. The smaller the out-of- pocket expenses, the smaller the significance of this element. Thus, farming is not affected as favorably as many other lines of industry by the low prices of supplies prevailing in a period of depression nor as unfavorably by the high prices of those supplies characteristic of the top of a boom. Finally, the power to utilize the advantages of large-scale production varies greatly in different industries. In farm- ing, for example, that power is proverbially low. The necessary operations are very diversified and there is little repetition of opera- tions which duplicate one another; the fundamental factor in this industry, the land, is also diverse in character, one part of a farm being fit for one purpose and another fit for another purpose; and, finally, the necessity for rotation of crops compels frequent changes in product and method. All these causes, taken together, make high specialization in agriculture imprudent where it is not impossible. Accordingly this industry and others of a similar kind are less in- fluenced in respect to costs by the general business situation. Their variation in cost as output expands is less considerable than in the other cases. Characteristic Tendency. The foregoing discussion has in a large measure anticipated what we need to say concerning our second question : what is the normal tendency of cost in a particular industry as output is expanded, or what tendency is characteristic of that in- dustry? The answer manifestly has little relation to temporary busi- ness conditions, being almost entirely a matter of the nature of the business itself. The significance of the first of our three causes the condition of the durable instruments already being used in the industry under consideration is obviously dependent on the extent to which such instruments are commonly employed in that industry. As compared with railway transportation, farming makes relatively small use of durable instruments, fixed capital. Naturally, then, the presence I5 6 PRINCIPLES OF ECONOMICS [XI of unused capacities in its durable instruments will be of much less potency to hinder farming from being in the condition of increasing cost, than it would be to keep railway transportation out of that con- dition. This cause, however, is apparently less effective in fixing the character of an industry than the next one to be mentioned. As respects the influence of the second cause the difficulty ex- perienced in duplicating instruments this naturally turns on the ex- tent to which the industry in question is dependent on natural factors. Those factors are absolutely limited in amount, instead of being sus- ceptible of increase like capital and labor services. If, then, they form a very large part of the necessary equipment of a given industry, for example, stock-raising, that industry will naturally pass into the con- dition of increasing cost sooner than one of which this is not true, for example, the manufacture of textiles. It follows from the above considerations that the extractive and agricultural industries are much more likely to be in the condition of increasing cost than manufacture of commerce. The narrower the field from which the natural factors can be drawn, the greater force will this cause exert. It will be felt much more in the producing of citrous fruit than in the producing of wheat and potatoes ; more in platinum mining than in copper mining ; more in copper mining than in iron mining. Finally, as to the influence of the third cause, an industry that consists largely of many similar or identical operations, and can therefore apply methods of large-scale production, will tend to be in a condition of constant cost, or even of diminishing cost. Manu- factures are conspicuously of this type, and agriculture*conspicu- ously not. Looking back over this discussion, we see that all the different causes combine to hinder manufacturing from being in the condition of increasing cost, and to keep it in a condition of constant or dimin- ishing cost. The manufacturing plant ordinarily has a large store of unused utilities; it depends relatively little on natural resources; and it is well adapted for the employment of large-scale methods. On the other hand, agriculture tends just as strongly, under the influence of all these causes, to be in a condition of increasing cost. It will seldom have any great volume of unused utilities to put it into the condition of diminishing cost ; the natural factors play a large part XI] OUTPUT AND COST 157 in its operation ; and the chance of employing large-scale methods is very slight. In the mining or extractive industries the result is much the same although the operation of the different causes is a little different. The mining industries make extensive use of fixed capital, hoisting machinery, machinery for crushing the rocks, facili- ties for transportation, etc. On this score we might be led to think of these industries as diminishing-cost industries or even constant- cost. And in fact when a new grade of mine has become available by a rise in price the industry is likely to be temporarily in the condition of constant cost. That is, it will be possible for a time to expand output far beyond the expansion of demand without any new increase in cost. This particular element, mining has in common with manu- facture. Nevertheless, the former industry naturally shows in gen- eral the same tendency as agriculture because of the influence of the second cause which we originally named. That is, the dependence upon natural factors is so great that the relative difficulty of obtain- ing these factors in the productive process offsets the advantage de- rived from the former element. We have just seen that the prevailing or normal tendency of the extractive and agricultural industries is to be in the condition of in- creasing cost; while that of the manufacturing industries is to be in the condition of constant cost. Not unnaturally economists are wont to classify the former as increasing-cost , the latter as constant- cost, industries. Further, as will appear in a later connection, this distinction among industries is of great importance in connection with the determining of price. A firm grasp upon the distinction is therefore of much importance. Remember, however, that in using this classification the economist does not mean to imply that an in- dustry of either type is always and necessarily in the class indicated, but only that this is, in general, its proper classification. At times, it may be temporarily in the other class. Summary. Summarizing the chief results of the preceding discussion we may set forth in conclusion the following propositions : ( i ) Any industry may be at some time or other in each one of these three stages : diminishing cost, constant cost, and increasing cost. 158 PRINCIPLES OF ECONOMICS [XI (2) Most industries are likely to be in the condition of dimin- ishing cost if the demand for their product is so small -that an increase in that demand would enable the industry to pass from small-scale to large-scale methods. (3) Most industries may be for considerable periods in the con- dition of constant cost whether their general classification is in dimin- ishing cost or increasing cost, because of the fact that at any particu- lar level of cost there is possible an increase in output which is very large as compared with the expansion of demand. (4) Practically all industries must some time reach the stage of increasing cost. (5) In general the agricultural and extractive industries natur- ally classify as increasing-cost industries. (6) In general manufacturing industries classify as constant- cost industries. ILLUSTRATIVE PROBLEMS 1. "Taken by and large, the mining of copper is probably an increas- ing-cost industry." Defend that statement. 2. Argue for the reasonableness of the proposition that, if the marginal cost of producing copper should rise from, say, 20 to 25 cents per pound, at the latter figure this industry would probably be for a time a constant-cost industry. 3. Give some reasons for believing that railway transportation is likely to be much of the time in the condition of diminishing cost. 4. An industry like the making of surgical instruments is likely to be in what condition as respects the relation between cost and volume of output? Explain. 5. Suppose that, while competition in the industry is still maintained, the conditions of production for a particular type of wooden chair are such that, if fewer than 1,000 chairs a year are produced, the cost per chair will be about $3; that, if output is between 1,000 and 20,000, cost will be about $2 ; that if it is between 20,000 and 50,000, cost will be $i ; if between 50,000 and 500,000, 50 cents; if between 500,000 and 2 millions, 30 cents; if between 2 millions and 3 millions, 40 cents; if between 3 and 4 millions, 55 cents; if between 4 and 5 millions, 75 cents; if between 5 and 6 millions, $1.25; and so on. XI] OUTPUT AND COST 159 (a) Suppose that in the year 1918, 700,000 of these chairs are pro- duced; that by 1920 the output has increased to 1,300,000; that by 1925 the amount is 1,600,000; and that by 1940 it is 1,800,000. To what class of goods would these chairs belong during the period of 1918 to 1940, looked at as a whole? (b) Suppose that between 1950 and 2000 the output should increase from 2,300,000 to 6 millions. To what class of goods would these chairs belong during that 50 years, looked at as a whole? 6. During the great boom in the prices of farm products character- istic of the war period, farmers who heard comments by other classes on the point were wont to say : "But look what prices we have to pay for all sorts of supplies, seed, fertilizer, binding twine, labor, etc. This in- crease in costs makes big prices necessary." Criticize that reasoning. CHAPTER XII MONEY EXCHANGE With the present chapter we begin the study of what has often been treated as one of the main divisions of economics, namely, Exchange, a division of our subject which, broadly interpreted, in- cludes nearly all the most important topics of the science. The starting point of this study is found in the fact already emphasized in our first account of the present economic order that, under that order, we obtain the goods which are necessary to the satisfying of our wants and which, generally speaking, have to.be produced, not by producing those goods ourselves, but by devoting ourselves to producing something which our neighbors want and using these to get from others through exchange the goods which we need. It fol- lows that exchange is the very central, pivotal, fact in our whole economic order ; every other fact and circumstance is directly or indirectly affected by it ; and every aspect of the exchange phenome- non may therefore reasonably be expected to repay the most care- ful inquiry. The most important topic naturally included under the division, Exchange, is value and price in their various aspects, their nature, function, the principles or natural laws determining them, etc. Our first duty, however, will be to give some account of the more con- crete side of exchange, at least of those aspects of exchange with respect to which there is need for more information than is commonly possessed by the student when beginning the study of economics. Of these matters, the first one taken up in this and the next chapter following is the mediation of exchange, the effecting of exchange through a middle term. From this standpoint we distinguish two principal exchange processes: (i) Money Exchange and (2) Credit Exchange. In the present chapter we take up the former Money Exchange. 160 XII] MONEY EXCHANGE 161 I The Nature of Money Exchange Inconveniences of Barter. Although the facts of money ex- change are familiar enough to everyone, their essential nature and the causes lying back of them demand a moment's examination. The beginnings of exchange, as found in primitive societies, have always taken the form of barter the direct exchanging of goods for goods. A man who has grain to spare and wants a canoe, gets into communi- cation with a neighbor who has canoes to spare and wants grain, and a mutual transfer is effected. But this method, even in the most favoring conditions, is highly inconvenient. The man who has pro- duced a surplus of grain which he wishes to exchange for a canoe is obliged first to seek out someone who has a canoe to dispose of and at the same time needs grain and who, further, needs grain in an amount exactly corresponding to the value of the canoe. But this necessary coincidence between exchangers as respects the kinds and amounts of goods wanted and offered can exist but rarely, and, where it does exist, can be discovered only after laborious searching. It would not be hard to find men who want grain ; but they may have no canoes to dispose of. So, it would be fairly easy to find men who have canoes to sell ; but they may not want grain ; or, if any one of them does want grain, he may want only half as much as would be needed to pay for a canoe. As civilization ad- vances these obstacles to barter become more and more serious. Occupations, tastes, and incomes grow more diverse, and a larger and larger number of workers produce things which, being unfitted to satisfy their own wants, must be exchanged, but which at the same time are wanted by only a few other individuals, and those perhaps widely scattered. For such persons that is, for most of us ex- changing their own products directly for all the different kinds of goods they require would be entirely out of the question. For a manufacturer of steel rails or mowing machines or microscopes or surgical implements to go about trying to obtain, in trade for these wares, sugar or flour or a suit of clothes, would be not merely in- convenient but futile. PRINCIPLES OF ECONOMICS [XII Mediated Exchange. But no highly developed society tries, or ever did try for long, to conduct its exchange on the barter plan. In the earliest trade of which we have any record, men were already making use of a medium of exchange some go-between which each one obtained in exchange for his own goods and, when he had ob- tained it, used to buy other goods. The exchange medium consists of some concrete good of such a nature that we can readily add to, or take from, the amount used, so as to make up an amount exactly equal in value to the object we wish to buy. With the assistance of such a medium, the troubles of the man who has grain to dispose of and wants a canoe quickly disappear. He simply sells his grain to the different persons who want grain, they giving him from their easily divisible store exactly as much of the exchange medium as the grain is worth; and then, taking to a canoe maker the medium thus obtained, he pays over as much of it as is necessary to purchase a canoe. i Various Functions of Money. Exchange, then, is mediated by money, and wherever the money institution exists its principal function is to serve as the medium of exchange. It perhaps ought to be remarked in passing, however, that jiist because money is the medium of exchange, it almost inevitably takes on other functions. It serves, for one thing, as a measure of value. Being exchanged against all other goods, it naturally becomes the thing in which the values of all other goods are computed and expressed. It sometimes performs this function even when not actually called upon to serve as the middle term in exchange, as for example when two people estimate the value of their respective goods in terms of money, and yet proceed to exchange them directly, barter fashion. In fact, the value-measuring function of money often exists quite independently of its exchange function, and often seems of almost equal im- portance. Again, money or its equivalent, bank credit (which comes up for treatment in the next chapter), serves as a medium of accumu- lation, the instrument through which accumulations of capital are immediately effected. Closely allied to this last is its service as a loan medium since, as we know, the man who borrows capital must usually obtain it first in the form of money or bank credit. Money is also XIII MONEY EXCHANGE 163 utilized as the legal means of payment, in the discharge of taxes, fines, etc. Finally, in backward countries it is much employed, along with precious stones, as a storer of wealth by men who, seeking to save their property from robbers or tyrannical governments, turn it into these easily concealed forms. Various other functions of money could doubtless be distinguished in a fuller analysis. The central one, however, the one with which we are chiefly concerned in this course, and hence the only one calling for more than passing mention, is to serve as a medium of exchange. In the earlier forms of exchanging society, the exchange medium or go-between was always some use-commodity, that is, a commodity which people generally wanted for some purpose to which it could be put directly, as for example, cattle, hides, tobacco, lumps of salt, or cubes of tea. But, with the passage of time and the increase of wealth, people got in the way of using as their medium of exchange something specially manufactured and set apart for this function. It is only when this stage is reached that we can properly talk about money; for by money we mean an instrument specially made for, and adapted to, the work of mediating exchange, and to those other tasks naturally performed by the exchange medium. For many centuries after its introduction, the money of even the most advanced countries was little more than an aggregation of rather crude coins of very few varieties or sizes. But with the prog- ress of industrial society, the money of each country has come to constitute an elaborate system containing many different kinds of money adapted to the performance of different functions, and all more or less perfectly co-ordinated into a coherent, self -consistent whole. We must now explain the principal features of such a system. II The Monetary System The Denomination System. The first element to be re- marked in the American or any other monetary system is the scale of denominations, the names employed for expressing quantities of money. The need for some means of doing this is easily seen. The use of money to effect exchanges or measure values plainly requires 164 PRINCIPLES OF ECONOMICS [XII that we should be able to express quantities of money. But this means, as in similar cases, that we should have some unit or units for doing this, some name or names which every one recognizes as meaning certain definite quantities. Such names are commonly designated "denominations." It would doubtless be possible to get along with just one of such denominations; but, on account of the great differences in the quantities of money which we need to make up for different purposes, it is obviously much more convenient to have a variety of such denominations, ranging from very small to very large ones. These different denominations usually differ by some convenient ratio, and form a coherent system of denominations. The different denominations in such a system are naturally dis- tinguished as Primary and Secondary. The primary denomination, more often called the monetary unit, is fundamental in the system, the other denominations being referred to it in defining their quan- tity. The precise significance of this statement is best explained by comparison with an analogous case, the unit of liquid measure. The gallon constitutes this unit, and other quantities are described as fractions or multiples of a gallon : thus a quart is a fourth of a gallon and a pint one-eighth of a gallon; thirty-one and one-half gallons make one barrel, and sixty-three gallons (two barrels) makes one hogshead. Similarly, in the American monetary system the unit is one dollar, and all secondary denominations are regarded as frac- tional parts or multiples of the dollar. The cent is a hundredth of a dollar, the dime a tenth of a dollar, the twenty-five cent piece a quarter of a dollar, the half -eagle five dollars, and the eagle ten dollars. In other countries, these denominations are different from the American and usually from those of any other nation ; but in all of them some kind of denomination system exists. The Monetary Standard. The second essential element in a monetary system is the monetary standard. The special office of the standard is to fix the meaning or value of the monetary unit. For purposes of explanation, let us again refer to the analogue of liquid measure. As we all know, there exist at the present time thousands of liquid containers treated as gallon measures. Obviously it is quite possible that these should be unequal in capacity, so that, if we were XII] MONEY EXCHANGE 165 to measure a given amount of some liquid in one of these measures, we should get one result; if we used another of these measures, we should get another result ; and so on. But of course it is quite im- portant that, when measuring liquids, we should use measures having the same capacity, else the way would be open for unlimited error and controversy. How is this brought about? How do we insure that the gallon shall always signify the same thing? Simply by requiring that a true gallon measure shall be able to hold a certain amount, by weight, of some one substance, no more and no less. The standard chosen is pure water under prescribed conditions of temperature and air pressure. The amount is 8.33 pounds. This fact we express by saying that 8.33 pounds of pure water is the standard of liquid measure in the United States. If any receptacle proves upon examination to hold more or less than this standard amount, it is not a true gallon, and to make it so one must measure it something less than full, or full and something over. Only by being equal to the standard gallon can it hope to pass as a true gallon container. The monetary system is in this respect the same as that of liquid measure. The money unit is one dollar. But we have many different kinds of money in which a dollar may be represented, gold coin, silver coin, greenbacks, bank notes, and so on. Now, all these forms of the dollar have very different degrees of intrinsic value ; the gold dollar is worth just as much whether it is coined or melted into a shapeless lump ; the silver piece is worth as much as gold when coined, but very much less when melted; the paper in itself is worth practically nothing. This being true, it would be very easy for the dollar as represented in different kinds of money to have different values, the meaning of the dollar might change with every change in the kind of money used, and any accurate reckoning or dependable business agreements would become impossible. But here, as in the case of liquid measure, uniformity is secured by means of a standard. Within the boundaries of the United States, in every conceivable connection unless otherwise specified, one dollar means the amount of value which attaches to 25.8 grains of gold, nine-tenths fine. This amount of gold is known as the monetary standard, and accord- ing to it every dollar of actual money is judged. A true dollar must 166 PRINCIPLES OF ECONOMICS [XII contain the same value as a piece of gold nine-tenths fine, weighing 25.8 grains. And if any so-called dollar happens at any time to con- tain more or less than this standard amount of value, it is not a true dollar, and to make it so, something must be taken away or something added. ILLUSTRATIVE PROBLEM From a conversation in a barber shop in the fall of 1919. "One thing I can't understand. The price of almost everything is climbing; but the price of gold stays just the same, always $20.67 P er ounce of pure gold." Why is this bound to be true as long as our money laws are unchanged ? The Different Kinds of Money. We have explained the denomination system and the standard essential to any monetary system. We must now distinguish the different kinds of money in which the denominations anc the standard are embodied and comment on their several functions. The Standard Money. First, we have the standard money, that particular kind of money which immediately embodies or repre- sents the monetary standard. As already noted, the standard in the United States is 25.8 grains of the metal gold, nine-tenths fine. But we do not, of course, actually make any use in ordinary commercial relations of the mere metal gold, unmanufactured, in the form ot dust or lumps. Neither do we have such a lump of gold locked up at Washington to act as a standard for our money unit, as we have a platinum-iridium bar locked up in that city to act as a standard for units of length. The plan we actually adopt is to issue one par- ticular kind of money called standard money, which is kept equal in value to the real standard, and, jtist as far as possible, to keep the meaning or value of the dollar in every other kind of money (as well as in all credit documents, prices, etc.) the same as the value of this standard money dollar. In the American system, the standard money is a coin made of the standard substance, gold, and containing just the amount of that standard substance which constitutes the standard. By devices which will more naturally be explained in a later connection, this kind of coin is all the time kept equal in value to the quantity of gold bullion which it is presumed to contain; so XII] MONEY EXCHANGE 167 that it may be said to embody the real standard supposed to lie be- hind it. The Immediate and the Ultimate Standard. If, as just ob- served, the value of the dollar in other kinds of money, in credit docu- ments, prices, etc., is kept equal to the value of the standard dollar, this does not mean that the dollar in these other relations is directly kept equal to the value of a lump of gold weighing 25.8 grains. It is kept equal to the value of the standard money, gold coin ; and the latter, in its turn, is kept equal in value to the lump of gold. If by any process the gold coin and the lump of gold should be separated in value, the dollar in other moneys, in prices, etc., would follow the gold coin rather than the bullion. This, compels us to notice the dis- tinction between the immediate monetary standard, the standard money, and the standard behind that, which is here called the ultimate standard, that is, the lump of gold which, under normal conditions, is the real determinant of the value of the dollar. In the American system, as just indicated, the standard money, being made of the same metal and the same amount of metal as that contained in the ultimate standard, may be said to embody the ulti- mate standard. This is also the plan followed in most good monetary systems. It should be noted, however, that such an arrangement is not absolutely necessary ; and we may better understand the relation between standard money and the ultimate standard by observing a quite different way in which substantially the same end could be accomplished. It is perfectly possible, theoretically, to have a system in which standard money is made of some other substance than the one which holds the place of ultimate standard. Thus, we might cut out gold coin altogether, issuing paper as our standard money, and yet retain gold as our ultimate standard, provided a dollar in paper was all the time kept equal in value to 25.8 grains of gold, while the dollar in all other forms was kept equal to that particular kind of paper money. The plan of having a standard money which does not embody the ultimate standard, but is kept at par by some special device, sug- gests various schemes, which have been favored from time to time, for improving the ultimate standard. Thus, some economists believe 168 PRINCIPLES OF ECONOMICS [XII that, instead of having a single substance as the standard, we ought to use a large number, say 100 or more, in order to avoid too great and rapid changes in the value of the standard. A natural way to work out such a plan would be to issue paper money as the standard money, and set up devices for keeping this paper money equal in value to the list of goods chosen. Another way would be to have for our standard money a coined money, as at present, but to redeem that money in varying amounts of gold, always larger than the amount in it, and always so adjusted as to keep the value of the coin equal to that of the list of goods originally chosen as the standard. ILLUSTRATIVE PROBLEM Suppose that Congress should pass a law making the money standard one one-hundredth part of the value of a certain bill of goods. (a) When the scheme was working as intended, what would be the total money value of said bill of goods? (b) If at a certain time the bill of goods proved to be worth $107, showing tbat the money unit had left the legal standard, which way would that unit have gone, up or down? (c) Answer the same question, supposing the money value of said bill of goods to be $95. Functions of Standard Money. Leaving this study of the nature of standard money, we must now add a word with respect to its functions. The standard money of our system, gold coin, though to a limited extent used as a medium of exchange in ordinary trade, is chiefly confined to two offices: (i) serving as the money of international trade, and (2) maintaining the gold standard by maintaining the convertibility of other forms of money. Standard money serves best as the money of international trade because it has a bullion or substance value as great as its nominal value, whereas other moneys do not. A man who accepts it, therefore, need have no misgivings lest he get less than he bargained for. To a limited extent international creditors accept non-standard moneys and, as we shall see in the next chapter, mere credit. But, in general, they must be paid in cash ; and that cash must be something which is worth its face value. Hence they demand standard coin, or, even XII] MONEY EXCHANGE 169 better, bullion or bar gold which has not been manufactured into money at all. But, while gold or standard money is needed for international trade, in the domestic exchange of most countries it is very little used. The chief function of gold money within a country is to maintain the convertibility into gold of other kinds of money and so to maintain the standard of the system. The standard, we know, has as its function the determining of the meaning or value of the mone- tary unit in all kinds of money. But most kinds of money, other than gold, for example, silver coin, copper coin, bank notes, etc., have in themselves as substance much less value than they claim on their face. A silver dollar, as silver, was, until quite recently, worth less than fifty cents ; a hundred copper cents are rarely worth more than fifteen cents; a paper dollar, as substance, has no appreciable value. It naturally follows that some effort is needed to keep these different forms of money at par with, or equal in value to, standard money. There are various ways of accomplishing this result, but none really certain except one which makes it possible to get gold money in exchange for any other kind. It is not necessary that we be able to exchange other moneys for gold in any and every case, but it is necessary that we be able to obtain gold when we really need it, for example, to make payments in other countries, and that without being obliged to pay a premium or suffer inconvenience or delay. If at any time when we greatly needed gold we could not obtain a dollar of it for a dollar of other moneys, those other moneys would inevitably cease to be equal in value to the standard money. In concluding this treatment of standard money, a word should be added concerning a form of paper money which is virtually equiv- alent to gold coin. I mean the gold certificate. This is a document certifying that the quantity of gold mentioned on its face has been deposited in the Federal treasury, and is held ready to be delivered in exchange for the certificate. The certificate is thus nothing more than a warehouse receipt for the gold coin in deposit. As long as the owner only wishes to hold this coin as a reserve or to use it in settlements at the clearing house, the certificate is all he needs, and is safer and easier to keep and carry about ; and should it happen that I 7 o PRINCIPLES OF ECONOMICS [XII he really must have the gold itself, he can always get it by presenting the certificate. Quasi-Standard Money. We have explained the nature and functions of a standard money, basic money, as it is sometimes called. We must now comment briefly on the other kinds generally present in the systems of our time. First, it is not uncommon to have a quasi-standard money consisting of a note issued by the government or some special institution, a note which is legal tender in most or all relations, and redeemable in standard money. Such a money will perform most of the functions of standard money. Being di- rectly redeemable in gold, every one will receive it readily, and only those who for some reason require the metal itself will insist on using the treasury note to get gold. Moneys of this sort, though not seldom employed in everyday circulation, have as a more distinctive characteristic the fact that they in large measure constitute the bank reserves of the country, particularly the central reserves. Doubtless, these reserves ought to contain a considerable quantity of gold itself ; but the treasury notes answer almost equally well so long as the treasury keeps ample gold reserves to redeem them. Other Moneys. The remaining moneys to be found in any system with which we are familiar are employed mostly as ordinary media of exchange. First come the notes of the national banks pay- able at the issuing bank and also at the Federal treasury, having the status of legal tender to all national banks, and being receivable for all public dues except import duties. Next come the Federal Re- serve bank notes. These are akin to the bank notes just named, being issued by the Federal Reserve banks on the security of certain types of national indebtedness. They were a compromise element in the law which established the Federal Reserve system, and would prob- ably have been of little moment but for special exigencies growing out of the late war. As a matter of fact, a large quantity of them was issued; but the present law calls for their later retirement. A third type of ordinary circulating medium is the Federal Re- serve note (not bank note), issued by the Regional Reserve banks under the authority of the Federal Reserve Board. In form they XII] MONEY EXCHANGE 171 are treasury notes, that is, they are promises to pay, signed by the Treasurer of the United States. But the regional banks are re- quired to assume the responsibility for them as if their own officers had made the signature. These notes are a full legal tender. It was hoped that they would in time replace all other notes, and even silver certificates; but the prospect for this result is not good. A fourth sort of paper money is the silver certificate, which, in form, is a warehouse receipt for a corresponding amount of silver dollars, but which, in practice, is a bill used for what has been called "large change." Until recently, the silver certificate constituted the major part of our everyday medium of exchange; but it has been latterly replaced by other forms of paper, especially Federal Reserve bank notes. Unless, however, some change is made in laws at present in force, the earlier condition of things is likely to be repeated. The silver certificate is exchangeable only for silver dollars, but it is worth its face value in gold j*ust as if it were redeemable in that metal. Subsidiary Coin. In addition to the moneys already enumer- ated, we have various sorts of coin. In general, they are literally or virtually subsidiary coins, though, in strict usage, this designation is limited to fractional silver. We therefore begin with explaining the distinctive characteristics of subsidiary coins. First, these coins are put out in small denominations, being specially intended for serving as a medium of exchange in minor transactions and as tools for "making change." Again, they are made of inferior metal, metal having low specific value; for a coin of small denomination, if made of valuable metal, would be too small for convenience in handling. Subsidiary coins are characterized also by shortness in weight: they contain a smaller amount of metal than would seem to be called for by their nominal value. As a result, they are worth less as mere pieces of metal than as money ; so that, unless the value of the metal changes greatly, no one will melt them for the sake of the metal they contain. Their circulation is thus assured. Again, subsidiary coins are strictly limited in the amount coined. They are issued only by the government, and the issue is limited to the amount which experience shows is really needed for the purpose I7 2 PRINCIPLES OF ECONOMICS [XII of trade. This policy is primarily intended to insure the coins of this sort against falling in value below their nominal value; and it has practically always been successful. So long as the needs of business keep subsidiary coins employed, so that few, if any, persons find themselves loaded up with an excessive stock, the coins remain at par. In the United States, this result is still more fully assured by a provision that the United States treasury shall redeem such coins at par in legal money. Still another characteristic of subsidiary coin is the limitation of its legal tender prerogatives. This provision has two objects. First, it is intended . to hinder any person from burdening creditors to whom he is making payment with a great quantity of inconveniently heavy coins. Second, it is intended to hinder subsidiary coins from displacing the standing money already established and putting them- selves in its place, a thing which might happen, if these coins were to become less valuable than standard money while still a full legal tender. How this would be brought about will be better understood when we have studied the principles governing the monetary standard given in Chapter XXXII. A final characteristic of subsidiary money, not universal, but present under our system, is redeemability. One purpose of this pro- vision to insure that the money shall be kept at par has already been explained, and needs no further comment. Another object is to enable persons coming into possession of considerable quantities of this kind of money to exchange it for more convenient kinds. The desirableness of such an opportunity is evident. Business con- cerns need enough small coin, but to be loaded up with thousands of dollars of such money, when the public generally would object to accepting it, would be very undesirable. The provision that the gov- ernment shall redeem all such coin meets this difficulty completely. The last few paragraphs have dealt with the sort of coin which is universally recognized as "subsidiary." A word or two should now be devoted to the varieties not always, or perhaps usually, counted in this class. First, we have token money or billon, consisting of very small coins made of cheap metals, for example, our nickel five- cent pieces and copper cents. This type of money was evolved earlier than the coins usually designated as subsidiary. But, theo- XII] MONEY EXCHANGE 173 retically, there is no good ground for distinguishing them from the latter; they usually have all the characteristics above enumerated for subsidiary coins proper. The other money which is virtually, though not literally, a sub- sidiary coin is the silver dollar already alluded to on page 172. This cannot be strictly described as a subsidiary coin, because it lacks the characteristic of limited legal tender which is present in true subsidiary coins everywhere, and also lacks the redeemability of American subsidiary coins. Furthermore, while the silver dollar is not a full weight coin, it does not possess the characteristic of short- ness of weight in so great a degree as the real subsidiary coins. Thus two half-dollars or four quarters do not contain quite as much metal as does one silver dollar. In effect, however, it is a subsidiary coin. It has most of the characteristics, and behaves as if it had them all. Although not limited, as are true subsidiary coins, in legal tender prerogatives, it does not displace the standard. And although not redeemable, it remains at par in spite of the fact that its metal value is much below its face value. These facts, however, should- not lead us to think that the silver-dollar situation is an entirely satisfactory one. On the contrary, most specialists are convinced that the silver dollar ought either to be withdrawn altogether, or frankly and com- pletely given the status of subsidiary coins. ILLUSTRATIVE PROBLEMS 1. Illustrate with concrete examples the drawbacks of barter as a method of exchange. 2. Illustrate the use of money as a measure of value in a case of barter. 3. In primitive communities the media of exchange have usually been objects desired for direct use and also objects commonly produced in the community. Give some reason or reasons for each of these facts. 4. During the first part of our history as a nation, silver fractional coins had the prerogatives of standard money, i. e., were freely coined and had the status of full legal tender. But in 1853 Congress deemed it necessary to put this kind of money into the position of subsidiary coin. How do you explain the fact that Congress got around to this opinion at about that particular time? 174 PRINCIPLES OF ECONOMICS [XII 5. Between 1890 and 1896 it was a common practice to put into notes and mortgages a clause providing for payment in gold coin of legal weight and fineness. Try to get the proper explanation of this fact. 6. When I say that 12.9 grains of gold .9 fine is the monetary stand- ard of the Philippines, what is meant? 7. In the United States in the year 1868, when gold payments on treasury notes were suspended so that a gold dollar was commonly worth from $1.20 to $1.40, one of the great political parties proposed to pay the national debt in these irredeemable treasury notes, which proposal, however, was defeated in the Federal election of that year. In discuss- ing the matter, writers commonly speak as if the national creditors ob- jected to being paid in treasury notes rather than gold; whereas no one of them probably would have thought of asking for literal gold money. Explain in scientific language what was the precise issue of the contro- versy. CHAPTER XIII CREDIT EXCHANGE I The Process of Credit Exchange We showed m the last chapter why exchange was not and could not to any great extent be conducted on the barter plan, and why a mechanism of exchange had been built up, consisting of specialized processes and instruments or media. We have thus far discussed one of the processes money exchange and one set of instruments, money. We now pass to a second process called Credit Exchange, and the set of instruments employed by it, called Credit. Deficiencies of Money. Money exchange, as we saw, is superior to barter chiefly because of the fact that it uses a single standardized medium which everyone is willing to accept. But it is easily possible to overstate the convenience and facility of trade re- sulting from the use of this device. Everyone is willing to accept money, we say ; but as a matter of fact, if a man sells a thousand or ten thousand dollars' worth of wheat or meat or land, he usually is very far from willing to accept actual money in exchange. In former ages, when actual possession of the money metal was prized as a sign of distinction, possibly most individuals received without hesita- tion practically all the money they could get. But this is not so today. No man however fond of wealth desires to have a bushel of money dumped on his floor. The heap would add little to his dis- tinction, and would greatly embarrass him. But the use of money may be inconvenient for other reasons also. It is unlikely that any would-be purchaser will have a bushel of money to give. Because of the difficulty of guarding it, and be- cause of its entire uselessness when not in active circulation, even I7 6 PRINCIPLES OF ECONOMICS [XIII the richest men prefer to keep in their possession at any one time only a small quantity sufficient to supply their everyday wants. When one Requires a large lump sum, then, how shall he obtain it? Wait till it gradually accumulates, hoarding it as it comes in ; scurry here and there, selling a little something to this man and a little something to that till he gets together a sum sufficient for his purchase? Fur- thermore, if he buys -at a distance, at the extreme end of the continent or beyond an ocean, must the purchaser undertake the toil and ex- pense and danger of transporting the money and delivering it into the seller's hands? By no means. These difficulties are obviated by the use of a still more highly developed medium of exchange, called Credit. Credit Exchange Defined. Briefly stated, credit exchange is the exchanging of goods for goods through the medium, not of money, but of a right to claim money. This is implied in the name "credit exchange." But this account of the matter is too compressed to be adequate. To serve as a medium of exchange is to be some- thing which enables us to trade goods belonging to us for other goods, more easily and conveniently than we could by direct barter : we trade our goods for that medium, and then trade that medium for the other goods. Unless both of these operations are performed, the thing in question is not serving as a medium of exchange. It is not such a medium if we merely get it in exchange for our goods, and stop there. If we use the right to money credit in this way, we have merely loaned to our customer the money equivalent of the goods. All in good time he will have to pay the debt with money, which money will be the real exchange medium of the transaction. In like manner, credit is not a medium of exchange when I merely give it in exchange for other people's goods. In that case, they have lent me the money value of those goods. All in good time I shall have to pay them money which will, therefore, have been the real medium of exchange for the transaction. Credit itself will be the real medium provided only I use the claim created by selling my goods, to buy the goods of the other people. Reciprocity of Credits Necessary. It follows from the last paragraph that, if credit is to be used as a substitute for money, it XIII] CREDIT EXCHANGE 177 must be capable of acting as a true medium of exchange, after I have accepted it in exchange for my goods, it must be able to buy the goods of other people. But, in order that this should be possible, it is necessary that the relation of debit and credit which is inherent in the system should be reciprocal. I must sell other people goods and other people must sell me goods ; and the words "other people" must in some sense refer to the same persons. If certain persons wish to buy goods from me, while I, in turn, wish to buy goods from them, then I can sell them my goods for credit the right to claim money and then use that credit to buy their goods. In such a transaction, credit will have served as a medium of exchange. The transaction uses a medium of exchange, since goods are not directly traded for goods but for a go-between ; and credit, rather than money, is that medium, since the reciprocal claims cancel, and so money is not used. A situation such as that outlined naturally arises between two neighboring dealers who are mutual customers. If Hoaglin, the clothier, is likely to sell Frost, the shoe dealer, one hundred fifty dollars worth of clothes in the course of the year and to buy from Frost one hundred thirty dollars worth of footwear, credit can easily serve as the medium, money being used only for the twenty- dollar balance. The Difficulty. In the illustration of credit exchange just used book credit it is commonly called reciprocity of claims was inevitably present because but two persons were involved: if two- sided trade went on at all, it could not help setting up reciprocal claims, which could be used as the medium of exchange. But situa- tions of this sort are comparatively rare. We do not usually buy from, and sell to, the same individual or set of individuals; we are far more likely to buy from one set and sell to another. Thus, the farmer sells his corn and oats to the elevator company and buys nothing from that company whatever ; while he buys clothing, car- riages, lumber, and other commodities from a set of merchants to whom he sells nothing whatever. Here mutuality of claims is non- existent ; hence cancellation is out of the question ; how then can credit be used as a medium of exchange? I7 8 PRINCIPLES OF ECONOMICS [XIII Solution: A Common Debtor and Creditor. The solution is not so difficult as it appears at first sight. Even in this situation a true reciprocity of claims exists, only it exists between each person and all the rest taken together. If the farmer could in some way take what he owes everyone and set it over against what everyone owes him, a practically complete cancellation would be possible. He may not sell anything to any of the particular persons from whom he has occasion to make purchases ; but he must sell to some persons, else he could not buy. It follows that, if the proper apparatus were avail- able, he could use the claims against other people taken as a whole, which his sales had created, to buy the goods for which he wished to exchange his own. That is, credit would here again act as a go- between, a medium of exchange. The carrying out of such a scheme plainly involves what we call a pooling of the claims for and against the persons other than the one we are considering, growing out of transactions with that one person. No plan has ever been adopted whereby such a system could be applied to all transactions. But a device early developed extends its use to the major part of wholesale transactions and in the United States to more than half the retail transactions. That device may be described as, in general, one which makes one institution or group of institutions, a sort of common debtor and creditor, and allows it to effect settlement with each of its patrons, as itself the representative of all the rest. Banks Fill This Position. The institution which commonly serves different individuals in this capacity is the so-called commercial bank or the commercial department in some other type of bank. The primary functions of such an institution are, in ordinary banking language, deposit and discount to care for the current funds of its patrons and make short advances to them as the need may arise. But an institution which takes care of its patrons' current funds al- most inevitably is called on to make payments for them at least this is the case in most English speaking countries ; and in doing that it naturally drifts into the position of common debtor and creditor. When Mr. A, one of the bank's depositors, orders the bank by check to pay $20 to another depositor, Mr. B, and Mr. B deposits the proceeds of the check in the same bank, this act makes Mr. A the XIII] CREDIT EXCHANGE 179 debtor of the bank for $20 and makes Mr. B the creditor of the bank for the same amount. When, now, some other depositor orders the bank to pay $18 for him to Mr. A, the latter becomes a creditor of the bank for this $18, which is entered on his account, cancelling all but $2 of the debt created by A's $20 check in favor of B. So, when B gives still another depositor of the bank a check for, say, $25, he thereby becomes the debtor of the bank, the pooling agent, for $25, which is cancelled by book entries against his former credit of $20, leaving a debit balance of $5.* Thus the process goes on indefinitely. Every check drawn by A makes him a debtor of the bank for the amount named, and every check drawn by another depositor in A's favor makes him the creditor of the bank for that amount ; and the same is true of B or C, or any one of the whole list of depositors. In short, we see per- fectly fulfilled the conditions mentioned as necessary for the working of credit exchange. Reciprocity is established between debts or claims; A's debts to other people are set over against other people's debts to him. And, given this reciprocity, cancellation becomes pos- sible, and so credit exchange exchange without the use of money becomes possible. In the preceding illustration we have supposed that Mr. A and his neighbors all keep deposits in the same bank. But generally there are several banks in one community ; some are used by a part of the population and some by another part ; and Mr. A, whose transactions we may suppose are many and various, will have debits and credits to settle with the patrons of banks other than his own. At first sight, this seems to result in a return to cash exchange, since a check on one bank deposited with another will not be debited to the former bank for any length of time, but will be promptly presented for cash. In fact, however, the bank which is debtor because of the supposed transaction will doubtless have come into possession of checks on the creditor bank which it can use to offset the claim against itself. Even if it has at the time no claims against that 1 It should be remembered that each depositor is expected to keep some balance with the bank, a practice which insures that the bank can safely assume the position of debtor on behalf of the man who writes a check in favor of another depositor. T 8o PRINCIPLES OF ECONOMICS [XIII particular bank, it will certainly have some against other banks in the community ; and, since all the banks will settle their mutual obli- gations on a pooling plan, these claims against other banks will do just as well in offsetting its debits as claims against its actual creditor. The Bank Clearing. We thus come to another very im- portant development of credit-exchange, the clearing, or settlement of mutual obligations among a number of different banks. Here the same device which enables Mr. A to adjust his debits and credits with a minimum use of actual money, is applied to settle the mutual obligations of banks. In general, the plan is to set up a common agent, a clearing-house association, which becomes the creditor of each bank for claims of all other banks against it, and becomes its debtor for claims against all other banks. At regular intervals a balance is struck and the one which proves to be debtor, the bank or the clearing-house, pays the balance. Naturally, the clearing- house settles first with the banks which prove to be debtors, and then uses the money thus obtained to pay the creditor banks. Inter-Local Exchange. Our discussion has thus far had to do with exchange carried on through banks between persons in the same community. Another and much older form is inter-local credit-exchange, or what we call Exchange in the pre-eminent sense. This form is resorted to for making payment between different cities and countries with a minimum use of money. Here we have again the same familiar device : claims for and against different countries, debits and credits, get into common hands so that reciprocity is es- tablished and cancellation is made possible. Certain institutions in each country, banks or exchange houses, buy up all the claims on the other countries and also sell for the use of their patrons claims on those other countries. Thus, they become the common creditors and the common debtors of the dealers of their country in its rela- tions to others ; and the debit and credit relations which they main- tain with other countries are maintained with institutions similar to themselves. It therefore becomes easy to set the debits of a country over against its credits, cancel these in so far as they are equal, and XIII] CREDIT EXCHANGE 181 effect a complete settlement by paying or receiving a small balance in money. II Instruments of Credit Exchange As coins and bills of various different kinds constitute the in- struments or media used in money exchange, so a variety of paper documents constitute those used in credit exchange. Some of these take the form of a direct promise between man and man to deliver a specified amount of money at a specified time. But, inasmuch as the promise must ordinarily be made good through the agency of a third party or institution, most of these documents are really orders made by one person, called the drawer, in favor of another person, called the payee, upon a third person or institution, called the drawee. If the payee does not himself find it convenient to present the docu- ment to the drawee for cash or for cancellation against his own promises to the drawer, he can transfer it to another person by in- dorsement writing his own name across the back, with or without some specific directions as to payment. The most familiar credit instrument is the bank check which has already been mentioned. It is an order for the payment of money drawn by a man upon the bank where his own money is kept in deposit. It is used principally within a single town or limited com- munity where the drawee bank is located, and where both drawer and payee are known. Inter-local exchange makes very considerable use of the check, though banks much prefer other instruments spe- cially adapted to this purpose. Most important of these is the bank draft, an order for the payment of money drawn by one bank on a bank in another place, in favor of another party. A bank draft is employed when the initiative in settling a debt is taken by the debtor. He buys the draft, and mails it to his creditor ; the creditor then gets cash or credit for it from his bank ; and the bank, if not itself the drawee named in the draft, proceeds to collect from the bank which is. Another class of exchange instruments similar to the bank draft are so-called money orders, postal or express orders. These are drawn by local agents of the institution issuing them upon the central office, are sold to the debtor, and sent by him to the 182 PRINCIPLES OF ECONOMICS [XIII creditor, who collects from the agent of the issuing institution located in his own town. When the initiative in settling a transaction is taken by the seller or creditor, the instrument employed is named a bill of exchange, though this phrase is also often applied to international bank drafts. Such a bill of exchange, also called a commercial draft, is an order for the payment of money drawn by a seller or creditor upon his debtor in favor of the drawer or his banker, (If in favor of himself, he indorses it over to his banker.) The creditor turns the draft over to his banker and gets credit for the amount named, where- upon the banker sets out to collect from the drawee through bank- ing correspondents. Ill The Rate of Exchange Definition. A matter of much importance in connection with credit exchange is the rate of exchange, particularly the rate in for- eign exchange. As we have just learned, money payments between the people of different communities are effected through agents who assume the position of common creditor and common debtor for each community. An agent in one community buys up money claims on other communities from persons having such claims to dispose of ; and he sells money claims on other communities to persons needing them to make payments in those other communities. Thus, there is developed a traffic in such claims, a traffic in "exchange," as it is called ; and the price at which exchange sells at least exchange be- tween different countries is called the rate of exchange. Stated more formally : the rate of exchange is the price in one country paid in the money of that country for the right to dispose of a unit of the money of some other country in that other country, or at least in some country other than the one in which the purchase is made. Thus, if I wish to buy from my bank the right to have five pounds sterling paid on my behalf in London, and find myself obliged to pay for that right $4.87 per pound, I say that the rate of exchange on London is $4.87. In domestic exchange, exchange between different parts of the same country, the rate of exchange usually means the difference between the face value of an instrument of exchange and what is XIII] CREDIT EXCHANGE 183 paid for it. Thus, if I say that the Chicago rate of exchange on New York is 15 cents premium per thousand, I mean that, in selling a claim for $1,000 on New York, a Chicago dealer would get his $1,000 and fifteen cents additional. The Par of Exchange. In working out the price or rate of exchange, the market starts with the natural value of the unit of the money wanted, as measured in the money with which it is bought that is, the value as it would be if there were no difference of place, if the buyer of English money bought it right in New York to be delivered in New York. If the two countries have the same standard, then the natural value of either money in terms of the other can be ascertained by a simple operation in division. Thus, one dollar contains 23.22 grains of fine gold ; and the English pound, 113 grains. The pound, therefore, is naturally worth in our money as many dollars as 23.22 is contained in 113, or $4.866. This natural price of a foreign money unit, measured in terms of the home money, is technically known as the par of exchange. Variations in the Rate of Exchange. The rate of exchange varies above or below the par of exchange according as the demand for exchange at par is in excess of the supply or vice versa. If the United States is selling great quantities of cotton and wheat to the people of Europe and buying comparatively little from them, then claims on Europe will be abundant and, other things being equal, cheap; those Americans who have claims on Europe to sell will be obliged to sell them cheap, while those who need such claims can buy them cheap. On the other hand, if the United States is buying many goods from the people of Europe and selling them comparatively few, then claims on Europe will be scarce and, other things being equal, dear; those Americans having claims on Europe to sell can obtain high prices, while those needing to buy such claims will be obliged to pay high prices. Limits: Gold Points. These variations of the rate of ex- change above and below par are limited by the cost to exchange houses of transporting the money itself from the one place to the other, 184 PRINCIPLES OF ECONOMICS [XIII it being understood that cost includes a reasonable profit to the ex- change dealer. Any wider variations would give exceptional profit to the exchange dealers, which would stimulate their competition, and so reduce the difference to this amount. In London exchange, the possible variation from par is commonly in the neighborhood of three cents; in other words, the rate ranges from about $4.835 to $4.895. These are called the gold points because, outside these points, sending gold would be cheaper than using exchange. ILLUSTRATIVE PROBLEMS * 1. Suppose that you send a check on the National Bank of Ann Arbor to the Newcomb-Endicott Company of Detroit to pay for some goods purchased; and suppose that when the check finally gets back to you it shows the following indorsements : ( i ) Pay to the Peninsular Savings Bank of Detroit, the Newcomb-Endicott Company. (2) Pay to the State Savings Bank of Ann Arbor, Peninsular Savings Bank of Detroit. (3) Paid through the Clearing House, State Savings Bank of Ann Arbor. Trace the course of this check from the indorsements. 2. Henry T. Crouch of Erie buys $1,275 worth of wheat from T. C. Craig of Detroit. (a) Suppose settlement to be effected with a wheat bill of exchange (also called a sight draft) and write out the substance of the bill which would be used. (b) Suppose settlement to be made with a check and write out a facsimile (in substance). (c) Suppose settlement to be made with bank draft and write out a facsimile (in substance). 3. Whichever method of settling the transaction involved in the last problem is used, the particular credit document employed will inevitably take quite a journey from bank to bank while it is being collected. (a) Describe an imaginary course, which it would very likely take if it were a sight bill of exchange. (b) Same, if it were a check. (c) Same, if it were a bank draft. (Compare Problem i.) 4. We buy a good deal from Brazil, but sell her little. We sell a great deal to Great Britain, but buy from her much less. Can you im- agine a way in which one of these trades furnishes a medium of ex- change for the other? XIII] CREDIT EXCHANGE 185 5. Oct. i, 1907, the different banks of Ann Arbor brought to the clearing claims against each of the other banks as follows: No. i against No. 2 against No. 3 against No. 2 $2213.19 No. 3 1865.09 No. 4 2415.96 No. 5 512.21 No. i $4284.78 No. 3 2172.45 No. 4 3043.18 No. 5 655.87 No. i $4974.66 No. 2 1607.79 No. 4 1093.24 No. 5 625.88 Total $7006.45 Total $10156.28 Total $8301.57 No. 4 against No. 5 against No. i $3078.73 No. 2 1793.16 No. 3 97373 No. 5 4633.96 No. i $ 332.15 No. 2 377-17 No. 3 151546 No. 4 181.56 Total $10479.58 Total $2406.34 Compute the balance for or against each bank. 6. Supposing all the claims of the Ann Arbor banks on one another which appear in the last problem to have consisted of checks which were used in the usual course of business transactions. (a) What must have been the total volume, expressed in money, of the transactions thus effected? (b) How much actual cash was needed to effect these transactions? (c) What per cent of the total volume of transactions did this cash amount to? (d) What is the significance of these facts? 7. Not many years ago it was estimated that the per capita money circulation of England was about $11 while that of France was about $51 ; yet, as every one- knows, there was at least as much business per capita carried on in England as in France. How could the difference in the amounts of circulating medium required be explained ? 8. Some writers represent the development of credit-exchange as a return to barter. Show that this is not true that credit-exchange is still mediated exchange, nay more, that it is money exchange. 9. Suppose I wish to buy a bank draft for 200 on London. With London exchange at $4.855, what should I be able to get the draft for? 10. A wheat exporter of New York draws a bill on his London customer for 1375. What should he be able to get for this bill with London exchange selling at $4.87? with London exchange at $4.84? !86 PRINCIPLES OF ECONOMICS [XIII 11. Suppose that a New York importer can get 50 gross of Sheffield razors delivered in New York for 44 pence each (the duty included), and that he can sell them for 95 cents each. What would be his profit on such a transaction if the rate of exchange on London were $4.84? if the rate were $4.87? 12. From the last two problems what principles can you deduce as to the effect which a high or low rate of exchange tends to have on exports? On imports? 13. "The greater part of our circulating medium consists, not of money, but of deposit currency." Explain what is meant by deposit currency. 14. Near what point would you expect the rate of exchange on Europe to be found in the fall of the year ? Why ? 15. "A matter very frequently overlooked by the public is that a large share of the bank deposits of a country like the United States grow out of loans and so do not add to the cash holdings of the banks." Explain how this is so. CHAPTER XIV SOME MONEY TRUISMS Having briefly analyzed and described the system of Money and Credit Exchange, it is now in order to set forth some of the prin- ciples governing that system. It is much too early in our study to attempt anything resembling a thorough exposition of the theory of money. Nevertheless a few of the simpler principles which, though little more than truisms, are frequently overlooked by the public with the result that foolish errors gain acceptance and lead to hurtful legislation, should receive attention at the very outset. Money Small Part of Total Wealth. The first point requiring emphasis has to do with the common fallacy which regards, or seems to regard, money as the only kind of wealth. In earlier centuries, whole communities have entertained such an idea, and even in our own day many people stand dangerously close to the same position. Anything that reduces the monetary stock of a community tends, in their opinion, to make that country poorer, no matter what the reducing force may be ; and anything that increases the monetary stock, whether a balance of trade causing the import of money from other countries, or coinage by the government within the country, must have the effect of increasing wealth. There is no doubt some little excuse for this attitude of mind in the predominant place which money holds in our everyday thought and speech concerning wealth. We express wealth, of whatever kind, in terms of money, for example, when we say that "Smith has inherited a half million of dollars," though as a matter of fact he has inherited only land, factories, and stocks valued at a half million dollars. It is a fact, too, that money will procure for us any other kind of wealth we may desire, and hence itself appears to us the most efficient and desirable form of wealth, the wealth par excellence. 187 !88 PRINCIPLES OF ECONOMICS [XIV Nevertheless these considerations surely do not justify us in con- ceiving money to be the only form of wealth. Any kind of goods capable of yielding satisfactions and having exchange value dia- monds, bullion, land, or what not are wealth just as truly as coined money. It is essential therefore to keep always in mind the follow- ing proposition : Money is simply one particular kind among many kinds of wealth. Money Small Part of Total Capital. The second fact need- ing to be insisted on at this point is that money is not the only kind of capital. Considered as an instrument which we employ to facili- tate the exchange of goods and to accumulate or transfer stores of value, money is of course capital, just as truly as buildings, engines, or machinery. But certain peculiarities of money have led careless persons into thinking and talking about it as if it were the only true capital. Thus all forms of capital, like all forms of wealth in gen- eral, are computed and expressed in terms of money, as when we say, "Mr. Craig has $200,000 of capital in the milling business." We seem to mean here that $200,000 in money constitutes the capital which Mr. Craig devotes to the production of flour ; but what we should mean is that Craig owns and devotes to such production cer- tain buildings, dams, races, and machinery which have a value measured in money of $200,000. He may not, and almost certainly does not, possess anything like that amount of money capital, as money. Again, people are sometimes led to look upon money as the only form of capital, from the fact that money constitutes the immediate form in which most capital is accumulated. A person desiring to accumulate a fund of capital, to invest in the milling business, let us say, puts away his savings in the form of money or credit with his bank ; and only after the sum of money or credit has grown large does he part with it, obtaining in exchange the capital goods lumber, engines, and machines necessary to commence production. Still, the money stage of capital is obviously only temporary and transi- tional ; it lasts only while enough is being stored up to bring in return an appreciable amount of capital in another sense. For this money XIV] SOME MONEY TRUISMS 189 is only the representative form of capital, the shadow, not the sub- stance. At the same time that the capitalist is accumulating stores of money or bank credit, other men are manufacturing, practically, if not literally, to his order, lumber, engines, and machines; and these other things for which the capitalist, or someone who borrows from him, exchanges his store of money or bank credit, constitute the real, final, form of capital. The truth embodied in the following proposition should, therefore, be constantly borne in mind. Money is simply one among many kinds of capital (capital goods), i. e., products which are wanted, not for their own sakes, but for the sake of other things which we can get through them; and relatively, money forms a rather small portion of the total cap- ital of the community. Only Enough Money Wanted. Another mistaken notion with respect to money, which has caused a great deal of trouble in the past and is still very widely held, conceives that a country can never have enough money, can to advantage increase its stock of this particular form of capital indefinitely. Every addition is eagerly welcomed ; every withdrawal is looked on with anxiety. Increasing the quantity of money is offered as a panacea for almost every un- desirable feature of business. All this is, of course, very hard for the student to comment on with patience. The quantity of money a country can advantageously supply itself with is wholly a matter of the need, the money work to be done, over against the quantity of its resources which it can afford to use to satisfy this particular need in view of the relation between its total needs and its total resources. Doubtless there is no way of ascertaining with precision just how much this means. But that it is a limited amount no one would deny. The actual work in which the money stock of a country is at any moment being employed is serving as reserves be- hind the credit of the country, passing from hand to hand in ex- change for goods and in payment of obHgations, and being held by people in reserve for current uses and in the process of accumulating capital. For the uses which involve passing from hand to hand, any particular pieces of money will be used over and over again, so that the total needed for this purpose will be much smaller than the xgo PRINCIPLES OF ECONOMICS . [XIV total amount of work to be done would seem to indicate. Further, a large share of the money work of this kind needing to be done is performed by credit substitutes which are extemporized for each transaction ; and their volume has little reference to the quantity of money proper in the country. It is thus possible that the country should experience great changes in the money work to be done with- out any inconvenience resulting, even though the quantity of money had not shown a corresponding change. But not only is the community's need for money a quite limited quantity, it is surely very foolish to want to have more than this. To insist on supplying ourselves with a larger amount is like filling up one's house with cook stoves or tubs or washing machines. Any time or energy which we expend in acquiring such objects beyond the needs of the kitchen and laundry lays upon us a burden in caring for them, and, worse, it reduces the time and energy which we have to use in supplying ourselves with fuel, food, clothing, and other needed articles. Putting this point into a formal proposition gives us a third principle. Money is simply one particular kind of useful instrument of which our stock should be large enough to do the money work need- ing to be done as well as we can afford to have it done, but of which we do not want an excess any more than we want an excess of chairs, clothes, stoves, engines, or any other useful article. Money Naturally in Circulation. A fourth widely accepted fallacy connects itself with the supposed advantages of "putting money into circulation." ^ Exactly what this phrase means in popular usage is often hard to determine. If it means causing money to flow, or pass from hand to hand, the phrase is merely an empty one without excuse for being. Money is always in circulation, passing from one person to another in purchase of goods, or held awaiting occasion for such use. It will circulate anyway ; from its very nature it is bound to circulate. Or perhaps the phrase means to render money more active, cause it to spend a greater part of the time actually going through the air, effecting exchanges, instead of lying motionless in men's pockets. But to expect that any benefit will result from causing money to change hands a greater number of times in an XIV] SOME MONEY TRUISMS 191 hour or in a day is of course absurd. There is nothing beneficial in the exchange, per sc, of money, because there is nothing beneficial in the exchange, per se, of goods. The exchange of goods should occur just often enough to enable us to dispose of those we have produced and to get possession of other goods which will be of most advantage to us as consumers. Any more exchanging would be, obviously, a waste of our time and effort. But, since money passes from person to person merely as a counter, a check against other goods, the number of times it can advantageously change hands is limited to the number of times those other goods can advantageously change hands. To pass it more frequently if that were possible would be merely a purposeless waste. There is one other possible interpretation for the phrase. By "putting money into circulation" some people mean creating a de- mand, which would not otherwise exist, for goods and services, thus increasing the sales and the incomes of people generally and making the whole community more prosperous. This belief is no more tenable than the ones j'ust discussed ; but since the particular fallacy involved is one in contravention of a principle of trade which we designate Say's Law, and which is treated in the next chapter, we must reserve the consideration of this fallacy for that connection. The chief point of our present discussion may be summarized as follows : Broadly speaking, it is of the very nature of money to circulate (in person or by proxy), that is, to pass from one person to another in purchase of goods or to be held awaiting the occasion for such use. Money Naturally Remains Money. Another truism which needs only to be understood to command immediate acceptance, and yet is constantly overlooked, has to do with the fact that the stock of money is not necessarily any measure of the existing wealth of a community. When we complain of the squandering of a great capital by a worthless heir, people at once say, "I don't see that any harm is done. The money spent by the foolish heir is still here. It has only been transferred to better hands." Of course the money is still here. Money is a bit of social ma- chinery of a highly durable character, which lasts almost indefinitely, 1 92 PRINCIPLES OF ECONOMICS [XIV needing only small additions to keep it intact, like such permanent forms of capital as roads, canals, etc. Of course, then, the money is still in existence just as if the spendthrift had not thrown it about him so freely for yachts, dances, feasts, and other frivolities. But, on the other hand, there is a total lack of something else which would have come into being if the son had followed in the footsteps of his father. The father would have looked upon his money as a tempor- ary or transitional form of capital, and would have gone on to consummate the process of capital production by the purchase of productive goods engines, cars, bridges, shops. These goods could have been produced by the same labor which was expended in min- istering to the young man's follies, and they would have continued for years to give off services, instead of totally disappearing, like the orchestra music or the champagne, over night. As a result of the young man's spending, therefore, society as a. whole is vastly poorer than it might have been, even though the quantity of money is not altered in the least. Broadly speaking, it is of the very nature of money to remain money not to be consumed in the sense of being finally absorbed into the life of any individual. Hence the fact that the stock of money is unchanged proves nothing as to how the amount of wealth or capital is affected by particular lines of conduct. Trade Does Not Drain Off Money. A final fact deserving- mention in this place relates to the effect of foreign trade upon the stock of money in any community. "Everything we buy abroad," so runs a popular fallacy, "takes just so much money out of the country," and the conclusion is drawn that the country thereby falls into great economic distress. Now a moment's reference to the facts set forth in our analysis of the Credit Exchange should make clear to anyone the error in this belief. We do not make our pur- chases abroad with money, but with instruments of credit. In like manner, we sell our goods abroad, not for money, but for instru- ments of credit. These two sets of instruments are cancelled against each other, only balances going in money; so that the amounts of money actually passing from one country to another are very insig- nificant. Further, of course, those balances will naturally be in favor XIV] SOME MONEY TRUISMS 193 of any particular country just as much as against it. That is, there will very likely be no net movement of money at all. There is indeed one condition under which there will tend to be a net outward movement of money from a country practically all the time. If we are a gold producing country and spend much of our strength producing this metal, and little in producing other goods which we can export to pay for our imports, then, of course, the balance of credit against us will be great, and we will have to export much money to cancel it. But even here we are not exporting money in any true sense. If we spend much time producing gold, we prob- ,ably mine, refine, and subsequently coin into money a far greater amount than we can advantageously use as money. So far as our internal business is concerned, therefore, this excess is hardly to be called money ; it is merely the metal, gold, a product of our labor, like wheat, or shoes, or pork, which we can and should ship abroad to those who desire it, in payment for the products which we desire of them. But, while a country which is a large producer of gold, the money metal, may show a large net export of this kind of money, this will not be the case with other countries. Those which produce none at all will in the long run show a net import of such money ; while those which produce just about enough to meet their own needs will have neither a net export nor a net import. Between countries, as within countries, money will act just as a medium of exchange must act. That is, it will come and go, go and come, being wanted not to use for eating or wearing or warming houses or for any purpose that involves retaining possession of it or destroying it, but to use in exchanging our products for the products of other countries. It is of the very nature of money to go back and forth between communities; trade with the outside world does not of itself tend to take away our money. ILLUSTRATIVE PROBLEMS i. "Foreign trade can add to the national wealth only when it brings in a money balance." (a) What is the principal thing to be gained by maintaining trade relations with the outside world? I94 PRINCIPLES OF ECONOMICS [XIV (b) When would it be of advantage to have our foreign trade bring in a money balance? 2. "A nation is so much poorer by every dollar it sends out, just as an individual is so much poorer by every dollar he spends." Criticize both clauses. 3. "Everything we buy abroad takes just so much money out of the country." Show that this cannot be true whether it is meant that such buying abroad takes the money out immediately or only ultimately. 4. Suppose that official reports from all the banks of a certain city show that, on an average, 93 per cent of the deposits received during a certain day consisted of checks, only 7 per cent being in the form of money. What important fact with respect to the conduct of business in that city would be thereby disclosed? 5. "It is sometimes asked whether the raising of a government loan to cover ordinary expenditures really causes capital to be lost, since the coins received by the government remain in existence, even remain in the country. This objection has no weight whatever" Pierson's Prin- ciples of Economics. Show that the statement in italics is correct. 6. "We pay no million dollars per annum for the carrying of prod- ucts between this and foreign countries. Think of it. One hundred and ten million dollars in gold coin has gone out of the commerce of this country into the commerce of other countries. Can New York stand this?" James G. Elaine in 1881. (a) Is it likely that we permanently lost no million dollars in gold from our circulation because we hired foreigners to carry our goods ? (b) Is it likely that we even temporarily parted with that much gold on that account? (c) Is it likely that as a nation we should have been richer if we had done this carrying of products for ourselves ? 7. "I don't see that society as a whole loses anything by the giving of a fireworks exhibition costing $1,000. Of course the people who pay for the fireworks are just so much out. But then the $1,000 goes to the other people who furnish the fireworks so that society as a whole comes out even." Criticize. 8. "My numerous armies promote the circulation of money, and dis- burse impartially among the provinces the taxes paid by the people of the XIV] SOME MONEY TRUISMS 195 state." Frederick the Great justifying his wars in a letter to D'Alem- bert. (Quoted from Bullock.) Was there anything in the facts stated to offset the sacrifices under- gone by the people in paying the taxes? 9. "The summer boarders are a great blessing to our little village; because they put into circulation a lot of money, which means at least temporary prosperity." What must we understand this phrase, "put into circulation money" to mean, if we accept the above as anything like an adequate explana- tion of the prosperity brought by the summer boarders? 10. "The individual can get rich only by selling more than he buys and saving the surplus in the form of money or bank-credit. So a coun- try can increase its wealth only by exporting more than it imports, and taking the difference in money." Discuss both parts. 11. "I am not convinced of the soundness of the orthodox doctrine that a country can have all the money it wants and needs, just as it can have all the engines, machinery, etc., which it wants. Money is very different from other things. It would be easy to give a man all the food and clothes he wants ; but, however much money you offered him, he would take it all gladly." Criticize. 12. From a Salt Lake supporter of the "Seeing America" movement: "We recognize that Americans are annually spending $200,000,000 in foreign travel. That practically every dollar of this vast sum is lost to the home circulation cannot be disputed." Criticize the last sentence. CHAPTER XV SAY'S LAW The preceding chapter sought to emphasize certain elementary principles governing the mechanism of exchange, principles which, though little more than truisms, are often overlooked. For exchange itself the process of trade between individuals and communities- there are similar elementary principles which are so commonly neg- lected or misunderstood as to call for early comment. One of these, perhaps the most fundamental of all, has already been given on page 33, in the proposition that the chief function of exchange is to make cooperation and specialization possible. In this chapter, we consider a second principle of this kind, one which we shall desig- nate Say's Law. General Demand Fallacies. Among the fallacious notions in popular thinking that have gained very wide currency are to be found a number which grow out of misconceptions as to the real source of the general or total demand for goods, and as to the methods by which that demand is increased or diminished. Several types of these fallacious notions may be cited. Thus, governmental improvements of all kinds, including even those of questionable value, are often supported by business men and others on the ground that such improvements increase the total demand for goods. Catas- trophes, such as the San Francisco earthquake, disastrous fires, tor- nadoes, or even only freezing weather which causes water pipes to burst, are frequently accepted as evils not unmixed with good inasmuch as the expenditures necessitated for reconstruction and re- pairs are supposed to increase the general demand. On the other hand, persons of thrifty habits who save a large share of their in- comes are frequently the objects of criticism on the ground that saving diminishes the total demand for goods. Again, many persons 196 XV] SAY'S LAW 197 seek economic support for the opposition to prison labor, and to the employment of women and children in industry, in the argument that such employment diminishes the number of jobs open to laborers generally. Finally, we have the fears of those who periodically prophesy universal overproduction a universal glut. A true under- standing of the nature of the total demand for goods will show that these notions are fundamentally unsound. Their Argument. What is meant by those who believe thav; governmental expenditures or destructive accidents tend to increase the general demand for goods is that they set up chains of purchases which would not otherwise be made, and, in doing so, bring about an increase in the total demand for goods. Now, the trouble witli this account of the matter is that only one half of it is true. The chain of purchases indicated is really set up; but it does not result in the increase in total demand which is claimed. The case for the chain is evident enough. Thus, take the example of a householder whose roof has been blown off by a severe storm or tornado. He at once proceeds to buy shingles and hire carpenters ; the carpenters and the lumber dealer, finding their incomes increased, buy more groceries and clothing; the grocer and clothier use their unusually large re- ceipts to improve their stocks by purchase from the wholesaler, or spend more freely for pleasure rides and concerts ; and so on. Thus the purchases made by the roofless householder extend themselves indefinitely down the line, business quickens everywhere, and the prosperity of the whole community seems to be heightened. The Fallacy. But, now, what about the second half of the popular account of this matter? Does the series of reactions which all admit follows the tornado result in an increase in the total de- mand? The correct answer is surely a negative one. The money which on account of the tornado our householder was compelled to spend putting on a new roof would ultimately have been spent any- how, though in some other direction ; and, being thus spent, it would have created just the same demand for commodities or services. Thus, for the sake of simplicity, let us suppose that our householder had planned to use the money spent on the new roof in putting a cellar I9 8 PRINCIPLES OF ECONOMICS [XV under a part of the house which was hitherto not provided with this convenience. A necessary result, then, of spending this money to repair the broken roof is to prevent it from setting up another chain of purchases, starting with those needed to excavate the cellar. This other chain would have begun with the hiring of cellar diggers and the buying of cement; the diggers and cement dealers would then have spent more for furniture and dental service ; and the furniture merchants and dentists in their turn would have spent more for automobiles and real estate. In short, the purchases made by the householder in digging a new cellar would have extended their in- fluence endlessly, stimulating business and apparently bringing pros- perity into the world, just the same as purchases made to repair a roof whisked off by a tornado. Hence the tornado does not increase demand in the least, it merely substitutes one chain of purchases for another. 1 Perhaps, however, the objector may argue that our householder need not spent the money at all. He may, instead, put it into a bank. Truly ; but then money that is put into a bank is not kept there. It is loaned out to people who need it to meet immediate expenses or who wish to increase the capital which they are employing in their business. In any case, they are people who, after borrowing the money, will surely use it to buy goods of some kind, and so will increase the general demand just as much as did spending that money to put on a new roof. Demand Coincident with Income. What, now, is the gen- eralization to be made from the story of our house owner? Imme- diately, it is this : The contribution made by any one person to the total demand for goods is, in the long run, bound to be just equal to his income, no more and no less. He cannot demand more goods 1 Incidentally, too, we should note that, from the standpoint of the original householder, the chain of purchases which would have been started by digging a cellar is much more desirable than the one actually started by repairing the roof. The second process leaves the man with a house no better than before a house having a roof but no cellar. The first would have left him a house already sufficiently well roofed, and improved by the addition of a cellar. Hence, while business in general gains nothing from the tornado, the householder suffers a positive loss. XV] SAY'S LAW 199 than that income will buy ; he or someone who borrows his money is certain to demand as large a quantity as that income will buy. Demand Coincident with Product. But this only starts us on our way. What determines the quantity of his money income? Broadly speaking, this is determined by the amount of goods or services which, under existing legal conditions, is credited to him as his product, 2 it being assumed that he is producing something de- manded and producing that something in the proper proportion to other goods produced. It follows that the contribution to total de- mand made by anyone is necessarily equal to the quantity of his product; it cannot be greater; it must be as great. Finally, since the total demand of a community necessarily consists of the sum of the demands made by the individuals who constitute the community, the total demand of that community must equal its total product; it can- not be greater ; it is bound to be as great. But these propositions are so important that they must be more specifically defended. Demand Not Greater than Product. Demand cannot be greater than product, cannot, at bottom, include anything outside of product. Imagine a shoemaker who makes nothing but shoes desiring to obtain a quantity of wheat from a wheat farmer who raises no other grain. Obviously, the only way he can hope to obtain wheat is to offer shoes either directly on the barter plan, or indirectly through a money medium in exchange. But these shoes which he offers he must first have produced they are a product; hence the shoemaker's demand for wheat cannot include anything outside of his product (shoes). Reversing the hypothesis, if the wheat grower desires a new pair of shoes, his demand for shoes cannot include anything outside of his own product (wheat) ; he simply has nothing else to demand with. Now, if this is true of two people in their relation to each other, it must be equally 3 This is not to be taken as meaning that the individual is morally entitled to the particular income which he is receiving on the ground that he produces it. The product is here whether or not the right man is credited with it; and the value of that product determines the volume of demand resulting, whoever ought to control that demand. 200 PRINCIPLES OF ECONOMICS [XV true of one person in his relation to society as a whole : the demand made by shoemakers for market goods of all kinds can include nothing but shoes produced by them and offered on the market; the demand made by wheat growers for market goods of all kinds can include nothing but wheat produced by them and offered on the market in each case nothing else will serve as a demand for goods in general except something which the individual has himself produced. Finally, this proposition, being true of every individual, must be true of all individuals taken together. The demand of all the people in the community, the total demand, can be no greater than the product of all the people of the community, the total product. Finally, what is true of each nation in its relations with the rest of society, is equally true of all society, of the whole world, in its complex, intricate relations with itself. The demand made by all society for market goods of all kinds can include nothing but goods which the same society has produced and offered on the market. Demand as Great as Product. Demand must be as great as product, must include all of the goods produced for the market assuming that producers have directed their production in true accord with one another's wants. It goes without saying that all goods produced for the market will be offered in exchange, that being the purpose of their pro- duction ; and, by being offered in exchange all these goods come to constitute a demand for other goods, in so far as this matter is determined by the purpose of their producers. Thus, if the shoe- maker produces and puts on the market each year two hundred pairs of shoes, then, as far as his intent goes, every one of these shoes constitutes a demand for bread, or meat, or clothing, or some other good which the shoemaker needs. What is true of the in- dividual is obviously true of the aggregate of individuals also. All the goods which they all produce constitute a demand for goods, in so far as the purpose of the producer affects this matter. But we have yet to deal with the proviso "in so far as this matter is determined by the purpose of their producers." This proviso is needed because the question whether or not a product shall form a part of demand depends not only on the attitude of XV] SAY'S LAW 201 the producer of that product, but also on the attitude of those per- sons who must be depended on to buy said product. For demand involves not only a desire on the part of the prospective buyer, but also buying power ; and buying power can be derived from products one has to sell only on condition that other people want those products, as well as have the power to offer other goods in exchange for them. It follows that a particular product comes to constitute a part of the total demand for goods only in so far as it is a product for which there is a corresponding demand. For example, the two hundred pairs of shoes of our shoemaker constitute a part of the total demand for goods only on condition that they are goods which other people demand, stand ready to buy. And this implies, it should be noted, that the product in question is demanded in the proportion in which it is produced when we produce a thing we do not add to demand in proportion to the volume for our product unless we are maintaining the proper proportion between our products and other products. The points just brought out with respect to the relation between demand and the output of goods are so evident that some will con- sider it scarcely legitimate to give them the dignity derived from formal statement. On the other hand, the continued prevalence throughout the larger part of the community of the fallacious no- tions which these considerations are designed to correct seems to furnish ample ground for any procedure which gives these points adequate emphasis. I shall therefore put the proposition we have discussed in the form of a principle. This principle, I have taken the liberty to designate Say's Law ; because, though recognized by many earlier writers, it was particularly well brought out in the presentation of Say (1803). This principle may be stated as follows : Principle Say's Law. The Ultimate Identity of Demand and Product. In the last analysis, the demand for goods produced for the market consists of goods produced for the market, i. e., the same goods are at once the demand for goods and the supply of goods; so that, if we can assume that producers 202 PRINCIPLES OF ECONOMICS [XV have directed production in true accord with one another's wants, total demand must in the long run coincide with the total product or output of goods produced for the market. Say's Law a Long-Run Principle. In the case of sciences even physical sciences which deal with highly complicated phenomena, many principles have to be affirmed as true in the long run ; and this frequently applies to the science of economics. Thus, everyone knows that the prices of goods tend to equal their cost of production; but everyone also knows that changes in cost do not immediately cause corresponding changes in price. Now, this comment is applicable to Say's Law to a more than usual degree. For this, there is one very substantial reason. It is this : save under the most primitive conditions, every exchange of product for product is broken into two parts (i) exchanging one's own product for money or bank credits, and (2) exchanging the money or bank credits thus obtained for the product of the other man. Obviously, an interval of time can be put between these two operations ; and, as a matter of fact, such an interval, short or long, almost always intervenes. It follows from the facts just brought out that it is possible for us to postpone for a long period, even indefinitely, the second part of the operation, thus cutting down for the time being the general demand for goods, though we have not cut down the amount of production. On the other hand, it is possible that, by getting possession of the medium of exchange, money or bank credits, in ways other than by exchanging our goods for that medium of ex- change, we should perform the second half of the exchange opera- tion before having performed the first half. In this way demand may be increased enormously, though production has not been in- creased at all. The qualification of Say's Law made necessary by this peculiar- ity of money exchange has little if any bearing on the use of that principle to correct the fallacious notions which were used to illustrate this discussion. But there are a number of matters in respect to which this limitation on Say's Law is of much im- portance. One of the lesser of these is closely connected with XV] SAY'S LAW 203 one of those fallacious notions which were brought forward in the earlier part of this chapter, namely: the idea that by increasing governmental expenditure we can increase the total demand for goods and so increase general prosperity. Such a device, looked at as something to be made use of in ordinary times when economic affairs are running along in normal fashion, is, from the standpoint of sound economic science, quite impracticable. It could do nothing more than deflect demand from some lines of production to other lines of production. But the case is very different if circumstances have brought us to a point where the first of the discrepancies between demand and output noted above has become quite general, that is, a point where buyers generally are suspending the second half of the ex- change operation. Such a procedure means a general decline in demand, hence of necessity a general slackening of productivity all along the line. A situation like this is characteristic of the depression which follows a business crisis. If, now, under such a condition of things, the public authorities step in and undertake a large pro- gram of road-making or building construction or harbor improve- ments, this will really mean a considerable increase in total demand and so an increase in general prosperity. 3 Much more important cases where the practice of breaking the exchange operation into two parts makes possible a change in the volume of demand in general which is not preceded by a change in the output of goods in general, arise in connection with the phenome- non of money and credit. But these are not suited for consideration at this stage in our economic study. ILLUSTRATIVE PROBLEMS i. "George Rankin is of course a big fool to spend $400 making a mill dam in a creek which is dried up every summer and never has enough water to run an ice cream freezer ; but he is doing one good thing, he is making a whole lot more demand for labor and so a lot more employment for laborers." Explain fallacy. 3 It may even be the beginning of a general revival of business. 204 PRINCIPLES OF ECONOMICS (XV 2. "There is just so much work to be done. The entrance of women and children into the field of labor must drive out an equal amount of adult male labor." Criticize. (There are no doubt objections of real weight to the ex- tension of child and female labor; but this is not one of them.) 3. "The real cause of the present standstill in trade is the inequality of incomes. There can be no effective demand, because those who have the money to buy have no unsatisfied wants, while those who have the wants have no power to buy." Criticize. 4. In a certain part of a recent novel, Mr. Blossom, a young painter and decorator, is trying to induce Miss Cynthia to give him a job re- decorating her house, which is somewhat behind the times in this respect. The latter part of the conversation on the matter is as follows: " 'Live and let live' is a good enough motto for me." " 'Live and let live/ " repeated Miss Cynthia, thoughtfully. "What do you think that means?" "Why, it's plain enough," said Mr. Blossom, strongly. "You're living all right, ain't you ? Got enough of everything and something to spare . . . ; but you've got to let other folks live. ... If there's any- thing you want done that you can't do for yourself, hire somebody that can do it ... so they can live, too. If everybody did that right along, I guess there wouldn't be so much talk about labor unions and strikes and all that sort of thing." (a) Would Miss Cynthia's deciding to spend and actually spending $600 to redecorate her house increase the employment of laborers gen- erally? (b) Why can we be certain that everybody is now doing the thing which Mr. Blossom thinks they ought to be doing? 5. Street comment on a cold snap which bursts numerous water- pipes: "Hard on householders, sure enough; but no great loss without some small gain. It's a bonanza for Ann Arbor plumbers." Is that sound ? 6. Mr. A, having earned and saved $10,000 in gold, buries it in the ground. Another, having earned and saved $10,000, spends it on a great banquet. Which makes the greater demand for products ? Ex- plain. 7. Would we naturally expect events like the San Francisco earth- quake and fire to increase the demand for labor in general? Explain. XV] SAY'S LAW 205 8. "Economically it is for the interest of every class of producers to see the efficiency of other classes of producers increase." Why ? 9. "The extraordinary advance in industrial technique characteristic of the last half century has so increased our productive capacity that, when things are running smoothly, output is bound, sooner or later, to exceed demand, which condition of things invariably leads to a com- mercial crisis followed by a general collapse of industry." Criticize. 10. The Chicago Record-Herald for April 18, 1908, contained the report of an interview with the head of one of America's great univer- sities, wherein various opinions and statements were attributed to King Haakon of Norway. Among these was the following: "I could black my own boots if I wished to ; I have done it and therefore know how ; but if I did, what would become of the people who make a living blacking boots ?" Criticize on the basis of Say's Law. CHAPTER XVI THE PRINCIPLE OF RECIPROCITY The Buy-Little Fallacy. One of the most persistent and widespread of errors with respect to economic matters is that, in the trade between countries, the condition of maximum desirability is to be always selling, never buying, or anyhow selling as much more than we buy as is possible. Almost every year our foreign trade reports seem to show a great excess .of exports; and this announcement always brings out a chorus of congratulatory com- ments from our press. 1 Now it is quite certain that such one- sidedness in trade selling without buying would be in the highest degree undesirable, if it were feasible. It would not be for our advantage to sell more than we buy. But, further, it is quite certain that such one-sided trade would not be feasible, supposing it to be desirable. Generally speaking, it is not possible for us to sell more than we buy, our exports cannot exceed our imports. The second of these propositions is more especially the principle with which we are here concerned ; but some comment on the first seems called for. Not Desirable. In showing that selling without buying would not be desirable, it will perhaps be best to start from the standpoint of individual trade. That such trade would not be de- sirable for the individual is almost self-evident; for this proposition necessarily follows from the very function for which trade exists. That function, as fully explained in our general account of the 1 As will be explained in a latter connection, there are times when, in view of the relation of foreign trade to another matter the stability of the monetary system it is desirable to have an export trade balance. For this reason, there is at times some propriety in thinking of such a balance as a favorable one. But this is not what the general public have in mind when accounting every such balance favorable. 206 XVI] PRINCIPLE OF RECIPROCITY 207 present economic order, is to consummate and therefore to make possible that cooperation between us and our fellows which is so essential to high productive efficiency. But obviously such co- operation would not be accomplished unless each bought as well as sold. The advantage which each derives from cooperation is de- pendent on getting the products of others, that is, buying. Selling his own products is of no significance to him except as it is a preliminary to buying the products of others. But the reader may be disposed to object that some exceptions to this account of the matter must be admitted. First, the seller may be a miser who only desires to heap up stores of gold, not caring for goods at all, or anyhow not caring for any goods in excess of the absolute necessities of life. Secondly, the seller may be a prospective capitalist, one who is accumulating surplus wealth in order to get from it an income, and who, therefore, saves the money he gets from the sale of his goods, instead of buying other goods. The first of these objections is easily answered as being only a seeming exception. The miser is really buying something, only in his case, that something is money. That is, in his thought money is not really money the medium of exchange but a commodity, the particular commodity which his perverted taste leads him to desire rather than the kinds of commodities most men desire. The unsoundness of the second exception is almost equally evident. It is hardly even a seeming exception. The person who is accumulating capital is merely postponing the buying half of the transaction, a thing every one has to do when buying expensive goods, in that he has to get together from different sales enough money to cover the larger amount of money needed to make the particular purchase in question. In the end, the capitalist buys goods or lends to someone else who buys goods. If he pursues the former policy, the only peculiarity of his case is that he buys a different kind of goods from those bought by other people, namely producers' goods goods used in the making of other goods. Doubt- less his decision to save his money until he has enough to buy goods of this sort is of much importance, may alter greatly the course of things; but it does not mean that the money he obtains 208 PRINCIPLES OF ECONOMICS from the sale of his goods is not used for buying other goods, that the second half of the exchange transaction is left incomplete. 2 The case is not materially different if our capitalist lends his ac- cumulations. The borrower will, of course, use those accumulations to buy goods. Thus, in the end, the buying half of the transaction which began with the original sale will finally be consummated. Not Feasible. We have seen that, in the case of trade be- tween individuals, selling without buying could be of no advantage, would not be desirable, if feasible. That such one-sided trade would not be feasible is quite as certain. We are not able to sel) without buying; reciprocity is inherent in trade; buying and selling mutually condition each other. The truth of this proposition is obvious in the case of direct exchange, barter. Unless I accept the goods of the other man, I get no pay for my own. But our proposi- tion is no less true when barter is broken into two parts, sale and purchase. First, the man who buys from me must be able to sell to some one in order to get the means to pay for his purchase from me. Secondly, this is feasible only provided I make purchases from him or from some person or persons with whom he is directly or indirectly connected in trade, Trade Must Be Reciprocal. The former of these two propo- sitions is so evident that it needs no discussion. The second, how- ever, may not at once command assent. For, at first thought, the reader may be disposed to say: True, someone must buy from my customer, else he cannot get the means to pay me ; but it is not necessary that I should be that someone ; another customer will answer just as well. Doubtless the statement is quite true as far as it goes; but it does not meet the difficulty. Mr. B who buys from me may have obtained the means of payment by selling his product to Mr. C; in turn, Mr. C may have obtained the means * Some care is needed in using or interpreting the word "spend." While there is no impropriety in attaching to the term the idea that the goods for which the money is given are not very necessary, are even goods which under all the circumstances we would better do without, we must not let ourselves drift into thinking that money paid out for necessary, approved, goods is not just as truly spent, if we mean "parted with," used to buy something. XV11 PRINCIPLE OF RECIPROCITY 209 of payment for his purchase from B by selling his product to Mr. D ; in turn, Mr. D may have obtained the means of payment for his purchase from C by selling to Mr. E; and so on until the last man in the world other than myself has been brought into the chain. But that last man must be able to sell to me in order to forge the first link in the chain which ends in purchases from me. In order to make this point clear beyond question, let us give it concrete illustration on the basis of an extravagantly simple hypothesis as follows : Our trading is limited to four persons whom we will designate A, B, C, and D, respectively. Each sells all his product to one other member of the group ; each also makes all his purchases from one member of the group, this time a different one; and each produces and exchanges $10,000 worth of goods. Let us now conceive one of the four, A, to be set over against the other three, and try to show that, if he would sell, he must also buy. Let us suppose that B stands ready to take A's $10,000 worth of products; C to take B's $10,000 worth; and D to take C's $10,000 worth; while A, by the original hypothesis, is determined only to sell, never to buy. What result must follow ? Plainly there is no one to whom D can dispose of his $10,000 worth of products; he, therefore, cannot buy those of C, though he desires to do so. As a result, C cannot buy those of B ; and finally, B cannot buy those of A. Thus all exchange is stopped because A makes no purchases. Let him reverse his policy, and all difficulty at once disappears. If A will buy the goods of D, the latter will have the means to buy the goods of C, who will then have the means to buy the goods of B, who will then have the means to buy the goods of A. Inter-Group Trade Must Be Reciprocal. The above argu- ment to show that trade between individuals must be reciprocal, that we must buy if we would sell, was only preliminary to our real task to show that trade between communities, countries, must be reciprocal, purchases and sales, imports and exports, must balance. Before getting into this task, however, we must take a moment to make more definite and precise just wJiat is meant by the thesis defended. 210 PRINCIPLES OF ECONOMICS [XVI First, the contention is that our foreign trade must show equality between purchases and sales, imports and exports of services and goods, not including money. In general, the money of a country is a necessary part of its economic equipment which it can no more spare, save for a very brief period, than a household could spare its cook stove or beds. Doubtless a country may for a time use its money stock to make purchases for which an altogether excep- tional need has risen ; but, generally speaking, such a policy will not, cannot, be continuous. To this exclusion of money from the list of exports and imports to be equalized, however, one exception must be pointed out. Standard money is usually a metal product ; and a product of very uneven distribution in respect to production. A few countries mine practically all the gold of the world. This being true, most countries must import their supplies of money metal, which obviously means that the producing countries must export that metal. But, again, this particular product is commonly marketed, not as a metal, but as money. Producers sell it directly to mints or assay offices or to banks which dispose of it to mints or per- haps at once treat it as international money. It follows that the distribution of gold from producing to non-producing countries will largely take the form of moving money (frequently gold in bar form) from the former to the latter. Accordingly, it is to a certain extent necessary to include as a part of the exports or imports of a country, money sent out or brought in. This exception, however, is commonly of little importance, save when the producing country has almost no other product, for example, the Klondike. Real Exports and Imports. A second point with respect to the proposition that exports and imports must be equal, which needs to be noted, is that the exports and imports had in mind are the real, the true, exports and imports, not those reported by the customs authorities. The latter are seldom if ever equal, though the former must be. The explanation is easy. Customs reports do not, and cannot, show all exports and imports. Thus, the true imports of a country obviously include everything bought by its people from the people of other countries. But some of these things bought from other countries cannot, or at least do not, come to the knowledge XVI] PRINCIPLE OF RECIPROCITY 211 of government officials. Of these the most important are (i) goods and services bought from the foreigner in his own country, e.g., by our people traveling there, and (2) services bought from the foreigner and delivered in our own country, but not appearing in import lists because as services they do not go through the custom house. In short, there are invisible, as well as visible, imports ; and it is the sum of both of these which must be equal to the total of exports. What has been said of imports applies of course to exports. Of these some are visible, some invisible; and it is their sum which must equal the total imports. Accordingly, if we wish to get a correct balance sheet of the exports and imports of a country, we must add to the figures fur- nished us by the customs officials, figures from other sources mostly mere estimates taking into account these invisible exports and imports. Thus, if it is true, as some say, that we get trans- portation done for us by other nations to the value of $200,000,000 per year, we must enter on the import side of the balance sheet an item like this : Services of Carriers $200,000,000 So, if it is true that we use capital borrowed from other countries to an amount which calls for $120,000,000 of interest per year, then we must enter on the import side this item : Services of Borrowed Capital $120,000,000 or, in the more usual form: Interest of Borrowed Capital $120,000,000 I hardly need add that the countries selling us these services would have to make similar entries on the export side of their balance sheets. Total Exports: Total Imports. As a final comment in in- terpreting the Principle of Reciprocity, we note that the equality of exports and imports which is declared to be necessary is equality 212 PRINCIPLES OF ECONOMICS [XVI between the exports of a country to all other countries and its imports from all other countries, not equality between its exports to each country and its imports from that same country. We buy from England much less than we sell to her; but, then, we buy from some other countries to which England sells an excess of goods, much more than we sell to them. In conventional language, international trade is triangular. More precisely, it is multiangular. But, however many angles it may show, the total in must equal the total out. Argument for the Principle. So much for the proper inter- pretation of the Principle of Reciprocity. We must now add the argument on which that principle rests. Perhaps the simplest proof is analogous to that used in establishing the same principle as applicable to the trade between individuals. That is, each must buy as well as sell, since otherwise the rest will not have the means to buy from it. Thus, let us suppose that the A, B, C, and D of our illustration on page 210 represent different countries. Now, as before, it is possible that each country should buy from some country other than the one to which it sells. It must, however, buy from some other country; since otherwise some member of the series will not have the means with which to make the purchases necessary to complete the series. It is not possible for Country A to be just a seller, not a buyer. It must buy from Country D, in order that D should be able to buy from C, in order that C should be able to buy from B, in order that B, should be able to buy from A itself. Inequality of Exports and Imports Self-Corrective. We have shown that the foreign trade of a country must be two-sided on the ground that only so can those to whom that country sells have the means to pay for their purchases. A more difficult, but perhaps more adequate, proof is that inequality between the exports of a country and its imports is self -destructive, that this fact of itself sets up reactions tending to bring about equality of exports and imports, so that equilibrium cannot be established until such equality of exports and imports has been secured. XVI] PRINCIPLE OF RECIPROCITY 213 Through Rate of Exchange. The first of the reactions tend- ing to bring about the result indicated is the effect produced on the course of trade through the particular rate of exchange made to prevail by an excess of exports on the one hand, or by an excess of imports on the other. As we will remember from the chapter on Credit Exchange, the means of payment (the medium of ex- change) in foreign trade is credit, the right to claim money in other countries, exchange, as it is technically named. It follows that the export dealers of any country will have such exchange to sell ; while importers will need to buy such exchange. As a consequence, a falling rate of exchange will tend to lower the profits of exporters, since the exchange they have to dispose of brings in less; while that same falling rate will tend to raise the profits of importers, since the exchange they need 'to buy will come cheaper. 3 But any cause which lowers the profits of exporters and raises those of importers will obviously tend to diminish the dealings of the former and in- crease those of the latter, that is, will tend to diminish exports and increase imports. Finally, an excess of exports is just the cause which tends to lower the rate of exchange ; since such excess means that there is more exchange offered for sale than the demand will take up. It thus appears that an excess of exports sets up a chain of causation tending to eliminate that excess: said excess makes a lower rate of exchange ; which lowered rate makes exporting less, and importing more, profitable; which decreases exports and in- creases imports ; which finally eliminates the excess of exports, that is, brings exports and imports to an equality. An analogous course of reasoning would show that an excess of imports must tend to disappear, must destroy itself. Through Money Movements. We have seen that an excess of either exports or imports is self -destructive or self -corrective, through its influence on the rate of exchange. Such an excess is self -corrective also through its influence on the movements of money* If a country is exporting more than it imports, the ex- 3 See problems u and 12, page 187. 4 This topic is more fully discussed in Chapter XXXIV. 2I4 PRINCIPLES OF ECONOMICS [XVI change dealers of that country will presently find themselves creditors, by a considerable balance, of the exchange dealers of other countries. Such a state of things may be allowed to continue for a few weeks through temporary loans to their correspondents in the debtor countries. But, in general, such balances are not permitted for any considerable period in international trade; and, in consequence, the continuance of an export excess soon leads to a movement of money toward the exporting country to make good the balance owing that country. Such a movement, however, presently causes the reserves of the banks to become excessive, makes borrowing easy, inflates business and buying in general, with the result that prices in general rise. An exactly opposite course of causation in the importing countries results in a general lowering of prices. But the raising of prices in the exporting country and the lowering of prices in the importing countries make the former an undesirable market to buy in, and the latter a desirable one. In consequence, the exports of the country having an excess of exports tend to decline while its imports from other countries tend to expand. Thus, again, an excess of exports is self -corrective. Exports and imports tend to become equal automatically. Let us now embody the result of this long discussion in a formal principle as follows: Principle The Principle of Reciprocity. 5 Exchange between communities, as between individuals, is necessarily reciprocal; and, speaking broadly, the total of goods (not including money) sold by any community to all other communities must in the long run equal the total of goods (not including money) bought by that community from all others, save that there will usually tend to be a "The Principle of Reciprocity here laid down should not be confused with the policy of reciprocity much advocated and occasionally practiced in this country. The latter, as indicated, is a policy in the conduct of a nation's commercial relations, not a natural law governing phenomena. Further, as a policy reciprocity has its chief theoretic basis in alleged natural laws which are quite inconsistent with the Principle of Reciprocity. Most advocates of the policy of reciprocity are more or less pronounced dis- believers in the Principle of Reciprocity. XVI] PRINCIPLE OF RECIPROCITY 215 slight excess of goods exported from communities not pro- ducing standard money metal and a more or less consider- able excess of goods imported into a country producing standard money metal it being assumed that the distribution of population among different communities remains substan- tially unchanged. ILLUSTRATIVE PROBLEMS 1. "Another important reason for keeping our fleets as far as pos- sible in our own ports is that under this policy the money they spend for ordinary supplies goes to our own people." Explain what the writer probably meant and criticize it. 2. "To the same extent that the home market is wrested from for- eigners and given to protected home producers, the foreign market is wrested from unprotected home producers." Explain and defend the statement. 3. "When I came to Marblehead they had their houses built by country workmen, and their clothes made out of town, and supplied them- selves with beef and pork from Boston, which drained the town of its money." Barnard's Autobiography. Criticize the part in italics. 4. From a supposititious editorial of a Benton Harbor newspaper: "The annual influx of students and other outsiders into the fruit belt to engage in fruit picking and packing is an abuse which should be stopped at once. These people consume very little, saving their money to take back to Ann Arbor, Chicago, and the other places from which they came. Thus, while making large sums off us, they give little or nothing to the support of our industries." Criticize. 5. "One reason for our almost constant excess of exports is that we are enterprising and so always opening up new markets." Objector: "Opening up new markets might increase our exports but could not increase our excess of exports unless somebody cheated us." Defend the second statement. 6. Remarks of a leading Congressman when it was announced that the Canal Commission would purchase supplies wherever they could be secured most cheaply : "The President should be able to see the de- sirability of purchasing the supplies in this country alone, because thus 2i6 PRINCIPLES OF ECONOMICS [XVI employment would be given to American capital and labor instead of foreign." Explain fallacy. 7. "The chief reason for our excess of exports is to be found in the fact that the things which we sell are more necessary to our neighbors than the things which they sell are to us." Criticize. 8. "The true way to quicken foreign demand (for British goods) was to open the ports to that foreign supply with which they paid us for what they bought from us." Morley's Gladstone, Volume i, page 267. Show that the above is sound doctrine. 9. "If we buy rails from England, we get the rails of course, but they get our money; while, if we buy the rails at home, we have the rails and the money, too." (a) Is there any reason to expect that our buying rails in England would carry off our regular stock of money ? Explain. (b) Substitute "cotton" for "money" throughout the above quotation, and show the fallaciousness -of the doctrine. 10. "The trade of the United States shows an excess of exports, because it is a large resourceful country which has to supply other coun- tries with raw materials." Criticize. 11. "I have always believed that free trade would secure the greatest general prosperity, provided that all countries would practice it. But, if neighboring countries are bound to maintain protection, it is only fair to ourselves to do the same." (a) What is the real economic evil of having our neighbors shut out our goods? (b) Would we better matters by shutting out theirs? 12. A Detroit physician who has a son in the University at Ann Ar- bor requires the latter to buy his clothes and other supplies just as far as possible in Detroit, on the ground that, since his income is earned in that city, it ought to be spent there. (a) Has the father placed himself under obligations to the people of Detroit by earning an income from them? (b) Supposing the distribution of population unchanged, would De- troit as a whole get any more employment on the one plan than on the other ? 13. A Western newspaper, anxious to hinder the people of the com- munity from buying outside, represents a silver dollar as appealing to a XVI] PRINCIPLE OF RECIPROCITY 217 home dentist about to send it to the Montgomery Ward Company of Chicago, in the following strain : "Now, look here, Doc. If you'll only let me stay in this town I'll circulate around and do you lots of good. You buy a big beef steak with me, and the butcher will buy groceries, and the grocer will buy dry goods, and the dry goods merchant will pay his doctor bill with me, and the doctor will spend me with a farmer for oats to feed his buggy' horse, and the farmer will buy fresh beef from the butcher, and the butcher will come around to you and get his tooth mended. In the long run, you see, I will be more useful to you here at home than if you send me away forever." (a) Clear up once more the fundamental errors in all talk of this kind. (b) Show that, even if we admit the principle implied in the quota- tion (that only the money spent at home can complete the circuit so as to get back to the original spender), only a very small portion of the dollar could -get back to the dentist. 14. English people own much capital which is earning interest or dividends in other countries. What effect does this fact tend to have on England's exports or imports? 15. "If it were possible for one county to provide by law or other- wise that no dollar which came into it could be sent out, within two years the county would be so much richer than its neighbors that they would begin to wonder, etc.'' Western newspaper. (a) What do you suppose are his reasons for expecting such a policy to produce the great prosperity predicted? (b) Show that his great expectations are unreasonable. (c) Show that the policy in question would be likely to make the county poorer rather than richer. 1 6. "You admit that it would increase the productive power of a given county to have a man with one hundred thousand dollars move in, bringing his money with him. How, then, can you deny that the county would grow richer if it could and should for three or four years stop all money which came in from going out?" Show that we are guilty of no inconsistency in admitting the one contention and denying the other. 17. The following was taken from a country newspaper in 1908: "It appears to this paper that all this severe criticism ... of Mrs. How- ard Gould's requiring $70,000 a year to pay her expenses is quite un- 218 PRINCIPLES OF ECONOMICS [XVI called for. What's the difference, anyway? If she and her folks have the 'dough,' let them spend it as fast as they like. That's better than hoarding it. When the money is spent it goes to some one and gets into circulation. We people whom circumstances compel to live on 30 cents a day would be glad to see all the old millionaires spending each $70,000 a year on himself, or ten times that amount if he wants to. The money isn't lost." (a) State clearly what advantage the writer of the above probably imagined that the public derive from the extravagance of Mrs. Gould and other rich people. (b) Explain the fallacy in the doctrine. (c) Show that the last sentence of the quotation is of no significance in the matter. 18. "The so-called Principle of Reciprocity is all rubbish. It is child's play to show that we can sell to other countries even if we do not buy from those countries'. No British buyer of American goods asks the question whether America buys British goods. His only question is: 'Does this article in character and price suit me?' If so, he buys it. Further, it is a matter of common knowledge that a country will often buy a great deal from some other country, even though it sells little or nothing to that other country. Thus Germany has no better customer than England, whose goods she keeps out by tariff. So we buy largely from Brazil, though we sell her very little." (a) State the Principle of Reciprocity. (b) Show that the arguments against this principle contained in the above quotation have no bearing on the case. 19. "Our neglect of the South American trade is simply scandalous. We buy a large amount from Brazil every year but sell her almost noth- ing, leaving her markets to be gobbled up by England and other European countries. We ought to subsidize a great merchant marine running to South America, and drive Europe out of a market which is naturally ours." Show that a very plausible argument can be made for the contention that we should be cutting off our own noses if we were to drive Europe out of the markets of South America. 20. "We are going to get from Germany an indemnity of forty or fifty billion dollars; but we are not going to let her utilize this fact to build up her industries again by exporting billions of dollars worth of goods to other countries. We shall take our indemnity in gold, not XVI] PRINCIPLE OF RECIPROCITY 219 goods." This was the sort of talk much heard in the Allied countries, particularly France, during the winter of 1918-1919. Show that, even if the Allies were to insist on being paid in gold, this would necessitate letting Germany export billions of dollars worth of her products, it being remembered that Germany has less than $300,000,000 in gold and is not a producer of that metal. CHAPTER XVII THE LAW OF COMPARATIVE COSTS We come now to a fundamental principle of trade which is somewhat more difficult than the two we have already considered, and yet is so fundamental as to call for treatment in this connection. It is commonly known as the Law of Comparative Costs. This principle may be looked on as a formal answer to the question: What condition must be fulfilled to make it worth our while to cooperate with our neighbors, individual or national, by engaging in trade with them? Not a few economists would very likely be disposed to affirm that there is really no necessity of answering the question in any other than the common-sense way. It is worth our while to trade with other communities when and only when their prices make it profitable to do so. "We can go deeper," he might say, "but we do not need to. There is no better index to the fulfil- ment of the deeper conditions necessary to make exchange-coopera- tion profitable than that given by comparative prices." How the Question Arises. This solution of our problem, however, meets serious difficulties. A great many people are con- vinced on personal grounds that it is not a good thing to have trade go just where it naturally would in view of price conditions; they usually want to shut out some goods which, if we had regard only for prices, we should naturally buy from other people. They find no difficulty, either, in adducing excellent reasons, of a political and social sort, why we should do this. But, in order to bolster up their cause they usually bring forward arguments which they be- lieve to be based on fundamental economic principles. They try to seek out some reason lying behind the surface fact of a favorable price, and this reason usually concerns our ability to produce for ourselves the thing we buy as well as, or better than, the country XVII] LAW OF COMPARATIVE COSTS 221 from which we buy it. If we can produce it more easily than the other people, we have a sure case for the wisdom of producing it ourselves. If we can produce it just as easily as the other people, the same conclusion is almost as certain. Even if we cannot produce it as easily but can only just produce it, many people are disposed to declare that we ought not to buy it from others. But these ideas are in part at least erroneous, and so the economist is forced to make a deeper analysis than would otherwise be necessary. Simplest Case. One condition under which trade between two countries would surely be profitable is that each country should be able to produce the commodity it sells at a cost which is abso- lutely smaller than its cost in the other country, meaning by cost, labor, waiting, and other primary factors. Thus, let us suppose that in country A broadcloth* is produced at a cost of only 3 days' labor (letting labor represent all real costs), while in country B it costs 4 days' ; and that, on the other hand, iron costs in country B only 1 6 days' labor, while it costs 18 days' in country A. That is, broadcloth is produced at smaller absolute cost in A ; iron at smaller absolute cost in B. Under these conditions, we will surely believe that A will profit by using broadcloth to buy iron from B ; and the latter will profit by using iron to buy broadcloth from A. But why will this be true? What is the real economic ex- planation of the matter ? For this we need to go a little deeper. If we look at the figures of our example from another standpoint, we note that the people of A spend only one-sixth as much labor on the cloth as on the iron ; while the people of B spent one-fourth as much on the former as on the latter. But it is a commonplace of business, though not yet treated in our discussion, that the com- parative prices of things must show at least a rough correspondence with their costs of production. It follows that, in country A, a yard of cloth will be worth only one-sixth as much as a ton of iron; while, in country B it will be worth one-fourth as much. Or, if we look at the matter primarily from the standpoint of iron, a ton of this will be worth, in A, six times as much as a yard of cloth ; while, in B, it will be worth only four times as much. In short, if each commodity be measured in terms of the other, broadcloth is much 222 PRINCIPLES OF ECONOMICS [XVII cheaper in A, iron much cheaper in B. It follows that B would profit by buying the cloth it wants in A, provided payment could be made in iron ; while A would profit by buying the iron it wants in B, provided payment could be made in cloth. But manifestly these two desirable possibilities exactly fit each other. B wants to use its iron to buy A's cloth ; and A wants to use its cloth to buy B's iron. Evidently, then, trade between the countries would be profitable under the condition assumed, namely, that each can pro- duce the commodity it exports more cheaply than the other can produce that commodity. Difference in Absolute Cost Unnecessary. It seems probable that the most important cases of profitable trade between different countries are included under the case just considered, each coun- try is superior in respect to the commodity it exports and inferior in respect to the commodity it imports. But, as was long ago brought out, this statement does not cover all cases, and is in fact misleading. If we stopped here the reader might very naturally conclude that trade would pay only when the condition just ex- plained was present, and that we ought never to buy a thing from other countries if we could produce that thing as, cheaply as those other countries. Case of the Individual. The unsoundness of the doctrine as applied to an individual is at once evident. Here, for example, is a lawyer who very likely can mow his lawn, cultivate his garden, and take care of his furnace much better than the person or persons whom he hires to do these things. Nevertheless, he devotes himself to the practice of his profession, and buys the services named from other people. And he of course acts wisely in doing so, for it is plain that he gains most by using his whole time and energy on the kind of work for which he is best fitted. He is not interested in the fitness or unfitness of his neighbor as compared with himself, but rather in the degree in which his own fitness in one line is greater than his fitness in another line. So long as he can find a market for his possible output, he would better devote his time entirely to doing the kind of work for which he is preeminently fitted, and get XVIII LAW OF COMPARATIVE COSTS 223 his supplies of other things from his neighbors, even though he can make those other things better than his neighbors. What the lawyer cares about is not whether he can produce the thing he buys less cheaply than the man from whom he buys it, but whether he can produce that thing which he himself sells more cheaply than he can produce the thing which it will buy for him. In other words, what is the cheapest way for him to get shoes to produce them himself or to produce legal services, sell these, and use the proceeds to buy shoes? It is his comparative efficiency in the two directions which determines his conduct. Put in another way, it is the comparative cost to himself of producing the two different commodities which determines whether he shall produce a given one or buy it. He naturally chooses to produce the one which has the lower cost to himself. Case of a Nation. Now, a community or nation is in this respect no different from an individual. England, let us say, pro- duces principally cloth, getting most other goods through exchange with outside communities. England is really better fitted to produce some of the things she buys than are the people who actually do produce them, and she is, moreover, perfectly well aware of the fact. But, like our lawyer, England, though superior to other coun- tries in many respects, confines her productive efforts to the industry or industries wherein she is most superior. The condition which makes her desire to trade is not a certain ratio between her own efficiency and that of other countries, but rather a certain ratio between her own efficiency in one industry put in terms of cost and her own efficiency put in terms of cost in other industries. But this alone would not make possible trade between England and other countries. These countries must also have a motive for wanting to trade. How is this possible ? England, we have assumed, is superior all along the line ; hence China must be assumed to be inferior all along the line. She is inferior in cloth, inferior in iron, inferior in potatoes. But while England, being universally superior, has a motive for trading, we must now find a motive for China, in spite of the fact that she is universally inferior. 224 PRINCIPLES OF ECONOMICS [XVII Though not so evident on the surface, this problem easily clears itself upon a little reflection. If China is inferior to England in respect to both cloth and iron, she will surely find an advantage in specializing where her inferiority is less. If she is three-fourths as efficient in producing iron, and only one-half as efficient in producing cloth, it will pay her to produce iron and buy cloth. Here again the matter which the country is interested in is, not the cost of each commodity at home, as compared with the cost abroad, but the comparative cost at home of the two commodities. Thus, both the country universally superior in production, and the one universally inferior, might have adequate motive for resort- ing to exchange. Before exchange could actually take place, of course, the particular exchange that is desirable for one country would have to be the same that is desirable for the other. The differences in comparative efficiency should be complemental to each other. If England is more efficient in the production of cloth than in the production of iron, while China is more efficient in the produc- tion of iron than in that of cloth, then it will be feasible for them to effect the specialization which would naturally be profitable to them; for the greater superiority of the one just fits the smaller inferiority of the other. By using its cloth to buy iron, England takes advantage of its greater superiority; while, by using iron to buy cloth, China takes advantage of its lesser inferiority. The principle which embodies the essential points brought out above has long been known as the Law of Comparative Costs. It may be formally stated as follows : Principle The Law of Comparative Cost. Broadly speaking, in order to make the exchange of two commodities between two countries profitable it is only necessary that the comparative cost of the commodity ex- ported by either of the two countries should be less in that country than in the importing country. Specific Proof. The general argument for this principle has perhaps been developed as fully as is necessary or desirable in the explanation leading up to its statement. However, it may be well XVII] LAW OF COMPARATIVE COSTS 225 to add a proof analogous to that just used in the case where each country was supposed to be superior in respect to the product it exported. Thus, let us change that hypothesis so as to make the cost of iron in A 30 days' labor and that of broadcloth in the same country 5 days', leaving costs in B the same as before: 16 days' and 4 days'. On this hypothesis, we shall have the same com- parative values of iron and cloth in each of the countries as under the former hypothesis. That is, iron will be worth 6 yards of cloth in A, and only 4 yards in B ; while cloth will be worth % of a ton of iron in B and only 1/6 in A. It will, therefore, pay the people of A to use their cloth to buy iron in B ; and will pay the people of B to use their iron to buy cloth in A. Thus the trade which was profitable to both under the first hypothesis continues to be so, though A is inferior, B superior, in both industries. Before leaving this topic one further comment should be added. We have all along spoken merely of the reciprocal trade of two countries. As a matter of fact, most international trade is not of any such directly reciprocal character it is triangular, or multi- angular. England sells cloth to Brazil ; Brazil sells beef and hides to America; America sells cotton and iron to England. At bottom, however, although a complete demonstration of the fact might prove very difficult, the cases of reciprocal and multiangular trade are substantially the same. The condition which makes specialization and exchange profitable is a difference between the comparative real costs to one country of the things exchanged and their comparative real costs to other countries. ILLUSTRATIVE PROBLEMS i. Country A can produce pig iron at a cost of 10 days' labor per ton and broadcloth at a cost of 5 days' labor per yard. Country B can produce the iron at a cost of 14 days' labor and the cloth at a cost of 6 days' labor. (a) What, in this example, are the comparative costs which our principle tells us must be unequal to make exchange pay? (b) Prove in detail that, if transportation and all costs other than labor be ignored, exchange of these two products will pay. (c) Which commodity will country A export? 226 PRINCIPLES OF ECONOMICS [XVII 2. Make a hypothetical case yourself and prove with it that ex- change will not pay if comparative costs are equal. 3. "We may often by trading with foreigners, obtain their commod- ities at a smaller expense of labor than they cost the foreigners them- selves." (a) Show with illustration that this is true. (b) Show how such a trade could be profitable to the foreigner. (c) What do you suppose is the ultimate cause which explains the fact that such trade can be profitable? 4. "We know that England can make ships more cheaply than we can, and so we should let her do the ship building and turn our capital to such things as we can do better than she can." Assuming the conclusion that we should turn our capital to other things to be correct, the reason given for it is not entirely satisfactory. Explain. 5. "It seems probable that Southern California would be very foolish to devote itself to raising wheat even if 'it could raise twice as much wheat per acre as any other district in the world." Why? CHAPTER XVIII SPECULATIVE TRADING AND INSURANCE In this chapter we purpose to comment briefly on two forms of economic activity a knowledge of which has not seemed quite essen- tial to the development of our study, but which, certainly, we ought not to ignore altogether. These are Speculative Trading and In- surance. Risk-Bearing a Necessary Function. It must be manifest by this time that risk, the risk of loss, both physical and economic, is an ever-present element in economic life. There is constant danger that goods shall undergo physical destruction or deterioration, and danger that the value the economic significance of goods shall decline. Now these risks, being ineradicable elements in economic life, individuals, or society as a whole, must in some way bear them. As has already been brought out again and again, a large number of the risks incident to productive activity are borne by the central figure in production, the entrepreneur. It has indeed been main- tained by some writers that not only the entrepreneur's greatest, but his only, function is the assumption of the risk of production. The position on this point taken in the present text has been some- what less extreme. We recognize that the assumption -of the re- sponsibility of production involves some other burdens as well as risk-taking, including some very general types of labor. Neverthe- less it must be admitted that the chief part of the entrepreneur's task or function is to bear risk. Types of Risk. Again, as has been explained in other con- nections, risks are chiefly of two types: (i) those which regularly recur and so are calculable and (2) those of irregular nature which cannot be reduced to any law of recurrence. The entrepreneur's 227 228 PRINCIPLES OF ECONOMICS [XVIII function in risk-bearing is especially connected with the second type. But he is not the only one who contributes to the bearing of this burden. In fact, no economic person can be completely rid of it; and one person especially, the man who engages in speculative trad- ing, shares in it very largely. Our first section, therefore, is given to an account of speculation or speculative trading. Speculative Trading Nature of Speculation. The nature of speculation can best be realized by contrasting it with related functions and operations. As already noted, speculation is akin to the function of the entre- preneur in that it assumes non-calculable risks. It differs, however, in that it frequently divorces this assumption of risk from owner- ship; whereas the distinctive mark of the risk -bearing of the entre- preneur is that he assumes that burden by the process of becoming the owner of the goods. He assembles the various productive ele- ments necessary for bringing a commodity into existence and accepts the responsibility from first to last, including the ownership of the products when completed. The speculator in the narrow sense does not necessarily do this; in fact, a very characteristic feature of his trading is the cutting apart of these two functions. Thus men who purchase wheat in large amounts and store it for sale at a future time commonly turn over to someone else the burden of bearing the risk of possible loss between the purchase and the sale of such wheat by selling against it other wheat for future delivery. Speculative Trading and an Ordinary Business. Again, spec- ulative trading is distinguished from ordinary or so-called legitimate business in that it expects to make a profit out of changes in the prices of commodities in the same market; whereas ordinary trade expects to get its profit out of price differences in different markets. To illustrate, the speculator in wheat on the Chicago market buys wheat today expecting to sell it at a later date in the same market when the price shall have advanced. He very likely sells to another person like himself who deals in the goods for the same purpose XVIII] SPECULATIVE TRADING AND INSURANCE 229 of making a profit through purchase and sale. In contrast with this we have ordinary or legitimate trading when a commission house buys wheat from someone really having it for disposal and sells that wheat, not to some other dealer, but to a miller who wishes to turn it into flour. That is, he buys in the wholesale dealers' market and sells in the millers' market. Between the prices of these two markets, there is a recognized and admittedly legitimate differ- ence at the same time. This .difference is the source of the profit to the dealer. Another way of characterizing legitimate or ordinary trade is to say that it carries the goods forward one stage on the way from the original producer to the ultimate consumer ; whereas speculation merely tosses it back and forth between dealers at the same stage, the wholesale market stage. It ought, perhaps, to be added to the above account of this matter that some admixture of speculative trading is often present in ordinary business or at any rate may be so present. Ordinary dealers of speculative temperament will every now and then load up with an unusually large stock of some commodity, the price of which, in their opinion, is likely to advance. This is in the strictest sense speculation, not what is commonly called legitimate business. Speculation and Gambling. We have distinguished the risk- bearing of the speculator from that of the entrepreneur and his type of dealing from that of the ordinary trader. We need also to dis- tinguish speculation from gambling with which it is often identified. Gambling, as pointed out in other connections, has, from the eco- nomic standpoint, this distinguishing mark : it involves the assump- tion of a needless risk. In many cases the risk is created for the occasion. For example, the gambler throws a pair of dice out of a box, betting on which side will turn up. On the other hand, gambling may take place in connection with chances which naturally exist, for example, in the outcome of some notable series of events, an election or a war. But although the chance is here of natural origin, the' assumption of economic risk with respect to that chance is not of natural origin. It is entirely artificial. It is, for the moment, uncertain whether Mr. Cox or Mr. Harding will be elected ; the uncertainty, the chance, is here anyhow ; but I am not 23 PRINCIPLES OF ECONOMICS [XVIII driven to assume any economic risk in connection with this uncer- tainty. In contrast with gambling, speculative trading not only involves inevitable uncertainty and chance, it also involves a neces- sary economic risk. The price of wheat may change between Septem- ber and March: In fact it is practically certain to change. No man experienced in such matters will anticipate the recurrence of pre- cisely the same price six months from date. This element of uncer- tainty or chance must necessarily entail loss to someone. If it should be a fall, the present owner will lose; if it should be a rise the persons who will need to purchase the wheat will inevitably lose. Speculation is, therefore, not gambling, but, within limits, the performance of a necessary economic function. Characteristics of Exchanges (Bourses) . The most thor- oughgoing forms of speculative trading are carried on in special markets, of which the wheat, cotton, and stock exchanges called bourses on the continent of Europe are the most conspicuous ex- amples. These markets have as their most notable characteristics the following: (1) Trading in common. The majority of the dealers taking part are brought together in one place at the same time; buyers competing with buyers and sellers with sellers. (2) Another characteristic is open-trading. There is no privacy as respects the dealings. The amounts, prices, and so on are at once announced and recorded by the proper officers. (3) The trading is through official dealers, brokers, as they are ordinarily called. (4) The dealings are usually on a very large scale. (5) The major part of the trading is speculative. There is, of course, some selling by persons who have produced the goods and brought them to the market for disposal, and so there are some persons who have come to the market to buy for actual use outside. This last is illustrated by men in the milling district who purchase their wheat supply in large amounts at these exchanges'. But the major part of the dealings, probably more than 90 per cent of them, are carried on by men who are engaged in speculation as such. By this is meant that they are not, if buyers, intending to make any XVIII] SPECULATIVE TRADING AND INSURANCE 231 use of the product, while, if sellers, they are not producers or ordinary middlemen who are bringing the goods to market. What they are doing is attempting to make a gain, if buyers, by getting at one price and presently selling at a higher one. If sellers, they have already purchased at a low price and are now reaping the gain resulting from the advance. Or they may be selling for future delivery, agreeing to deliver the goods at some future date, con- fident that they will be able to make the necessary purchases at the time of delivery at a lower price than that agreed upon. (6) This last statement suggests another characteristic of produce speculative trading, namely, dealing in futures. By this is meant nothing more than contracting to deliver or to accept at some future time a quantity of goods at a price now agreed upon. Such contracts for future delivery are of course present in all lines of business. We order a suit of clothes, we order wood, or coal, to be delivered at some future time; the contractor orders structural steel and lumber in advance of the time when he will need it. But the future trading of the speculative market differs from these cases in that it is not something occasional, growing out of a special need of the consumer or producer, but is systematically and con- stantly entered into for the sake of the possible profits to be obtained, or for some other ends which will be explained in a moment. Technique of Speculative Market. It may contribute to our understanding of this matter to note some of the technique of the speculative market. As stated above, the dealers directly concerned in the processes of buying and selling are known as brokers, and they are constantly taking and fulfilling orders. (The brokers, however, are usually supposed to refrain from personal dealings, and to buy or sell only on the account of other persons.) The real dealer in the transaction is commonly some outside party, perhaps located in a remote city. Some of the dealers on the market habitually deal with the ex- pectation of making a profit from a rise in prices ; that is, they buy today with the intention of selling later when prices have advanced. They are known as bull speculators, or simply bulls. In contrast, some dealers habitually anticipate and deal with an eye to a fall in 232 PRINCIPLES OF ECONOMICS [XVIII prices. Such dealers sell for future delivery, "go short," is the expression frequently used. They agree to deliver certain goods which they do not at the present moment own. Dealers of this type are known as bear speculators, or simply bears. A special feature of short selling on the stock market 'is the borrowing of stock. On most stock exchanges, in this country at least, the rules require the delivery of the goods sold within twenty- four hours. By hypothesis, however, the dealer is not in possession of those goods. It, therefore, becomes necessary that he should borrow from those persons who do own the required stock. As a rule, he has no difficulty doing this because the owners are glad to be released of the burden of interest-bearing which ownership involves. Circumstances may arise, however, under which the de- mand for stock to deliver on short sales is so great that it is prac- tically impossible to find enough stock to meet the emergency. The result in this case is a crisis to the bears in which great sums are lost. Marginal Trading. Another bit of technique of importance is the so-called margins and marginal trading. Everywhere in busi- ness life there is dealing on borrowed capital. Probably the majority of traders in all highly-developed countries depend on the capital of other people for a considerable part of that which is needed in their business. They borrow outright from capitalists on personal notes, or they meet any particular bill from wholesalers by raising a special sum for that emergency. Essentially the case is no differ- ent in margin trading on exchange. That is, the purchaser wishes to buy five hundred shares of Pennsylvania stock and has not more than a tenth of the capital necessary to do so. He naturally desires to borrow the rest of the money needed from someone else. This is particularly easy in stock transactions or speculative transactions generally for the reason that the security is readily realized upon and very efficient machinery for facilitating the process has been built up. The man who wishes to make such a purchase, therefore, de- posits with his broker that portion of the purchase price which he himself expects to pay, authorizing the broker to borrow the rest of the money needed. The sum which he deposits with his broker XVIII] SPECULATIVE TRADING AND INSURANCE 233 to cover his part of the money advanced is called a margin and trading of this type is known as marginal trading. As explained above, this borrowing is in essence no different from borrowing in other lines of business. In practice, however, it is a more dangerous type. This is partly, of course, due to the more dangerous character of the business. In addition, the facilities given tempt dealers to go into the speculation on a much larger scale than their own capital will warrant. It is always provided that the broker can dispose of the stock he holds as security for the loan whenever his client fails to maintain his margin, and this of .course makes that broker perfectly willing to lend to the limit of reason- ableness. The last remark suggests two or three other technical phrases employed in speculative trading. To keep up one's margin is to send in more money if at any time the change in the value of the stock makes the previous margin inadequate. So when the broker realizes on the loan he has made by selling the stock of his client he is said to close him out. Functions of Speculative Trading. We have seen that speculative trading is one of the several methods by which the risk burden incident to all economic life is borne. 1 And this risk-bearing naturally would be thought of as the primary function of specu- lative trading. A second, perhaps equally important, function is maintaining conditions for the determination of the right price. Let us now consider more carefully these two functions in detail. The Risk-Bearing Function Illustrated. The way in which speculation carries out its primary function of assuming the burden of risk-bearing is best illustrated in the wheat business. As already remarked, it is inevitable that there should be losses unmerited and gains unmerited from changes in the price of any commodity from one part of the year to another. Further, there will be persons in the community who are not fit to assume this burden, although so situated that they will be forced to do so unless some device is 1 From the standpoint of society at large it is a cheap and efficient method of bearing these risks. 234 PRINCIPLES OF ECONOMICS [XVIII created whereby the burden can be unloaded. Thus, millers must have wheat, and they must buy it considerably in advance of the time when they can market the flour made from that wheat. But in the interim the price of wheat may fall greatly and as a result the price of flour will fall. The millers will therefore be liable to a serious loss growing out of this possible change in prices. It might be argued that this is only one of the inevitable burdens of their particular function in industrial life and so they ought to bear it without murmur. A very characteristic feature, however, of modern industrial life is extreme' specialization, the working out of devices whereby the different burdens of productive activity can be separated and assigned to different agents. Now the miller has as his primary function the turning of wheat into flour. It is his performance of this service that entitles him to a living. He has no ambition to speculate in wheat as such, to make a living by dealing in this commodity so subject to changing prices. He would there- fore be glad to utilize some device whereby this part of the burden would be thrown onto someone else. The wheat exchange fills his need exactly. He wishes to buy, let us say, ten thousand bushels of wheat to be turned into flour in the course of the next few months. Accordingly, he gives an order to a broker on the Chicago exchange for that amount of cash wheat, that is, of wheat to be delivered at once. At the same time he orders the broker to sell for future delivery at the date when he expects to have his flour ready for the market, ten thousand bushels of wheat, the price being fixed at the present moment, in relation to the present price of cash wheat. In the fall of the year this will mean a higher price for future deliveries because of the cost of storing, insurance and interest on the investment. Now when the future period comes he will get for the ten thousand bushels of wheat the price agreed upon anyhow. If, in order to meet this sale that he has made, he has to pay a higher price than was antici- pated, he loses on the deal, but makes a corresponding amount from the advance of his flour. On the other hand, if at that time he is able to buy in the wheat for delivery at a lower price, he gains on this future deal, but loses on the flour which has fallen because of the fall of wheat. In short, the net resultant of the whole transac- XVIII1 SPECULATIVE TRADING AND INSURANCE 235 tion is that he neither gains nor loses by changes in the price of wheat. He is thus limited to what he calls legitimate business, the milling business, the turning of wheat into flour. Out of that he makes his living and leaves other people to speculate in wheat. It will contribute to a better understanding of this explanation to follow an imaginary transaction in detail. Let us suppose that our milling company sets out to supply itself with wheat at a time when that grain is quoted for immediate delivery at $i and for future delivery at $1.04. Our problem, then, is to determine by experiment what the result will be when the trans- action is quite ended for each of the different possibilities as to the price actually prevailing when the future deal is consummated. Manifestly, these possibilities will be covered by three hypotheses: a price at the future date exactly equal to the expected one, $1.04; any price higher than the expected one, say, $1.10; and any price lower than $1.04, say, $.90. The three tables following give the results for these three hypotheses in their order. Each time the net result is neither gain nor loss. TABLE I CASH WHEAT FUTURE Original cost $10,000 Cost $10,400 Storage, insurance, etc 400 Total cost $10,400 Value 10,400 Selling value 10,400 Gain or loss $00,000 Gain or loss $00,000 TABLE 2 CASH WHEAT FUTURE Total cost $10,400 Cost $11,000 Value 11,000 Selling value 10,400 Gain $ 600 Loss $ 600 TABLE 3 CASH WHEAT FUTURE Total cost $10,400 Cost $ 9,000 Value 9,000 Selling value 10,400 Loss $ 1,400 Gain $ 1,400 236 PRINCIPLES OF ECONOMICS [XVIII ILLUSTRATIVE PROBLEMS 1. A Liverpool miller buys through a Dutch commission house 30,000 bushels of wheat, paying 93 cents a bushel, and at the same time sells 30,000 bushels for May delivery, the price being 95/4 cents. (a) Assuming that 2j4 cents covers the cost (storage, insurance, and interest) of carrying the wheat from the date of purchase till May, show that the miller will lose nothing on the wheat even if by May the price should fall to 70 cents. (b) Would he gain if the price should rise to $1.10? Prove. (c) What did the word "carrying" in the second sentence of the problem mean? 2. "One of the most important functions of speculation is to hasten the working of the processes whereby production is adjusted to fluctuat- ing demand." Explain how speculation does this. Speculation and Right Price. We have explained the pri- mary, central function of speculation, the assumption of the risk burden of a particular type of economic activity. The second of the two functions mentioned above working out a proper price must be commented upon briefly. As already so often remarked, price is pre-eminently regulative mechanism of the present economic order. And we mean by right price that price which will regulate eco- nomic activity in accord with the demands of the situation as a whole. Now it is manifestly of the utmost importance that the right price should prevail. If there is likely to be a diminution of the acreage put into wheat because of the outbreak of the great war it is highly important that something should happen to induce countries unaffected by the war to increase the amount of wheat which they raise. But of course nothing can contribute so effectively to this result as an advance in the price of wheat, and that an early advance. But again nothing can so surely bring about this much-needed result as the efficient working of a great speculative market. In these great markets we have a large number of competing dealers on both sides, men of exceptional capacity, keenness, and knowledge, furnished with every facility for getting information regarding the probabilities of demand and production in all parts of the world. In consequence, if there is good reason to believe that XVIII] SPECULATIVE TRADING AND INSURANCE 237 prices should naturally change, that the conditions of demand and supply will create in the near future a much higher price, that higher price is likely to be brought into existence much sooner, much more completely than without such a market. This was exactly what happened in the summer of 1914 at the outbreak of the Great War. It happened again in the summer of 1916 when the failure of the new crop was in prospect, and it was just what ought to have hap- pened, although it was constantly misinterpreted and lamented by men in power who were too little informed with respect to the working of economic laws. The sharp advance in the price of wheat meant that the farmers who could produce winter wheat, which was to be sown in the fall of the year, would promptly im- prove their opportunity, would proceed to increase the acreage as rapidly as possible. A rise in price which had waited for months till after the consumer began to feel it clearly, would have been too late to bring the needed result. An advance in price brought about early; before any but the trained and well-informed speculator could anticipate the whole result, was just the thing which the situation called for. II Insurance: Its Nature and Functions Nature of Insurance. The essential nature of insurance con- sists in the pooling, putting into one mass, of a large number of risks. In other words, the many persons interested act, for this particular purpose, as if they constituted just one person. Thus, if the indi- vidual owners of a thousand houses desire to insure themselves against loss by fire, they proceed to act in the matter as if all the houses were owned by them as a group. If any house burns down, the group replaces it by contributions raised from all members of the group. Otherwise the houses are treated as if owned by individuals, but in this respect they are treated as if owned by the group. Now the function of this economic activity, this industry, if you please, is readily seen by considering the advantage derived from the practice indicated. If, in the illustration, we suppose each house to be worth $2,000, then without such pooling as insurance pro- 238 PRINCIPLES OF ECONOMICS [XVIII vides, the burning of one of these houses would mean a total loss to the owner, a loss of $2,000. On the other hand, if pooling takes place, the result of the fire is that each owner loses $2. The ad- vantage of such a procedure, supposing only a few houses burn down, is manifest. Each owner is, indeed, obliged to lose something. But this amount is quite small and in exchange for it he is saved from the risk of losing his whole $2,000. In other words, the individual's advantage from insurance may be summarized as the substitution of a series of small, though certain, losses for the chance of a great loss. 2 But this means that insurance makes less burdensome to the individual the risk incident to economic ownership. Accord- ingly, the function of insurance is to secure the easier bearing of risk. All Insurance Mutual. The preceding account seemed to deal only with what is called mutual insurance, insurance in which the parties insured are responsible for the procedure, manage the whole business. But most insurance, as we know, is not technically of this character. Instead, it is undertaken by a great corporation which "sells" insurance, as the agent would say, as other corpora- tions sell gas and electricity. Has our account covered this, case? Surely, yes. In essence, all insurance is mutual. The fund from which the company makes good the losses to householders whose houses burn in reality comes not from the company, but from all the householders. If these were not making regular payments adequate to cover the total losses of the group, the company would have nothing to pay. The only difference between this case and that of strict mutual insurance is one of management, procedure. In the latter, the insured householders organize to manage the business themselves, accepting all the responsibilities and burdens. In the former case, speculative insurance it is often called, a corporate entrepreneur undertakes to carry out the plan, assume all the responsibilities, and do the necessary work. The essence of the matter, as before, is the "This surely is a social as well as individual advantage. The strain upon industry, the loss of efficiency due to the falling of a great loss upon a single individual is much greater than that of a trifling loss experienced by many individuals. XVIII] SPECULATIVE TRADING AND INSURANCE 239 pooling of risks, the acting as one owner in respect to the burden of ownership. It should be said also that while the foregoing account of in- surance dealt only with loss from fire, an exactly similar analysis would fit the case for insurance ^against any type of economic loss, for example, cyclone, shipwreck, collision, etc. What Risks Insurable. The last remark suggests that we need some comment on the question : Under what conditions is the insurance principle, the principle of pooling risks in order to diminish their economic burden, applicable? The answer is this: the insur- ance principle can be used wherever risks are fairly calculable. If we can prove statistically that, when any large body of losses are taken together, the per cent of loss is only moderately high, and fairly regular, insurance is feasible. Doubtless this is a somewhat vague rule; but it has answered in the building up of great busi- nesses. With the improvements in statistical art, and the enlarge- ment of the pools, it has been possible to extend the operation of this industry more and more widely ; and doubtless we have not yet seen the end of its development. Life and Endowment Insurance. Thus far we have had in mind only insurance against direct loss, for example, fire insurance, tornado insurance, burglar insurance. But the student is aware that very important forms of insurance are so-called life and endow- ment insurance. Are these to be explained in the same way? In the main, yes. In one respect, however, they obviously differ from the cases already considered. The payments made to the insured or his family are not intended to cover losses incurred. They rather represent savings, accumulations of capital, which he has made or is treated as having made. The payments which the insured makes to the officers of the association or company premiums consist, in the cases already considered, of two parts, (i) a real insurance premium, his share of the losses incurred, and (2) his share of the costs of carrying on the business. In life or endowment in- surance, the major part of the payment is different from either of these. It is savings deposit, money accumulated and placed in the 240 PRINCIPLES OF ECONOMICS [XVIII hands of the company as if it were a savings hank. The insurance element in his payments is so much as is needed to cover the risk that he will not live and save long enough to accumulate the full amount he has set out to save and for which he is insured. The insuring company or association is concerned with knowing how many payments he is likely to make, which is usually the same as saying how many years he will live. Their statistics concern the average longevity of men in his class ; the statistics of the com- panies concerned in fire insurance concern the probable number of houses of certain types which will burn in a given period. Within the memory of people still living, not a few persons of intelligence and standing were wont to look on insurance, par- ticularly life insurance, as a form of gambling. 3 What has been said ought to convince us of the unsoundness of this opinion. In- surance manifestly performs a very real service. It does easily and cheaply something which must be done. Risk cannot be eliminated from economic relations. It must be borne. Our only freedom of choice concerns the method of bearing it. Insurance is surely the best one yet devised. ILLUSTRATIVE PROBLEMS 1. Suppose 1,000 owners of 1,000 buildings worth each $7,000 wish to insure themselves against fire. If the risk for the class of buildings involved is such that 7 out of 1,000 burn down each year, what annual payment from each owner would be necessary to insure all against total loss, expenses of management, interest, etc., being ignored? 2. Suppose 1,000 persons propose each to save for his family before his death, $2,000. All are twenty-five years of age. Knowing that any- one is liable to die before he has had time to save so much, they combine to insure one another that $2,000 shall be ready for the family even if death comes before that sum has been regularly accumulated. Assum- ing that the organization is continuous, new members joining as old ones * In one notable case, the spirit and even the practice of gambling has not been kept out of connection with legitimate insurance. This is the great Marine Insurance Association known as Lloyds of London. Here men are able to put up bets on any conceivable event without any admixture of necessity or social gain to make it a legitimate economic operation. XVIII] SPECULATIVE TRADING AND INSURANCE 241 pass away, and, assuming the average death rate to be 18 in 1,000, what annual payment would each one need to make, expenses of management, interest, etc., being ignored? 3. Suppose that a certain corporation owns 500 buildings worth each $100,000; that to insure in an ordinary company would cost the cor- poration $250 a year on each building; and that the corporation is con- vinced that by an annual expenditure of $10,000 the fire loss can be re- duced to an average of one building every three years. Under these conditions, would it pay the corporation to insure with some company ? Prove. CHAPTER XIX VALUE AND PRICE: PRELIMINARY With the present chapter we begin the study of value and price, a topic which, as indicated in an earlier connection, consti- tutes the very heart of economic science. This topic will continue to form the subject of our study during the seven chapters follow- ing in fact, it will receive much of our attention throughout the remainder of the text. In this chapter we shall confine ourselves to some preliminary topics. Economic Value. The fundamental idea which in this text is usually attached to the phrase "Economic Value," and not in- frequently to the word "value" standing alone, was brought out in our opening chapter. Economic value is the property of having definitely mensurable and effective worth, the property of making the thing to which it attaches conduct-determining in a definitely mensurable fashion. As thus conceived, the word does not carry any suggestion of power in exchange.. From our present point of view, the latter property is only a manifestation of economic value in the more fundamental sense. Economic value, as thus under- stood, would be present in the economic life of a Crusoe, though exchange, and so exchange value, would be completely shut out by the circumstances of the case. For the same reason, this would also be the conception of economic value appropriate to a communistic system of economic organization. In our study of the present economic order, we need this deeper conception of economic value to help us both in getting a more adequate comprehension of exchange value and in supplying our- selves with a standard for judging whether or not the present system of price determination is working properly. For this second purpose, however, we need the broader concept of value as modified 242 XIX] VALUE AND PRICE: PRELIMINARY 243 by the adjective "real." By real value we mean the value attaching to things in view of all the fundamental facts of the situation, momentary, accidental elements being ignored. It is the value which most persons would say ought to be embodied in the actual prices of the market, though all would agree that this result is seldom or never precisely attained. It may also be conceived as the value which the government of a communistic order would endeavor to make their guide in regulating the economic action of the community, in trying to insure that the productive resources at their disposal were utilized to the very best advantage. Valuations. When any person comes to realize that his wel- fare is dependent upon the possession of particular units of any good, that is, when he realizes that each unit of such a good has effective importance for him, he inevitably comes to take a certain psychological attitude toward it, he prizes it or sets store by it. 1 Further he estimates the degree to which he prizes it, the degree to which it seems to him important, essential to his welfare, in terms of some measuring unit, usually money. This process we call evaluation ; and the estimates themselves, we call valuations. These valuations, obviously, must play a very important part in the processes by which value or price is determined, if the desires of the persons who are to consume goods are to be taken into account. As we shall see in a later chapter, these valuations vary with the quantity of the commodity in question 'which the person interested con- ceives himself to have in possession; and these different valuations, corresponding to differences in quantity, together make up what we call his valuation schedule, which in turn helps to determine what we call his demand schedule. Price. This concept of valuation brings us to another of very great importance in this connection, price. The valuations of the buyer's schedule, looked at as sums of money which he is in effect offering to pay for the goods in question, are prices. That 1 The property or state of being thus prized is sometimes designated subjective value. 244 PRINCIPLES OF ECONOMICS [XIX is, a price in this connection is a sum of money which is being offered for a unit of the goods under consideration. This concept, price, also appears when we approach the matter from the stand- point of those who wish to sell the commodity in question. That is, price includes the idea of a sum of money for which sellers actually offer to exchange a unit of some given commodity. Again, we apply the designation, price, to the sum of money which actually passes from buyer to seller in a specific transaction. In all these three cases, there is reference to an actual transaction, though in the first two cases, the transaction is merely contemplated, not consum- mated; and, in most good usage, this reference to an actual transac- tion, contemplated or consummated, is an essential element in the con- cept. For example, if, in speaking of a particular object, say a residence, we have in mind nothing more than what informed per- sons would consider its real worth, a reasonable price for it, we say that its value, not its price, is so and so. We speak of the price of that residence only when we are thinking of a figure at which the owner has offered to sell it, or at which someone has offered to buy it, or at which it has actually changed hands. A further mark of price is that it is concerned with a single conventional unit of the commodity, not with an aggregate. We speak of the price of a bushel of wheat; but not of the price of the wheat crop of the United States. For this latter purpose, the term value is used, and means simply the price multiplied by the total number of units. ILLUSTRATIVE PROBLEM It is not uncommon to find in economic textbooks the statement that price is exchange value expressed in terms of money. Do you suppose that the author of such a text would say that the annual gold product of the United States has a price of ninety million dollars? How would he probably express the fact? Exchange Value. A fourth concept which seems essential to an adequate theory of value is exchange value. By this we mean the property belonging to economic goods of being able to command in exchange other economic goods. Though, as already remarked, XIX] VALUE AND PRICE: PRELIMINARY 245 this is really no more than a special manifestation of economic value in the fundamental sense, under the present order it is char- acteristic of practically all economic goods, and, therefore, is most usually in our minds when we employ the word value alone. Thus, in interpreting the antithesis brought out under the last heading be- tween value and price, we ought probably to understand by value, not the fundamental concept explained under the phrase "economic value," but rather exchange value. For example, when the statisti- cian says that the value of the corn crop of 1900 was seven hundred and fifty million dollars, we understand this to mean that this sum was what the crop of two billion bushels would presumably have brought on the market, a particular price being assumed for the pur- pose of making this computation. The Scope of Value Theory. The chief general task of value theory is to ascertain the causes and principles which regulate value and price, though it is usual also to give considerable attention to the origin of value and price. In this text, comment on the latter topic is chiefly incidental. The problem of value and price de- termination, taken by itself, is of very broad scope, including much more than we can hope to cover. In fact, one might say with pro- priety that a really complete theory of value would consist of a group of theories, each devoted to the topic developed in one special way. For example, it would be very natural to undertake to work out (i) a theory of real values from the standpoint of the individual, (2) a theory of real values from the standpoint of society, (3) an abstract theory of competitive prices prices under an order of free private initiative like the present one, (4) a concrete theory of competitive prices under the present order prices as they actually work out under the present order, (5) a theory of values under communism, (6) a theory of prices under a socialistic order, and so on. As a matter of fact, traces of all the types of theory specifically named above are present in most economic treatises, though often probably without clear recognition by the author himself. The particular one of these which avowedly occupies the principal place in economic texts is the third, the abstract theory of competitive 246 PRINCIPLES OF ECONOMICS [XIX prices, though this is usually preceded or accompanied by discus- sions belonging under the first theory. Incidentally, the second, the theory of real social values, receives some attention, particularly when the author is trying to pass judgment on the satisfactoriness of the present economic order. The fourth point of view is im- plicit in the comments usually made with respect to discrepancies between the working of things as represented in the abstract theory of competitive prices and their actual working. In like manner, notions belonging to a value theory for communism or socialism not infrequently appear in the course of a discussion of our present topic. As noted above, however, the major part of the conven- tional treatment of our present topic belongs to the third type of value theory, that is, the abstract theory of competitive prices; and this statement will be true of the present text. The Abstract Theory of Competitive Prices. By an abstract theory of competitive prices, we mean a theory which confines its attention to a few of the major causes and conditions at work in a competitive society like ours, and, on the basis of these, works out a body of principles with respect to the determination of prices in such an order when perfectly realizing the conditions proposed. It should be added that this type of value theory is not only abstract, in that it limits our attention to a portion of the causes and con- ditions present; it is also hypothetical, in that it assumes a greater degree of uniformity in the forces and conditions which it retains than actually exists in the real world. As already indicated, the treatment of value in the present text follows this conventional line. That is, the main discussion will be concerned with the abstract theory of competitive prices, and that even more completely than is usual ; but matters belonging to other bodies of value theory will appear at various points. Definition of Market. A concept quite necessary in the study of value or price is represented by the word "market." By this we mean a total constituted by a group of freely and directly com- peting sellers or buyers over against a coordinate group, of freely and directly competing buyers or sellers. Here some careful ex- XIX] VALUE AND PRICE: PRELIMINARY 247 planation is needed. The phrase "directly competing" in the above definition is intended to bring out the idea that the sellers or buyers of a given commodity, say, coffee, are not all members of the same market. Thus, the importers of coffee, the jobbers distributing it to retailers, the retailers selling it to consumers, though all sellers of coffee, do not as sellers belong to the same coffee market. The first belong to the coffee market constituted by themselves as sellers and the jobbers as buyers, the importers' market. In turn, the job- bers, looked at as sellers, belong to the market constituted by them- selves as sellers and the retailers as buyers, the wholesale market. In turn, the retailers, as sellers, belong to the market made up by themselves as sellers and consumers as buyers, the retail market. The above statement must not of course be understood as deny- ing that the sellers in the importers' market have an influence on the price of coffee in the wholesale market, or that the sellers in the wholesale market have an influence on the price in the retail market. On the contrary, in each case, such influence is very great or even decisive. This influence, however, is only indirect, being affected through the buyers in the particular market under consideration, who in turn become sellers in the next market. Thus, jobbers, though not members of the retail market, influence the price in the market by helping to determine the price at which retailers are willing to sell. This way of looking at the matter explains the phrase in our above definition "directly competing." That is, the sellers or buyers who are directly competing in any particular market form a part of the group of sellers or the group of buyers who truly belong to that market. The preceding explanation with respect to the distinction be- tween the buyers or sellers of a given commodity in one market and the buyers or sellers of that commodity in another market, shows the necessity for the phrase "coordinate group" which ap- pears in our definition. The only proper course, surely, is to combine the selling group of the importers' market with the buy- ing group of that same 'market, not with the buying group of the wholesale market nor with that of the retail market. It should be noted that the above definition of market omits any reference to a specific place. Though a market usually has a 24 g PRINCIPLES OF ECONOMICS [XIX location, the really essential element in it is rather a threefold set of relations: (i) those among the sellers, (2) those among the buyers, and (3) those between the two groups over against each other. If men in Chicago, Detroit, and Duluth are freely competing with each other in selling wheat to the same general group of buyers, they belong to the same market though located in widely separated cities. On the other hand, if two persons living in the same city and both selling coffee are after all dealing with different groups of buyers, they do not belong to the same market. Thus, Mr, For- syth, a resident of Poughkeepsie, who sells to jobbers coffee which he imports from Brazil, does not belong to the same market as Mr. Sanders, another resident of Poughkeepsie, who retails coffee to consumers in that city. Competition. In an earlier chapter we made some reference to competition, defining it in a general way as the striving for the same prizes, the pursuit of the same opportunities, by similar units. It is not necessary to repeat any large part of those earlier com- ments; but, in view of the fact that competition comes to a focus, so to speak, in the field with which we are now concerned, the determining of prices it seems desirable to introduce one or two comments here. Competition is between Units of Same Group. First, let us once more remind ourselves of one of the most fundamental features of true competition, namely, that, as in all cases of true rivalry, the competing persons must function in the same general way. Buyers are competing with other buyers, not with sellers ; sellers are competing with other sellers, not with buyers. The applicants for a job with the Michigan Central Railway Company are com- peting with one another, not with the railway company. So the railway company is competing, not with the applicants, but with other employers of such types of labor. Doubtless the successful applicant and the company will each try ' to gain some economic advantage at the expense of the other, the applicant to get higher, the company to pay lower, wages than the market justifies. But this antagonistic striving is not competition. It belongs rather to XIX] VALUE AND PRICE: PRELIMINARY 249 another line of action, namely, bargaining, the process through which seller and buyer come to an agreement. Involves Action of Opposite Group. A second comment with respect to competition which it seems desirable to make is that, in a sense, full competition on the part of the persons belonging to either group buyers or sellers really involves some action on the part of the members of the other group. Strictly speaking, the competi- tion of sellers is only partial, not truly complete, unless every seller really gets his bid or offer before every buyer. So the com- petition of buyers is not complete, unless every buyer gets his bid or offer before every seller. Since the utmost effort on the part of sellers would never suffice to get their offers before all buyers, unless the latter did something to help in the process, we may say that competition could not be even approximately complete, unless the buyers contributed to the result. So, since the utmost probable effort on the part of buyers could scarcely suffice to get their bids before all sellers, unless the latter did something to help in the process, competition on the buyers' side could not be complete, unless sellers contributed in some degree to the result. In other words, complete competition within either group requires that there shall be alertness, openness of mind, and enterprise in the opposite group. Assumptions. The abstract and hypothetical character of value theory has already been remarked. We start with a few assumptions respecting the causes and conditions present and respect- ing their uniformity of action ; and, on the basis of these assumptions, work out a body of doctrine with respect to the processes and principles by which prices are determined. Let us now give a moment to comment upon the assumptions which are actually em- ployed by the economists in connection with this task. A Purely Economic Individual. We assume, first, that each man taking part in the exchange process is an ideal or perfect economic man. His feelings and motives are predominantly, if not wholly, concerned with getting the maximum of satisfactions for himself, and they consistently remain so from day to day and year 2 5 o PRINCIPLES OF ECONOMICS [XIX to year, all other motives such as charity and sympathy being shut out. The man has also full knowledge of market conditions and excellent, not to say perfect, judgment in making decisions. And his actions are entirely free of caprice, passion, and prejudice, so that he would naturally buy always in the cheapest market and sell in the dearest. A Perfect Market. The assumption of a perfect economic man naturally carries with it the assumption of a perfect market where the man's operations are performed. In this market every seller is -supposed to be successful in putting before every buyer the particular opportunity he is offering, and every buyer is sup- posed to be successful in putting before every seller the opportunity which his desire to purchase creates. . In other words, perfect com- petition is present in such a market. The most essential features of such a market would be, first, extensive and efficient means of gaining information and disseminating it among buyers and sellers, and, second, conditions favorable for allowing men to act ration- ally on the information received. Finally, this perfect economic man in the perfect market is supposed to carry the principle of competition to its logical conclusion to continue competing so long as there is a surplus of immediate economic advantage over the sacrifices made. Perfect Competition Is Not Unlimited Competition. At this point, however, it is important to note that the perfect competition of economic science does not involve the idea of a competition which is without limits, a competition which defeats one's rivals at whatever the cost. It does not include such conduct as underselling a rival even at a loss in order to accomplish some ulterior purpose, for example, to punish him for a personal injury or to drive him out of business. The competition of economics is a competition which is directed to the gaining of an economic advantage derivable from the opportunity to make a particular sale or purchase. This means that, on the one hand, the seller will continue to lower his price until he gets for his commodity no more than it costs him (including a profit to himself), but no longer than this; and, on the other hand. XIX] VALUE AND PRICE: PRELIMINARY 251 that the buyer will continue to raise his bid until he pays for the commodity as much as it is worth to him, but no longer. It is only on competition when understood in this sense, that the principles of price to be explained in the following chapters are founded. They assume that competition will always cease when the immediate economic gain is completely eliminated. Cut-throat competition, predatory competition, to use a term having much vogue in recent years, is not included in the competition of economic theory. Discrepancies between These Assumptions and Reality. Now, as everyone knows, the ideal conditions described are never fully realized in any actual exchange situation. Men are influenced by motives other than the economic, their knowledge and judgment are imperfect and their actions incon- sistent. The perfect market, too, is rarely if ever to be found. The great exchanges which provide our nearest approach to it, have ample means of disseminating information ; but they often fall short in other respects, because the excitement, the rumors, the tendency to imitation these and other conditions which flourish among a large number of men gathered in the same room cause buyers and sellers to act without rationality. Moreover, we know that the pure competition of the economic hypothesis is only partially realized, being at times replaced by monopoly on the one hand or unbridled competition on the other. Legitimacy of Our Procedure. But, although these ideal conditions are never entirely realized, we are compelled, if we wish to make any progress at all in our science, to accept them as the fundamental basis of our reasoning. The human intellect is of but limited reach and power ; and in economics, as in any other science, it is quite incapable of studying simultaneously all the forces at work, or all the varying intensities of even one force. We have to study the different forces separately and under simplified condi- tions, eliminating many elements and assuming a fictitious purity and uniformity in those retained. It should be added, however, that if this is the only way to make progress, it is in economics, as in other sciences, a perfectly feasible way. It enables us first 252 PRINCIPLES OF ECONOMICS [XIX to gain a knowledge of fundamental principles, uncon fused by ex- ceptions. When we undertake to apply the principles in actual life, it may be necessary again to take into account the various forces from which our attention has been abstracted in the purely eco- nomic analysis. But after all, exceptions to the principles are much less important than the principles themselves; and, anyway, we cannot even begin to understand the former until the latter come to hold an assured place in our minds. However abstract, there- fore, however dependent upon imperfect or unreal hypotheses, the principles constitute the deepest, most vital facts in actual price- determination, and so must be fully mastered. CHAPTER XX MARKET DEMAND SCHEDULES It is a fact with which probably everyone has some acquaintance that the determination of price, in any but its most superficial aspect, is somehow a matter of demand and supply. Accordingly, we must now give some attention to these elements. The present chapter will be devoted to a study of demand. The Nature of Demand By the demand for any commodity, the economist means in general the quantity of that commodity which buyers stand ready to take at some specific price. In this definition let us emphasize, first, the point that demand is the amount which buyers stand ready to take, offer to take. That is, demand must not be confused with (i) the amount men want on the one hand, nor (2) the amount men actually buy on the other. Demand must not be confused with the amount of a commodity which men want. Mere want, mere desire, not backed by buying power and not brought to an issue in a decision to purchase if the price is satisfactory, does not con- stitute demand. The penniless man looking in at the baker's window, however hungry, adds nothing to the demand for bread. It is plain, of course, that men's needs, wants and plans play a vital role in determining demand. Thus, if an electric company is in- tending to use the water-power of the Huron River on a great scale for supplying current to Detroit and other cities, the company will need a large amount of copper wire, and so will doubtless come on the market to buy such wire. But while needs and plans constitute one condition of demand, they do not constitute demand 253 254 PRINCIPLES OF ECONOMICS [XX itself. Demand exists only when the company stands ready to buy the wire. But, if we take care not to confuse demand with the amount which people want or need, we must be equally careful to distinguish it from the amount actually bought. Demand in the correct sense might be characterized as potential demand; the amount bought, as realised demand. Of course, the amount of the commodity in question which was actually bought at a certain price must have been the same as the amount which men stood ready to buy at that price, else it would not have been bought. That is, realized demand and potential demand at a given price must be equal. But the meanings of the two expressions are very different; and this difference is of great importance. Potential demand, the amount of any commodity which men stand ready to take at each of many different prices plays, a very great part in determining what price will actually prevail. Realized demand, on the contrary, is determined by actual price rather than helping to determine it. A Conditioning Price. A second point in our definition which needs emphasis is the phrase "at some specific price." Every proper statement affirming the existence of a demand must explicitly or by implication represent this demand as conditioned on a 'certain price. Thus, it is proper to say, "The demand for silver at 55 cents per ounce is 120,000." It is not proper to say "The demand for silver is 120,000 ounces," leaving out the phrase "at 55 cents per ounce," except on condition that both the person making the remark and the one to whom it is addressed already have one particular price in mind, as for example, the price at which sales are actually being made at the time the statement appears. The grounds on which this contention rests are perhaps sufficiently evident. The affirma- tion that "the demand for silver is 120,000 ounces," strictly inter- preted, ought to mean that there is a demand for 120,000 ounces of silver whatever be the price. But, of course, no such affirmation could reasonably be made. Everyone knows without having studied economics that, if the demand for silver were 120,000 ounces when the price was 55 cents, it would be smaller were price to rise to 60 cents. Accuracy, therefore, requires us to specify a price XX] MARKET DEMAND SCHEDULES 255 whenever we affirm demand to be so and so ; though it is doubtless possible that, in any particular case, the conditioning price might be implied with sufficient clearness. Thus if any person familiar with business matters were to make a statement like the above, he would doubtless mean, and other persons would understand him to mean, that the demand for 120,000 ounces existed at the current market price or at some price approximately equal to the market price. But such carelessness of statement, trusting to mere im- plications, often misleads the uninformed and causes confused think- ing even with the trained student. One further point in explanation: Our definition implies that the relation between the volume of 'demand and the conditioning price is twofold. It means, first, that if price is the one named, the demand will be of the volume indicated, and secondly, that, only if price is as low as the one named, will demand be of the volume indicated. Accordingly, if we say that the demand for silver is 120,000 ounces at 55 cents, we should be understood as affirming both the following propositions: (a) If any person wishes to insure that demand shall not get as large as 120,000 ounces, he must insure that price does not go as low as 55 cents, (b) If any person wishes to insure that demand shall be as great as 120,000 ounces, he must insure that price does go as low as 55 cents. Demand Price. The point so strongly emphasized in the preceding paragraphs, that the appearance of a given demand is conditioned on the appearance of a given price, gives rise to a con- cept of much importance and one constantly in use, namely, that of "demand price." In the illustrations just used, 55 cents is as- sumed to be the demand price of 120,000 ounces of silver. This means that, if, and only if, the actual price were to become 55 cents, would the demand be 120,000 ounces. Further study will show us that at times this statement may seem to need qualification be- cause of the fact that demand may remain the same at several different prices, so that any one of these might seem to be the demand price, which would amount to saying that none was. It will become evident as we proceed, however, that, of these several prices, only one really conditions the appearance of the given de- 256 PRINCIPLES OF ECONOMICS [XX mand, and that, therefore, only one price is really the demand price of the given volume of demand. ILLUSTRATIVE PROBLEM "The demand for labor is almost always less than the amount offered." Criticize that method of statement. Remodel the statement in two or three different ways to show what the writer might have meant. II The Dependence of Demand on Price In the preceding discussion, it was shown that the quantity of demand is conditioned upon price. We must now explain this 40 80 120 160 200 1 i i i I i i i I i i i I i i i I i i i I i 55 Figure i. Demand Dependent on Price A conditioning more fully. Let us suppose that, on a certain day, the demand for silver at a price of 55 cents is just 120,000 ounces as in our last illustration. This quantity is represented in the accom- panying diagram by the shaded rectangle, the vertical scale at the left indicating the price in cents and the horizontal scale at the top indicating the number of ounces in thousands. The arrow at the left pointing from the figure 55 toward the rectangle is in- tended to bring out the idea that the price of 55 cents is the im- mediate condition or cause which insures that the demand shall be the amount indicated. Now, starting with this hypothesis that 120,000 ounces are demanded at 55 cents, we may be quite sure that the same persons who stand ready to buy that amount at the price stated, or, anyhow, some other persons, are ready to buy, have the mental attitude needed to induce them to buy, say, 10,000 ounces more at a price of 54 cents ; 40,000 ounces more at price of 53 cents; 80,000 ounces more at a price of 52 cents; and so on. That is, right alongside of the 120,000 demand which would be XX] MARKET DEMAND SCHEDULES 257 realized if a price of 55 cents were reached, and a part of the same general situation, we have various other potential demands which would just as surely be realized if lower prices were established. In Figure 2, we have these other demands presented along with de- mand at the 55-cent price. But, not only is it involved in the demand situation that larger amounts would be taken were the price lower than 55 cents; the complementary statement is also true. Given the present mental attitude of buyers, the amount demanded by them would be smaller if price were higher than 55 cents, instead of lower. Thus, some 40 80 120 160 200 1 I I I I I I I I I I I I I I I I I I I I I 66- 66 64- 63- 62- 51- E$$$^^$^^^ * ^^^^^^^ Figure 2. Demand Dependent on Price P. of the people whose offer to buy at 55 cents aggregated 120,000 ounces, would, if price rose to 56 cents, withdraw a part or all of their former demand; they, or others, would withdraw still more of that demand, if price rose to 57 cents; still more, if it rose to 58 cents; and so on. That is, as a part of the same general situa- tion from which we set out, we have a series of potential demands at prices above, as well as at prices below, the assumed one of 55 cents. Supposing these demands to be 110,000 ounces at 56 cents, 80,000 ounces at 57 cents, 40,000 at 58 cents, and so on, and com- bining them with the demands indicated in our last diagram, we should have the result represented in Figure 3. The Demand Schedule. We are now prepared to explain the meaning of a phrase which will be frequently used in the follow- ing pages, the phrase "demand schedule." Demand, as we have just seen, is always relative to a particular price stated or implied, 258 PRINCIPLES OF ECONOMICS [XX and the amount of demand, generally speaking, varies inversely though not proportionally to price: the lower the price, the greater the demand; the higher the price, the smaller the demand. It follows that the facts of demand at any time require for their ade- 40 80 120 160 200 1 I I I I I I I I I I I I l I I I I I I I I 69- 68- 67- 66- 55 54- 63- 62- 61- Figure 3. Demand Dependent on Price C quate statement a series of conditional propositions. Thus, the sup- posed case for silver would be most adequately stated as follows : The demand would be 40,000 oz. if price were as low as 58 cents The demand would be 80,000 oz. if, and only if, price were as low as 57 cents The demand would be 110,000 oz. if, and only if, price were as low as 56 cents The demand would be 120,000 oz. if, and only if, price were as low as 55 cents The demand would be 130,000 oz. if, and only if, price were as low as 54 cents The demand would be 160,000 oz. if, and only if, price were as low as 53 cents The demand would be 200,000 oz. if, and only if, price were as low as 52 cents Such a series of propositions, we call a demand schedule. In order to abridge the statement of it, we will put it in the form of two columns of figures with the proper headings, Price and Demand, as shown in Table i. The student must always remember, however, that it is, in effect, a series of conditional statements, such as those already given. A demand schedule of the general type just presented probably comes nearer to represent- ing the facts of experience than would a more symmetrical one. But as our purpose in using TABLE i PRICE CENTS 58 57 56 55 54 53 52 DEMAND ooo oz. 40 80 1 10 1 20 130 160 200 XX] MARKET DEMAND SCHEDULES 259 these schedules is primarily pedagogical, we shall change this one to a form which can be used more effectively in clearing up the theory of price. In this new schedule, the variations of demand consequent upon changes in price TABLE 2 are represented as uniform, 10,000 ounces in PRICE DEMAND each instance. Thus altered, and carried both CE ?^ S oz * higher and lower, our schedule will appear as 59 go in Table 2. In diagrammatic form it is pre- 58 90 A ' TT- 57 100 sented in Figure 4. 56 no 55 120 Real Changes in Demand. One further 53 I40 point which should be noted before we leave this immediate topic is a possible ambiguity in so 170 our use of such expressions as "demand has changed," "demand has increased," "demand has diminished," etc. Usually we mean, perhaps always ought to mean, that the whole de- mand schedule has changed, at each of the prices of the schedule, demand is different from what it was. Such a change is a real change in the demand situation and is sure to cause a change in price unless some other change in the conditions neutralizes this one. But not seldom people say that demand has changed, when they mean merely that another part of the existing demand schedule has been realised because actual price has changed and so fulfilled the con- dition necessary to make that part effective. Such a change is not really a change in demand at all. The total demand situation is just what it was before; since, as we have already indicated, the de- mand of any one moment is not just the demand at one particular price, but the whole series of demands at a series of prices, which demands and prices together embody or express the total demand situation. In order to avoid the ambiguity just referred to, it might be well to use the expression "the demand schedule has changed," when we mean that demand at the same prices has changed. As we shall see, a general change in the demand schedule, not in just one item of demand, is really necessary to bring about a change in price; and so this method of expression would be more adequate than any other. But it would probably be futile to attempt to make such 26o PRINCIPLES OF ECONOMICS [XX a change in usage. We must, therefore, be careful not to confuse the two possible meanings of "changes in demand." 55- 40 80 120 160 50- The Inverse Elasticity of Demand. Since the points estab- lished in the preceding discussion are of much importance in later connections, we will give them the emphasis derived from definite formulation in a principle. Principle Demand. -The Law of the Inverse Elasticity of Demand is always relative to a particular price ex- pressed or implied, and, broadly speaking, varies inversely as said price, though not proportionally. ILLUSTRATIVE PROBLEM "The statement 'price depends on supply and demand' is not the whole truth; it is equally true that 'supply and demand depend on price.' " XX] MARKET DEMAND SCHEDULES 2 6l Comment: The impression naturally received from the above state- ment that the two propositions contrasted are really coordinate proposi- tions, that supply and demand on the one hand and price on the other are reciprocally dependent is quite erroneous. The supply and demand which are dependent on price are not the supply and demand on which price is dependent. The latter are the supply and demand schedules, the total supply and demand situations of any moment; the former are the particular parts of a given supply or demand schedule which corre- spond to the different prices. An increase in supply (the supply schedule) will cause a fall in price, other things being equal. A fall in price, however, does not cause a real decrease in the supply (the supply sched- ule) ; it merely brings into operation a different part of the same un- changing supply schedule. Explain and defend that statement. Ill The Interpretation of Demand Schedules Demand Schedules Composite. As we shall have frequent occasion, during our study of the theory of price, to make a dis- criminating use of demand schedules, it is very important that, at the outset, we should gain familiarity with the true nature and significance of these schedules and their various parts. First, it is to be noted that demand at any particular price is a composite made up of many sections or increments, each one of which, except the last, would appear at some higher price. To clear this up, let us start with the lowest line in our demand schedule on page 259, the demand at 50 cents. Manifestly, this 170,000 ounces consists of the 10,000 which came in only when price fell to 50 cents, added to the 160,000 already wanted at 51 cents. But the 160,000 ounces, in turn, consists of the 10,000 which came in at 51 cents, added to the 150,000 already wanted at 52 cents. And the 150,000 ounces, again, is the 10,000 coming in at 52 cents added to the 140,000 wanted at 53 cents and so we might continue all the way to the top of the schedule. Accordingly, the 170,000 ounces wanted at 50 cents is the sum of all the increments of demand which would successively appear, if price were to pass through all stages from the highest to the lowest. The point just made is graphically pre- 262 PRINCIPLES OF ECONOMICS [XX sented in Figure 5, where the small letters represent the successive additions to demand which are supposed to appear at each price. Thus, q comes in at 50 cents itself ; p came down from 51 cents ; o, from 52 cents; n, from 53 cents; m, from 54 cents; /, from 55 cents ; and so on. Included and Excluded Increments. Another important mat- ter concerns the different divisions into which the various sections 40 80 120 160 65- 60- 1 1 1 a b c d e f g h i 3 k a b c d e f g h i j k ,1 a b c d e f g h i | k 1 3 a b c d e I g h i i k 1 m n 1 a b c d e f g h i j k 1 m n o a b c d e f g h i 3 k 1 m n o p a b c d e f g h i 3 k 1 m n o p q Figure 5. Demand Schedules Composite or increments of demand group themselves when any particular price has been established. The first break occurs between the excluded increments and the included ones. Thus, if price proves to be 55 cents, all the increments of demand which depend upon a price lower than this will, of course, be shut out; while all increments which depend upon this or a higher one will be included, for the man who was ready to buy at 56 cents or 57 cents or 58 cents will surely be in the same frame of mind if price falls to 55 cents. Marginal, Intra-Marginal, Extra-Marginal. A still more useful classification of the different increments of demand takes as its starting point a particular one of the included increments called the marginal increment and divides all others into two groups, one XX] MARKET DEMAND SCHEDULES 263 inside and one outside this marginal increment. The one chosen for our starting point the marginal increment is the last of the included ones, the last to appear when an actual price of 55 cents was being established. 1 In conceiving this idea, however, we should not emphasize the time aspect of the matter. For it is quite possible that, as a matter of fact, the marginal increment came in earlier than some of the other included ones, though it would not have done so had the conditions all been what they are now. That is, the real point involved is that the marginal increment is the in- crement which, in view of all the conditions present, would be expected to come in last, the one which the conditions at work would naturally cause to come in last. At what stage it did actually appear is a matter of no moment. This aspect of the case frequently leads the economist to substitute for this method of characterizing the marginal increment, one which represents it as the increment which would be the first to drop out if price should rise. Since we have chosen to designate the increment of demand which would naturally have come in last or would naturally go out first that is the increment which lies at the boundary line between included increments and excluded ones the marginal increment, we naturally designate all other included increments, all those inside the marginal one intra-marginal increments ; 2 while all ex- cluded ones all outside the marginal we call extra-marginal in- crements. As will appear in a later chapter, only two among all these various increments of demand play an immediate, direct part in the determination of price, namely: the marginal and first extra- marginal. The location of these various increments of demand is brought out in Figure 6. The rectangle opposite each price figure repre- sents the included demand, the demand which would appear if that price were established; the space beyond the rectangle included a It may help us to realize the true nature of this concept of marginal increment, as also several other very important concepts in which the marginal idea is present, if we think of the marginal increment as that one of the included increments which comes just before we are through them, just before we pass to the excluded ones. It is, so to speak, at the margin of the lake, just before we reach the shore. a Sometimes designated ,yM/>ra-marginal. 264 PRINCIPLES OF ECONOMICS [XX between the dotted lines represents the excluded demand, the demand which at a given price would be shut out. The demand excluded at any price is of course made up of demands which would appear at lower prices. The figure opposite the 55-cent price represents a condition of things brought about by an actual price of 55 cents. 40 80 120 160 60- 55- 50- 1 1 1 1 1 1 1 1 1 1 1 1 1 Figure 6. Increments of Demand Schedule Classified A The included demand is shaded as well as being bounded by the continuous lines; while the excluded demand is represented by the space between the heavy dotted lines. The square cut off from the right-hand end of the shaded rectangle and further marked by the inclosed square stands for the marginal increment of demand, the increment which last comes in when actual price becomes 55 cents. Since all demands outside this one are extra-marginal ones as well as excluded ones, the space between the dotted lines represents such extra-marginal demands. The square cut off from the left-hand end of this space and further distinguished by the inclosed circle XX] MARKET DEMAND SCHEDULES 265 represents the first extra-marginal increment of demand. This in- crement of demand is obviously the same as the one which would come in if actual price were to fall to 54 cents, that is, at 54 cents it would be the marginal increment of demand. It may therefore be represented in our diagram by the square cut off from the right- hand end of the 54-cent rectangle and having a small square in- 40 80 120 160 I I I I I I I I I I I I I I I I I 60 55 50 Figure 7. Increments of Demand Schedule Classified B scribed. Its representation in the 55-cent figure, however, brings out better its character as extra-marginal. Different Demand Prices. On page 256 it was explained that the particular price which was necessary to bring out any particular amount of demand is known as the demand price of that amount of demand. In the case before us, therefore, 55 cents is the demand price for 120,000 ounces of silver. But it is also plain that 55 cents is in a peculiar sense the demand price of the marginal 266 PRINCIPLES OF ECONOMICS [XX increment of demand, the 10,000 ounces which would come in only when price fell to that point. Being thus the demand price of the marginal increment of demand, it is very naturally called the mar- ginal demand price. In like manner, 54 cents, the price which would be necessary to bring out the first extra-marginal increment, the increment which would come in only if price fell to that point, is naturally called the first extra-marginal demand price. To give our ideas with respect to these de- DEMAND PRICE , . - . . . , . , . ooo oz. CENTS mand prices greater dejimteness, it is desirable 50 62 t deal with demand schedules in which demand 70 go is supposed to remain constant through several 80 59 prices; for such a schedule makes possible a go sharp separation of actual price, marginal de- 80 56 mand price, and first extra-marginal demand Qf\ C C 80 54 price. 3 A schedule of this sort is represented 9 53 in the accompanying table and in Figure 7, 100 52 , . . . ... IIO ej demand remaining just 00,000 ounces while actual price ranges from 59 cents down to 54 cents. Under this schedule, if actual price were 56 cents, the mar- ginal demand price would be 59 cents, since this is the price which brought in the last increment of demand; while the first extra- marginal demand price would be 53 cents, since this is the price necessary to bring in an extra-marginal increment of demand. Fur- ther, the marginal demand price would continue to be 59 cents, and the first extra-marginal demand price would still be 53 cents, so long as price was not more than 59 cents nor less than 54 cents. As a matter of course, we often have occasion to apply the terms marginal, extra-marginal, and intra-marginal to buyers. Marginal buyers are those who make some or all of their purchases only when, and because, actual price has fallen to the marginal demand price; or marginal buyers are those included buyers who would be the first to drop out of the market if the price should rise. In other words, the marginal buyers are the ones who are responsible for *As we shall learn in a later chapter, long-time demand schedules, schedules which sum up the demand facts for a whole period often show this peculiarity. XX] MARKET DEMAND SCHEDULES 267 the marginal increment of demand. So, the intra-marginal buyers are the ones responsible for the intra-marginal increments of de- mand. Their purchases would be assured, even if price were higher than it proves to be. The extra-marginal buyers are the ones responsible for the extra-marginal increments of demand. They make no purchases and are frequently called the excluded buyers. yypo . ILLUSTRATIVE PROBLEMS 1. Suppose that on the second Saturday of October a section of the demand schedule for wood in Ann Arbor is as follows : i cord wanted at $6 ; 2 at $5.75 ; 4 at $5.50 ; 3 more at $5.25 ; 3 more at $5 ; 7 more at $4.75 ; 8 more at $4.50 ; and so on. Put this into tabular form. 2. Suppose that the conditions of demand for Milton's autographs are such that i would be wanted if the price were $200; 2 if price were $175; 4 if $150; 5 if $140; 8 if $125; 9 if $110; DEMAND PRICE 12 if $100 ; 13 if $90; 15 if $75; and 20 if $50. ooo oz. CENTS Put this demand schedule into tabular form. 70 07 (If the problem had said: i wanted at $200; 7O 66 2 at $175; and so on, it would have meant the 7 65 same thing.) g 64 3. Suppose that the demand schedule for sil- I0 ^ 2 100 61 ver at a certain time is represented by the ac- IOO 50 companying table, answer the following : 100 59 107 58 120 57 (a) Interpret the first three lines; the last five I2O 55 lines. 120 55 (b) What would be the marginal increment of demand if actual price were 67 cents? 65 ^ 52 cents? 63 cents? 59 cents? 57 cents? 55 cents? i53 Si (c) What would be the first extra-marginal increment of demand if actual price were 66 cents ? 65 cents ? 61 cents ? 59 cents ? 54 cents ? (d) What would be the marginal demand price if actual price were 67 cents? 66 cents? 63 cents? 60 cents? 56 cents? 52 cents? (e) What would be the first extra-marginal demand price if the actual price were 65 cents ? 66 cents ? 67 cents ? 63 cents ? (f) Who would be the marginal buyers if actual price were 66 cents? 53 cents? 55 cents? 60 cents? 54 cents? (g) Who would be the first extra-marginal buyer if actual price were 66 cents? 65 cents? 61 cents? 58 cents? 56 cents? 52 cents? CHAPTER XXI MARKET SUPPLY SCHEDULES I The Nature of Supply We have considered one of the two most essential elements in price-determination, demand ; we must now take up the second, supply. In general, we shall understand the supply of any com- modity to mean the quantity of that commodity which sellers stand ready to dispose of at some specific price. Supply and Stock. Here we need to emphasize, first, the statement that supply is the amount which sellers stand ready to dis- pose of. In particular, the supply of anything should not be con- fused either (i) with the total amount in the hands of producers or dealers, or (2), on the other hand, with the amount actually sold. Supply should not be confused with the total amount in the hands of producers or dealers. This total we call stock; and only a part of it constitutes supply, so much of it as people stand ready to sell at some price or other. But, though stock is not the same as supply, it is of course the immediate source of supply, and, there- fore, does much in determining supply. On the one hand, it always sets an upward limit to supply. On the other hand, it exists only to become supply, and so must ultimately make supply as large as itself. The supply of wheat in the market today may be only 10,000,000 bushels, though the stock is 1,000,000,000 bushels; but, in the course of the season, most of the 1,000,000,000 bushels is bound to be offered for sale, and, therefore, taking the season as a whole, the supply is certain to become substantially coincident with the stock. 1 1 The distinction between stock and supply is more particularly applicable in the discussions of the next chapter. When we come to consider normal 268 XXI] MARKET SUPPLY SCHEDULES 269 Again, supply must not be confused with the amount actually sold. The reason is analogous to that which was given to show that we should not confuse demand with the amount bought. As a matter of fact, "the amount which people stand ready to dispose of" may be, but need not be, equal to "the amount which is actually sold." But, even if the two were always quantitatively equal, the meaning, the connotation of the two phrases would be different. "The amount which sellers stand ready to dispose of" plays a very great part in determining price; but "the amount actually sold" is itself determined after price is determined. A Conditioning Price. A second point in our definition which needs emphasis is suggested in the phrase "at some specific price." No statement affirming the existence of a given volume of supply can be recognized as adequate unless it represents supply as conditional on some particular price. Thus, it is proper to say, "The supply of silver is 120,000 ounces at 55 cents an ounce"; but unless the current market price is implied and understood, it is not proper to say, "The supply of silver is 120,000 ounces." For the latter statement, literally interpreted, means that sellers stand ready to dispose of 120,000 ounces whether the price be low or high; and such a statement would in most cases be absurd indeed. In analogy with the case of demand, this conditioning relation between actual price and the volume of supply gives rise to a special concept of great importance, namely : that of "supply price." This means, of course, the particular price which is necessary to bring out the marginal increment of a particular volume of supply and, therefore, is necessary to bring out that volume as a whole. II The Dependence of Supply on Price Supply Schedules. We have just seen that supply, like demand, is always relative to a specific price. We must now ex- plain this relation more precisely. First, the facts of supply, like price, the price which tends to prevail over some considerable period, we usually have to regard supply as conterminous with stock. 270 PRINCIPLES OF ECONOMICS [XXI those of demand, require for their complete presentation a supply schedule, a series of statements giving the amount of supply at each of a series of prices. This follows from the fact already brought out that the volume of supply is always relative to price. In the second place, though supply is like demand in the sense that its volume is relative to price, the supply changes which follow changes in price are exactly opposite to the demand changes. The volume of supply increases as price rises, and diminishes as price falls, whereas the volume of demand, as we have seen, dimin- ishes as price rises and increases as price falls. In short, supply varies directly, though not proportionally, as price. Accordingly, the supply of any commodity should always be conceived as a series of different supplies, each one of which is conditioned on one par- ticular price. A series of this sort we call a supply schedule. Such a supply schedule for silver analogous to the demand schedule given on page 258 would read as follows : The supply would be 200,000 oz. if, and only if, price were as high as 58 cents The supply would be 160,000 oz. if, and only if, price were as high as 57 cents The supply would be 130,000 oz. if, and only if, price were as high as 56 cents The supply would be 120,000 oz. if, and only if, price were as high as 55 cents The supply would be 110,000 oz. if, and only if, price were as high as 54 cents The supply would be 80,000 oz. if, and only if, price were as high as 53 cents The supply would be 40,000 oz. if price were as high as 52 cents As in the case of demand, we shall substitute for this schedule T BLE i one Better adapted to the work of explanation, that is, one in which the changes in volume ENTS ooc> P oz Y consequent on changes in price are uniform. 60 170 Such a supply schedule for silver is represented 5 | J5 in Table I and in Figure i. 57 MO Real Changes in Supply. The expression 54 no "supply has changed" shows the same fault of ambiguity that we found in "demand has 51 80 changed." It ought to mean that the whole supply situation, the supply schedule, has changed. It often does mean merely that another part of the exist- ing supply schedule has been realized because of a change in the actual price. A change in supply in the former sense is sure to XXI] MARKET SUPPLY SCHEDULES 271 cause a change in actual price, unless neutralized by some other change in conditions ; a change in supply in the latter sense is caused by a change in actual price. The Direct Elasticity of Supply. The points thus far ex- plained concerning the relation of supply to price, may be put into formal shape as follows: 40 80 120 160 60- 55- 50- 1 1 1 1 1 1 1 1 1 1 1 1 1 Figure I. Supply Schedule Principle The Law of the Direct Elasticity of Supply. Supply is always relative to a particular price expressed or implied and, broadly speaking, varies directly, though not proportionally, as price. 2 2 Remember that we are now dealing with the immediate supply schedule, the supply schedule which is effective at any one moment. Later we shall have to do with long-time or normal schedules, covering a whole period of some length. To these latter schedules, the principle just laid down is not always applicable. In one set of cases, the supply may be equivalent to the whole stock and, therefore, does not vary at all. In another set, the supply is a potential output, which may be indefinitely large, provided cost 272 PRINCIPLES OF ECONOMICS [XXI III The Interpretation of Supply Schedules Supply Schedules Composite. The first point to be noted in the interpretation of supply schedules exactly corresponds to the first one noted under demand schedules. The supply at any par- ticular price is a composite, made up of many different portions, each one of which, save the last, would appear at some other price, in this case, a lower one. Thus, the supply at 60 cents, 170,000 ounces, consists of the 10,000 which comes on the market when, and because, price advances from 59 cents to 60 cents, added to the 40 120 160 - _ a b c d e f g h i i k 1 m n o p q v, ri f h j i k 1 m n o ~pl 55 w FJ __ a b c d e f g h i j k 1 m n O a b c d e f g h i j k 1 m n a b c d e f g h i j k 1 m a b c d e f g h i j k 1 H h e A p f tr h i i k Figure 2. Supply Schedule Composite 160,000 already offered when the price was only 59 cents; this 160,000, in turn, consists of the 10,000 which comes in when, and because, price rises from 58 cents to 59 cents added to the 150,000 already offered at 58 cents; this 150,000, again, is the 10,000 com- ing in at 58 cents added to the 140,000 already offered at 57 cents; and so on. The facts are illustrated in Figure 2, where the little squares marked with small letters show the increment which supply of production is covered; and, hence, the schedule shows no supply at prices below the one covering cost and an indefinitely large supply at that cost price and others above it. But these points will be more fully presented later. XXI] 273 receives in each instance as price rises to the level indicated. Thus, in the case of the 6o-cent rectangle, the last increment, q, appeared first when the 6o-cent price itself was reached; p came up from 59 cents ; o from 58 cents ; n from 57 cents ; m from 56 cents ; and so on. Different Increments. With supply, as with demand schedules, a second very important task is to distinguish the differ- 40 80 120 160 60- 55 I I I I I I I Figure 3. Increments of Supply Schedule Classified A ent divisions into which the different sections or increments group themselves just as soon as any particular price is established. The principal grouping, as before, is into included and excluded portions. Supposing actual price to be 55 cents, all possible increments of supply which are conditioned on a price of 55 cents or anything lower, will be included increments; while all possible increments of 274 PRINCIPLES OF ECONOMICS [XXI supply which are conditioned on a price of 56 cents or anything higher, will be excluded increments. Again, among the included increments, the most important is the marginal one, the one which is the last to come in when a particular price is being established. As in the case of demand, we should note that the marginal increment is the last to come in, logically not chronologically. That is, it is the one which the conditions present would be expected to bring in last. So, again, another effective way of conceiving this increment is to think of it as the increment of supply which would be the first to drop out if actual price should fall. As in the case of demand, the included increments other than the marginal one are designated infra-marginal increments; and all the excluded ones, extra-marginal increments. The location of these various sections of supply is plainly indicated in Figure 3. Different Supply Prices. We have seen that, in our example, if actual price was 55 cents, the marginal increment of supply would be the 10,000 ounces coming in at 55 cents. It hardly need be said that this 55 cents would constitute the ry* '-' marginal supply price, meaning of course the PRICE SUPPLY p r j ce which is necessary to bring out, and will CENTS ooo oz. . * 62 no bring out, the marginal increment of supply. Similarly, the prices bringing out the intra- 59 80 marginal increments of supply would be the intra-marginal supply prices, while the prices 56 80 which would bring out the extra-marginal in- &J crements of supply would be the extra-marginal 53 70 supply prices. Of these last, as in the case of fcj demand prices, only one is of importance, that is the first extra-marginal supply price. As in the case of demand, the easiest way to master the dis- tinction between these various supply prices is to study a supply schedule in which supply remains constant for several steps. A schedule of this sort is represented in Table 2, and diagrammatically in Figure 4, supply remaining at 80,000 ounces while actual price ranges from 54 cents up to 59 cents. Under this schedule there is a sharp separation between the actual price, the marginal supply XXI] MARKET SUPPLY SCHEDULES 275 price, and the first extra-marginal supply price. If actual price were 56 cents, the marginal supply price would be 54 cents the price which brought in the last increment of supply and the first extra-marginal supply price would be 60 cents the price necessary to bring in any extra-marginal increment of supply. Moreover, the marginal supply price would continue to be 54 cents, and the first extra - marginal supply price would continue to be 60 cents, so long as actual price was not lower than 54 60 cents nor higher than 59 cents. I I I I I I I 55 Marginal Supply Price Highest. --In our analysis of demand sched- ules, it was brought out that the marginal in- crement of de- mand is the one coming in at the lowest of the prices at which any comes in ; and so, of course, the marginal de- mand price is the lowest of those prices at which any demand comes in. The case of supply exactly reverses this. The marginal incre- ment of supply is that one among the several increments which comes in at the highest of all the prices at which any supply comes in ; and, so, the marginal supply price is the highest of those prices at which any supply comes in. Manifestly, similar antitheses appear in connection with the other significant prices. The intra-iuurginal demand prices are 50 Figure 4. Increments of Supply Schedule Classified B 276 PRINCIPLES OF ECONOMICS [XXI higher than the marginal one; the mtra-marginal supply prices are lower than the marginal one. On the other hand, the extra-marginal demand prices are loiver than the marginal one ; the extra-marginal supply prices are higher than the marginal one. It is hardly necessary to add that we often have occasion to apply the terms marginal and extra-marginal to sellers. Marginal sellers are those who offer to sell some or all of their offerings only when, and because, actual price has risen to the marginal supply price. In other words, marginal sellers are the ones responsible for the marginal increments of supply. Their offerings would not be made, if price were lowered. Extra-marginal sellers are those responsible for the extra-marginal increments of supply. They, of course, make no sales and are commonly referred to as excluded sellers. ILLUSTRATIVE PROBLEMS i. Suppose the conditions of supply of Milton's autographs to be such that 15 would be offered if the price were $200; 13, if it were $175; 12, if $150; 9, if $140; 8, if $125; 5, if $110; 4, PRICE SUPPLY if $IOO 2 if $ and if $? CENTS ooo oz. v, ' ' ; /0 . 68 163 ( a ) Make out this supply schedule in tabular 67 150 form. (b) Make out a combined demand and sup- 64 135 Pty schedule using a demand schedule of your 63 120 own. 62 120 61 120 2. Suppose the supply schedule for cordwood 60 112 on a certain Saturday to be as follows: I cord Q J offered if price is $4.50; 2, if price is $4.75; two 04 more, if $5; three more, if $5.25; 10 in all, if 96 85 $5.50; 17, if $5.75; and 8 more, if $6. Make out a combined demand and supply sched- 72 ule for this wood using a demand schedule of 52 72 your own. 3. Suppose that the supply schedule for silver at a certain date is represented by the accompanying table, and answer the questions which follow: (a) Interpret the last five lines, beginning at tbe last; also the tenth to the fifth. ' (b) What would be the marginal increment of supply if actual price were 55 cents? 60 cents? 63 cents? 58 cents? 52 cents? 65 cents? XXI] MARKET SUPPLY SCHEDULES 277 (c) What would be the first extra-marginal increment of supply if actual price were 54 cents ? 56 cents ? 59 cents ? 64 cents ? 67 cents ? (d) What would be the marginal supply price if actual price were 67 cents ? 65 cents ? 63 cents ? 62 cents ? 59 cents ? 55 cents ? (e) What would be the first extra-marginal supply price if actual price were 66 cents? 63 cents? 61 cents? 59 cents? 55 cents? 52 cents ? (f ) Who would be the marginal sellers if actual price were 67 cents? 64 cents ? 63 cents ? 59 cents ? 56 cents ? 54 cents ? (g) Who would be the first extra-marginal sellers if actual price were 66 cents? 61 cents? 59 cents? 58 cents? 55 cents? 52 cents? 4. "In the case of a large majority of commodities, profits do not form a part of the marginal supply price. For, in almost every industry, the marginal producers, the ones whose costs determine the marginal sup- ply price, are getting no profit at all in many cases are taking losses. I have in mind producers who are way behind the times in the methods they employ and hence are producing at the greatest cost of all producers in their line, but who are bound to stay on producing until they are bank- rupt just because they have no other way of making even a semblance of a living." Answer : "The producers described are intra-marginal, not marginal, producers." Defend the last statement. 5. Mr. A produces a certain commodity at an actual outlay of 12 cents per unit, while the outlay of another producer, Mr. B, is 15 cents; yet Mr. A may be producing the marginal increment of supply. How could that be true? 6. "One of the most exasperating things in the lot of the laboring man is the fact that, however high-minded he may be, however anxious to get wages which insure himself and his family a decent living, his actual wages are bound to be fixed by the rate which the meanest-spirited of his fellow workmen stand ready to take." Supposing that wages were fixed by the attitude of laborers only, that is, by the amount which they stand ready to take, show that the par- ticular laborer performing this function would not be the meanest-spirited one. CHAPTER XXII PRINCIPLES GOVERNING THE IMMEDIATE PROCESSES OF PRICE DETERMINATION In order to make an adequate study of price, it seems almost indispensable to attack that problem at successive levels, in other words, with successive degrees of thoroughness. We shall begin, therefore, by trying to settle the more superficial phases of the problem ; follow this with a solution somewhat more thorough ; and finish with an attempt to penetrate the whole matter to the bot- tom. Our study will thus break roughly into three parts: (i) the immediate processes of price determination, market price, (2) the intermediate processes, normal price, and (3) the ultimate processes. All such divisions are of course more or less arbitrary, but the one used will, I believe, justify itself as we proceed. The present chapter, then, is concerned with the immediate processes of price determination. I The Law of Single Price From the facts of demand and supply presented in the last chapter, the student might naturally expect to find the same com- modity selling for several different prices. The appearance of a particular portion of demand, we learned, is conditioned on the establishment of one particular price, the appearance of another portion on the establishment of another price, and so on; and an exactly similar statement is true for supply. At almost any price, then, buyers could find someone ready to sell, and sellers could find someone ready to buy. Even if the forces we are about to study seemed likely to set up a certain price, say 55 cents in our silver problem, why is it not reasonable to expect that sales would after all be made at both higher and lower prices? 278 XXII] IMMEDIATE PRICE DETERMINATION 279 Under some circumstances, this would undoubtedly prove to be the case. If several buyers with different notions as to what they wish to pay, go to as many different sellers, and, without inquiring of more than one seller make their purchases, some will certainly pay more and some less for the same commodity. The reason is that each buyer is unaware of the offerings of sellers other than the one he has visited. Similarly, if various sellers are dealing each with an isolated customer, some will get larger prices and some will accept smaller, because each is unaware of what other customers might be willing to pay. Even in the same trading room it some- times happens that the noise, crowding, and excitement so operate as practically to separate the sellers and buyers into different groups, making sellers in one part of the room unaware of what buyers in another part will pay, and buyers in one part unaware of what sellers in another part will take. Here also, therefore, some buyers will pay more than they would really need to if they looked about them a little, and some sellers will accept less. But the cause of these variations is plainly something abnormal. The market described is not even approximately the perfect market which our study postulates. Full competition between the different sellers on the one side and the different buyers on the other is not realized. Some of the sellers do not have a chance to provide every buyer with an opportunity to purchase from them. Some of the buyers do not have a chance to provide every seller with an oppor- tunity to make a sale to them. If all sellers and all buyers did so provide, the result would be very different. No buyer would pay more than any other, because other sellers, desiring to get his custom, would underbid the seller about to receive the exceptionally high price, would, so to speak, -force the buyer to take their wares at the lower price. Neither would any seller accept less than any other, because buyers other than the one about to get the commodity at the lower price would promptly overbid that one, would, so to speak, force the seller to take a higher price. In a market which is truly single and theoretically perfect, therefore, any commodity at any one time must be selling at a single price. In the real world, of course, there are no theoretically perfect markets. The great exchanges for wheat, cotton, and steel where 280 PRINCIPLES OF ECONOMICS [XXII many buyers and sellers actually meet in the same room and where almost every conceivable means is available for informing one's self of the facts, doubtless at times approach perfection ; but ignorance, folly and the failure of competition always prevent the condition from being reached ; and in ordinary markets, naturally, this is much more emphatically true. Nevertheless, the tendency toward a single price set up by the forces mentioned above is always sufficiently strong to be of real and practical significance. Even in the retail trade, differences between the prices of the same commodity in the same market or in connected markets are at once recognized as ab- normal. The smallest differences are remarked upon ; anything like an indefinite enlargement is quite impossible ; and with the spread of greater knowledge, alertness, and skill among buyers and sellers they must tend rapidly to diminish and disappear. Summarizing the above discussion, we have the following prin- ciple : Principle The Law of Single Price. Within the limits of a truly single and theoretically per- fect market, no commodity can have more than one price at the same time; and even within the limits of imperfect markets or groups of connecting markets, any commodity must tend to have a single price, allowance being made in the latter case for the expense of shifting from one to an- other of the connecting markets. Corollary i. The law of single price secures to many consumers a differential advantage known as buyer's sur- plus, i. c., a quantity of other commodities which they can enjoy because of the fact that they can secure the one under consideration at a lower price than the price which they would be willing to give, even for the marginal unit. Corollary 2. The law of single price secures to owners of some scarce and exceptionally efficient factor in produc- tion a differential gain. In the case of land, this is called rent; elsewhere, a quasi-rent. XXII] IMMEDIATE PRICE DETERMINATION 2 8l II The Law of Supply and Demand We are now prepared to explain the actual processes of price- determination through what is commonly known as the law of supply and demand. In doing this, we shall deal with demand and supply schedules of the regular, symmetrical sort which we have called typical, though it will be necessary later to note some varia- tions from these. Let us begin by placing before ourselves, in both tabular and diagrammatic form, our typical demand and supply schedules combined into one. In the table, the common price is placed in the middle DEMAND PRICE SUPPLY column, while the demands corresponding ^ OZ - CE ^ TS ^^ z - to the several prices appear in the first col- 80 59 160 umn, and the supplies in the third. The ^ diagram in the figure on page 284 repre- no 56 130 sents the supply rectangles superposed on those of demand in such a way that the 140 53 100 boundaries of the rectangles which express ^ j?^ g demand and supply, respectively, at any 17 5 7 particular price, coincide as far as their length will permit. Since the demand rectangles are shaded from left to right downward, while the supply rectangles are shaded from left to right upward, the portions which coincide are cross-shaded, while the parts not coincident have only the parallel shading. Some Price Equates Supply and Demand. From all the data now before us, it is easy to derive a series of propositions em- bodying the most important facts of immediate price-determina- tion. First, from the very nature of demand and supply schedules, there is bound to be, generally speaking, one price at which demand and supply arc equal. This obviously grows out of the fact that changes in price affect demand and supply in precisely opposite ways : demand varies inversely as price ; supply varies directly as price. Two quantities moving in opposite directions under the influence of the same cause are bound to coincide at some point. 282 PRINCIPLES OF ECONOMICS [XXII This is illustrated in the figure, in which the rectangles representing demand and supply coincide throughout their length at a price of 55 cents. Seeming Exception. A seeming exception to the above statement might indeed be found. That is, we might have so con- structed our schedules that, at a price of 55 cents, supply would have been greater than demand; while, at 54 cents, demand would have been greater than supply. 1 This exception, however, is only a seem- ing one. Under the conditions supposed, the unit of price variation used is too large for actual market conditions. Making that unit a half cent, instead of a whole one, would probably bring out a coin- cident price; for a fall in price from 55 to 54^ cents, though in- creasing demand, would not increase it to the 120,000 which 54 cents would bring out ; while that same fall to 54^2 cents, though cutting down supply, would not cut it down to 110,000. In fact it is highly probable that, if our schedules had used this smaller money unit, demand and supply at this new price of 54^2 cents would each have been just 115,000, and so the equality required would have been reached. If not, still further subdivision of the unit would have been made, until one would appear fulfilling the condition affirmed as necessary, that is, bringing demand and supply to equality. We have seen that, from the very nature of demand and supply schedules, there is bound to be a price at which demand and supply are equal. It is equally evident that, in the case of what we have called typi- cal schedules, any price higher than the equating one is bound to show a supply in excess of demand, zt'hile any lower price is bound to show a demand in excess of supply. This, again, grows out of the very nature of demand and supply schedules. As price rises, demand falls off while supply increases, thus making the latter ex- cessive. As price falls, demand increases while supply falls off, thus making the former excessive. 1 Leave the supply schedule as before, but make the demand schedule read : 60,000 at 60 cents ; 70,000 at 59 cents ; 80,000 at 58 cents ; and so on. XXII] IMMEDIATE PRICE DETERMINATION 283 Sellers and Excess of Supply. A third proposition which is easily established affirms that any price at which supply is in excess of demand is bound to be replaced by a lower price through the competition of sellers: any price higher than the one which equal- izes demand and supply is bound to be eliminated. This grows out of the fact that it is to the interest of all sellers who wish to make sales at or below the price which equalizes demand and supply to use every means in their power to change a condition which shows supply in excess, in other words, to destroy that excess. The reason for this is that, as long as such an excess of supply over demand is present, there is danger that said sellers, though willing to sell at a lower price will not, after all, be able to sell at all ; some seller who would come in only if the higher price was reached, may have the luck to make sales before the more willing sellers do, so that when the latter appear, buyers will already have been satisfied. But not only have the more eager sellers motives for using every means to eliminate the excess of supply, they have the power to do so. First, they are willing and so can afford to offer the goods at a lower price. Secondly, this lowering of the price would reduce the excess of supply over demand reduce the discrepancy between supply and demand, in two ways : ( i ) it would increase the de- mand, (2) it would diminish the supply. This is plainly seen from the accompanying demand and supply schedule for silver. Sellers ready to dispose of the metal at a price of 55 cents cannot afford to permit a price higher than this, even if only one cent higher, 56 cents. For, since at 56 cents demand is 10,000 ounces smaller and supply 10,000 ounces larger, supply at this figure shows an excess over demand of 20,000 ounces, so that some sellers willing to supply silver at 55 cents or less may fail to sell at all. But, by bidding price down to 55 cents, they insure selling their whole supply; since they increase demand by 10,000 and diminish supply by an equal amount, and so make demand just equal to supply at 120,000 ounces. This reasoning is diagrammatically illustrated in the accompany- ing figure. At 55 cents the rectangles of demand and supply precisely coincide at 120,000 ounces. At 56 cents, however, supply shows an excess represented by the portion of this rectangle having only the 284 PRINCIPLES OF ECONOMICS [XXII parallel shading. Again, this excess rectangle is divided into two equal squares by the dotted vertical. Of these two squares, the left one represents that portion of the discrepancy between demand and supply due to the falling off of demand, while the right square repre- sents the portion of the discrepancy due to the fact that with the rising price supply increases. When sellers bring down the price to 80 120 If 40 60- 55- 50" I I I I I I I I I Price Equating Supply and Demand 55 cents, the first portion of the discrepancy is eliminated by the in- crease of demand as shown in the square at the right end of the 55-cent rectangle cut off by the dotted vertical, and the second portion is eliminated by the decrease in supply shown by the disappearance of the square which appeared at the right end of the 56-cent rectangle. Buyers and Excess of Demand. We have seen that any price higher than the one which equalizes supply and demand is bound to be shut out by the competition of sellers. Analogous XXII] IMMEDIATE PRICE DETERMINATION 285 reasoning easily shows that any price lower than the one which equalises supply and demand is bound to be shut out by the com- petition of buyers. All such lower prices must cause demand to be in excess of supply. But buyers willing to pay a price as high as the equalizing one cannot afford to let demand remain in excess, lest the lower-price buyers should take off a part of the supply and leave them in the lurch. They the higher-priced buyers will therefore bid up the price ; and this process will eliminate the excess of demand and that for two reasons as before: (i) the higher price will increase supply and (2) the higher price will diminish demand. In the diagram these two sources of the discrepancy between de- mand and supply are represented in the 54-cent rectangle by the two divisions of the single-shaded portion divided by the dotted line. The left represents the falling-off in supply; the right repre- sents the increase in demand. When the actual price is bid up to 55 cents, the increase in supply at once takes place, as indicated by the cross shading of the square at the right end of the rectangle; on the other hand, a decrease of demand takes place, as represented by the blank at the end of the 55-cent rectangle which takes the place of the last shaded square in the 54-cent rectangle. It is obviously implicit in the points made in the last few para- graphs, the points namely: that actual price cannot be either higher or lower than that price which equalizes demand and supply, that actual price cannot be different from said equalizing price. Equi- librium among the price-making forces could not be established as long as a price other than the equalizing one prevailed. There still remains the question whether even that equalizing price could prevail. Would it secure equilibrium among the price- making forces and therefore stand? Our answer must be in the affirmative. The price-making forces which are supposed to be operative in our problem are those which grow out of the competi- tion of sellers on the one hand and that of buyers on the other. These forces consist of that fact about the self-interest of sellers which leads them to underbid other sellers in order to insure getting a market, and that fact about the self-interest of buyers which leads them to overbid other buyers in order to insure getting the supply they desire. But just as soon as a price has been reached which 286 PRINCIPLES OF ECONOMICS [XXII equalizes demand and supply, these forces become quiescent ; neither sellers nor buyers need to do anything in order to accomplish their ends. At a price of 55 cents, included sellers will market all their wares, included buyers will make all the purchases they desire to. At this point, therefore, there is no disturbing condition left, there is no force derived from competition which tends either to lower price or to raise it. This price, therefore, tends to secure equi- librium among the price-making forces. No other can prevail ; this one can. Accordingly, it is the price which tends to be estab- lished. Law of Supply and Demand. We will now summarize the preceding discussion in a formula which contains the most essential elements of what is commonly called the Law of Supply and Demand. Principle The Law of Supply and Demand. Given a typical demand and supply schedule, price must tend to rise so long as demand is in excess of supply and to fall so long as supply is in excess of demand; it must therefore move up or down till it reaches a figure which equates supply and demand; and at this point it can rest, since here the price-moving forces become quiescent. The principle just set forth covers the main part of what is really essential in the law of supply and demand. Other significant points are little more than corollaries of this. One of the first of these concerns the effect on price of changes in either supply or demand, meaning, remember, changes in the schedules, the different supplies or demands at a series of prices. As respects supply, the answer is contained in the following corollary : Corollary i. A rise or fall in the supply schedule tends to bring about an opposite (not proportional} change in price. A glance at the facts will show this conclusion to be inevitable. A rise in the supply schedule means that supply is now in excess XXII] IMMEDIATE PRICE DETERMINATION 287 at the going price. But the principle tells us that price must tend to fall so long as supply is in excess of demand. The rise in supply must therefore tend to bring about a fall in price, that is, an opposite change. On the other hand, if the supply schedule declines in volume, demand at the going price, the price which made supply and demand equal, will be in excess of supply. But the principle tells us that price must tend to rise so long as demand is in excess of supply. A decline in the supply schedule must, therefore, tend to bring about a rise in price, an opposite change. Corollary 2. A rise or fall in the demand schedule tends to bring about a like (not proportional} change in price. The argument is similar to that employed for the corollary above. A rise in the demand schedule makes demand at the going price in excess of supply; under the principle, therefore, it tends to cause a rise in price, which constitutes a like change. A fall in the de- mand schedule makes supply at the going price in excess of demand ; and this, under the principle, tends to bring about a lower price, which is also a like change. Corollary 3. A commodity, the schedule of which shows a higher ratio of demand over supply at a given price than the schedule of another commodity shows at the same price, will usually show a higher actual price also. Thus, if at a price of 51 cents, the ratio of the demand for silver over the supply is 2 to i, while that of copper is 2 to 3, the price of silver will naturally be higher than that of copper. The price of silver would have to move up to equate supply and demand; while that of copper would have to move down. This corollary emphasizes the point which the business world somewhat inexactly expresses in saying that "price is all a matter of the ratio between supply and demand." Its importance lies in the explanation it pro- vides of the great, and often very trying, differences in the prices of things, and especially in the remuneration obtainable for supplying different types of services. 2 88 PRINCIPLES OF ECONOMICS [XXII ILLUSTRATIVE PROBLEMS 1. "On the Black Friday of 1869, gold was sold on one side of the room for $1.60 when it was being sold on the other for $1.35, etc." Sumner. (a) Why is such a fact noteworthy from the economic point of view? (b) How was it to be explained, do you suppose? 2. Professional men, especially those of the medical profession, fre- quently try to eliminate the law of single price in respect to their services. (a) Why is it for the interest of physicians to get rid of this law? (b) Give some reason why they are quite likely to have more or less success in carrying out this policy. 3. "The price cannot long remain above cost of production. For, so long as it is above, profits will be exceptionally high ; this fact will cause production to increase; as a result supply will become . . . , and price will ..." Fill in the blanks, using the Law of Supply and Demand. 4. "The demand for wheat was increased beyond the capacity of the best lands to furnish it, and so a new supply was brought out by putting inferior lands under cultivation." To make that reasoning quite complete, one or two other links should have been put in between the premise and the conclusion. Supply those links. 5. "Demand having increased, price rises. But this higher price cuts down demand; and so price comes right back to where it was in the first place." Show that this result could not be reached in a normal case. 6. The high rate of exchange made exporting more than usually profitable. As a result, the supply of cotton for the foreign market . . ., the price . . ., this caused the foreign demand to . . ., and so exports . . . Fill out the blanks, applying the Law of Supply and Demand. CHAPTER XXIII LIMITING PRICES In the reasoning employed in the last chapter to establish the principle of supply and demand, we necessarily touched upon some of the deeper forces and processes which are determining prices and bringing them under the rule of supply and demand. We will now inspect these forces a little more closely. In particular, we will show the dependence of the prices actually established on certain special prices among the different demand and supply prices. 1 The method which we employed to prove that the one price at which demand and supply are equal must prevail was to show that all other prices are certain to be shut out by the competition of either buyers or sellers. Actual price, we saw, must not go above 55 cents lest it should shut out the marginal buyers, nor up to 56 cents lest it should let in new sellers ; and, on the other hand, it must not go below 55 cents lest it shut out the marginal sellers, nor down to 54 cents lest it let in new buyers. Now, if these same facts be interpreted from our present standpoint, they tell us that the upper limits of price are fixed, or may be fixed, by either of two prices of the schedule, and that the lower limits are, or may be, fixed by either one of another two prices of the schedule. Let us now define more precisely these limiting prices. Upper Limits. Price could not go above 55 cents lest it should shut out the marginal buyers. But 55 cents, as the price which brought in the marginal buyers, is the marginal demand price. It follows that actual price cannot go above the marginal demand price, that is, cannot go to the price next above the marginal demand price. Thus, one of the upper limits of price is the price next above 1 In later connections, we shall comment on various facts and forces lying behind these special demand and supply prices. 28Q 290 PRINCIPLES OF ECONOMICS [XXIII the marginal demand price. Again, price could not go up to 56 cents because this would let in new sellers. But the price which will let in new sellers we have already defined as the first extra- marginal supply price. Consequently, actual price cannot go up to the first extra-marginal supply price. 2 Accordingly, the second pos- sible upper limit of price is the first extra-marginal supply price. Lower Limits. Turning now to the lower limit, price could not go below 55 cents lest it shut out the marginal sellers. But 55 cents, as the price which brought in the marginal sellers, is the marginal supply price. Actual price, therefore, must not go below the marginal supply price, that is, as low as the price next below the marginal supply price. Accordingly, one of the possible lower limits of price is the price next below the marginal supply price. Finally, price must not go down to 54 cents because that figure would let in new buyers. But the price which would let in new buyers we have already designated the first extra-marginal demand price. Hence, actual price must not go down to the first extra-marginal demand price. Thus, a second possible lower limit of actual price is the first extra-marginal demand price. We thus have four prices which act, or may act, to fix the limits within which actual price must be estab- lished, namely: the marginal demand price, the first extra-marginal supply price, the marginal supply price, and the first extra-marginal demand price. 8 1 In one important case, the first extra-marginal supply price and the marginal supply price coincide. This happens when possible output at a certain cost is indefinitely large : producers can supply much more than is demanded without incurring increased costs. In that case we cannot say that actual price must not go up to the first extra-marginal supply price. It must do so, else supply will not be adequate, since this is the marginal, as well as the first extra-marginal, supply price. For this case, we have to say that actual price cannot go beyond the first extra-marginal supply price. The competition of producers who stand ready to supply an indefinite amount at this figure will shut out any higher one. Note, however, that actual price cannot go above this price, not because it is the marginal supply price, but because it is the first extra-marginal supply price, because it is the price which conditions the forthcoming of more supply. 1 Remember that the marginal demand price and the marginal supply price are limits beyond which actual price cannot go, while the first extra-marginal supply price and the first extra-marginal demand price are limits to which actual price cannot go. LIMITING PRICES 291 In reading the above account of this matter, the student may object that, since both the limiting prices, above or below, fix the same price, it is hardly worth while distinguishing more than one of them. If actual price cannot go below 55 cents, it certainly can- not go down to 54 cents ; if actual price cannot go above 55 cents, it of course cannot go up to 56 cents. This is no doubt quite true as applied to these perfectly symmetrical schedules which were used to explain the working of the law of supply and demand. We shall find, however, that many schedules, anyhow many supply schedules, are much less regular than those used. In such cases only two or, sometimes, only one, of the four limiting prices may be actually operative. Our analysis, therefore, could be adequate only if it brought out all the limiting moments, as was done above. Applied to Irregular Schedules. To clear up more com- pletely the matter just commented upon, let us imagine a schedule in which the limits set by the different moments would not coincide. Thus, in the accompanying table, demand remains constant at 120,000 ounces, from 56 cents to 54 inclusive, while supply icmains constant at 120,000 ounces from 58 cents to 52 inclusive. Since supply 80 61 150 and demand are equal only at three prices, ^ 56, 55, and 54 cents, the actual price must no 58 120 be one of these. But with actual price one ** s6 of these, the marginal demand price must 120 55 120 be 56 cents, since this is the one which ^ brought in the last increment of demand; 140 52 120 the first extra-marginal supply price must ^ ^ * be 59 cents, since this would bring in the next increment of supply | the marginal supply price must be 52 cents, since this brought in the last increment of supply; and the first extra-marginal demand price must be 53 cents, since this would bring in the next increment of demand. But actual price, as already noted, cannot go above 56 cents, the marginal demand price, though as far as the first extra-marginal supply price is concerned, it could go to 58 cents. The latter price, therefore, plays no part in the final fixing of the actual price. Again, 292 PRINCIPLES OF ECONOMICS [XXIII actual price cannot go down to 53 cents, the first extra-marginal demand price, though, as far as the marginal supply price affects the matter, it could go down to 52 cents, supply does not begin to fall off till 51 cents has been reached. Plainly, then, in a case of this sort, two of the limiting moments of price, those which come from supply, are inoperative, both the upper and lower limits of price being fixed by demand prices. Further, it is plain that both of the moments coming from the demand side have to be taken into account ; for neither actually fixes price, each of F E. M. them only fixes one of the * s. P. limits within which price may range. These points just brought out are presented in the ac- companying figure. The rect- angles DD' and SS' represent two guide posts between which K s P moves a counterweight repre- sented by the rectangle AP. The guide post DD' stands for a series of demand prices from 48 cents to 62 cents ; SS' stands for a series of supply prices covering the same range; the counterweight AP stands for actual price; and the triangles projecting inward from the left-hand post represent the limits of price movement set by demand prices, while those from the right-hand post represent the limits set by supply prices. Since actual price must not go above the marginal demand price, 56 cents, it cannot go as high as the first price above this, 57 cents ; hence the stop block representing the limit fixed by the marginal demand price is set at a price of 57 cents. On the other hand, since actual price cannot go down to the first extra-marginal demand price, 53 cents, the stop block which represents the limit set by the first extra-marginal demand price is set at 53 cents. Turn- 'D 1 'S The Four Limiting Prices XXIII] LIMITING PRICES ing now to the side of supply, since actual price must not go below the marginal supply price, 52 cents, it must not go as low as the next price, 51 cents; hence the lower stop block on the supply side is set at 51 cents. On the other hand, since actual price must not go as high as the first extra-marginal supply price, 59 cents, the upper stop block on the supply side is set at 59 cents. Manifestly, the two limits set by demand prices are inside those set by supply prices; hence they only would be operative under this hypothesis. Reverse of Last. In the schedule just used to show that only a part of the four limiting prices may be operative in any par- ticular case, supply remained constant for a longer series of prices than demand, and so was prevented from taking part in actual price determination. It is manifest that, if the hypothesis had been re- versed, the results also would have been reversed : the limits of price variation would then have been fixed by the marginal supply price and the first extra-marginal supply price. While buyers would not have permitted actual pi ice to go below the former point lest this should have shut out a portion of supply, sellers would not have permitted actual price to go up to the latter point, lest this should have let in a new supply. A special variation of this second case is of much practical importance, namely, one in which the two limiting supply prices, the marginal and the first extra-marginal ones, coincide the price necessary to bring out a given supply and the one necessary to bring out the next increment of supply are the same. This is the case of constant-cost goods to be commented on later. Other Cases. It is hardly necessary to add that the two types of schedules just used do not exhaust the possible variations from our original situation. Another could be imagined under the working of which the upper limit of price would be set by the marginal demand price, while the lower would be set by the marginal supply price. Under still another type, the upper limit would be set by the first extra-marginal supply price, and the lower by the first extra-marginal demand price. Many others beside these could be imagined. 294 PRINCIPLES OF ECONOMICS [XXIII Summary. In general, there are two determinants of both the upper and lower limits of price variation. The determinants of the upper limit are the marginal demand price and the first extra- marginal supply price : the former fixes the point above which actual price must not go; the latter fixes the point to which actual price must not go. The determinants of the lower limit are the marginal supply price and the first extra-marginal demand price: below the former actual price must not go and to the latter actual price must not go. In all cases in which the variations in the prices necessary to effect changes in the volume of demand or supply are considerable, only one of the two upper or lower determinants is likely to be effective. Other Demand and Supply Prices Assist. The purpose of the preceding discussion was to emphasize the immediate dependence of actual price on one or more of just four demand and supply prices. To avoid possible misunderstanding, it is perhaps best to insert a caution at this point. In giving so decisive a place to certain special demand and supply prices, we do not mean that other demand and supply prices have no part in the matter. To establish any price whatever, demand and supply must come to an equality. With the schedule which appears on page 291, this equality of demand and supply was reached with each at 120,000 ounces, and at an actual price of 56, 55, or 54 cents. But with neither demand nor supply was this total brought out by the last or marginal price acting alone. Thus, the marginal demand price, 56 cents, con- tributed to this total only 10,000 ounces, 110,000 ounces coming down from previous, higher prices. If these earlier increments of demand had not come in, if the total demand had been limited to the 10,000 ounces which appear at 56 cents, equality of demand and supply could have been reached only at a much lower point, and, so, actual price would have been much lower. The whole demand of 120,000 ounces was necessary to make possible an actual price as high as 56 cents. It follows that the intra-marginal demand prices, the prices which were able to bring out the earlier increments of demand, have a part in the fixing of the actual price as truly as do the marginal and the first extra-marginal demand prices. XXIII] LIMITING PRICES 295 The Four Occupy Key Positions. But now we must be careful lest, in trying to avoid one misunderstanding, we fall into another equally objectionable. Although we admit that demand and supply prices other than the marginal and first extra-marginal oiies share in the fixing of actual price, we by no means relinquish the contention that the limits of actual price are immediately de- termined by one or more of the four prices named. While total demand is obviously made up of the sum of all the increments of demand, these different increments must not be thought of as per- fectly homogeneous units entering into the total in just the same way. The case is not analogous to that of a pair of scales, the measuring pan of which is loaded with several different weights to balance the object being weighed. In bringing down the pan, each of those weights acts in just the same way as every other. The case is quite otherwise with the different increments of demand or supply. While all influence the result, they function quite differently in doing this. The explanation is that each increment is in a very important sense different from every other. This difference consists in the fact that the emergence of any one depends on the appear- ance of its own special price, or one lower, in the case of demand, or one higher, in the case of supply. This being true, the different increments cannot be treated as interconvertible, as if each played a like role with every other. The lowest-priced of all the demand increments and the highest-priced of all the supply increments hold key positions. Any price which will bring them out can prevail, even though it differs ever so much in one direction from the special price necessary to bring out any other increment of the total. On the other hand, no price which does not bring them out can prevail, though it brings out every other increment of either demand or sup- ply. In short, the immediate determination of price limits is with the four demand and supply prices which have been so often named ; the part of other demand and supply prices is to assist in determin- ing what prices shall occupy these key positions. Illustration from Analogy. In closing this rather long dis- cussion, I am going to add one more illustration from analogy to the very considerable number which have been used by different writers 296 PRINCIPLES OF ECONOMICS [XXIII in this connection. Suppose that the owner of a meat market lo- cated in a small town starts out to buy a dozen cattle among the neighboring farmers, and that he can get two from the first farm on his route, one from the second, three from the third, one from the fourth, and so on. How far will he have to go to get the whole twelve? Manifestly, the answer is: As far as the distance to the farm at which he buys the last one or more necessary to make up the full number. In other words, the total distance to be traversed will depend immediately on the distance to the marginal increment, and, immediately, on that only. But this distance, in turn, will manifestly depend in part on the increments obtainable at farms nearer by. In consequence, these earlier increments share in de- termining the total distance. Their influence, however, is only in- direct. They help to make the total distance short or long because, and in so far as, they make the distance to the marginal increment short or long. ILLUSTRATIVE PROBLEMS 1. The holding up of prices always depends on the bidding of in- cluded buyers; the holding down of prices depends on the bidding of included sellers. Explain the meaning of that statement and maintain its correctness. 2. While the proposition laid down in the preceding problem is entirely sound, it is still true that the attitude of sellers has a part in holding up price ; while that of buyers has a part in holding down price. Defend that statement. 3. Change the demand and supply schedule on page 291 so that the limits of price-variation would be fixed by the marginal supply price and the first extra -marginal supply price. 4. Two conditions are really necessary to the existence of a price for any commodity or service : ( I ) the demand at some price above zero must be as great as any supply which will be forthcoming at that price, and (2) the demand at zero price must be greater than any supply which will be forthcoming at that price. Defend that statement with respect to both conditions. 5. "On the other hand, if the price fell to 4 cents, the demand would exceed the supply by 500 pounds, and those demanding this extra amount XXIII] LIMITING PRICES 297 would be unable to get it except by bidding a higher price, and so their competition would drive price up." Criticize. 6. "On account of the very weak bargaining power of the laborer, there is nothing to hinder the rate of wages from going down to the lowest amount laborers can be induced to take." Criticize. 7. "Five persons from a shipwrecked steamer are temporarily saved by getting on a raft; a sixth climbs on, and the raft sinks. Obviously it was not just the sixth person who sank the raft, but all the six persons. No more do the marginal and first extra-marginal demand and supply prices by themselves fix actual price. All the demand and supply prices equally share in the process." Show that the analogy is false. CHAPTER XXIV NORMAL DEMAND SCHEDULES At the beginning of the last cnapter, it was explained that our study of price-determination was to be divided into three parts according as it was concerned with the immediate, the intermediate, or the ultimate stages of price-determination. The first of these stages has already been covered. In the present chapter, we begin our study of the second. Need for Normal Price Theory. The necessity for a separate treatment of these two stages can be made clear by means of an illustration. In the early nineties of the last century the bicycle, which had just recently been invented, was in process of evolution. At that time, the price of any machine likely to prove serviceable to the buyer was in the neighborhood of $100 to $125. That this price was more or less fully the result of the natural working of the laws of price which were considered in our last chapter, there can be no question ; at any rate it was doubtless one which brought demand and supply into approximate equality. However, the price was believed by all well-informed persons to be something quite temporary in character. Prospective buyers with lean pocket-books or with more than the usual amount of prudence and patience con- fidently expected and waited for a decided fall. "The present price," said they, "is plainly abnormal. Doubtless for the time being various causes may enable producers to hold the price up to $100; but this cannot last many years." Here we find implied the chief reason for distinguishing between the study of the immediate processes of price-determination which occupied the last two chapters and the study of deeper processes which begins in this. Behind the price temporarily prevailing under the influence of immediate forces, there is a price which tends to be 298 XXIV] NORMAL DEMAND SCHEDULES 299 established by the more permanent forces and toward which the actual price is constantly being driven. And this other price, which we call the "normal," is in the long run of far greater significance than the one established by immediate forces. Three chapters will therefore be given to the study of normal price ; this chapter and the next to preliminary matters, and the last to the actual processes of normal price-determination. Meaning of Normal Price. While the meaning of the phrase "normal price" is indicated in the last paragraph, an additional comment or two may serve to make it clearer. It means a price which is always tending to prevail during a given period as a result of the action of those forces which operate throughout the period, especially the larger of those forces. But, though always tending to prevail, we should note that, because of the interference of tempo- rary forces, normal price seldom if ever does prevail; and for this reason it is often denned as the price toward which actual price constantly gravitates, or about which actual price constantly oscil- lates. Again, normal price should not be confused with average price, which is a mere arithmetic concept. The two might coincide quantitatively, though it is probable that they seldom do. In any case, they differ radically in meaning or connotation; and, if a certain price were at once the average of all actual prices for a given period and the price tending to be established by the permanent forces of that period, we should call it a normal price solely because it fulfilled the second condition. Supply and Demand Not Superseded. One of the first mat- ters to be emphasized in connection with normal price is that the law of supply and demand already presented still governs the immediate processes of price determination. In creating a tendency for some particular price to prevail, the permanent forces necessarily operate through, and only through, their power to influence the immediate demand or supply schedule. Thus, if certain forces tend to estab- lish a normal price of 30 cents for wooden chairs, they do this simply because they have the power so to influence the supply schedule that every time the price goes above or below 30 cents, a 300 PRINCIPLES OF ECONOMICS [XXIV tendency is established to pull it back to that point under the natural working of the Law of Supply and Demand. But the law of supply and demand dominates normal price in a deeper sense. Besides the immediate demand and supply schedules which at any moment prevail there are long-time or normal demand schedules and long-time or normal supply schedules covering the whole period under consideration. Thus, when the immediate de- mand schedule for silver on a particular day in 1918 was 20,000 ounces, if price were 60 cents; 22,000, if 59; 25,000, if 58; there must also have been a schedule for the whole year 1918, a schedule which might have read something like this : 260,000,000 ounces wanted if price were 60 cents; 275,000,000, if it were 59; 290,- 000,000, if 58. Similarly, alongside the immediate supply schedule there must also have been a long-time supply schedule on a much larger scale. Now the price which is tending to be established all through this period the normal price, is determined by the relation between these long-time or normal demand and supply schedules. Thus, suppose that the schedules for silver given on page 281 represent the long-time supply and demand conditions for that metal, rather than the immediate ones. Then the price which these schedules would naturally establish, 55 cents, would tend to be the normal price for the whole period, one year ; just as, in the example given, it tended to be the market price for the single day when those schedules were effective. With these long-time schedules, as with the market schedules, there would be one and only one price at which demand and supply were equal ; and, under the normal working of economic forces, this one price would tend to be established. In undertaking our deeper study of price, therefore, we are not leaving behind the law of supply and demand, but merely bringing out forces and processes which lie a little deeper. In fact, all our later ex- position of the theory of price will, in a sense, do little more than elaborate and complete our account of the principles of supply and demand. Normal Demand Schedules. We have seen that the deeper forces determining normal price necessarily act through supply and XXIV] NORMAL DEMAND SCHEDULES 301 demand, long-time supply and long-time demand; so that behind normal price we find normal supply and demand schedules, just as behind market price we find market supply and demand schedules. The remainder of this chapter will be devoted to normal demand schedules. Begin with Individual Schedules. In analyzing normal de- mand schedules, our first need is to consider the deeper factor or element which lies behind demand prices. What determines the prices which in the long run buyers stand ready to pay for a given quantity of goods? In answering this question, it is necessary that we should go to the schedule of the individual buyer and ask ourselves what motive or motives finally determine his conduct. For, obviously, the general or social schedules with which we have to deal are composites or aggregates of numerous individual schedules. Thus, when we say that, according to the general demand schedule for silver, 180,000,000 ounces are wanted if price is 55 cents, we mean that the different amounts of demand at 55 cents from the schedules of all the different buyers of silver will, when added to- gether, give a sum of 180,000,000 ounces. The student should not, of course, be misled by this emphasis upon the priority of individual schedules over the general market schedule, into thinking those individual demand schedules are made up independently of social forces. The wants of any individual, and, therefore, the valuations which he puts upon goods, are necessarily in a very great measure the creation of the community in which he lives, just because his standards, ideals, and tastes arc in great meas- ure the creation of that community. We are born into the family, into society, into the state; and our ideals are never formed inde- pendently of these groups. But this admission does not at all conflict with our doctrine that the demand schedules of the market are com- posites, made up by adding together the demand schedules of indi- viduals. For, however large may be the share of social forces in the determination of our wants, those forces finally express them- selves through the demand of individual men. Goods are purchased not by the group will, nor by the group ideal, but by concrete and separate persons. We proceed, therefore, to consider the normal 302 PRINCIPLES OF ECONOMICS [XXIV demand schedules of the individual. Here our chief task is to study the principles which regulate individual demand prices and the forces lying behind them. Demand Price and Marginal Valuation. First, let us remind ourselves that each demand price appearing in the schedule of the individual is the price which is necessary to induce him to purchase the corresponding quantity of the goods in question. But, secondly, we must remember that the price in question was necessary only in the case of the last increment of the total amount involved. For earlier increments of that total the prospective buyer would have been willing to pay higher prices. Immediately, then, his demand price for a given total is really his demand price for the last increment of that total. It follows, therefore, that, in tracing causation in the case of demand prices, we have to follow the history of the mar- ginal demand price. Accordingly, what is the immediate cause which makes the prospective buyer's marginal demand price what it is? Surely the answer is that such cause is the valuation which the buyer puts on that last increment. He puts that price on the volume of demand of which this is the last increment, because he esteems such last increment that much sets that much store by its possession. Thus, if his schedule for apples reads as follows: one peck wanted if price is $2.00; two if price is $1.50; three if price is $1.25; and so on, this shows that he values a single peck at $2.00 ; a second at $1.50 ; a third at $1.25 ; and so on. Valuation Based on Significance. But, again, these valua- tions of the prospective customer must have something behind them. There must be a reason for valuing the apples in our illustration. That reason, immediately speaking, is the fact that the apples have significance or importance for the welfare of the prospective custom- er, and the further fact that he realizes that they have such signifi- cance. Because of these facts he attaches value to the apples and gives measurement to that value in terms of a common measure, usually money. In short, the valuations of the customer are his XXIV] NORMAL DEMAND SCHEDULES 303 estimates of the significance or importance to himself of the several increments of apples or whatever good is in question. 1 It is hardly necessary to say that these valuations, these estimates by the individual of the significance of particular increments of goods, lack the precision which would be required in most other measure- ments of a scientific character. Nevertheless, these estimates are very real and sufficiently precise for the purposes of economic life, as is abundantly proved by the fact that, if in view of all the circum- stances the price seems reasonable, our buyer actually decides in favor of the apples rather than using his money to buy something else. Significance Based on Utility. We have seen that the de- mand prices of buyers grow out of the valuations which those buyers put on the goods, and that these, in turn, grow out of the significance or importance to said buyer of the goods in question. But, plainly, we are not yet at the bottom of the matter. Why do goods have significance to the individual, and what determines the degree of their significance? The immediate, and from the economist's standpoint, the ultimate ground of signficance or importance in any commodity or service is the utility of that commodity or service, its capacity to satisfy wants, to make some contribution to our welfare. Because things can bring us advantage, they have significance or importance for us ; having such significance, we value them ; because they are valued by us, we stand ready to give a price for them. Our demand prices for things, therefore, are the final result of a series of causes beginning with utility. 2 1 Remember that these are the valuations of the individual interested, not those of some absolute intelligence outside himself nor those of society as a whole. How far they are of interest from the standpoint of society at large will have to be considered in later connections. 2 The above account of the causes, forces, lying behind, and determining demand schedules confines its attention to the demand schedules of con- sumers in the strict sense, that is, persons who wish to buy the commodity in question as a means of satisfying some want, though some portion of the demand for the same commodity often comes from producers, while the demand for some types of goods comes almost entirely from producers. It can scarcely be doubted, however, that, indirectly and in the long run, the attitude of consumers must be decisive in determining that of producers, else the latter would find themselves bankrupt. The processes by which this result is reached are necessarily obscure ; but some notion of their character will be brought out in Chapters XXIX and XXX. 304 PRINCIPLES OF ECONOMICS (XXIV Diminishing Marginal Utility. Our analysis has brought us to utility as lying behind and determining the significance of products to buyers, just as these lie behind and determine the valuations of buyers, just as these, in turn, lie behind and determine the demand prices of buyers. From the standpoint of the economist, this brings us very near the end of the matter. It might indeed be argued that, since utility is the capacity to satisfy wants, we ought now to under- take a careful study of the nature and origin of wants and the pe- culiarities or qualities of things which fit them to satisfy those wants. As a matter of fact, we mostly leave these things to investi- gators in other fields. In the present connection, anyhow, we shall confine ourselves to a single fact about wants, and that a fact which is so familiar to everyone that, when understood, it is at once ac- cepted. That fact is that, in most cases, the process by which a want is satisfied to the point of satiation is one which may be characterized as a declining progression. That is, said satisfaction has to take place in successive stages and the addition to gratification derived from the addition of a unit of commodity is each time less than proportional. Thus, if one were quite hungry, a single slice of bread would give very great gratification ; a second would give some- what less ; a third decidedly less ; and so on ; till satiation was reached. 3 It follows that the gratification derivable from the last unit of a given quantity of any commodity is bound to be smaller than that derivable from the last unit of a smaller quantity of that commodity. But, in view of our 'use of the word "marginal" in other connections, we naturally designate the gratification derivable from the last unit of a given quantity of any commodity the ''marginal" gratification. Hence we say that the marginal gratification derivable from a given quantity of any commodity diminishes as the quantity of that com- modity consumed increases. But it is, of course, implicit in this statement that the power of marginal units of any commodity to give gratification diminishes as the quantity in possession increases. Fur- ther, the power of a commodity to give gratification we call its utility. Hence we have the following principle : ' Doubtless this account of the matter does not apply to all cases ; but it is of sufficiently general application to be of great importance XXIV] NORMAL DEMAND SCHEDULES 305 Principle The Principle of Diminishing Marginal Utility. The marginal utility of any economic good varies in- versely as the quantity at disposal. Diminishing Effective Significance. Since, as we saw above, the utility of any commodity is the source from which its significance or importance is derived, it follows that, if the marginal utility of a given commodity diminishes as the quantity at disposal increases, the marginal significance of such a commodity must also diminish in the same way. But we can go further. Not only does the marginal significance of such a commodity diminish with its quantity, the effective significance of every unit of that quantity also has the same experience. That is, its effective significance cannot be greater than the significance of the marginal unit. The true importance of any commodity is determined by the loss which we should experience if deprived of a unit of that commodity. But, since different units of commodity are interchangeable, it is quite certain that, if deprived of a particular unit, we would not permit ourselves to be deprived of one of the higher gratifications to be derived from such a unit of that commodity. Instead, we should relinquish the lowest gratifica- tion of all, withdrawing, if necessary, the unit formerly put to the marginal use from that marginal use and devoting it to the higher service which had formerly been cared for by the lost unit. In short, the effective significance of any commodity varies inversely as the quantity of that commodity at our disposal. Diminishing Valuation. Having now reached the conclusion that the significance of a commodity varies inversely as the quantity in possession, we inevitably take another step and recognize the ex- istence of a similar law for valuation. Since the effective significance or importance of a commodity diminishes with the quantity at our disposal, it necessarily follows that our valuation of such a com- modity takes the same course. If a unit of a given commodity has less effective importance than hitherto because I have at my disposal a larger quantity, and my want schedule for that commodity has not altered, I will naturally evaluate that commodity at a lower figure 306 PRINCIPLES OF ECONOMICS [XXIV That is, the consumer's valuation of a commodity varies inversely as the quantity at his disposal or that conceived to be at his dis- posal. Diminishing Demand Prices. We come, finally, to the de- mand prices of the consumer. These surely must take the same course as has his valuation. That is, when he is contemplating the purchase of a certain number of units of a commodity, the price upon which will be conditioned his taking that quantity will depend on the valuation which he has put upon said quantity. His demand prices, therefore, will take the same course as his valuations. That is, the demand prices of a prospective buyer vary inversely as the quantity of the commodity which he conceives himself to be pur- chasing. These analogous propositions with respect to valuations and demand prices are illustrated in the diagram of Figure I. Valua- tions or prices are measured vertically on the line at the left, while the quantity of the commodity supposed to be in possession, actual or contemplated, is measured along the horizontal line at the base. The heavy verticals side by side indicate the valuation or demand price attached to the particular quantity of the commodity which is measured by the distance from zero to the point where the vertical is erected. The commodity under consideration is supposed to be sugar, the unity of quantity 5 pounds, and that of valuation or price 5 cents. Thus if the quantity be 5 pounds, its valuation or demand price will be indicated by the tallest vertical at the left, that is, will be 100 cents; if the quantity be 10 pounds its valuation or demand price will be represented by the second vertical, that is, will be 65 cents ; and so on. The line of causation, the fact that in this prin- ciple the quantity of the commodity is the condition and the utility or significance or valuation or demand price the consequence, is indicated by the vertical arrows starting from the base line on which quantity is measured. As required by our principles, the verticals representing valuations or demand price grow shorter with every increase in the quantity assumed, being, for example, 75 cents for 30 pounds; 45 cents for 60 pounds; 30 cents for 75 pounds; and so on. XXIV] NORMAL DEMAND SCHEDULES 307 Inverse Elasticity of Demand. Very little reflection should be necessary to convince the student that, in the principle just brought out, we have, in part anyhow, the explanation of the principle of the Inverse Elasticity of Demand discussed in Chapter XX. Since the consumer's valuation and demand price for the first 5 pounds of sugar is $1.00, it necessarily follows that an actual price of $1.00 100- 75- 50- 25- III, f t t t t t 1 1 1 1 t t t t t M 1 1 ' i i i i I i i i i I i i i i I i i i i ii 25 50 75 100 Figure i. Utility, Valuation, and Demand Price Schedule will make his demand 5 pounds. Similarly, since his demand price for a second unit is 95 cents, an actual price of 95 cents will make his demand 10 pounds; since his demand price for 15 pounds is 90 cents, an actual price of 90 cents will make his demand 15 pounds ; and so on. This is brought out in Figure 2, which shows the particular quantity of demand resulting from each actual price. In this diagram, therefore, the arrows start from the price scale and run from left to right. A I -dollar price results in a 5-pound de- 3 o8 PRINCIPLES OF ECONOMICS [XXIV mand ; a 95-cent price results in a lo-pound demand ; a cp-cent price results in a 1 5-pound demand; and so on. Social Demand Schedules. Thus far we have considered only the demand schedule of the individual. But, obviously, the demand schedule which plays a decided role in the general market 100- 75 50 25- 1 1 1 1 1 1 1 1 i i i i J J I I I I 75 100 25 50 Figure 2. Demand Schedule Resulting from Valuation Schedule in Figure i is the social or general schedule. Hence we must bring our discussion to a focus in the general or social demand schedule. Inverse Elasticity of Social Demand. Here the chief thing to be noted is that the general schedule shows just the same relation to valuation and demand price schedules, as did the individual de- mand schedule. That is, the general demand schedule results from the general valuation and demand price schedule. Thus, the demand schedule represented by the figure on page 260 results from a marginal valuation or demand price schedule analogous to the one XXIV] NORMAL DEMAND SCHEDULES 309 considered above. Such a schedule for silver is represented in Figure 3. According to this diagram, a stock of 70,000 ounces has a marginal valuation and so a demand price of 60 cents ; one of 80,000 has a marginal valuation and so a demand price of 59 cents ; and so on. And it is because of these facts that the results in respect to 60 55- 50- t t t t t t 40 80 Figure 3. Utility, Valuation, and Demand Demand Schedule 120 Price 160 Schedule Producing demand which appear on page 260 emerge. Thus, since 70,000 ounces have a demand price of 60 cents, therefore an actual price of 60 cents will bring out a demand of 70,000 ounces. Since 80,000 ounces have a demand price of 59 cents, therefore an actual price of 59 cents will bring out a demand of 80,000 ounces ; and so on. Most Social Demand Schedules Elastic. I will now close this discussion of normal demand schedules with a statement regard- ing their general character. Generally speaking, all normal demand schedules are of the kind which in the chapters on Immediate Price 310 PRINCIPLES OF ECONOMICS [XXIV Determination were characterised as typical. Doubtless this must be affirmed less roundly of some than of others. A few are relatively inelastic, for example, those of the prime necessaries of life; but, over a wide range of prices, most schedules show fairly uniform changes in demand with every material change, in price. This fact, as we may easily see, is quite inevitable. ( I ) General schedules are composites of numberless individual schedules. (2) The tastes and wants of individuals differ greatly. (3) Most of all, the incomes of individuals are very unequal. As a result, there will be some effective demand at almost every price level. Even at very high levels, those who are rich and wish a commodity intensely will continue to demand it ; while, with each fall in price, some persons who care less or have smaller incomes or who fulfil both these conditions will come in with a new demand. The general schedule, as a whole, therefore, will show a high degree of continuity, regularity, and symmetry. ILLUSTRATIVE PROBLEMS 1. "The common teaching of economists that the normal price of products equals cost of production is entirely untenable. Normal price of course means the price which usually prevails. But, now, every one knows that the price of any product rarely, if ever, coincides with its cost of production. Hence a price which actually did coincide with cost would be an abnormal rather than a normal one." The above quotation may furnish a valid reason for choosing some word other than "normal" to designate what the economist has in mind ; but it does not furnish a valid argument against the doctrine that the normal price of the economist coincides with cost. Explain. 2. "All talk about normal price is simply silly. There isn't any such thing. The economist teaches that normal price corresponds to cost of production ; whereas every one knows that, during the last two or three years (written in 1918), the prices of almost all commodities have been far above cost of production." Is his denial of the existence of normal price reasonable? Explain. 3. One of the possible upper limits of the actual price of any com- modity is its marginal utility or significance; while one of the possible lower limits of that price is the first extra-marginal utility or significance of said commodity. Give the argument needed to support those propositions. ft' l-n CHAPTER XXV NORMAL SUPPLY SCHEDULES In the preceding chapter we considered various topics prelim- inary to the study of normal price, including normal demand sched- ules. In this chapter we continue the study of preliminaries, especially matters connected with supply. Market Supply Schedules. The supply schedule with which we were concerned in our first study of the processes of price- determination is most naturally designated the market supply sched- ule. In that schedule we are looking at the immediate attitude of sellers. At a certain time, for a great variety of reasons, sellers are ready to sell a certain number of units of a commodity if price is so and so, another number if price is something else, and so on. This attitude of sellers is a momentary one, an ever-changing one. If they hear a little different news as to conditions in other markets, the probabilities of demand in some other community, or the success of production during the current season, they will alter their supply schedule, will change the quantity they are willing to sell at any particular price. Normal Supply Schedules. We wish now on the other hand to study the attitude of sellers throughout a longer period. During a season, a year, or a series of years, sellers are acted upon by certain larger and more permanent forces, and under the influence of those forces, they stand ready to sell a particular number of units of a commodity if price is so and so, another number if price is some- thing else, and so on. This attitude of sellers is represented in the normal or long-time supply schedules. As a final preliminary to our study of actual normal price and its determination, we must now investigate the nature of these normal supply schedules. 3" 3I2 PRINCIPLES OF ECONOMICS [XXV Different Classes of Goods. In undertaking this task, our first step is to note some fundamental differences among goods, since these differences are responsible for marked differences in the normal supply schedules of such goods. The most important of these dif- ferences gives rise to two main classes of goods : ( I ) those goods the stock or output of which is increasable producible goods and (2) those of which the stock or output is fixed. The first obviously includes the great majority of commodities in everyday use, food, shelter, clothing, etc. The second class includes a few objects of direct use in the .satisfaction of wants, for example, the paintings of an artist now dead ; but it mostly consists of certain primary fac- tors in production derived from nature, for example, ultimate or primary raw materials such as iron and copper, the services of land, and water powers. The former of these two classes again divides for our purpose into two sub-classes: increasing-cost and constant- cost goods. Accordingly, we shall study more or less fully the supply schedules of three types of goods: (i) Increasing-Cost Goods; (2) Constant-Cost Goods; and (3) Fixed-Supply Goods. Costs and Supply Prices The most obvious, as also the most important, fact about the normal supply schedules of producible goods is that the supply prices of such a schedule, that is, the prices on which depends the forth- coming of supply, are fixed by costs of production, including, of course, suitable remuneration for such contributions as are made by the entrepreneur himself. If a certain price will insure to the entrepreneur that he will get back the money he has put into a product and in addition will get a reasonable return for his own direct contributions, he will surely be ready to furnish the product at that price. Doubtless he would be glad to get a higher price ; and, under some conditions, he may be able to do so. But that fact has no relation to our present problem, which is concerned solely with the normal supply schedule the series of mutually dependent sup- plies and prices. What price will be necessary to secure the forth- coming of a given supply? or what volume of supply will follow XXV] NORMAL SUPPLY SCHEDULES the appearance of a given price? these are the questions of immedi- ate interest. And the general answer is that the price which will be necessary to bring forth a given supply is that price which equals the greatest cost of producing said supply, supposing differences of cost to exist; and the volume of supply which will follow the ap- pearance of a given price is that volume which will have as its great- est cost an amount equal to said given price. Test of a Cost. It follows from the relation between cost and supply prices above brought out that one method of testing whether or not a given element is a cost is to see whether or not it appears in the supply price. Supposing competition to be free, does the producer insist on getting a price higher than would otherwise be necessary just because the element under consideration has to be supplied? If the answer is "yes," that element is certainly a cost; if the answer is "no," that element is not a cost. II Theory of Cost Concerned with Entrepreneur's Cost. We have seen that the supply prices of the normal supply schedules of producible goods ;ire quite certain to be in general the costs of production. But, as there is considerable room for misunderstanding with respect to the meaning of cost, it seems necessary to make some more specific com- ments on this matter. First, it is important to note that the costs with which we are here concerned are costs to the entrepreneur, the person or persons responsible for the production of goods. This obviously grows out of the fact that we are interested in costs as determinants of supply prices, and supply prices are the prices which the entrepreneur sets up as necessary to the forthcoming of supply. 1 1 There is a good deal of criticism directed against the prominence piven by most economists to the standpoint of the entrepreneur. This criticism does not seem to me justified. The entrepreneur is the person, natural or legal, who undertakes the responsibility of production decides the kind, amount, and method of production. As entrepreneur, he must hold the place of first importance. Perhaps a function of such magnitude ought not to be delegated to private persons at all ; but whoever undertakes this task neces- sarily holds the center of the stage. PRINCIPLES OF ECONOMICS [XXV Concerned with Immediate Costs. In saying that we are concerned here with entrepreneur's cost, we almost of necessity affirm that we are concerned with immediate rather than ultimate or intermediate costs. The steel which a producer of automobiles buys as raw material is of course a product, and so has its own cost which indirectly must be a cost of the automobiles. In turn, the factors necessary to the producing of steel, namely : pig iron, coke, etc., are products having their costs, which costs, therefore, must indirectly be costs of the automobiles, remoter costs, intermediate costs. Finally, there must be factors beyond which we cannot go, the original raw materials given by nature, the earth itself, the services of laborers, etc., what we call ultimate or primary costs. 2 But, though there are costs other than the immediate ones, we are not, generally speaking, concerned with such other costs, in our present connection. To this it is necessary to make the one exception of primary costs incurred by the entrepreneur himself and not to be purchased from other persons, for example, the risk burden of the business. Money Costs : Explicit and Implicit. The largest constituent in entrepreneur's cost is usually direct money cost the money out- lay for factors of different sorts which he buys on the open market, for example, raw materials, fuel, machinery, labor, the use of capital, etc. A closely allied constituent consists of the money value of such of the above purchasable factors as the entrepreneur himself fur- nishes. Thus, the individual entrepreneur commonly supplies labor services of much importance which he might purchase on the open market. Again, in almost all cases he is obliged to put in some capital of his own. Further, he may use his own land, instead of rent- ing from someone else. Now, for his labor services, he will naturally try to get as good wages as he would have to pay others for the same services. Similarly, on the capital which he put in, he will of course insist on getting the usual interest. So, for the use of his land, he will expect as large a return as the rent which he would 'The former designation lays stress on the logical finality of these costs; the latter places them in their temporal or causal order. XXV] NORMAL SUPPLY SCHEDULES 315 have to pay another landlord. Accordingly, in estimating what the product costs him, he will make allowances for all these items. They will, therefore, constitute a part of the cost of production, quasi- money costs, we might call them, or implicit money costs, as con- trasted with his direct money outlay which we may call explicit money costs. Cost of Entrepreneur's Contribution. We have just re- marked on two constituents of entrepreneur's cost, explicit and im- plicit money costs. There is still a third which must not be ignored. In addition to the various contributions often made by the entrepre- neur which he might buy from others, implicit or quasi-money costs, there is another, one corresponding to his distinctive func- tion as entrepreneur. Some person natural or legal must undertake the responsibility of deciding, willing, that production shall go for- ward, else of course there will be no production. This distinctive function of the entrepreneur is, therefore, a factor in production. But the fact that the distinctive contribution of the entrepre- neur is a necessary factor in production is not sufficient to make it an element in cost. In order to be such an element, it must also be an economic factor, a factor having an economic character, having value. But the question whether this factor has an economic character is not so easily determined as in the case of the other factors which have been considered. Just because the services of labor, of capital, and of land are purchasable on the open market, we have no difficulty deciding whether or not they have value, for that is evidenced by the prices at which they are bought and sold. The distinctive func- tion of the entrepreneur, on the contrary, cannot thus be bought and sold. The assumption of final responsibility and a certain residue of management cannot be separated from the ownership of the busi- ness, hence cannot be delegated to anyone else, cannot be hired from anyone else, therefore cannot be bought and sold, so cannot have a price to prove its economic character. It follows that we can ascer- tain whether or not this factor in production has economic value and so is a true economic factor, only by finding that at the margin the total return to undertakings has a money value in excess of all costs of the kinds already enumerated, that is, explicit and implicit money 316 PRINCIPLES OF ECONOMICS t XXV costs. In short, business in general must yield a profit, if the dis- tinctive services of the entrepreneur are to be accounted as having value, hence as being economic factors, and therefore as entering into the cost of production. Meaning of Profit. But at this point it becomes quite im- portant to avoid a possible misunderstanding as to the meaning of this word profit. Profit is the implicit price of those services of the entrepreneur which are peculiarly his own, distinctive of his office. We do not have a profit, in the strict sense, just because we have a return in excess of the money outlay, the explicit money cost. Such an excess would very likely be necessary to cover the wages due the entrepreneur as a laborer or to cover the interest due him as having supplied a portion of the capital. The excess in return which spells profit must go beyond the implicit, as well as the explicit, money cost. Thus, a small merchant investing $2,000 and clearing $1,600 a year from the business might be thought of as getting 80 per cent on his investment; when in fact $1,300 out of the $1,600 was the wages of his labor as manager, salesman, etc., while $120 was interest on his $2,000 at 6 per cent ; so that his true profit was only $180 or 9 per cent. Profit a Part of Cost. That this peculiar contribution of the entrepreneur, or the profit representing that contribution, is at the present time a true cost of production can scarcely be doubted, and is seldom denied by economists. 3 Generally speaking, the prices of products are high enough to insure that entrepreneurs shall get a return in excess of all money costs, explicit and implicit. During the late war, most governments, when making contracts for supplies and when taxing business, assumed that, as a matter of course, pro- ducers must be allowed to make from ten to fifteen per cent gross profit or five to ten per cent net profit profit in excess of interest. It seems to follow that, in the opinion of practical men, true profit commonly is, and in fact must be, an element in cost. 3 Some economists hold that profit would not continue to exist as a cost under a static set of conditions. Some even hold that this element is not a part of cost at present. For comments on some arguments in support of this opinion, see Note 4 in the Appendix. XXV] NORMAL SUPPLY SCHEDULES 317 Interpretation of Profit. We have seen that profit forms a necessary element in the cost of production : the supply price of a commodity the price necessary to bring out the marginal units of supply must be great enough to include a profit to the entrepreneur as well as to cover the other items which have been enumerated. This topic, profit, must not, however, be passed without a further word of explanation as to how the word is to be interpreted. There has been from the first, and continues to be, considerable confusion in economic writing in respect to the proper method of computing profit. Even business practice is not wholly uniform, though the interpre- tation which will here be given is probably the generally accepted one. Profit proper should be computed on the basis of the capital invested, not on the basis of the outlay. Thus, let us suppose that $50,000 is invested in a given business ; that this business yields an annual output of 100,000 units; that the cost per unit profit not included is $4 ; and that the rate of profit proper required is 8 per cent. Under these conditions, the producer does not say: "Since each unit of product costs me $4, and since 8 per cent of this is $.32, I will supply the commodity in question for $4.32" ; instead, he says: "Since I have in the business an investment of $50,000, since 8 per cent on this is $4,000, and since the other costs equal $4 per unit, I will supply the commodity at $4 plus $4,000 divided by 100,000 units, that is, for $4.04." 4 Rent Commonly a Part of Cost. In the above account of entrepreneur's cost, it was more than once implied that such cost includes rent, that which is paid for the use of land unmodified or modified only by such improvements as are practically irremovable and indestructible. We seem to be justified in doing this, in view of the precise nature of the problem before us : What are the elements included in the cost of the individual entrepreneur ? For, from this 4 This of course does not mean that producers would not be glad to get the larger profit reached by the former method of computation. If they are regulated by government and have to get the consent of government in fixing their price, they often try to induce the regulator to adopt the method of reckoning which gives the larger profit. But where competition is free, producers will in the long run offer to supply the commodity provided the price is high enough to give them a profit on the capital actually invested. 318 PRINCIPLES OF ECONOMICS [XXV standpoint, rent must, in the great majority of cases, be looked on as a part of cost. The reason for this is that, in the great majority of cases, a given piece of land may be put to many different uses, and the individual entrepreneur will be obliged to compete against other entrepreneurs who want that land for other purposes, just as he would be obliged to compete against them for labor services or capital services. That is, rent would participate in determining the entrepreneur's supply price just as truly as wages or interest. Disutility or Pain-Cost Not Included. One or two further comments will complete this long discussion of cost of production. First, we note that entrepreneur's cost, as above described, does not in the main include what is often called psychic or disutility cost. What this sort of cost means is best seen in the case of labor. While to the entrepreneur the cost of labor is his money outlay for that labor, to the man who supplies it, the cost of that labor may be the dis- comfort, weariness, lack of leisure, which supplying the labor in- volves; that is, he may think of these as constituting the sacrifice which he is making when he furnishes the labor. 5 Some writers, indeed, have insisted that this is the only cost which deserves the name. It is the true, the real cost of production, they say. Doubt- less such a view of the matter has some point; but it is not sound doctrine in our present connection. We are here concerned with supply prices, and are interested only in those costs which influence the entrepreneur in fixing his supply prices. But, these, obviously, must be his own costs, his own sacrifices, not those of the persons from whom he purchases particular contributing services. But his costs, in the case of the contributing services of other persons, are plainly the sums of money which he pays for those services. When we come to consider the principles governing the prices of the pri- mary factors of production, those factors behind which we cannot go, such as the original raw materials, the uses of the earth's surface, labor services, etc., we shall find that, with some of these, disutility does play, or may play, a part in determining their prices. In that 8 The laborer may, however, have in mind the fact that he can get wages from some other employer. In that case we have, not a psychic or disutility cost, but an opportunity cost. XXV] NORMAL SUPPLY SCHEDULES 319 part of our study, therefore, we shall have to recognize the influ- ence of disutility. But in our present connection it is of interest to us only in so far as it determines the attitude of the entrepreneur himself, that is, his attitude in settling what reward is necessary to compensate him for the peculiar sacrifices incident to his position as entrepreneur, in other words, what profit he must insist on having. Prices of Cost-Goods Constant. Another comment which needs to be made in this connection is that from the standpoint of normal price, the prices of cost-goods, materials, labor, etc., are as- sumed to be constant, fixed. We conceive the entrepreneur as look- ing over the field and saying to himself : I shall have to pay so much for a place of business, so much for material, so much for labor, so much for the use of borrowed capital, and so on. In addition, I must get something for the capital and labor which I myself put in ; and, as I am not in the business for my health, I must get some- thing more for my trouble and risk, that is, I must have a profit. From these data, he computes what he must fix upon as his supply price. In doing this, he assumes the fixity of the prices of those goods and services which he has to buy. Of course, he knows that, as a matter of fact, those prices are not finally fixed, that they are liable to change even during the productive process. But, roughly speaking, they do not change. As a totality, they are fairly well fixed for the period of time with which he is concerned. Further, it is just his business to assume the burden of taking the inevitable risk of such changes. That risk he in part covers by adding something to his supply price; while at the same time he makes another addi- tion to that supply price, in order to provide compensation to himself for taking the chances involved. ILLUSTRATIVE PROBLEMS i. "Wages are the remuneration of the laborer for the sacrifices which he has to make in supplying labor services. It is ridiculous to call them a cost of production." Is there any reason why we should not say that wages are at once a cost and a remuneration? 320 PRINCIPLES OF ECONOMICS [XXV 2. To one laborer, on account of poor health, the day's work in a particular factory will mean much greater disutility than it means to another laborer in the same factory. Will this difference affect the sup- ply price of 'the commodity produced at the factory? 3. A tailor carrying on business in a small town tells a prospective customer from Detroit that he can make him clothes more cheaply than an equally good Detroit tailor because his costs are lower, mentioning among other things the rent of the site where his shop is located. Can he legitimately treat rent as a cost in this case? Defend an affirmative answer. 4. A railway lawyer is trying to prove before a court that a pro- posed 2 cents per mile passenger rate is unjust to his road in that it will not permit paying a reasonable profit, say 6 per cent, on the investment. He admits that this rate will be realized on the physical equipment of the road, valued at $5,000,000; but argues that the company has to provide for a pay-roll of $50,000 every month and ought to earn profits on this as well. Now this claim may or may not be reasonable. It all turns on whether providing for this pay-roll involves . . . Finish the sentence. Ill The Normal Supply Schedules of Increasing-Cost Goods We have seen that the supply prices of the normal supply schedules of producible goods are in general costs of production. But producible goods are not all of one kind. As noted in the begin- ning of this chapter, we distinguish at least two different classes of such goods in studying their normal price, increasing-cost goods and constant-cost goods ; and the supply prices which cost gives to these different sorts of goods are quite different. We take up first "in- creasing-cost goods." The general character of these goods was brought out in Chapter XI. The larger the amount of these goods we try to produce, the greater will be the cost of the additional units of product. In other words, the larger the amount produced, the greater will be the marginal cost of production. But the cost of producing any particular part of output determines the supply price of that part of output ; hence the marginal supply price must rise with every increase in the output. As a result, the normal supply schedule of increasing-cost goods must be of the sort earlier called typical, sup- XXV] NORMAL SUPPLY SCHEDULES 321 ply varying directly with price and vice versa. The table and dia- gram given for a typical market supply schedule on page 270 would, therefore, illustrate well enough the normal supply schedules of in- creasing-cost goods. With every rise in price, supply increases ; with every fall in price, supply diminishes. IV The Normal Supply Schedules of Constant-Cost Goods The second class of producible goods with which we have to deal is constant-cost goods. By these we mean goods the output of which can be increased from a very small to a very large amount so large as compared with the natural range of demand that it may be called indefinitely large without substantial change in the cost of produc- tion. Emphasis is laid on "substantial," since it is probable that any change in the volume of output can seldom be effected without some change in cost. But, in the case of a host of manufactured com- modities, the degree of change in cost necessary to effect a given change in the volume of output is practically negligible. Thus, only under quite exceptional conditions would the cost of producing the numberless articles supplied by five- and ten-cent stores be increased by any ordinary increase in the amount supplied. Doubtless it is possible to have in mind periods of time so long that decided changes in cost prices would take place. But normal price, from its very nature, is not concerned with periods of such length. The very idea or normality implies constancy with respect to the principal condi- tions ; for, without such constancy, there would be no price which tended to prevail throughout the whole period, that is, there would be no normal price. The character of the normal supply schedule of goods of this sort is easily seen. By hypothesis there is no change in cost over a wide range of output. It follows that these goods have but one supply price. At any price below this one, no supply will be forthcoming; at this price, an indefinite amount will be available; and, at higher prices, no more will appear, since the amount at the one price is in- definitely large. It follows that the supply schedule of constant-cost goods takes the following form : At prices below the one supply price. 322 PRINCIPLES OF ECONOMICS [XXV supply is zero ; at the one price, supply is indefinitely large or varies within the range specified in the hypothesis ; and, at prices above the one, supply remains at the same indefinite figure as at the one price. Such a schedule is given in the first 2 columns of the table on page 333. Output Adjusted to Demand. One peculiarity of the supply schedule of this particular type of producible goods seems to call for special comment. This is the statement that, at the one supply price, supply is indefinitely large. Now this account of the matter must not be interpreted as meaning that producers actually get out and put on the market an indefinitely large amount of the product in- volved. Supply always means the amount sellers stand ready to dis- pose of at the given price; and, in the case of normal schedules for producible goods, standing rea^y does not necessarily involve that the given volume is actually produced if the given price is reached. Producers stand ready to go this far, but have time to experiment with the situation and of course will not effect such production unless they are warranted in doing so by the actual demand conditions. If they cannot usually market the goods they will not produce them, though their supply price has been reached. The appearance of their price is not alone sufficient to insure production. The volume of product is consciously adjusted to the actual demand. V The Normal Supply Schedules of Fixed-Supply Goods The preceding section was occupied with the consideration of the supply schedules of producible goods. We now take up the schedules of goods which are strictly non-producible or, for some reason, behave as if they were of this sort. They may be goods of which the stock is fixed, like the land on the earth's surface, or goods having a regular output but one which is fixed, like the annual uses of land as a site or as a something on which a crop can be raised. The former we might call fixed-stock goods ; the latter, fixed-output goods. We here designate them fixed-supply goods, because, as will appear in a mo- ment, the situation makes their normal supply constant and so makes this a characteristic mark for them all. XXV] NORMAL SUPPLY SCHEDULES 323 Supply Price Anything above Zero. We may take as one of the most important of these fixed-supply goods, the uses of land just mentioned. Thus, within the area of a given city, there are just so many sites, say 10, of a certain degree of desirability for busi- ness purposes. Broadly speaking, no human action can increase or diminish their number. From the standpoint of normal price, what will be their supply schedule? Doubtless their market schedule would present itself as similar to the one given on page 270. That is, the number offered would vary directly with the price. But the situation for the normal schedule is different. Normal price is not concerned with momentary tendencies as is market price, but with tendencies covering a period of some length, a period long enough to eliminate uncertainty with respect to real values and the real attitudes of possible buyers. Now, over any such period, the attitude of owners will be that all the uses of such sites must be marketed at some price whatever price can be obtained. The site uses not being produced, the owners cannot save a cost of production by withhold- ing them from the market. Those owners would prefer to get higher prices ; but anything is better than nothing. Hence, in the long run, owners will offer all these uses of sites for whatever price they will bring. In this particular case of sites, there is another consideration which makes the period necessary to bring all the sites on the market a rather short one. While some types of non-producible goods are capable of indefinite preservation,, hence can be reserved for future use, and so can profitably be withheld from the market for consider- able periods, 6 nothing of the kind is true of the uses of a site. These cannot be preserved at all ; they are absolutely perishable, live but for the moment. If the owner of a site does not sell the 1920 use of that site during 1920, he can never sell it at all. He can of course sell the 1921 use, the 1922 use, and so on; but the 1920 use is gone forever. Doubtless, in the process of bargaining with possible ten- ants, it may be of advantage to owners to forego the opportunity to " Doubtless the owners of such goods will not carry out this policy indefinitely. The risks are too great ; and man, being mortal, his interest in possible future gains is limited. 324 PRINCIPLES OF ECONOMICS [XXV dispose of some of the uses of a site. But the operation is evidently an expensive one ; and will not be engaged in to an indefinite extent. From all this it follows that, in this case of the ten sites, the supply of uses will be just ten at every price: the supply will be a fixed, unchanging, supply. Accordingly, the normal supply schedule of these sites would read as in the accompanying table : 10 offered when the price is $12,000; 10 offered when the price is $11,000; 10 offered when it is $10,000 ; and so on. Cases Among Producible Goods. To get a perfect case of fixed-supply goods, we chose a special kind of non-producible goods, the annual uses of land. We find, how- PRICE SUPPLY ever that cases of this sort arise among ooo No. OF . . DOLLARS SITES producible goods. Thus, the designation 12 fixed-supply goods is obviously applicable to I0 I0 goods which were produced by some one no 9 IO longer living. Another case is supplied by 7 10 goods which have gone out of fashion. Such 6 10 goods can, literally speaking, still be pro- I0 duced ; but, not being longer wanted, they 3 10 will not be produced, they are economic- j I0 ally non-producible. A much more impor- 9 10 tant case is that of some agricultural prod- I0 uct between two harvests. Thus, roughly speaking, our stock of wheat cannot be in- creased from the end of the 1920 harvest to that of the 1921 harvest ; so that, during this period, the supply could not be extended beyond the existing stock. On the other hand, the prospect of a new crop putting in an appearance usually insures that the whole existing stock will pass into supply during the current year. Thus, the nor- mal supply for the year is identical with the existing stock, and so that supply is a fixed one. It is plain that these later cases of fixed-supply goods fulfil the condition from which their designation is derived much less per- T Remember that wheat is a fixed-supply good only when we are looking at it for the brief period between two harvests. Over a longer period, it is an increasing-cost good, having its price determined by a different law- NORMAL SUPPLY SCHEDULES 325 fectly than the one first chosen for illustration. They do, however, fulfil that condition in a sufficiently large measure to merit the designation. In the process of price determination, they behave, in a general way, as do the strictly non-producible goods. It should be added that cases of this sort quasi -fixed-supply goods we might call them are likely to appear temporarily in quite unexpected places, in connection with all sorts of goods. But these will more naturally receive comment in a later connection. CHAPTER XXVI In the two preceding chapters we have discussed normal demand schedules, with the significances to consumers which lie back of them, and normal supply schedules, with the costs of production which in two cases lie behind these. It is through these normal demand and supply schedules that the normal prices of goods are determined. We are now, therefore, in a position to take up the di- rect study of those principles which are commonly given as govern- ing normal price. We shall treat in succession the three classes of goods the supply schedules of which were studied in the last chapter, taking them up in reverse order, fixed-supply goods, constant-cost goods, and in- creasing-cost goods. By this process we prepare ourselves to handle almost every case of normal price determination; for the three classes of goods named have their normal prices determined in three different ways, and those three ways include practically all the ways, and indeed quite all the most important ones, in which normal price can be determined. Speaking generally, we may say that the goods of the first class have their prices determined from the demand side only through the prices of the demand schedule; that goods of the second class have their prices determined from the supply side only through the prices of the supply schedule; and that those of the third class have their prices determined by elements from both demand and supply through the prices of both the demand and the supply schedules. We begin with that class the prices of which are determined from the demand side only. 326 XXVI] NORMAL PRICE DETERMINATION 327 Normal Price of Fixed-Supply Goods We will take as an example of fixed-supply goods copies of the Basel edition of Sir Thomas More's Utopia. Suppose that, at about the same time in the year 1925, three or four finds are made, bring- ing on the market a new supply of these books amounting to ten copies. Suppose, further, that the demands of libraries and private collectors are such that the aggregate demand schedule is as follows : i copy wanted, if price is $200; 2 copies, if price is $175; 4 copies, if $160; 6 copies, if $125 ; 10, if $100; n, if a, .<*. i TTJJ.U DEMAND PRICE SUPPLY $90; 14, if $75; and so on. Under these DOLLARS conditions, what must the price tend to be, i 200 10 and what principles will regulate that price ? J^o The accompanying demand and supply 6 125 10 schedule shows that the price could not be * : ^ above $100; for, if it went above this figure, 14 75 i 4 buyers would withdraw, making demand * 50 deficient, and, in order to guard against this result, the sellers would bring price down to $100. On the other hand, price could not go down to $90; since, if it did one new buyer would come in, making demand excessive, a result which $ioo-buyers would have to guard against by bidding price up to at least $91. Actual price, then, must tend to be some price between $91 and $100, inclusive. The first and most obvious comment on this case is that our familiar law of supply and demand is still operative. A price must be reached at which demand and supply are equal. If demand and supply were not quite equal at one of the prices given in the schedule, the necessary equating would be effected in practice by compromise prices between those given. Equality of demand and supply would be reached at $95 or $94 or $97 or at some other figure between $90 and $100. Further, it is manifest that the law of supply and de- mand is regulating not merely market price but normal price also. The market price, under this law, would in successive hours or days or weeks probably run both above and below $100, perhaps mostly 328 PRINCIPLES OF ECONOMICS [XXVI above. But under the same law, as a final resultant, a normal price of $100 would be affirming itself. We have noted that, in this case of fixed-supply goods, the law of supply and demand is still operative and is determining normal price. It may be worth while to add that the law may here be af- firmed in a somewhat special sense. Since supply is, by hypothesis, constant and so demand must do all the changing, and since supply is in the long run identical with stock, we are justified in restating the principle as follows : In the case of fixed-supply goods, the nor- mal price must tend to be that price or some one of that series of prices which will cause demand to become equal with the unchanging supply. Or, more briefly, the normal price must tend to be that one or at least some one of that series which will equate demand to stock. In seeking a deeper knowledge of the processes by which nor- mal price is determined, the natural procedure is to note first the re- lations between the price which is necessary to equate supply and demand and the particular supply prices and the particular demand prices which are the immediately effective ones in the regulation of price. These, we remember, are the marginal demand price and the first extra-marginal supply price for the upper limit of price and the marginal supply price and the first extra-marginal demand price for the lower limit. Are all of these operative in the case of fixed- supply goods, and if not, which ones are? The answer is quickly given: Only the demand price limits are operative. As we saw in our first analysis of the Utopia example, at least one reason why normal price could not be above $100 is that, unless price is as low as $100, the last increment of demand will not appear at all, and sellers, therefore, will be obliged to bid actual price down to $100 to insure disposal of the stock. That one of the two variables fixing the upper limit of price which comes from demand, the mar- ginal demand price, is thus actually operative. But the other variable fixing this limit, the one which comes from supply, is not operative. Sellers are not compelled to bid price down in order to prevent the appearance of a new supply ; for there is no new supply to appear supply is constant. In other words, the first extra-marginal sup- XXVI] NORMAL PRICE DETERMINATION 329 ply price has no share in fixing the upper limit of actual price. That limit is fixed by the marginal demand price only. 1 Turning, now, to the lower limit of price of this same com- modity, it is evident that actual price could not go down to $90 be- cause this would make demand increase by one copy, thus compelling buyers to bid price up to some higher figure in order to exclude this increment of demand. But, on the other hand, buyers do not have to hold price up in order to keep in the marginal supply; for, by hy- .pothesis, supply is constant and therefore will not fall with a de- clining price. In short, that one of the variables fixing the lower limit of price which comes from demand the first extra-marginal demand price is the only one actually operative. From this analysis, it follows that, in the case of fixed-supply goods, the normal price must be one of the prices ranging from a limit fixed by the marginal demand price, and that only, down to a limit fixed by the first extra-marginal demand price, and that only. The above formula confines itself to defining the limits within which normal price must tend to fall. But, as already noted, actual demand schedules for most commodities are continuous, show changes in the volume of demand for practically every change in price. In consequence, the marginal and the first extra-marginal de- mand prices will be in juxtaposition and therefore actual price can- not go below the marginal demand price at all without reaching the first extra-marginal demand price. In practice, then, it will usually be sufficient to define normal price by one of these limiting moments, the marginal demand price. Hence the following formula: Principle. Generally speaking, the normal price of a fixed-supply commodity must tend to coincide with its mar- ginal demand price. The formula just given makes the marginal demand price the decisive factor in determining the normal price of fixed-supply goods. But as was explained in Chapter XXIV, the marginal demand price must usually be an expression of the marginal significance to the marginal buyer, as estimated by himself, of the quantity of' a com- 'The limit is the first price above. 330 PRINCIPLES OF ECONOMICS [XXVI modity he proposes to buy; and this, in turn, must be determined by his estimate of the marginal utility he expects to derive from that quantity of the commodity. Further, the marginal significance or utility to the marginal buyer is the general marginal significance or simply the marginal significance. And, finally, in any formula con- taining the phrase "marginal demand price," we can substitute the phrase "marginal significance" or the phrase "marginal utility." Hence the following formula: Principle The Marginal Significance or Utility Principle. Generally speaking, the normal price of a fixed-supply commodity must tend to be that price which expresses the marginal significance or utility of the existing stock of said commodity. ILLUSTRATIVE PROBLEMS 1. During the current year, there came on the market from various sources twelve specimens of a certain rare object. If the ultimate de- mand schedule proves to be as follows : i wanted at $60 ; 2 more at $55 ; 4 more at $50 ; 5 more at $45 ; 6 more at $40 ; etc., what price will in the long run tend to be reached? Prove. 2. In a certain year the output of wheat proved to be 2,000 millions of bushels. The ultimate demand schedule for the year ensuing till the next harvest was as follows: 1,600 million bushels wanted if price were $1.30; 1,800 millions if price were $1.25; 2,000 millions if $1.20; 2,200 millions if $1.15; and so on. (a) What price would tend to prevail for that year? Prove in detail. (b) What would determine it? (c) What price would tend to prevail if the demand moved up a step, making the schedule 1,800 millions at $1.30; 2,000 millions at $1.25; 2,200 at $1.20; 2,400 at $1.15; and so on? (d) What price if demand moved up two steps, making the sched- ule: 2,000 millions at $1.30; 2,200 at $1.25; and so on? (e) What price if demand moved down two steps, making the sched- ule: 1,200 millions wanted at $1.30; 1,400 millions at $1.25; 1,600 at $1.20; 1,800 at $1.15; 2,000 at $1.10; and so on? XXVI] NORMAL PRICE DETERMINATION 33! 3. "In 1348-49 the black death carried off from one-third to one- half of England's workingmen. In consequence wages greatly ad- vanced." (a) Explain the advance in wages on the basis of the Law of Sup- ply and Demand given on page 286, constructing for the purpose im- aginary demand and supply schedules. (b) Explain the advance in wages on the basis of the Marginal Significance principle given above. (c) Discuss this statement: "Wages rose because the demand for. the laborers who were left had greatly increased." I'- ll Normal Price of Constant-Cost Goods In sharp contrast with the class of goods just considered, fixed- supply goods, are the constant-cost goods with which we now deal. The former had no supply price, or perhaps better, their supply price was indeterminate. Constant-cost goods, on the other hand, have just one supply price. Within the limits of the demand likely to develop, an indefinitely large supply will be forthcoming at that one price, while none will be forthcoming at any lower price. As a hypothetical example of this class of goods, we will take the wooden chair used in the fifth problem on page 159. This chair is a con- stant-cost good at the single price of 30 cents, so long as demand is not less than 500,000 and not greater than $2,000,000. That is, a price as high as 30 cents is necessary to bring out any supply at all, since this is the cost of production ; and this price will bring out a supply indefinitely large as compared with demand. The law of normal price for this case is easily derived. As we found in Chapter XXIII, the limits of price variation may be fixed by two prices from the demand side, or by two prices from the supply side, or by some combination of these. But, in this particular case, the operation of supply prices in fixing these limits is so de- cisive that demand prices may be ignored altogether. There is but one price which supply conditions will permit to exist; that one, therefore, must prevail. This results from the fact that in this case, the limits fixed by the marginal and first extra-marginal supply prices coincide. Our chair will not be supplied at all, unless the price 332 PRINCIPLES OF ECONOMICS [XXVI is as high as 30 cents; and any additional chairs wanted will be forthcoming as long as this price is offered. The former condition insures that actual price cannot be lower than 30 cents; the latter insures that it cannot be higher than 30 cents. It is thus rigidly fixed at this one point. The normal price of such a commodity must tend to co- incide with the single supply price without respect to demand prices. 2 The principle just brought out, the exclusive dependence of con- stant-cost goods on the supply price, is so important that it seems best to give it the benefit of ample illustration. We take for this purpose our wooden chair. The accompanying table shows the single supply schedule for amounts between 500,000 and 2,000,000, and several hypothetical demand schedules. Strictly speaking, our supply schedule should show but one price. But, since producers who are ready to supply any amounts between 500,000 and 2,000,000 at 30 cents will of course be ready to furnish these amounts at any higher price, we can without inaccuracy set down these figures for supply at the higher prices of the demand schedules; and, since this procedure will contribute to convenience, it is adopted in the table. Combining, now, supply schedule S with demand schedule A, it is plain that price must tend to be just 30 cents. Price could not be higher than this; since sellers, being ready to supply much more than the total amount demanded at 30 cents, will bid down to that figure in order to get as much of the market as possible. On the other hand, since there is no supply forthcoming at prices below 30 cents, buyers will bid price up to that figure to insure getting what they want. Exactly similar reasoning would show that the price must necessarily tend to be just 30 cents with demand schedule B or C or D or, in fact, with any one we could imagine which made de- mand at 30 cents more than 500,000 and less than 2,000,000. But not only will price be 30 cents, the single supply price, it will rest at that point uninfluenced by demand prices. 3 The most ' Of course this does not mean that actual price can be emancipated from all relation to demand prices. Actual price could never be higher than the marginal demand price. But this simply means that, if the marginal demand price were not as high as the single supply price, the commodity in question would not be produced at all, and hence the problem of its price determination would not arise at all. 3 Remember, however, the qualification already noted. XXVI] NORMAL PRICE DETERMINATION 333 clearly decisive proof of this assertion is to be found in the fact that the same price would be reached if our demand schedule were so altered as to put the demand prices which might influence the matter quite outside of the price bound to prevail. Thus, let us suppose the schedule D to be so altered that from 50 cents to 15 cents there is no change in the volume of demand. Now, under this schedule as under the others, normal price must tend to rest at 30 cents ; buy- ers will hold it up to this point; sellers will hold it down to this point. But with a normal price of 30 cents, the marginal demand price for schedule E would have to be 50 cents, since that price is low enough to bring in the whole demand actually satisfied; while the first extra-marginal demand price would have to be 15 cents, since no addition to demand takes place till this price is reached. But neither of these prices influences a price set at 30 cents. A marginal demand price of 50 cents would permit actual price to rise to 50 cents; while a first extra-marginal demand price of 15 cents would permit actual price to fall as low as 20 cents. But, in fact, actual price cannot rise above 30 cents, nor fall below 30 cents. Its position, therefore, is uninfluenced by the demand prices. SUPPLY PRICE DEMAND ooo Schedule S Schedule Schedule Schedule Schedule Schedule 000 Dollars A B C D E 500-2000 3 2 3 3 5 5 500-2000 2 10 12 15 20 20 500-2000 I 50 51 60 80 80 500-2000 75 300 500 Sio IIOO IIOO 500-2000 50 500 750 IO2O 1400 1400 500-2000 .40 6OO 895 1200 1520 1400 500-2000 30 7OO 950 1540 1840 1400 o .25 IOOO I2IO 2OOO 2560 1400 o .20 1500 I800 256O 2800 1400 o 15 2500 3000 3800 4563 2000 We are now in a position to observe the final results of our study of constant-cost goods. These goods, we have just shown, must tend to have a price coincident with their single supply price, un- influenced by their demand prices. But that single supply price, a? we learned in the chapter on supply schedules, is the cost of pro- 334 PRINCIPLES OF ECONOMICS [XXVI duction to the representative producer; and demand prices, as we learned in the chapter on demand schedules, are expressions of the marginal significance or utility of the commodity to marginal con- sumers. 'Making the substitution of terms, therefore, we may say that the price of a constant-cost commodity tends to coincide with its cost to representative producers, uninfluenced by the significance or utility of the commodity to consumers. 4 The result of the preceding discussion has been to set up cost of production as the determinant of the normal price of constant- cost goods. However, a word of caution is here necessary. The power of cost to determine price is derived from its power to in- fluence the forthcoming of supply. Its influence, therefore, is ex- ercised through the future rather than the past. It is not because the existing product had a cost that price has to equal cost, but be- cause the future output will have a cost. From this fact it results that unless there is call for future production, cost can have no influence on price. If, for example, a change in fashion makes the existing stock of a particular style of shoe in excess of any possible demand at a price as high as cost, there will obviously be no need for further production, and so cost will have no influence on the price. Such a commodity will, as seen in our classification of com- modities, pass into the class of fixed-supply goods. Its price will then become purely a matter of demand prices and, therefore, of the forces lying behind those prices, namely, significance or utility. To insure our recognition of this point, our principle will explicitly state that the continued production of the commodity in question must be called for. Another caution is suggested by the consideration on which the last was based, that cost of production acts only through its re- lation to future product. Cost of production may change, rise or fall ; and, after every change, it will be the new cost which must de- termine price. To anticipate this difficulty, some writers have argued that we ought to say "price must equal cost of reproduction." To this, however, the answer of Cairnes is perhaps sufficient: All scientific principles assume constancy of conditions ; the cost of which * Remember the qualification. XXVI] NORMAL PRICE DETERMINATION 335 is decisive at any period is the cost of that period, conditions sup- posed to be unchanged. But, if anyone prefers, there is no serious objection to saying cost of reproduction. The principle brought out in this discussion may now be formu- lated as follows : Principle. The normal price of constant-cost goods, the continued production of which is demanded, must ap- proximately equal their cost to representative producers. ILLUSTRATIVE PROBLEMS 1. From a cement factor promoter in 1901 : "We can easily satisfy any fair-minded person that our proposition is a veritable gold mine. Cement can be put on the market by a well-equipped mill at a cost of about $1.75 a barrel, while it is selling for $4, thus giving a profit of over 100 per cent. With the supply of raw material practically unlimited, our mill will soon be turning out 600,000 barrels per year, and our annual profits will be nearly $1,500,000. You can't afford to stay out." Supposing the facts to be as stated, what economic law was over- looked in drawing conclusions? 2. "Labor once spent has no influence on the future value of any article." (a) Show that this is true as applied to the wooden chair which was used in working out our principle. (b) Does the above statement, admitting it'to be true, invalidate our principle? 3. At a certain time the price of whiskey in this country was about fifty cents, the cost of producing it. The United States government thereupon levied on each gallon produced a tax of one dollar. What naturally happened to the price of whiskey? Why? 4. "Let us suppose that five or six concerns are supplying the build- ing brick used in a certain district, and that by a new method of manu- facture they manage to double their output for the former expenses of labor. What will happen as regards the price of brick? From our knowledge of what competition usually does, we are apt to say: the price of brick will fall 50 per cent. This may be the final result, but not necessarily so. ... Manufacturers in normal times will increase their production of brick. ... To take off the extra supply of brick they must 33 6 PRINCIPLES OF ECONOMICS [XXVI find a wider circle of demand. ... It may, however, happen not in the case of brick probably, but in large articles of limited consumption that there is no such circle of demand at lower levels; then what will happen is that the manufacturers will cut down their output to the same quan- tity of brick as before, and maintain the former high price. ... It is contrary to all experience to think that employers will voluntarily raise wages or pay higher interest because costs have decreased. They only do so under compulsion of fear that their rivals will cut the feet from under them. Where competition is active it will often seem as though reduction of costs were almost immediately followed by fall in prices of products, but, in the last resort and that is what concerns us in seeking for a universal law of value the new prices are determined by the lower and wider levels of want which are ready to take up increased supply of the majority of ordinary commodities." The above quotation is taken from the writings of an able economist. It has been modified at a few points to eliminate ambiguities. I think, however, that it does not misrepresent his views. In any case, it brings out a way of looking at the matter which the student should be familiar with. (a) State clearly what is the precise point which the author seems to be trying to make. (b) Show that it is unsound. 5. A certain residence in Ann Arbor is taxed each year, let us say, $42, of which sum $12 is properly chargeable to the land while the re- maining $30 is chargeable to the house. Under the operation of the two principles of normal price which we have now had, the $30 will really be paid by the tenant, being shifted from the landlord to him, while the $12 will not be shifted and so, as far as the future is concerned, will re- main on the landlord. Explain how it is that things come out this way. Ill Normal Price of Increasing-Cost Goods Fixed-supply goods, we have found, have their prices determined by demand forces only. Constant-cost goods, on the other hand, have their prices determined by supply forces only. But in the case of increasing-cost goods with which we now deal, forces from both sides participate. This grows out of the fact that the supply schedule is of the sort called typical in our first account of these schedules. XXVI] NORMAL PRICE DETERMINATION 337 Since, by definition, the cost of these products increases as the out- put increases, their supply schedule will show a change in supply for every change in the supply price. But general demand schedules, as explained in Chapter XXIV, are practically always of the typical sort, showing change in the volume of demand with every change in price. Hence our present case is one wherein both schedules are of the regular type. In consequence, any price which does not equalize demand and supply sets up reactions tending to displace that price, on both the demand side and the supply side; and these reactions influence the determination of the point where price finally rests, whether they come from the side of demand or that of supply. Normal price, then, for increasing-cost goods is determined by both demand and supply forces. Perhaps the best way to confirm this reasoning is to show by illustration ( i ) that every variation in either the demand schedule or the supply schedule would cause a change in price, and (2) that the determination of the new price would have been influenced, not by the changing element only, but also by the one which remained constant. The first point may be seen by a moment's study of the accompanying table, which gives three different schedules of the typical sort on each side. Whichever ones we combine at the outset (not including D'" or S'") if we keep the supply schedule constant and unite with it a different one of the demand schedules, a new price necessarily emerges. A precisely similar result is reached if any one of the demand schedules is kept constant .and a different supply schedule combined with it. The second point is not so easily seen, but is no less certain. When a new price is fixed by the use of a new demand (or supply) schedule, that price after all is not made what it is simply by this new demand (or supply) schedule it is also influenced by the schedule which was kept constant. To illustrate, let us start with two combinations both of which give a price of 55 cents, namely, demand schedule D with supply schedule S, and the same demand schedule with supply schedule S'", a schedule which shows supply unchanging from 53 cents to 57. Let us now substitute demand schedule D' in the two combinations successively and note the differ- ent results. The first experiment, putting D' with S, causes price 338 PRINCIPLES OF ECONOMICS [XXVI DEMAND, 000,000 oz. SUPPLY, 000,000 oz. Schedule Schedule Schedule Schedule A itn r. CENTS Schedule Schedule Schedule Schedule D"' D" D' D S S' S" S'" 230 100 230 2IO 60 310 330 290 20X) 240 200 240 22O 59 300 320 280 280 250 2IO 250 230 58 200 310 270 270 260 22O 260 240 57 280 300 260 260 260 230 270 250 56 270 290 250 260 260 24O 280 260 55 260 280 240 260 260 250 290 27O 54 250 270 230 260 260 260 300 280 53 240 260 22O 260 270 270 310 2OO 52 230 250 2IO 250 280 280 320 300 5i 22O 240 200 240 290 200 330 310 50 2IO 230 IQO 230 to advance i cent, from 55 to 56. The second experiment, putting D' with S'" makes price advance 2 cents, from 55 to 57. The obvious reason is that, in the latter case, unchanging supply left to demand alone the equalizing of demand and supply and so price had to advance two full steps ; while, in the former case, increasing sup- ply made possible the equalizing of demand and supply I cent earlier, and so stopped the rise of price at one step. We have seen that the normal price of increasing-cost goods must tend to be one which is influenced by the forces of both demand and supply and so by all four of those moments which fix the limits of price variation, namely, the marginal and first extra-marginal demand prices and the marginal and first extra-marginal supply prices. But in Chapters XXIV and XXV we learned that the de- mand prices are expressions of the significance or utilities of the several amounts of the product in question, while the supply prices are the different marginal costs of production. Hence in the above statement we may substitute for the phrases "demand prices" and "supply prices" the words "significances" and "costs." In short, the prices of increasing-cost goods are determined by both significance, or utility, and cost. More precisely the price of an increasing-cost good must not go above that price which expresses its marginal significance nor up to one which equals its first extra-marginal cost, and must not go below its marginal cost nor down to a price which expresses its first extra-marginal significance or utility. XXVI] NORMAL PRICE DETERMINATION 339 If we assume for the sake of convenience that both the demand and supply schedules are perfectly typical and regular, it follows that the two upper limits would fix the same price, as in the schedule on page 281, and the same would be true of the two lower. It would then leave our formula still adequate if we were to omit the limit fixed by extra-marginal significance or cost and say : "The price of an increasing cost product must be one which approximately ex- presses its marginal significance or utility and equals its marginal cost." Before finally accepting this formula, however, it seems desir- able to make some comments in the nature of cautions. First, in order to anticipate an objectionable interpretation which some have made, it is perhaps best to insert the word "normal" before marginal cost. The marginal cost is the greatest cost at which production is being carried on, and this might be taken to mean the cost to pro- ducers who are quite behind the times in methods and facilities and are perhaps losing money but have no other alternative than going on till they become bankrupt. But actual price is commonly lower than cost to such producers ; hence the formula breaks down. The answer is that such persons are not true marginal producers. A marginal producer drops out if price falls below his figure, while the persons in question continue whatever the price. They are far within the margin, or, better, are wholly abnormal elements. Not their cost, but the normal marginal cost, determines price. Another point calling for a moment's attention is the following : If either or both of the schedules considered are discontinuous, price will not necessarily coincide exactly with either marginal significance or marginal cost. But it will be in so far fixed by both of these that, on the one hand, it must not go above the marginal significance nor down to the first extra-marginal significance ; while, on the other hand, it must not go below the marginal cost nor up to the first extra-marginal cost. Finally, it is of course always possible to argue that, in making up a formula, either one of the determinants might be chosen and the other one omitted, on the ground that either implies the other. But if we affirm the relation of price to either factor, making no men- tion of the other, there is danger that we shall be understood to mean 340 PRINCIPLES OF ECONOMICS [XXVI that the one we do mention is alone responsible for the price, to the entire exclusion of the other. So, in the opinion of the writer, it is unsafe to carry the ellipsis further than we do in the formula now to be stated. Principle. The normal price of increasing cost goods, the continued production of which is demanded, tends to be a price which both expresses the marginal significance of the output and equals its normal marginal cost. ILLUSTRATIVE PROBLEMS 1. Suppose that the production schedule of silver reads as follows: At a marginal cost of 55 cents, 170 million ounces can be furnished; at a marginal cost of 56 cents, 175 millions ounces; at 57 cents, 180 millions; at 58 cents, 185 millions; at 59 cents, 190 millions; at 60 cents, 195 mil- lions; at 6 1 cents, 200 millions; at 62 cents, 205 millions; at 63 cents, 210 millions ; etc. Suppose, secondly, that the demand schedule is as follows : 1 60 millions ounces wanted, if price is 65 cents; 165 millions, if price is 64 cents; 170 millions, at 63 cents; 175 millions, at 62 cents; 180 millions, at 6 1 cents; 185 millions, at 60 cents; 190 millions, at 59 cents; 195 mil- lions, at 58 cents; 200 millions, at 57 cents; etc. (a) Make out a table giving the ultimate demand and supply sched- ules. (b) What must price tend .to be ? Prove. (c) What will it tend to be if demand moves up two steps, becoming : 170 millions wanted if price is 65 cents; 175 millions if price is 64 cents; and so on. Prove. (d) What determines price in these two cases? 2. "At the present time (1896) silver is being produced at a marginal cost of approximately 65 cents per ounce. But the price of silver is in the long run determined by its marginal cost. Hence it is ridiculous to expect that the adoption of free coinage by the United States will raise the price of silver, as measured in gold, to $1.29 per ounce, or any other figure above 65 cents." Admitting that the normal price of silver must in the long run coincide with marginal cost, still the above conclusion is unsound. Explain. 3. Suppose the production schedule in Problem I to be changed so as to read as follows : At a marginal cost of 55 cents, 175 millions ounces XXVI] NORMAL PRICE DETERMINATION 341 can be furnished; between 55 cents and 59 cents no change is possible; at a marginal cost of 59 cents, 500 millions ounces can be furnished; at 60 cents, 525 millions ounces; and so on. (a) What would price tend to be when the demand schedule was the same in Problem i (a) ? Prove. (b) What would price tend to be if the demand schedule were moved up ?.s in Problem i (c) ? Prove. (c) What would price tend to be if the demand schedule were moved up two more steps so as to begin: 180 millions ounces wanted at 65 cents? Prove. (d) What is the point to be made? 4. The author of a recent textbook in Economics expresses himself on the relation of cost to price in this vein : In the case of reproducible goods, "cost of production seems of commanding importance." "In fact, however, marginal efficiency (utility) is the real determinant of price," "cost of production adjusts itself to this." "There is an abundance of silver below the surface that is not mined because it will not pay; if the marginal efficiency or value of silver should rise, these more expensive grades would at once be marketed and the new marginal cost of produc- tion would adjust itself to the price." (a) Construct a sentence running parallel to the last one quoted, but exactly reversing the roles of marginal utility and marginal cost, whereby it would seem to be proved that marginal cost really determines price while marginal utility merely adjusts itself to price. The sentence should start out something like this : "Generally speaking, it would seem as if marginal utility chiefly regulated price. In fact, however, marginal cost is the real determinant; marginal utility adjusts itself to this. Below the present demand for silver there are numerous layers of demand which are now merely potential because the corresponding utilities are below the present market price; if, now, the marginal cost of producing silver should fall, and so the price should fall, these lower layers of demand, etc. . . ." (b) Show that both the original quotation and our substitute are inadequate, that the price reached in the former case is influenced by marginal cost, while that reached in the latter case is influenced by mar- ginal utility. CHAPTER XXVII SPECIAL CASES OF NORMAL PRICE The general principles governing normal price have been brought out in the preceding chapter. But there are some cases of a rather unusual character which call for special treatment. Some, on ac- count of peculiar complications, are not provided for at all in the foregoing principles. Others could be fairly covered by a careful interpretation of those principles ; but, because of certain peculiarities, further explanation is needed to guard against misunderstanding. In still other cases, there is reason for attempting a special state- ment, because, although the principles already laid down quite plainly apply to them, it is possible for various reasons to go deeper, to find some more ultimate statement of the process whereby price is de- termined. I Rare Products A very interesting special case is that of produced goods which are so limited in possible amount that they behave almost like non- producible goods. We speak of them as rare products. Notable ex- amples are the very rare metals, such as radium, iridium, even plat- inum. We should probably have to count in the same class various vegetable products, special brands of tea, tobacco, or wines. As already indicated, the distinguishing mark of this class of goods is the fact that the total possible output is extremely restricted as compared with the demands at very high prices. In consequence, increases in output through increased expenditure, though they can be made, are practically negligible. Goods of this sort give us a production or supply schedule which looks something like a regular increasing-cost schedule. In fact, however, the extreme smallness of increase in output with rise in price differentiates these from the typical cases such as we had in silver. The accompanying schedule, 342 XXVII] SPECIAL CASES OF NORMAL PRICE 343 an imaginary one for a very rare brand of tea, may be taken as representative. Every considerable increase in output takes place while cost is still quite low, and after cost has passed $25 the ad- ditions are all in single pounds and even fractions of a pound. If this supply schedule be combined with the demand schedule marked D, a price of $250 per pound results, and this price is really deter- DEMAND OOO POUNDS PRICE DOLLARS SUPPLY OOO POUNDS D" D' D S S' i 6 3 500 11.683888 40 2 8 5 450 11.683885 25 3 10 6 400 11.68388 18 5 12 8 350 11.68387 15 6 13 10 300 11.68385 13 8 15 12 250 11.6838 12 10 18 13 200 11.6835 10 12 25 15 150 11.683 8 13 40 18 IOO 11.682 6 15 60 25 50 11.680 5 18 100 40 25 11.675 3 25 120 60 10 11.650 2 40 160 IOO 5- 11.600 I 60 180 120 4- 11.500 100 200 160 3- 11.350 1 20 500 180 2.50 II. IOO 160 700 200 2. 10.800 180 1,500 500 1-75 10.500 200 3,000 700 1.50 9.900 500 10,000 1,500 1.25 9- 700 15,000 3,000 I. 7-7 1,500 20,000 10,000 75 6. 3,000 30,000 15,000 50 4. mined in just the same way it would be if the possible output for each year were absolutely fixed at 11,000 pounds, by the marginal significance. The fact that the output can be increased beyond 11,000 pounds, and the further fact that in the end the price actually coincides with the marginal cost of production, have really nothing to do with fixing the price at $250. Marginal significance alone is effective. This contention is most plainly established by noting the effect of raising or lowering the demand schedule and seeing how the re- sults differ from what they would be if we had a typical case of 344 PRINCIPLES OF ECONOMICS [XXVII increasing-cost goods. Thus, when demand schedule D', represent- ing demand as having advanced two steps all along the line, is com- bined with the supply schedule, price also advances two steps, from $250 to $350. So demand schedule D", which represents one re- sulting from a decline of two steps in demand, causes the price also to drop two steps, from $250 to $150. If now our supply schedule had been a typical one wherein supply appreciably increased as the mar- ginal expenditure increased represented in schedule S', the result would have been quite different. Our original demand schedule D combined with this new supply schedule would have given us, as before, a price of $250. But the change to D' would have caused an advance in price, not of two steps, but only of one, from $250 to $300. So, combining D" with the new supply schedule would have caused a drop in price, not of two steps, but only one, from $250 to $200. The reason is plain. In the latter case, the substantial increase in output, as price rose under schedule D', brought supply and de- mand together at an earlier price; while the substantial falling off in output, as price fell under schedule D", brought supply and de- mand to equality at the earlier point. With the original supply schedule, both of these conditions were lacking. The increase as price rose was negligible, the decrease as price fell was negligible. The new prices, therefore, were fixed without respect to supply or cost. We have here in effect a fixed-supply or fixed-output com- modity, the price of which is determined by marginal significance alone. II Joint-Cost Products In studying not a few producible goods, we strike a complication due to the fact that several different commodities emerge from the same productive process. Thus, the dairyman simultaneously and by productive efforts, a large share of which are inseparable, brings into existence milk, butter, cheese, beef, and hides. The refining of pe- troleum yields not only common illuminating oil, kerosene, but also vaseline, gasolene, and naphtha. Again, the coal tar resulting from the distillation of coal for the making of gas gives us a whole line XXVII] SPECIAL CASES OF NORMAL PRICE 345 of by-products, including various drugs, perfumes, and a large number of dyes. Now, in cases like these it is impossible, save in very small measure, to isolate the share in the cost of production which is properly chargeable to each of the several products. This being true, we surely cannot apply to these goods, without qualifica- tion, the principle laid down for other producible goods. The special theory needed here was set forth by Mill. It is that the price of each of the individual products must "be such as to equalize supply and demand for that product; while the money value of the whole group of products must equal their cost of production. In consistency with the modern analysis which goes behind demand to significance or utility, we should change the first part of this formula to read "the price of each of the individual products must tend to be that price which expresses the marginal significance of the quantity of that particular product which is put upon the mar- ket." The second part of the formula can remain unchanged. The argument in support of this principle is as follows : First, the price of each member of the group of products must be such as to express its marginal significance, because, under the conditions given, the quantity of each of the products is virtually fixed, and hence it comes under the laws of fixed-supply goods. This, of course, does not mean that the supply of each commodity is literally unchanging; but that its changes do not take place in response to conditions which affect that commodity itself only, but rather in re- sponse to conditions which affect all the commodities of the group. When, therefore, the price of any one of them is in process of de- termination, the supply of that one is virtually fixed ; and hence the principle governing its price is the one which governs the price of fixed-supply goods. But the principle in question makes the price of these goods depend upon marginal significance ; and so marginal significance governs the case now before us. It is no less certain that the prices of all the members of the group must be such that the sum total of their money values will equal their joint cost of production. This result is bound to be brought about through processes already thoroughly familiar. If at any point the sum total of the group prices should rise above this total cost of the group products, capital will move into the industry, supply all along 346 PRINCIPLES OF ECONOMICS [XXVII the line would increase, marginal significance would fall, and so prices would fall. Conversely, if the total costs were not covered by the total values, capital would withdraw from the industry, the supply of the several commodities would fall off, their marginal significance would rise, and so prices would rise. Doubtless this readjustment would be much more complicated and hence much slower than in the case of isolated individual products, but in the long run it would inevitably come about. Principle. The price of each member of a group of joint-cost products tends to be that price which expresses the marginal significance or utility of the quantity of that particular product which is put upon the market, provided that the sum of the money values of all products of the group tends to equal their joint cost of production. ILLUSTRATIVE PROBLEMS 1. Enumerate some products of a Michigan farm which might be thought of as by-products. 2. Discuss the question as to whether the transportation between De- troit and Jackson of products of quite different types, for example, coal and dry goods, truly gives rise to a case of joint-cost products. 3. "The recent fall in the price of cotton is largely due to the im- proved manufacture and (increased) uses of cotton-seed oil." Marshall's Economics of Industry, page 225. Explain why these facts should tend to cause a fall in the price of cotton. Ill Diminishing-Cost Goods If the wooden chair, the output schedule of which was presented in Chapter XXVI, is taken in the earlier stages of this schedule, it belongs in the class of diminishing-cost goods, the more output producers try to furnish, the smaller is the cost per unit. This case we sometimes treat as a third subdivision of variable-supply goods. The general principle for variable-supply goods that price tends XXVII] SPECIAL CASES OF NORMAL PRICE 347 to equal cost, if properly interpreted, is really adequate here, and proper interpretation only requires us to remember that the cost of production meant in our principle is the cost which is representative at the very time mentioned, not at an earlier or a later date. Never- theless, as this case is one of unusual practical importance, it seems to deserve special comment. The theory is comparatively simple. So long as the demand for commodities of the type considered is still relatively small, persons producing them are obliged to employ expensive methods of produc- tion ; hence cost and, so, price is high. Presently, demand shows a large increase, and in consequence producers are able to realize the various gains of large-scale production, with the result that cost and, so, price is greatly diminished. Accordingly, if we wish to look at the period which includes these changes as a totality and state the law which governs that period as a totality, we have to say that price tends to equal the lowest of the costs of production. The importance of this law is best seen in connection with the theory of investment. In the earlier stages of a new industry, while crude or experimental methods are being employed, price is so high that producers who intend to introduce improvements which will greatly reduce cost are wont to anticipate therefrom enormous profits, and perhaps attempt to attract investors by representations to this effect. But investors should remember that, just because it is going to be possible to reduce cost of production, the price itself is bound to fall, and the great profits described by promoters will, in all likelihood, fail to be realized. The principle may be succinctly stated as follows : Principle. The price of diminishing-cost goods tends to equal their cost to producers working on the largest scale justified by the existing conditions of demand, monopoly being excluded. IV Fixed-Supply Income-Bearers Another special case is furnished by the fixed-supply income- bearer, for example, a piece of land rented for business purposes. 348 PRINCIPLES OF ECONOMICS [XXVII First, with regard to income-bearers in general, we remark that, between their prices and their incomes there must tend to prevail at all times a fixed ratio approximately equal to the current rate of interest. When the rate of interest on money loans is approximately 5 per cent then, between the price of an automobile, let us say, which is to be used for purposes of hire and the net money income derived from that automobile, due allowance having been made for repairs, replacement, labor services, and so on, the ratio is bound to be ap- proximately 100 to 5 or 20 to I. Now, the establishment of this ratio may conceivably be brought about in either of two ways: (i) the price of the automobile hav- ing been fixed, the income may move up and down till it settles at a figure just 1/20 of the price of the automobile, or (2) the income having been fixed, the price of the automobile may move up and down till it settles at a figure just 20 times as great as the income. Which will it be? This depends surely on which of the two things, the income or the price of the auto, is free to move, and so able to put itself in the required relation to the other. With a commodity like the automobile, the one which must do this is surely the net income. For the automobile is a producible good, and, as we have already learned, prices of producible goods must approximate their costs of production. The price of the automobile, therefore, is not free to move. The income, however, moves with perfect freedom. If the net incomes derived from renting automobiles are too large considering the price of machines, then competition will increase, and in consequence rentals and incomes will decline. If incomes are too small, competition will lessen, whereupon rentals and incomes will increase. Accordingly, we may say of a producible income-bearer, that its price is first fixed and to this price the net income is ad- justed. 1 Passing, now, fo non-producible income-bearers such as land, we find ourselves facing a very different problem. No element of cost 1 The student must remember, however, that the price of constant-cost goods is not always governed by cost. A necessary condition was expressed in the phrase, "the continued production of which is demanded," which ap- pears in the formula on page 340. Producible income-bearers at times pass into the status of non-producible ones. XXVII] SPECIAL CASES OF NORMAL PRICE 349 is here in operation. Utility or significance only can affect price; and the particular significance which affects it is obviously that given off by the land for a certain definite time. In short, the first thing to be fixed is, not the price of the land as a whole, but the price of a year's use of the land, its income ; which income, having been fixed, determines in some way the price of the land itself. Here again, as with producible income-bearers, the relation be- tween the price of any income-bearer and its income is fixed in advance 2 by the existing ratio between capital in general and the in- come therefrom. When 5 per cent is the prevailing rate of interest, we can be pretty sure that the net yearly income of a piece of ground which commands a price of $1,000 is about $50. In this respect, then, the piece of ground and the automobile are alike. But, in the matter of the causation, as we said, the cases are entirely different. The income of the machine adjusts itself to its price or cost ; the price of the land adjusts itself to its income. We cannot say: The land is worth $1,000, hence its net income must be $50. Rather, we must say : The net income of the land is $50, hence its value must be about $1,000. To use another illustration, sup- pose a certain building site regularly yields a net income of $100, and that the current rate of interest on long-time loans is about 5 per cent. Then, the price of the site will tend to be as many dollars as .05 is contained in 100, or $2,000. The usual procedure, when 5 per cent is the rate, is to multiply the income by 20, which gives the same result as dividing it by .05. If, now, we put into formal shape the point here elaborated, we have the following: Principle. The price of an income-bearing property not capable of duplication tends to equal the sum of money 1 This is not to say that the income-bearer in question has no weight in determining the ratio between capital in general and the income therefrom. Doubtless every transaction involving an exchange of present wealth for the right to a series of future incomes helps somewhat in firing the rates at which all such exchanges take place. But as we have already seen, the price- making forces come to a head, so to speak, in a particular class of transactions, those which are marginal, those in which marginal significance or marginal cost or both are determined. Accordingly, we can safely treat almost any particular transaction of the kind here engaging us, as one to which is being applied a ratio of exchange already determined elsewhere. PRINCIPLES OF ECONOMICS [XXVII which, lent at the current rate of interest, would yield yearly income equal to the net yearly income of the said property. ILLUSTRATIVE PROBLEMS 1. If a certain mining stock pretty generally yields a net income each year of $54 per share, what would its price tend to be, supposing that the usual rate of return expected in such lines of industry is about 7 per cent? Prove. 2. If the dividend of the above stock fell to $37, what would you expect the price of the stock to become? 3. Suppose you are considering the purchase of a $100 government bond, untaxed and paying 2 per cent interest. What price could you reasonably pay, if the rate commonly obtained on securities of this grade was 1.9 per cent? Prove. 4. Here is a piece of farm land which regularly yields a net income of $1,700. What would its price tend to be when the rate of interest in such lines was about 5.5 per cent? 5. Here is a site in a large city which yields a ground rent of $51,000 a year. Suppose that the Henry George ideas came to prevail in said city, so that the tax on the site named is fixed at 93 per cent of its rent. (a) What would the price of the site tend to be when the rate of interest was about 5 per cent? (b) What would it be if the rate of taxation were raised to 100 per cent, the rate of interest remaining 5 per cent ? 6. Supposing that there were no interfering causes, what would you expect the price of a government bond bearing 2 per cent interest to do in times when the rate of interest has been exceptionally high for many months ? 7. A certain building site regularly yields a net income of $300 a year. This fact would cause it to have what market value when the rate of interest was 8 per cent ? 6 per cent ? 5 per cent ? 8. A certain automobile which is hired out, regularly yields its owner a clear income over all expenses of about $300 per year. With interest at 6 per cent, this fact would cause the car to have what market value ? Is this a reasonable problem? XXVII] SPECIAL CASES OF NORMAL PRICE 351 9. An automobile costs $1,200 and lasts only three years. With interest at 6 per cent and with 6 per cent added for the trouble and risk of running an automobile livery, what must an automobile earn during a year to make the business pay? 10. A certain building site is worth $22,000. With interest at 6 per cent what surplus over other expenses must any business located on the given site pay in order to make the use of the site for that purpose profitable ? Interpret this problem so as to make it a legitimate one. Interpret it so as to make it an illegitimate one. >" V Price Under Monopoly As we have emphasized repeatedly, our discussions of price determination assume perfect freedom of competition. The con- sistent distribution of topics would therefore seem to require that the discussion of monopoly should appear separate from, and sup- plementary to, the treatment of price in general. We shall not, however, be able to undertake an adequate treatment of the topic in any connection, so that it seems best to touch upon some of its most significant features here. Moreover, this procedure is in a sense justified by the fact that price-determination under monopoly is not a process entirely different from those already described, but merely a variant from them. Monopoly, as it were, injects into the situation a new condition under which the principles already noted as operative work out the result. The first point to be made is that, in respect to its more immedi- ate determination of price, we have under monopoly merely a spe- cial case of fixed-supply goods. The supply of the monopolized good is a fixed one ; but this fixedness is not of natural origin, is not due to any absolute limit nor to the limit of our capacity to produce. Rather, the monopolist consciously, arbitrarily, limits the amount produced, or, at any rate, the amount put on the market. It follows that, immediately speaking, the law governing monopoly price is the same as that given for fixed-supply goods. The normal price of goods sold under the condition of monopoly must be one which ex- presses the marginal significance or utility of the output. The only 352 PRINCIPLES OF ECONOMICS [XXVII qualification needed is one which recognizes the artificial nature of the limit set. We might then restate the formula as follows : The normal price of monopoly goods tends to be one which expresses the margined significance of the supply as fixed by the free choice of the monopolist. The second point to be noted gives us a more fundamental gov- erning principle, a principle which tries to define the normal price of monopolized goods, the price which, in view of all the circum- stances, including "the free choice of the monopolist," tends to be established. The use of the word "normal" here may sound strange ; for it is probable that most people think of monopoly and the monop- olist's free choice as doing away with all normality of price, as fix- ing price in a purely arbitrary way. This, however, is going much too far. Monopoly prices, though less submissive to natural laws than competitive prices, are not, after all, entirely free from such laws. The monopolist is coerced by conditions in fixing his prices, not according to his own caprice, but in conformity with certain broad principles over which he has no control. In the first place, if a monopolist puts his price too high, he will be disappointed in finding his gains smaller than they would be if he had set his price lower. Thus, suppose that petroleum is a monopolized product, and that a section of its demand schedule is as follows: 1,900 million gallons wanted if price is 9 cents; 2,500 million if price is 8 cents; 3,000 million, if 7 cents; 4,000 million, if 6 cents. Suppose, further, that the total cost per gallon is 4 cents, so that there is a clear profit of 5 cents per gallon if the selling price is 9 cents; of 4 cents per gallon, if price is 8 cents; and so on. If, under these circumstances, the monopolist fixes the price at 9 cents, he will clear $95,000,000, whereas at 8 cents he would have cleared $100,000,000. What he gains through larger profit on each unit of product he will more than lose by diminishing the total number of units sold. On the other hand, it would be foolish for the monopolist to go to the opposite extreme in carrying out a policy of lowering price in order to increase demand. Thus, if he puts the price down to 7 cents, he will indeed cause demand to increase from 1,900 millions to 3,000 millions; but the lowering of profit on each unit will more XXVII] SPECIAL CASES OF NORMAL PRICE 353 than offset this gain in amount sold. His net profit will drop to $90,000,000. In short, the self-interest of the monopolist will dictate that he fix on the price which insures that the product of the net profit per unit output into total output is the highest possible ; and this gives us the general principle determining normal price under conditions of strict monopoly. Principle. Broadly speaking, the normal price of any monopolized commodity tends to be that price which will secure the largest net return to the monopolist. A cursory examintion of the preceding analysis shows plainly that the cause which hindered the monopolist from pushing price upward indefinitely was the fact that as price rose demand fell off, in other words, demand was elastic, varying inversely as price. If demand had diminished more rapidly with increase in price, the price actually established would have been still nearer cost of production. If demand had changed less rapidly with increase in price, price would have been put still farther above cost of production. Hence the following: Corollary. The tendency of monopoly price to rise above the competitive normal varies inversely as the elas- ticity of the demand for the monopolized commodity. It obviously follows from this corollary that every cause which increases the elasticity of the demand for a given commodity dimin- ishes the tendency of price in said case to separate from the com- petitive normal. Thus, the appearance on the market of a com- modity which can be used as a substitute for some monopolized one diminishes our dependence on the latter and so makes its demand schedule more elastic. The preceding discussion has brought out the general principle governing normal price under monopoly. But it is possible to be a little more specific regarding one particular type of monopoly which has much prominence in our day. This is known as the capitalistic monopoly, one which owes its origin to the control by the monopo- list of an exceptional volume of capital. Such a condition enables 354 PRINCIPLES OF ECONOMICS [XXVII a man or group of men to attain the position of monopolist, to gain and maintain exclusive control of output, largely because it enables them to produce more cheaply than rivals and hence drive them out of business. But it is plain that, to succeed, monopolies of this sort must keep prices fairly low, somewhere in the neighborhood of cost to outsiders; since otherwise competitors will be continually starting up, and will have to be bought out at considerable cost or driven out by destructive commercial wars. Formulating this point, we have the following : Principle. The normal price of goods produced by capitalistic monopolists tends to approximate a figure not much above cast of production to outsiders. ILLUSTRATIVE PROBLEMS 1. Suppose the demand schedule for Milton's autographs to be as follows: I wanted if the price is $200; 2 if it is $175; 4 if $150; 5 if $!4 O ; 8 if $125; 9 if $115; 12 if $100 ; 13 if $90; 15 if $75; 20 if $50; and soon. (a) If there came on the market 9 autographs, what price would they tend to have under free competition ? (b) What price if all were owned by one man? (c) Answer the same questions, supposing the number of autographs to be 15. (d) Answer the same questions, supposing the number to be 20. 2. When the United States Steel Company was fully organized, many independent producers desired the Trust to join with them in raising the prices of steel products. The authorities of the Trust, however, refused, thinking it expedient to maintain the old level. What do you suppose was the reason? MISCELLANEOUS PROBLEMS IN PRICE 1. There come on the market eleven specimens of a certain rare object to be disposed of at the best price attainable. If the demand is as follows : I wanted at $65 ; 2 more at $60 ; 4 more at $50 ; 5 more at $45 ; 6 more at $40 ; etc., what price will tend to be reached ? Prove. ' -' 2. In the last problem, suppose a tax of $5 to be levied on each speci- men sold. XXVII] SPECIAL CASES OF NORMAL PRICE 355 (a) What effect on price would be produced? (b) Who would bear the tax in the end? 3. A friend of mine owns in a Chicago suburb a house and lot which used to rent for $300 a year. Last year real estate in his neighborhood had a boom, with the result that his property increased in value $3,000. In consequence he raised the rent to $480. What is the matter with the economic doctrine involved? 4. "If the state should inaugurate the policy of levying on the livery business a lo-per-cent income tax, the value of all plants devoted to this business would necessarily fall off 10 per cent." Criticize. 5. "Every owner of a railroad, of a patent, of a book, or of a (monopoly) property of any kind, finds that he makes more money by putting prices down to figures that are reasonable, that is, to figures which correspond to the values to the buyers of the things sold, than by keeping them up beyond those figures." (a) Show that the words "which correspond to the values to the buyers of the things sold," are useless as a definition of "reasonable" prices. (Try to think of some object which has a price greater than that one which would express the value of the object to buyers.) (b) In the case of producible goods, what price is commonly con- sidered a reasonable one? (c) When "reasonable" is understood this way, is it probable that the first half of Stickney's statement is true? (d) Point out some cases of monopoly of which the statement can be affirmed with a fair degree of accuracy. 6. "Analogous arguments . . . might be made with regard to mu- nicipal railways, lighting companies, and water companies. These are all, for one cause or another, of a monopolistic character. The public enjoys no guarantee of fair treatment on account of any competition that can affect them." Adams' Finance, page 264. What is the doctrine with respect to competitive industries which is implied in the last sentence of the quotation? 7. "When the demand for wheat increases so as to exceed the ca- pacity of the best land, the price of wheat rises .so as to leave an excess or surplus over cost of production, and this surplus is driven into the hands of the landowner as rent by the natural competition of tenants. But, now, the high price of wheat leads to the cultivation of inferior 356 PRINCIPLES OF ECONOMICS [XXVII soils, which increases the supply of wheat so as to satisfy the demand, and thus brings the price of wheat back to its old place." Criticize the part in italics. 8. A certain man improves the opportunity offered by a growing city of 40,000 inhabitants to develop a messenger service business, from which at the end of three years he finds himself getting a net return, after allowing himself wages for management, of $700. The capital in- vested, which includes a bank balance of $200 which he commonly main- tains, is only $500; but he has to provide for a pay-roll of about $200 a month or $2,400 a year. He now tries to sell out the business, asking for it $8,750. Assuming that the good will of the business is worth $500, and that 8 per cent is a reasonable rate of interest and profit, is the price proposed a reasonable one? Does the size of the pay-roll make any difference ? Explain. CHAPTER XXVIII Final Price Determination. In introducing the study of mar- ket price, we explained that our complete treatment of the principles and processes of price determination would fall into three parts. The first two parts, one dealing with the more immediate processes of market price determination, and the second concerned with a set of the deeper forces involved in the determination of normal price, have been completed. These two studies have treated of the nature and operation of those processes with which the business man in general is most immediately concerned, and a knowledge of which is usually sufficient for his immediate purposes. There is a third set of forces, however, lying deeper than any yet treated, which it is now our task to study. We must now try to get beneath the surface processes already considered, to processes and forces which are, in a logical sense, ultimate; to go beyond conclusions which are often merely provisional, to those which are in some sense definitive; to leave points of view which are partial, for one which includes the field as a whole. In a word, our task now is to attempt a considera- tion of those fundamental forces and processes which govern the field of price as a totality. Inadequacy of Our Previous Treatment. The essential de- ficiency in our previous treatment of the price problem is to be found in the fact that, in all those cases in which cost of production has been represented as playing a part in price determination, we have assumed that nothing need be said about the determination of that cost itself. In other words, we have assumed that costs are data given in advance, determinate from the beginning. As we have pictured the matter, the entrepreneur, starting out to produce some J57 358 PRINCIPLES OF ECONOMICS commodity, finds that he must pay so much for raw materials, so much for tools and machinery, so much for labor, so much for the use of capital, and so on. In consequence of these outlays, and in consideration of his own sacrifices, he fixes upon a price which con- ditions the forthcoming of his supply, the supply price of a given quantity of the commodity in question. Since it is a supply price, it is bound to influence actual price, is bound, at any rate, to furnish a point below which actual price cannot go if this increment of the supply is to be had. But, now, what are the outlays which the entrepreneur has to make? Plainly, they are nothing more than the sum of money values of the factors he puts into the product, such value in each case being equal to the price of the factor involved, multiplied by the number of units employed. That is, costs, in so far as they con- sist of outlays, are themselves nothing but aggregates of prices, the prices of the factors or cost-goods used up in the process of pro- duction. This applies not only to the factors and cost-goods which the entrepreneur buys on the market, but also, in large measure, 1 to those which he himself contributes. If he supplies labor services, he cannot hope to get in return higher wages than the market rate for similar types of labor; nor can he get a higher rate of interest for the capital he himself puts into the business than the rate pre- vailing on the market. It follows from what has just been said that in treating costs as data given in advance, as independent of the problem of price de- termination, we have ignored quite evident facts. Costs are not fixed in advance. They are not fixed outside of the price-determinat- ing process. Being themselves dependent on the prices of cost- goods, the explanation of the process whereby they are determined forms an integral part of the total problem of price determination. In so far then as we have built on costs, as if these constituted a foundation below which it was unnecessary to go, we have left our task incomplete. Such a procedure was doubtless legitimate from the standpoint of what we called normal price, since it was reason- case. profit on capital received by the entrepreneur furnishes a special XXVIII] PRIMARY FACTORS AND DISUTILITY 359 able to assume that, from the standpoint of the individual entre- preneur, for periods sufficiently short to be of interest to him, the prices of cost goods have in normal times a degree of fixity sufficient to warrant his acting as if they did not change. Nevertheless, from the point of view of the entire problem of price determination, there is a gap in our explanation. We have not explained the process by which the prices of cost-goods are determined, although it is now evident that these prices play a very important role in the process of price determination. Produced Factors Partly Covered. This account of the in- sufficiency of our previous treatment of price determination, how- ever, needs some qualification, and comment upon this qualification will aid in further defining our present problem. A large number of the factors used by the entrepreneur in production are them- selves products. This being true, an account of the principles under which the prices of products in general are determined, must also explain, in part at least, the processes whereby the prices of those factors of production, which are themselves produced, are deter- mined. In fact, the great majority of cases to which our previous account of normal price is applicable, are not final products, that is, such as are destined for the direct satisfying of wants, but they are factors used in making these final products. It follows, therefore, that in treating immediate price determination and normal price, we have covered to some extent this type of factor or cost-goods as well as final products. At this point, however, we must again guard against over- statement. If, in our theory of the prices of products, those prices had been made dependent on cost of production solely, there would naturally have been no difference in the case of goods intended for final consumption and goods employed in further production. In fact, however, prices of goods for final consumption were repre- sented as influenced not only by cost but also by their importance or significance to consumers. But this significance to consumers as a determining element in price, cannot be directly applied to goods which are used only in production. A footnote on page 303 called attention to this gap in our explanation. While affirming at that 360 PRINCIPLES OF ECONOMICS [XXVIII point the almost certain influence of the significance of final or con- sumers' products on the prices of producers' goods used in their production, we then reserved further comment on this matter; and now, while studying the problem of final price determination, we are still facing the task of explaining the connection between the sig- nificance of the final products to the consumer and the prices of intermediate products entering into them. Primary Factors. We have seen that our study of price determination needs to be supplemented in order to provide a fuller explanation of the prices of those products which serve as factors in further production. The case of factors which are not produced, factors behind which it is not possible to go in the analysis of the productive process, primary factors, these, still more notably, present to us a supplementary problem, a problem which has to be taken up in any explanation of-the final processes of price determina- tion. In attempting the solution of this general problem of the prices of factors or cost-goods, we shall confine our attention to the second case, that is, the case of primary factors, on the ground that, in so far as the case of produced factors has not already been provided for under normal price, the conclusions reached with respect to primary factors will be applicable without material change to produced factors. Accordingly we will now enter upon the task of answering the question : How are the prices of primary factors determined? Different Solutions of Problem. In economic texts, the prob- lem we have thus set ourselves has seldom been clearly isolated, being usually confused with that presented by the more superficial processes of price-determination which have been studied in previous chapters. Nevertheless, one may distinguish at least three types of doctrine concerning this problem, as being implicit in price discus- sion. One group of writers teach that the value or price of the pri- mary factors is determined solely by their marginal utility: the pro- ductive capacities and resources of man are progressively distributed over the whole field of production, from the most important products downward till they are all used, and their utility in the marginal use XXVIII] PRIMARY FACTORS AND DISUTILITY 361 fixes their value. A second group find the sole determinant in the cost, the disutility cost of supplying directly the human elements and making available the elements coming from nature, outside of man. Psychic cost is the original cost of everything, and determines what we must pay to secure the forthcoming of supply. A third group recognize the presence of both utility and cost determinants in the process, advocating what is often called an equilibrium theory. The Doctrine of This Text. The doctrine maintained in this text is a form of the equilibrium theory. It gives most weight to significance or utility, but it insists on recognizing the influence of disutility cost in the case of those primary factors which can be supplied only by processes which involve that element. It may be formulated for the sake of definiteness in the following statement : Principle Significance-Disutility Principle. The price of any primary factors tends to be that price which expresses the effective significance or value of that factor over the whole field of production, and which also expresses a disutility, not less than the marginal one and not as great as the first extra-marginal one, in- volved in supplying the quantity of said factor which is actually supplied, in case such a disutility exists. In maintaining this proposition, we will begin with the second or disutility part as involving fewer difficulties in analysis and presentation. This topic will occupy the remainder of the present chapter. Primary Factors and Disutility. It is a fact too evident to need argument that the supplying of those primary factors which are of human origin may, at any rate, involve a disutility or "pain-cost." Working or saving or taking responsibility can be carried so far as to be distasteful. Further, it cannot be doubted that at the present time, in societies which have attained to any high economic develop- ment, the supplying of these services has, with many of the persons concerned, gone so far that disutility is actually felt. Much or 362 PRINCIPLES OF ECONOMICS fXXVIII most of the labor furnished carries with it a psychic sacrifice, and the same is true of some part of the saving and responsibility-taking. Still again, it is a familiar fact that the disutility or pain-cost of supplying these human primary factors increases with the amount supplied and diminishes as that amount diminishes. That is, dis- utility varies directly with the quantity supplied. Human Factors Have Supply Prices. Again, it cannot be doubted that the amount of supply is influenced by the disutility involved. Some persons, anyhow, supply less than they would if the disutility of doing this were diminished. Most of us do not work as many hours per week, or month, or year, as we would if there were no disutility attaching to our efforts ; and the same surely is applicable to saving and responsibility-taking. It follows that any primary factor of human origin may be expected to have a supply price for each different quantity of such factor supplied, that is, a price on which is conditioned the forthcoming of that particular quantity, and, therefore, may be expected to have a supply schedule closely analogous to the perfectly elastic supply schedule which appears on page 270. If, at any time, an increase in the amount is demanded, a higher price will be necessary to bring out that increase, and, conversely, a higher price will bring out that increase. 2 Supply Prices Influence Actual Price. But, admitted that primary factors the supplying of which involves a disutility have a supply schedule of the typical sort, it necessarily follows that such a factor would tend to have its price fixed by the same limiting prices from the supply side which are effective in the case of com- modities generally. That is, the actual price of such a primary factor could not go below the marginal supply price nor up to the first extra- marginal supply price. Buyers could not let price fall below the marginal supply price ; since, in- that case, they would lose the mar- 1 Interesting exceptions to this principle have been noted, particularly this one : that the higher price of labor at times brings out, not a larger, but a smaller, supply. The men furnishing this factor prefer to increase their leisure rather than their income. But it would seem that this sort of thing must be looked upon as an irregularity only, not as materially affecting the Whole course of things. XXVIII] PRIMARY FACTORS AND DISUTILITY 363 ginal increment of supply. On the other hand, included sellers could not let actual price go up to the first extra-marginal supply price; since, in that case, they would let in an excess of supply and so would run the risk of failing to dispose of some portion of their offering. Disutility Principle Established. The foregoing would seem to establish beyond question the second part of our principle with respect to the prices of primary factors, the part, namely, which affirms that the price of any primary factor tends to be a price which expresses a disutility not less than the marginal one and not as great as the first extra-marginal one involved in supplying the quantity of said factor which is actually supplied, in case such a disutility exists. CHAPTER XXIX THE PRICES OF PRIMARY FACTORS AND SIGNIFICANCE Whether or not the significance of factors in production has any considerable part in fixing their value or price is still a matter of controversy among economists. The wide-spread acceptance of the so-called marginal productivity doctrine, which characterized eco- nomic writing perhaps twenty years ago, has been followed by some reaction. Indeed, not a few of the younger economists speak with some contempt of this whole point of view. Nevertheless, it is doubtful if anyone would have the hardihood to deny the existence of some connection between the significance of factors and their prices. For practically everyone assents without hesitation to the general proposition that, as far as buyers are concerned, there is no reason why factors should have any price at all except the fact that the products which result from the use of those factors have significance or value. Probably, in this case as in so many others, the real difference between the advocates and opponents of the doctrine here maintained has respect to the degree to which the pre- sumable connection between the prices of factors and their impor- tance in products is realized. At one extreme will be found those who seem to speak as if there were almost exact correspondence between the significance of any factor in production and the price which it commands on the open market ; while at the other extreme appear a group of thinkers who seem to consider the correspondence between importance and price so slight as to be almost negligible. In the opinion of the present writer, neither extreme is defensible. Significance influences very greatly the prices of primary factors ; but precise correspondence between the two is surely not realized. Our defense of the contention that significance plays a large part in determining the prices of primary factors will follow two lines : 364 XXIX] PRIMARY FACTORS AND SIGNIFICANCE 365 First, we shall try to show that there are conditions under which there is some clue to the significance of a specific factor in the particular productive processes in which it is employed, in which case the reciprocal competition of producers tends to give such factor a price expressing its effective significance over the whole field. Secondly, we shall try to show that, even under conditions where no such clue is to be had, where there is no way of ascertain- ing the significance of any factor in the particular productive pro- cesses in which it is employed, nevertheless the spontaneous work- ing of the price-making forces tends to give each factor a price ex- pressing the effective significance of that factor. In this chapter, we shall confine ourselves to the former of these two lines of argument. I Knowledge of Significance in Particular Operations when a Factor is Acting Alone In the first place, there is an appreciable number of cases in which only one of the factors involved is an economic factor. For example, let us suppose that the productive process involved is piling into proper shape a cord of wood just delivered, a process requir- ing only a very simple form of labor. In such a case, manifestly, the buyer of the single factor required could, without difficulty, ascertain quite precisely the product of that factor the physical result which it accomplished in the particular productive process ; since that product is simply the changed condition of the wood the condition of being piled. Again, it is plain that the buyer of the factor could easily ascertain the significance of that factor in this particular productive process ; for, obviously, that significance is just the same as the significance of the product itself the changed condition of the wood. Many examples analogous to this are supplied by laborers en- gaged in furnishing various sorts of personal services, including services to the household. These laborers may properly be regarded as acting alone, furnishing one factor which is operating, not jointly with other factors, but by itself. It is true that in such cases other factors are usually involved, but they may be disregarded because 3 66 PRINCIPLES OF ECONOMICS [XXIX the quantity of these other factors used is so small, in comparison with the quantity of labor employed, that their influence is negligible. Free Land Available. A much more important example of a single factor acting alone is found in new countries where there is an abundance of free land available to which labor can betake itself and make a living. Under these conditions, there is substantially but one factor, that is, labor, the other principal factor, land, being non-economic. It is true that, in cases like this, some little capital is needed, but the amount is so small that it may be regarded as negligible. Whatever the laborer produces, then, is recognized as his product in a specific and special sense. Numerous Cases Not Needed. It may be objected to giving the cases just commented upon much weight in our present problem that, at the most, cases of the sort form but a small per cent of the total, so small, indeed, that one cannot help wondering if they have any influence in the matter. To this objection, the easy answer is that, in nearly all cases of price determination, it is small quantities of supply which are decisive, namely, the marginal and first extra- marginal increments. These, to be sure, must be sufficiently large to affect appreciably the total supply, else sellers would not trouble themselves to bid price down in order to include the marginal in- crement of demand, and buyers would not trouble themselves to bid price up in order to exclude the first extra-marginal increment of demand. But a very small per cent of the total is sufficient for this. Accordingly, a correct decision in respect to the question whether or not the cases of factors which act alone have any material in- fluence on the prices of those factors, turns on whether or not the cases where the specific economic product of a factor can be isolated occupy the crucial positions indicated : Do they lie at the margin ? There is certainly a possibility that they do occupy this position. Historians have nearly always agreed that, in the case of colonial America, the possibility, open to laborers, of going over the moun- tains into the unappropriated land constituted a first extra-marginal demand for labor which compelled the employer in the settled dis- tricts to bid wages up to a higher figure than they would otherwise XXIX] PRIMARY FACTORS AND SIGNIFICANCE 367 have reached. Even in a highly developed and static society, it seems not unlikely that the types of casual labor, which largely act in isolation, play a considerable part in that they are exceptionally mobile, exceptionally determined to have the best price the market will justify. At any rate, this much is certain, that in so far as the type of labor which is substantially acting alone does in reality oc- cupy the crucial place at the margin, the price of that factor must tend to settle at a point not above the marginal significance of such labor, nor as low as the first extra-marginal. II Knowledge of Significance in Particular Operations when Several Factors are Cooperating Allocation or Imputation of Economic Product. We have com- mented on those cases where the particular significance of a factor can be ascertained because that factor, economically speaking, is acting independently, all other factors are either non-economic or negligible in amount. But no one would contend that cases of this sort are predominant. Almost always many different factors are acting jointly. It follows, therefore, that, if we are to get much help from cases wherein the significance of the factor in particular processes can be ascertained, we must find some method of isolating the significance of an economic factor even when it is operating jointly with other economic factors. But this, in turn, requires that we should discover some process whereby we can isolate a specific portion of the product of the particular operation in which our factor appears, as being a portion which can legitimately be imputed or credited to that factor. The process by which such isolating of portions of the common product may be accomplished, if accom- plished at all, is frequently designated "imputation." To distinguish it from other analogous processes to which we may find it convenient to apply the term, we shall call the case before us "product imputa- tion" or "imputation of economic product." Meaning of Economic Product. Before commenting on the possible solution of the problem of product imputation, we must 368 PRINCIPLES OF ECONOMICS [XXIX realize quite fully in just what sense the word "product" is used in this connection. First, we surely must not think of ourselves as try- ing to discover some method of ascertaining the literal product of each factor in a joint process. The very notion of accomplishing such a result is absurd. Literally speaking, the whole product is produced by all the factors acting together. All we can hope to do, all we need to do, is to isolate the economic product of the factor in question. By economic product we mean the portion of the product which we can properly treat as if it were the product of the one factor under consideration. In other words, if in our eco- nomic conduct we behave as if a certain portion of the product were literally produced by the given factor alone, and find that, in doing this, we have done just the right thing, economically speaking, then that portion of the product which we treated as if it were the product of the factor in question alone, actually is the economic product of that factor. This case is most easily illustrated from the product rent of a piece of land used for farming. Let us start with the idea that land is of many grades in respect to efficiency ; and that there is such an abundance of the land of the lowest grade which it pays to cultivate that much of it is unused when we have put under cultivation all that we need. In such a case, the lowest grade of land under culti- vation, called marginal land, will not be accounted an economic factor at all, will be a free good. If, now, an acre of better land yields to a certain amount of expenditure six bushels of wheat more than this marginal or non-economic land yields to the same expendi- ture, that six bushels of wheat will be properly credited to said acre of land as being, economically speaking, the specific product of that land alone. This, of course, does not mean that those six bushels are produced by the land without the aid of the other factors ; but merely that we can behave as if this were the case and in doing so will act wisely. In other words, a farmer .wishing to cultivate this piece of land would act wisely were he to pay for the privilege of doing so a share of the product not in excess of six bushels. Surplus Method of Imputation. Having now before us the concept of economic product, the question presents itself : How far XXIX] PRIMARY FACTORS AND SIGNIFICANCE 369 can this product be isolated, how far can the problem of imputation be solved ? One method of doing this is suggested by the illustration just used in explaining what we mean by economic product. That method we may call the surplus method, since it depends on showing that the factor which is under consideration yields a surplus over another specimen of the same kind of factor which is a non-eco- nomic factor. This particular method of imputation is habitually applied to land ; and has long been looked on as fairly adequate to isolate the specific product of this factor in the particular operations where it is being employed. Since it isolates the product economi- cally imputable to the services of the land, it also, of necessity, isolates the importance or significance of those services ; and this, in turn, insures that those services shall have a price expressing a significance not as low as their first extra-marginal one, nor higher than their marginal one. It follows that land, or land services, when used in farming anyhow, may be looked on as a primary factor which in a very high degree realizes the principle we are defending^ that is, the principle that a factor tends to have a price expressing its effective significance over the whole economic field. And it is probably fair to say that this view has been held explicitly or im- plicitly by the great majority of economists. Dosing Method of Imputation. A second method of product imputation which has wide acceptance may be called the "dosing" method. This method thinks of the entrepreneur as making a series of experiments in which all but one of the factors engaged in a joint productive process are kept constant, while successive units of that one are added. The addition to product which follows the addition of the last or marginal unit of this particular factor is accounted the economic product of that unit. Further, since the different units of said factor are reciprocally interchangeable, the addition to product which follows the addition of the marginal unit of the factor is accounted the effective economic product of any unit of said factor. If this method is theoretically sound and feasible in practice, such experimentation would give each producer informa- tion as to the effective economic product and hence as to the effective significance of the factor in question in his particular business. 370 PRINCIPLES OF ECONOMICS [XXIX Whereupon, the competition of producers in different fields would insure that the price of that factor could not be as low as its first extra-marginal significance, nor above its marginal significance over the field of production as a whole. In the opinion of the writer, this method of imputation is of much less general applicability than its advocates seem to believe. A good case can be made for its feasibility only in the simpler types of industry, particularly, farming. Nevertheless, since such indus- tries utilize a very considerable portion of our store of primary factors, a method which can claim a considerable degree of success in isolating the economic product of factors in that particular field, surely ought not to be ignored in connection with the question we are now considering. Economic Product and Significance. It is hardly necessary to say that, if by any of the methods commented upon above we are able to isolate the economic product of a given factor in a particular productive operation, we shall also be able to isolate the significance of said factor in that particular operation. For the significance of said factor would of course be the same as the significance of its product; and that, we may assume, would be clearly expressed in the money value of that product. Ill Knowledge of Significance in the Particular Industry Insures a Price Expressing Significance over the Whole Field We have tried to show that in not a few cases the entrepreneur is able to ascertain in one way or another something about the significance or importance of a given factor in the particular indus- trial process in which it is operating. We have now to show that when this is true the natural working of competition must tend to establish for said factor a price which expresses its effective sig- nificance over the whole field. The reasoning by which this propo- sition is supported is plain. If the producer is able to ascertain the true significance of the factors in his particular operation, he will, of course, be ready to bid for a unit of such factor a price as high as XXIX] PRIMARY FACTORS AND SIGNIFICANCE 37! one which expresses such significance. But, with such a condition realized, the reciprocal bidding of different entrepreneurs must cer- tainly keep the price from going as low as one which expresses the first extra-marginal significance, since this is necessary in order that extra-marginal buyers should be excluded. On the other hand, the persons who supply said factor must bid the price down to a price not higher than the one which expresses the marginal significance of said factor, since otherwise the marginal buyers would be ex- cluded. Accordingly, under the condition supposed, that is, the condition which makes significance in the particular case ascertain- able, the ordinary working of economic forces will tend to set the actual price of each factor at a point not as low as the first extra-' marginal significance of that factor over the whole field, but, at the same time, not higher than its marginal significance over the whole field. CHAPTER XXX THE PRICES OF PRIMARY FACTORS AND SIGNIFICANCE (CONTINUED) The method employed in the preceding chapter, in maintaining the doctrine that the effective significance of a primary factor over the whole economic field has a part in determining its price, was built on the assumption that it is possible, to some extent at any rate, to isolate the significance of such factor in particular productive opera- tions. The result of that argument seems to justify the claim that we have a strong presumption for the fairly complete dominance of our principle in some cases, notably that of land, and for a decided tendency toward such dominance in not a few other cases. I am not content, however, to leave the matter at this point. It seems to me that we have it in our power to go much further, that we are able to show the presence of price-determining processes, which, though indirect in their action, are more important than all the direct ones enumerated, which processes, under the theoretically perfect conditions of abstract economics, would make the prices of all primary factors precisely the ones which express the effective significance of those factors, and that without the assistance of any of the processes which have been discussed hitherto. Further, I be- lieve that, even under actual conditions, this proposition has suf- ficient applicability to make it of great importance. This being so, it now becomes our duty to give this matter a full presentation. Conditions Assumed. In order to make clear that the processes upon which this theory depends have no connection with those which were presented in the preceding chapter, and also to make the precise nature of these processes stand out in the most definite manner possible, I propose to start with a hypothesis where- in we could have no clue whatever to the significance of a factor in 372 XXX] PRIMARY FACTORS AND SIGNIFICANCE 373 the particular operation in which it was being employed. That is, we shall start with a hypothesis under which, by assumption, there is no possibility of finding a case in which the factor we were study- ing was working unassisted by other economic factors ; and there would be no possibility of ascertaining the specific product of that factor by either the "surplus" method, or the "dosing" method of imputation. 1 I shall try to show that even under these rigorous con- ditions every primary factor would inevitably come to have a price which expressed the effective significance of that factor, provided always that the fundamental conditions assumed in all price theory are fully realized. I Each Factor in Joint Processes Has Its Specific Significance in Such Processes Even if That Specific Significance Cannot Be Ascertained Our first task in maintaining this thesis is to convince ourselves that there really exists such a specific significance attaching to each factor for this proposition is not manifest on the surface. In fact, a case could be made for the contention that the very idea of such a specific significance for each factor under the conditions which we have assumed, is absurd. Thus, let us suppose that one unit of a certain commodity, which we will designate as P, requires for its production the cooperation of three factors which we will designate Fi, F:, F 3 , respectively; that these factors are combined in the pro- portion of 4Fi's, 3F 2 's, and nF 3 's; and that there is no possibility of isolating some fractional part of the product as being produced by the 4Fi's, another part as being produced by the 3F/s, and another part as being produced by the nFs's. If, now, we assume that a unit of the product, Pi, has a significance of 86 cents, then, obviously, the 4Fi's, the 3F 2 's, and the uFa's must together have a joint significance of 86 cents, since their product has that significance." But, is it not absurd to talk about the specific significance of the 4Fi's or that of the sFs's or that of the nFs's ? Only an affirmative answer seems 1 One condition on which the dosing theory claims to be able to build would be retained. That condition is the possibility of using different com- bining proportions. 374 PRINCIPLES OF ECONOMICS [XXX possible. So long as we are dealing with a single situation like the one supposed, the very idea that each kind of factor, the Fi's or the F's or the F's has its own specific significance in the process, in- volves a logical absurdity. But, now, this is not the end of the matter. It is quite true that, with no other facts before us than those contained in the single proposition that the 4Fi's, 3F's and nFs's would together produce a product worth 86 cents, we could not, with propriety, speak of the specific significance of any one of these three factors. But, then, it is quite incredible that these facts should be the only ones before us. We should doubtless have many others at our command, else our complete hypothesis would be so far from reality as to have no interest for us. In particular, there would doubtless be many other kinds of goods beside the Pi we have supposed, which other goods we were producing with these same three factors, Fi, F 2 , and F; and, in producing those other kinds of goods, we should, in many cases at least, be using combinations of the three factors different from the combinations used in producing Pi. It is in view of this change in our way of looking at the matter that we are easily able to show that each factor in joint processes really has its own pe- culiar, specific significance in the productive process. That is, we are easily able to show that, though the data derived from the single proposition concerning the production of Pi with which we started would not warrant our imputing specific significance to each factor, these data combined with data derived from other facts of the sit- uation, other productive operations, would do so in short, if all the facts of the situation be taken into account, each factor in produc- tion has its own specific significance. Proof. Let us suppose, then, that we use but three primary factors as above, Fi, Fi, and F 3 ; that we know on just what goods our stock of factors ought to be expended, and just what combin- ing proportions ought to be used ; that our productive processes are all direct from primary factors to consumers' products; and that there are at least three cases in which the proper combinations are different each from the others. Let these cases be as follows: (i) one in which 4Fi's, 3F 2 's, and nFs's unite to produce a product, XXX] PRIMARY FACTORS AND SIGNIFICANCE 375 Pi, having a value of 86 cents ; (2) one in which 4Fi's, ioF 2 's and 2F's unite to produce a product, P*, having a value of 60 cents; and (3) one in which loFi's, 3F 2 's, and 3p3's unite to produce Ps, having a value of 50 cents. Now, letting x, y, and s represent the unknown values or importances of Fi, p2, and Fa, respectively, we obviously are able to derive three equations as follows : 4-*" + 3^ -f- 1 12 86 cents 4jr + 103; + 22 = 60 cents i cu: -f- 33; -f- 32 = 50 cents Solving these equations for the three unknowns, we get the following results : x = 2 cents y 4 cents 2 =. 6 cents That is, in view of the values of the products into which our factors must be put and of the proportion in which those factors must be combined, if most wisely used, each Fi has a value or significance of two cents, each F 2 a value or significance of four cents, and each Fa a value or significance of six cents. II Meaning of Significance or Importance over the Whole Field We have seen that, under our hypothetical conditions, each factor in a joint productive process has its own special significance. Before going on to maintain that the said significance influences the price of said factor, we must remark on the peculiar character of the sig- nificance or importance which has been here affirmed of factors, that is, significance over the whole Held. The point needing special com- ment is that the term, significance, in this connection has a less con- crete meaning than in previous connections. Most frequently we have meant by the significance of an economic good a significance derived from the direct dependence of some gratification upon con- trol over specific units of that good, and which, therefore, is the same as the significance of that gratification. Thus, if a certain gratifica- 376 PRINCIPLES OF ECONOMICS [XXX tion of one's want for fruit were dependent on possessing a par- ticular quart of berries, the significance of that quart of berries would be the significance of that particular gratification. Now, strictly speaking, such a conception of significance is applicable only to final products, consumption products ; but it could without great difficulty be applied to the case of a factor whenever we could isolate some particular unit of some consumption good as the specific eco- nomic product of said factor. The connection in such a case would, indeed, be indirect, one or more stages removed. But, after all, a specific.gratification would be dependent on the particular unit of that factor, and hence those particular units would have the significance which attached to that specific gratification. Thus, assuming that the quart of berries in our illustration above had but one cost, fifteen minutes' labor, then the significance of that labor would be the same as the significance of the berries, that is, the significance of the grati- fication derivable from those berries. Significance to the System. But, now, in our present con- nection, such a concept of significance is too direct, too concrete The significance of a factor the specific product of which we are unable to isolate cannot be directly traced to the gratification deriva- ble from some particular consumers' product, because the course of causation between such factors and the particular consumption- product cannot be traced. The different factors are all thrown, so to speak, into a vast organic system and out of that system, viewed as a whole, all consumers' goods are drawn. Immediately, then, all goods are the product of the system ; and all the services of the fac- tors are services to the system. As a consequence, the significances of the factors must, in the first instance, be found in the system, not in products. In short, the significances of factors cannot be traced to the significances of particular units of goods. Significance to Concrete Persons. These comments, how- ever, should not mislead us. All economic significance, whether sig- nificance of products or of factors, is ultimately due to the gratifica- tions advantages to be derived from such products or factors by living human beings, not by systems. But, since the product on XXX] PRIMARY FACTORS AND SIGNIFICANCE 377 which the gratification of our wants depends necessarily comes to us through the system, that gratification necessarily depends on the proper, satisfactory zvorking of the system. Hence, significances which attach to the system or to the whole body of products rather than to specific products, are, after all, very real significances for each of us as living human beings. Ill The Spontaneous Working of Economic Forces Tends to Give Each Primary Factor a Price Expressing Its Specific Significance The preceding discussion has shown that, despite the fact that we have eliminated in our hypothesis the possibility of ascer&ining directly the significance of factors in the particular processes in which they are employed, still each has its own specific significance over the industrial field as a whole. We must now try to show that each one of such factors tends to get a price which expresses this specific significance which we have proved must exist. 2 The argu- ment which we shall employ in maintaining this contention may be summarized in the following proposition : The presence on the market of an abnormal price for any pri- mary factor, that is a price different from one which would ex- press the effective significance of that factor, would, of itself, be sufficient to set up a series of reactions tending to replace said abnormal price with one which did express the effective signi- ficance of the factor in question; and these reactions would not cease until the latter price had been established. In developing the line of reasoning summarized in this proposi- tion, our first task is to comment on the initial steps which set up the different series of reactions. In general, these consist of abnormal policies adopted by producers because of the abnormal price for some factor which we have assumed. Such abnormal policies have their 3 Remember that our algebraic operations were used to show merely that, even under our extreme hypothesis, each factor would really have its own specific significance. Those operations did not show that said significance would determine the price of said factor. This task is yet to be performed. 378 PRINCIPLES OF ECONOMICS [XXX origin in the fact that the abnormal price of the factor in question makes abnormal (i) the comparative costs of producing different goods, and (2) the comparative costs of using different combining proportions in producing the same goods. Because of these ab- normalities in cost due to the assumed abnormal price of some factor, the policy of producers would tend to be made abnormal in a variety of ways. In our argument, however, we shall make use of but two of these, namely : ( i ) Abnormal decisions in respect to the goods to be produced, and (2) abnormal decisions in respect to the combining proportions to be used in producing those goods. Comparative Costs of Products Abnormal. That an abnor- mal price for a given factor must alter and, therefore, must make abnormal, the comparative costs of producing different goods is almost self-evident. If, for example, the price of a given factor were abnormally low, though this fact would lower the cost of all products more or less, the effect would be greater in the case of those goods into which the abnormally cheap factor entered in larger proportions. Thus, if we suppose the third of the factors used in our illustration on pages 374 and 375, Fs, to have a price of 4 cents instead of the normal one of 6 cents, the cost of every one of our 3 products would be lowered, Pi from 86 cents to 64 cents or 25 per cent ; Pz from 60 cents to 56 cents or 6 per cent ; and Pa from 50 cents to 44 cents or 12 per cent. On the other hand, although an abnormally high price for F 3 would raise costs for each of the three products, it would have more effect on the goods into which that factor entered in larger proportion. Thus, with a price of 8 cents for Fs, the cost of Pi would be raised from 86 cents to $1.08 or 25 per cent, the cost of Pz from 60 cents to 64 cents or 6 per cent, and that of Pa from 50 cents to 56 cents or 12 per cent. Costs of Combining Proportions Abnormal. But an abnormal price for a given factor would alter not only the comparative costs of producing different goods, but also the comparative costs of using different combining proportions in the production of the same com- modity. Thus, let us suppose that a combination of iFi, iF 2 , and i4Fa's would produce a unit of our commodity Pi quite as well as our XXXI PRIMARY FACTORS AND SIGNIFICANCE 379 original combination of 4Fi's, 3F>'s and nF's. At the normal price for Fa's, which was assumed to be 6 cents, this new combination would be shut out, since its total cost would be 2 cents plus 4 cents plus 84 cents, or a total of go cents, whereas the cost of the original combination was only 86 cents (8 plus 12 plus 66). If, however, the price of one F 3 should leave the normal, falling to 4 cents, the cost of the new combination would fall to 62 cents (2 plus 4 plus 56), while that of the old combination would fall to only 64 cents (8 plus 12 plus 44). Comparative Profitableness Abnormal. But it is hardly necessary to say that an abnormality in the price of a factor which lowered the comparative cost of producing a particular commodity or of using a particular combination would necessarily increase the comparative profitableness of producing that commodity or using that combination. Further, this process would reverse the positions of two products or two combinations as respects comparative profitable- ness wherever the conditions were such that the differences between the comparative costliness of different products and different pro- ductive combinations were slight differences, a condition which prob- ably obtains in the majority of cases. Choice of Products and Combinations Abnormal. Finally, since the original abnormality in the price of one of the factors tends to reverse the positions of different products and different combining proportions in respect to their profitableness, it tends to reverse the policies of producers in respect to which of two products they will produce and which of two different combining proportions they will employ. On the one hand, an abnormally high price for a given factor will cause them to produce less than the normal amount of goods which call for a large quantity of said factor and to employ in less than the normal amount the particular combinations of factors which contain the particular factor in large quantity. On the other hand, an abnormally low price for a particular factor will cause entrepreneurs to produce more than the normal amount of the goods which call for a large quantity of said factor and employ to a more than normal extent the combinations of factors which contain this 380 PRINCIPLES OF ECONOMICS [XXX particular factor in large quantity. In the former case, the reaction just noted, that is, the too scanty production of goods and the too scanty use of combinations which call for large quantities of the factor in question, prepares us for the final one to appear in the next paragraph. In the second case, however, one more reaction precedes the final one. When the abnormally low price of the factor in question has led entrepreneurs to drain off the supplies of that factor to produce goods and use combinations which were profitable only because of said abnormally low price it becomes inevitable that the production of other goods which, in view of the situation as a 'whole, are needed 'more than these into which our factor is supposed to have gone, should fall below normal. That is, the too low price of the factor in question results in an abnormally small output of products having a higher importance. Final Reactions. We come now to the last step in these reactions set up by the abnormality in the price of our primary fac- tor. First, what is the final reaction in the case of an abnormally high price for our factor? The answer is easy. Since a too high price for that factor inevitably results in an abnormally small produc- tion of those goods and an abnormally small use of those combina- tions in which that factor plays a large part, there comes to be on the market an excess of this factor, with the result that those who supply ?aid factor are obliged to bid down the price in order to get a market for their commodity. Accordingly as respects this case of an abnormally high price for a factor, we have reached our goal. The abnormality in that price inevitably sets up a series of reactions which tend to eliminate said abnormality : the too high price of the factor is bound to be its own undoing. What, finally, is the end of the series of reactions which results from an abnormally low price ? The last reaction already noted had brought us to an abnormally small output of various goods which the situation called for, but from which producers had been drawn off to produce goods the production of which had been made un- usually profitable by the abnormally low price of the factor in ques- tion. It is this decrease in the output of goods really called for which brings on the final reaction. Such decrease in the output of XXX] PRIMARY FACTORS AND SIGNIFICANCE 3 8 r these goods necessarily raises their marginal significance ; this raises their price; such rise in price increases the profit to be earned in producing them; and finally entrepreneurs, as a condition of earning that profit, bid up the price of the factor which is too cheap. To sum up these reactions in a sentence we may say : On the one hand, an abnormally high price for any factor necessarily throws out of employment a greater or less quantity of that factor and so in the end tends to destroy itself; on the other hand, an abnormally low price for any factor shifts production from more important to less important commodities, and the reaction necessary to correct this misdirected production eliminates or tends to eliminate the abnormal price supposed to exist. Reactions Cease only with Price Normal. We have seen that the presence of a price for a factor which did not express the effective significance of that factor would, through its influence on the conduct of producers, set in motion reactions tending to remove the original cause of the trouble, the said abnormal price of said factor. We have only to add that these reactions could not cease till they had replaced the abnormal price of the factor with its normal one, that is, with one which expressed the effective significance of said factor. This is, of course, implicit in the contention already maintained. Any departure from the normal price of the factor must tend to set up the reactions described. Doubtless a large dis- crepancy between the normal price and the actual price would set up the needed reactions more quickly and give them greater energy. But the existence of any discrepancy, however small, must tend to set up the reactions described ; and nothing would completely shut them out except the entire disappearance of such discrepancy. CHAPTER XXXI THE SYSTEM OF PRICES AS A WHOLE In the last two chapters we have tried to work out a tenable doc- trine as to the processes by which the prices of the most funda- mental elements in the economic order the primary factors or cost- goods are determined. It now becomes our duty to try to bring these ultimate x processes into relation with those more immediate or superficial ones which are embodied in the law of single price, the laws of supply and demand, the laws of cost, and so on. In other words, we must try to get some notion of price determination as a complete process, some notion of the system of prices. There Must Be a Coherent, Self-Consistent System of Prices The Interdependence of All Prices. Perhaps the most natural introduction to an attempt to get a bird's-eye view of the price sys- tem as a whole is to make ourselves realize that there is such a sys- tem. Prices are not a mere aggregate of unrelated entities or only slightly related entities. Instead, we should realize that, in very im- portant senses, the prices of all goods are interdependent and must tend to form a coherent, self-consistent system of prices. Obviously this doctrine is in some degree explicit or implicit in our previous study of prices. Thus, in saying that the price of a wooden chair is determined by its cost of production, we thereby say that there is interdependence between the prices of products and the prices of the cost-goods entering into those products. Again, in affirming such determination of the price of the chair by its cost, we implicitly affirm that there is interdependence between the prices of all products from one common cost-good, such as wood or steel or labor. 1 Logically ultimate, 382 XXXI] SYSTEM OF PRICES AS A WHOLE 383 But, while the interdependence of prices has in some degree been brought out in our previous study, it has been so little emphasized that one might easily get the impression that the determination of the price of each commodity is a matter by itself, or anyhow that there is no general, all-inclusive interrelationship among prices. In an account of final price determination, therefore, it is important to lay some stress on this point. Put in a formal way, it may be stated as follows : All prices, especially the prices of produced goods, are inter- dependent; and equilibrium among the price-making forces can be approximated only when all prices have come to form a coherent, self -consistent system. Cost-Goods and Products. As already noted, two very im- portant reasons for affirming the interdependence of prices are ex- plicit or implicit in the doctrines which make the prices of products coincident with their costs of production. In the first place, this very relationship of cost-good and product directly involves interdepend- ence. If two things have to be equal, there must be interdependence between them. This conclusion is unavoidable whatever theory we may hold as to the direction of causation between cost-good and product. If we accept the doctrine given in Chapter XXXI that, generally speaking, the value of the cost-goods is communicated to the product, the interdependence of the prices of the two types of goods is manifest. If we accept the doctrine which is apparently held by some writers that the price of the product always deter- mines the prices of the cost-goods, the result is the same: the two sets of prices must coincide, must therefore be interdependent. Common Intermediate Cost-Goods. A second reason for the necessary interdependence of prices, derived from the principle that the prices of cost-goods and products must coincide, is the fact that many products involve the consumption of one common cost-good. Thus, rails, girders, saws, knives, razors, watch springs, etc., be- ing all made from steel, must have their prices influenced by that of steel and at the same rate, hence those prices must be interde- pendent. The price of any one of them could be determined in- 384 PRINCIPLES OF ECONOMICS [XXXI dependently of the others only in case the steel used in making them were sold, in the same market at the same time, for different prices corresponding to its different uses. But such a state of things we have already shown, in the law of Single Price, to be impossible. Common Primary Cost-Goods. But, admitting this point, cannot the prices of all products made from one particular kind of raw material be determined independently of the prices of products made from other kinds of raw materials? For example, though the prices of rails could not be determined independently of the prices of engines, girders, saws, planes, and knives, still the prices of all products made from steel could surely be determined independently of the prices of all products made from lead or copper or zinc or wood. On the contrary, this doctrine is scarcely less absurd than the former. Like the steel knives, steel saws, and steel girders re- ferred to in our first example, products made from steel and products made from lead, copper, and zinc also have common sources, the human labor of many different kinds and the capital or carrying power which is required in all the industries concerned. Conse- quently if the prices of products made from steel were to be deter- mined independently of the prices of products made from lead or zinc or copper, then the different kinds of labor, the waiting power, and the other factors which constitute common sources for steel, lead, zinc, and copper would each have to have many different prices in the same market at the same time, in contravention of the Law of Single Price. Different Goods Reciprocal Substitutes. We have seen that the interdependence of the prices of many goods anyhow is assured because of the principle that the prices of products and cost-goods must coincide. Other more inclusive reasons why there must be in- terdependence of price grow out of the fact that different kinds of goods occupy toward one another the relation of reciprocal sub- stitutes; if there are serious obstacles to buying a particular good, some other can more or less completely take its place. This is con- spicuously true in the case of groups of goods intended to serve the same general purpose, such as the different means for furnishing XXXI] SYSTEM OF PRICES AS A WHOLE 385 illumination, or the different foods, methods of transportation, and so on. As a result of such possibility of reciprocal substitution, the demand schedules of these different goods are interdependent, each one is affected by changes in the others. A change in the price of gas modifies the demand schedules of electric lighting, of kerosene oil, of candles, etc. ; a change in the price of wool modifies the de- mand schedule of cotton ; a change in the price of meats modifies the demand schedules of potatoes, beans, etc. But, if the demand schedules of different commodities are interdependent, their prices must also be interdependent ; since changes in their demand sched- ules, other things being equal, must change their prices. Interde- pendence of prices, therefore, follows as a result of the fungibility of different goods, the possibility of their reciprocal substitution. The particular ground of interdependence just brought out is most certainly present and most clearly seen in the case of groups of goods intended for the satisfying of the same want. But the same statements apply in a degree to almost all kinds of goods. In a broad but legitimate meaning of the language, practically all goods occupy toward one another the relation of reciprocal substitutes. Each is competing against every other for the opportunity to satisfy our wants. A rise in the price of any one tends to cause a change in the demand schedules for all or many others. Changing their demand schedules, it must of course tend to change their prices. Thus, again, all prices are interdependent. 2 A Self-Consistent System of Prices. We have shown the soundness of the first part of our general proposition, which says that all prices are interdependent. The second part follows as an immediate inference from the first, and should call for no other argument. Since all prices are interdependent, are reciprocally de- termined, reactions among them cannot cease equilibrium cannot be reached till they together form a coherent, self^consistent whole. 2 It is hardly necessary to warn the student that there is some danger of exaggerating the importance of this interdependence of prices. It would certainly be a serious error to imagine that the facts just brought out seriously impair the value of the principles of price hitherto presented. These facts must rather be thought of as qualihcations of those principles, minor forces modifying their effects. 386 PRINCIPLES OF ECONOMICS (XXXI ILLUSTRATIVE PROBLEMS 1. It is quite unsound to imagine that the wages paid in a particular coal mine or in coal mining generally are determined independently of wages in other lines of industry. Wages are prices, and, like other prices, they are bound to be interdependent. Give specific reasons for the correctness of that statement in the case of wages. 2. It has been held by some writers that almost any tax system, if only it is old enough, will fall on the different classes of citizens with about the same weight as would any other system raising the same amount of revenue. This doctrine is doubtless overstated; still it contains an element of truth. Give the general argument in support of it. 3. (a) "A protective tariff is a device for taxing the consumers of the commodity involved in order to give big incomes to the producers of that commodity." (b) "A protective tariff is a device for taxing the consumers of the commodity involved in order to insure the maintenance of the industry which produces that commodity." Looked at broadly, the second statement is much nearer the truth. Assuming the tariff to be kept constant, there is no reason for expecting that the producers of the protected industry will reap exceptional profits therefrom. Argue in support of that statement. II Price Determination as a Complete Process We have seen that all prices are in greater or less degree inter- dependent and that they tend to form a coherent, self -consistent sys- tem of prices. We must now attempt to get a bird's-eye view of this system, to see it as a totality, with its parts articulated. In do- ing this, we shall set up a series of hypotheses, the earlier ones very simple yet helping us to understand some aspects of the present order. First Hypothesis: Only One Primary Factor; No Disutility Cost; Many Products Wanted; Both Demand and Supply Schedules Elastic; Conditions Static We begin with the hypothesis that there is but one primary factor ; that this has no disutility cost ; that many products are wanted ; that XXXI] SYSTEM OF PRICES AS A WHOLE 387 all are increasing-cost products, hence have elastic supply schedules ; that all demand schedules are elastic ; and that conditions in respect to population, tastes, methods of production, etc., are substantially unchanging. Starting with such a hypothesis, let us suppose that the number- less forces at work have acted and reacted till they have brought about a condition of equilibrium, that is, a condition under which all forces have become exhausted or neutralized by opposing forces till there is no longer any tendency to change in the prices prevailing. What, now, in such a state of things will be true with respect to the operation of our laws of price and their relation to one another? All Price Laws Operative. In the first place, it is evident that in such a state of equilibrium the results naturally worked out by every law of price must have been realised. The single primary factor and the several products must each have but one price. Sup- ply and demand for the single factor and for each product must have come to equality. The price of each product must express its mar- ginal significance or utility. The price of each product must equal its marginal cost of production. The price of the one primary factor must express its marginal significance in products; and, under our present hypothesis of perfect elasticity in all demand schedules, this marginal significance will be found, not in just one or a few products, but in each product. One Law Finally Determinative. A second and much more important fact of the situation would be that, though the results of all the laws of price would have to be realized in the state of equi- librium supposed, one of these and only one is finally determinative. The condition of single price, of supply equalling demand, of price coinciding with cost may be realized many times temporarily, pro- visionally, without final equilibrium's thereby having been reached. But, just as soon as the law that the price of the single primary factor must be such as expresses its marginal significance in products has been realized, equilibrium, final equilibrium, will have been attained. This condition this coincidence of the price of the primary factor and its marginal significance and this condition only, will establish 388 PRINCIPLES OF ECONOMICS [XXXI a definitive, final, set of prices. Doubtless such a state of things can be reached only after there have taken place innumerable reactions in which other forces and other laws will have been operative. But the reaction bringing about this coincidence of the price of the pri- mary factor and its marginal significance in products will be the f.nal reaction. With the coming of that price, equilibrium will have been reached, tendency to further change will cease. It follows that, under our present hypothesis, the marginal significance of products viewed as the determinant of the price of the single primary factor must be conceived as the ultimate determinant of the prices of prod- ucts. But, in interpreting this proposition, we must not fail to bear in mind the phrase in italics. The marginal significance of products is the final determinant of the prices of products only when viewed as the determinant of the price of the single primary factor. But the clearing up of this point must wait for the statement of our next hypothesis. Other Laws Subordinate. As a complement to the point last made, we have to note that, under our present hypothesis, the principles or laws of price other than the one affirming the coincidence of the price of the primary factor and its marginal significance, are little more than instrumentalities through which said coincidence is established and through which the domination of the whole situa- tion by the marginal significance or utility of products is assured. The principles of single price and of supply and demand are opera- tive every moment, responding to every slightest change in condi- tions, while the final equilibrium is being worked out. The principle of cost lags a little behind, but only a little. Together they are in- suring that equilibrium cannot come till the finally determinative condition the coincidence of the price of the primary factor and its marginal significance is realized. ILLUSTRATIVE PROBLEM "The law of single price tends to insure the domination of marginal significance over the entire stock of any single commodity; the laws of cost tend to insure such domination over the whole field as between different commodities." Defend that statement. XXXI] SYSTEM OF PRICES AS A WHOLE 389 Second Hypothesis : Same as Before ; but Most Demand Schedules Inelastic We now make a slight change in our hypothesis in order to bring out unmistakably the fact that the marginal significance of products was the final determinant of prices only when viewed as fixing the price of the primary factor. This doctrine was indeed implicit in the case embodied in the preceding hypothesis, and has already been noted. But, under that hypothesis, we could not easily make the point clear. As long as all demand schedules are perfectly elastic, the price of every product will coincide with its own marginal sig- nificance, so that we are in danger of fancying that the marginal utility of products directly determines the prices of products with- out reference to the marginal significance of the primary factor. In fact some writers who have done much to establish the correct doc- trine have more than once carelessly spoken as if the price of each product were determined by its own marginal significance only. 3 The unsoundness of this view is easily seen when we change our hypothesis so as to make some of our demand schedules inelastic. To be quite specific, let us suppose that only two of our demand schedules are elastic, those of the marginal and first extra-marginal products; that the marginal significances, and so the marginal de- mand prices, of the supra-marginal products are all much above their marginal cost of production ; and that there are no extra- marginal demands for these products. Under this hypothesis, the competition of producers would bring the prices of all supra-marginal products down to their cost of production, that is, to figures below their mar- ginal significances. In other words, the prices of these supra-mar- ginal products would not even coincide with their marginal signifi- cances. Those marginal significances, therefore, could not be credited with fixing their prices. It is only the marginal significance of the marginal product which figures in the process. But even this is not the end of the matter. This highly important thing, the marginal significance of the marginal product, could not be determined in- dependently of the quantity of the primary factor available. Had 1 Writers of the Austrian school. See Note 6, Appendix. 390 PRINCIPLES OF ECONOMICS [XXXI there been more of that factor, more products could have been pro- duced, and so the marginal significance of the marginal product would have been lower ; had there been less of that factor, the opposite re- sult would have been reached. It was possible, therefore, to reach final equilibrium only when the marginal significance of the marginal product had communicated itself to the primary factor and brought the price of said factor into coincidence with that significance. That is, as affirmed above, the real condition of final equilibrium is not the coincidence of the price of each product with its own marginal significance, but rather the coincidence of the price of the primary factor with its marginal significance as determined by the marginal significance of the marginal product, In order to make this rather difficult matter as definite as pos- sible, we may summarize the doctrine applicable to our present hypothesis in the four following propositions : 4 (1) The marginal significance of the marginal product having been determined, determines the price of that product ; 5 (2) The price of the marginal product having been determined, determines the price of each unit of the primary factor entering into that product; (3) The price of a unit of the primary factor entering into the marginal product having been determined, determines the price of all other units of that factor ; and (4) The price of all units of the primary factor having been determined, determines the prices of the supra-marginal products. Here the logical starting point of causation is the marginal signifi- cance of the marginal product ; but it is such a starting point because it fixes the price of the primary factor, and through it of all products. Under our first hypothesis the case seems otherwise because the price of every product coincides with its own marginal significance. But this arises from the accidental circumstance that all products have perfectly elastic demand schedules. The fact that, when this condition is altered, final price determination still goes on without the necessity of any correspondence between the prices of the supra- 4 It may be worth the student's while to go over tne diagrammatic presenta- tion of this case in Note 7 of the Appendix. 8 See Note 8 of the Appendix. XXXI] SYSTEM OF PRICES AS A WHOLE 391 marginal products and their marginal significances shows that the really essential thing is the coincidence of the marginal significance of products in general with the price of the single primary factor. 6 ILLUSTRATIVE PROBLEM If we ignore the influence of disutility, we have to say that, as re- spects the course of causation between cost-goods and products, this runs from the former to the latter in the case of individual products, but from the latter to the former in the case of products taken as a whole. Explain what is meant and show why it is true. Third Hypothesis: Same as Last with Disutility Cost Added Our hypothesis up to this point has involved the use of a single primary factor of which we have a fixed amount, or output. We now modify that hypothesis so as to make the supplying of the pri- mary factor dependent on human consent, and involving a dis- utility, thus giving variability to the quantity supplied. The change in our analysis which this change in the hypothesis makes necessary, is easily anticipated in view of the discussion on pages 361-363. The price of the primary factor must be such as expresses a signifi- cance at least as great as the marginal disutility involved in supplying that factor; and, of course, the prices of products must be high enough to justify such a price for the primary factor. This does not mean that the price of the single primary factor is no longer coinci- dent with the marginal significance of its marginal product, but that said price must also be coincident with the marginal disutility of supplying said primary factor. The final condition of equilibrium among the price-making forces is a price for each unit of the primary factor which fulfils both these conditions. 7 9 An interesting variation from our last hypothesis would be one in which the demand schedule of even the marginal commodity was discontinuous, so that the marginal significance of this product was separated by a considerable interval from its first extra-marginal one, and at the same time it was separated by a considerable interval from the highest significance of the next possible product wanted. Under this hypothesis the decisive factor would be, not necessarily the marginal significance of products, but a significance not higher than that marginal, and not as low as the first extra-marginal one. T For the diagrammatic presentation of this, see Note 9 of the Appendix. 392 PRINCIPLES OF ECONOMICS [XXXI Fourth Hypothesis: the General Situation of Real Life: Many Factors, Some Fixed, Some Variable in Amount, Some Having a Disutility Cost ; Some Demand Schedules Elastic, Some Inelastic The conditions of real life are, of course, vastly more complicated than any of our previous hypotheses quite too complicated, doubt- less, to permit a really adequate statement of the processes of final price determination under those conditions. Nevertheless, it may perhaps be worth while to summarize in a general statement the ac- count of this matter which naturally follows from the doctrines with respect to the prices of primary factors which were laid down in Chapters XXVIII to XXX, and from the conclusions reached for the highly simplified hypotheses which we have just considered. Summary. Supposing static conditions and the perfect free- dom of competition postulated in economic theory to be realized, equilibrium disappearance of all tendency to further change can come only, and then must come, when the price of each primary factor is brought into substantial coincidence with a significance not higher than its marginal one and not as low as its first extra-marginal one, and, if said factor involves a disutility, into coincidence with a disutility as great as the marginal disutility of supplying said pri- mary factor and not as great as the first extra-marginal one. When that equilibrium is reached, the price of each product having a per- fectly elastic demand and supply schedule will be one which ex- presses its marginal significance and equals its marginal cost; the price of each product having an elastic supply schedule but an in- elastic demand schedule will be one which equals its marginal cost and is likely to be one which is below its marginal significance, though it may coincide with that significance ; and the price of each constant-cost product must be one which equals its cost of produc- tion and coincides with its marginal significance, if at all, only because that significance adjusts itself to a price determined by cost. CHAPTER XXXII PRINCIPLES GOVERNING THE MONEY STANDARD The preceding chapter brought to a conclusion our discussion of that broad division of Economics known as Exchange. Before finally dismissing this subject, however, we shall find it useful to give some further attention to the study of Money. Money, as we know, is the medium of exchange; and as preliminary to the treatment of exchange, we set forth in Chapter XIV some of the more simple and obvious truths concerning Money. But now, with a thorough study of Exchange as a whole behind us, it becomes possible, as also necessary and proper, to make a deeper investigation of the medium by which it is conducted, and to present the more essential principles governing that medium. In this chapter we take up the principles governing the money standard. The monetary standard, the student will remember, is that some- thing which fixes the significance or value of the money unit. Thus in the United States, 25.8 grains of gold, nine-tenths fine, fixes the value of the dollar ; whatever value may at any time attach to 25.8 grains of gold, that same value will attach to one dollar. Now this very definition shows that the monetary standard is, in an important sense, the foundation of the whole system, and that a change from one standard to another, or even mere liability to change, may carry with it the threat of serious harm. Further, experience has shown that it is by no means an easy task to insure that such changes will not take place. The monetary standard has many times been dis- pl^ed in spite of the utmost preventive efforts a government could make; and, in fact, governments themselves have more than once through mistaken legislation inadvertently brought about the very displacement which they were trying to avoid. Manifestly, then, it is quite important that we should know the natural laws which con- cern the monetary standard in order that we may be able rightly to manage that standard. 393 394 PRINCIPLES OF ECONOMICS [XXXII These principles may be grouped in two classes: (i) those concerned with the immediate standard, standard money, which di- rectly, immediately, fixes the value of the money unit, and (2) those concerned with the ultimate standard or the something which fixes the value of standard money itself, and, in doing so, finally fixes the value of the money unit. 1 I Defining and Determining Standard Money The first principle to be laid down with respect to standard money is the following : Principle I. The standard money of any system must be a money which is at par and which has its value fixed independently of its relations to other moneys. The proposition that standard money must be a money which is at par is hardly more than a corollary from the definition of standard money. Standard money is the immediate standard of the system, the money which immediately determines what the money unit is worth. To it, the money unit is anchored. Its value is the value given to the unit. But, plainly, we cannot say of a given money that it fixes the value of the money unit unless a unit of that money has the same value as the money unit it is said to fix. Thus we cannot regard gold coin as the standard money of the United States if we find that ten-dollar gold pieces are worth eleven dollars each ; for, in that situation, some other money worth ten-elevenths as much as gold must really be fixing the value of one dollar. No money which has a value above or below the value of the unit can be fixing the value of f hat unit. We have just seen that the standard money must be one which is at par. But we commonly find two or more moneys fulfilling this condition, and which one of the money at par will then be standard? This question is answered by the second part of our principle. The 1 See pages 165, 166. XXXII] THE MONEY STANDARD 395 standard money is that one of the par moneys which has its value fixed independently of the other moneys. In most cases the sound- ness of this contention is evident enough. Thus, in our system, gold coin is firmly anchored to the metal contained in it, has its value fixed by that metal quite without regard to the values of the other moneys. On the other hand, the values of treasury notes, bank notes, and small silver have no sort of relation to the value of the material in them, but are kept equal to that of gold coin by being made directly or indirectly exchangeable for gold coin. Manifestly, then, as between gold coin and the other moneys named, the former is the standard : it is the thing which determines', they are things which are determined. The case of a par money which is not kept either directly or in- directly convertible with gold coin is not so plain ; but the conclusion must be the same. Such a case is illustrated in most countries by small silver which is not redeemable, 2 and, in this country, by silver dollars. No institution is bound to redeem these coins in gold or its equivalent. 3 Further, the metal in the coins is much less valuable than gold coin, and is changing in value, as measured in gold, every day. Yet all the time these silver coins remain just equal in value to gold coin. Just why they do so is a problem with which we are not here concerned. Here we are asking: Which of these two is standard money ? Which is principal and which subordinate ? Which determines and which is determined? Surely there can be but one answer. The gold coin is fixed in its position, being anchored to the metal it contains, while the silver coin, showing no constant relation to the metal in it, is free to move. Hence, unless their equality of value is to be attributed to mere coincidence, and surely this is out of the question, we must conclude that the value of the sirVer coin adjusts itself to that of the gold coin, is determined by that of the gold coin. Gold coin, therefore, the money which has its value independently determined, is established as the standard money. 3 It is redeemable in this country. 3 The United States Treasury would probably undertake to do so, if they became less valuable than gold. 396 PRINCIPLES OF ECONOMICS [XXXII ILLUSTRATIVE PROBLEMS 1. In the United States in 1870, gold coin was worth $1.21 per dol- lar, silver coin $1.23 per dollar, and greenbacks $1.00 per dollar. Which, if any, must have been standard money? 2. For several weeks during the panic of 1837 coined money, whether silver or gold, was at a premium of from 2 to 4 per cent, while bank notes were at par. Which, if any, must have been standard money? 3. Add to the first problem that in 1870 national bank notes were worth $1.00 per dollar and were redeemable in greenbacks. Which money, under this condition, must have been standard money? 4. Supposing that all kinds of money are at a premium, only bank credit in the form of checks being at par, what then would be standard money or the immediate standard? Our first principle has given us little more than a rule for recognising standard money. The second gives us one of the most important laws determining what particular money occupies this place. Principle II. // among those moneys in any system which are a valid tender in the payment of debts, differ- ences of exchange value arise, the cheapest of such valid tender moneys establishes itself as the standard money, and the rest go to a premium. A good illustration of this principle is found in the monetary history of 1870. At that time paper money, gold coin, and silver coin showed differences in value, measured in paper, as follows: Gold was worth 21 cents more than paper, and silver was worth 2 cents more than gold. These differences could have manifested them- selves in any one of at least three ways: (i) paper might have been quoted at $i, gold at $1.21, and silver at $1.23, or (2) gold might have been quoted at $i, silver at $1.02, and paper at $.82; or (3) silver might have been quoted at $i, gold at $.98 and paper at $.81. If the first hypothesis had been realized, it can be seen by reference to Principle I that paper would have been the standard money; if, XXXII] THE MONEY STANDARD 397 instead, the second hypothesis had been realized, gold would have been the standard money; finally, if the third hypothesis had been realized, silver would have occupied the place of honor. In fact, the first hypothesis was realized ; and the natural law which insured that it would be is the one stated in our second principle. The cheapest of these legal tenders was bound to establish itself against the rest. The proof of this principle is relatively simple. By hypothesis all the moneys in question are valid tenders for debts. Under that condition which will be the standard money for debts? If I have a right to pay my debts with either of two moneys, one of which is worth three cents more than the other, which will I naturally choose? The cheaper, of course. And what I would naturally do, experience proves that debtors generally do. It follows then that the cheapest of two or more valid tenders will be the standard money of debts. Secondly, for the sake of convenience in business transactions the standard money of debts and that of prices must, if possible, be the same. One can imagine the inexpediency of having in business one meaning for the dollar in debts, and another for the dollar in prices. A grocer fixing the prices of his goods in one kind of dollar, while his note to the jobber was in another sort of dollar, would meet serious inconveniences; so he surely would not conduct business in this way unless obliged to. But, thirdly, he will not be obliged to do this, because the standard money for debts and the standard money for prices naturally draw together and become one. The standard money of debts is fixed by natural law as the cheapest of all the valid tenders, and this result men cannot change, save under very exceptional circumstances. But the standard money of prices, on the other hand, is determined wholly by the choice of the individual dealer. He may freely rate his goods in gold dollars or silver dollars, or greenback dollars, or even pounds or marks if he desires. It is accordingly possible for the standard money of prices to adjust itself to the standard money of debts; and since, as we have already seen, such an adjustment is for business reasons highly desirable, it will inevitably be brought about. In a word, the cheapest of the valid tenders becomes not only the standard for 398 PRINCIPLES OF ECONOMICS [XXXII debts but also the standard for prices the standard money in general. Three special applications of the principle just established give us three corollaries of that principle which have played a part of very great importance in the monetary history of modern times. Those corollaries are as follows: Corollary i. // two \metallic moneys are freely coined and full legal tender at a coinage ratio different from the market ratio, the money coined from the overrated metal will establish itself as the standard money. Corollary 2. If, in the case of a legal tender circulating note which has hitherto been kept redeemable in what has hitherto been standard money, a suspension of payments takes place, such legal tender note will almost certainly estab- lish itself as standard money. Corollary 3. // any form of credit money or money substitute ceases to be redeemable in standard money or its equivalent, and, though not a true legal tender, is made in effect a valid tender in payment of debts by any set of cir- cumstances, such money or money substitute will for the time being usurp the place of standard money. To illustrate the first of these corollaries, suppose that, when i ounce of gold is worth on the market 16 ounces of silver, the government mint treats i ounce of gold as worth only 15 ounces of silver, putting into each silver coin less metal than is needed, considering the market value of the two metals. The mint thus treats silver as worth more than it really is; in technical language, it overrates silver. Under these conditions, each silver coin will be worth less it will be cheaper money than the corresponding gold coin. Hence it follows from Principle II that the silver coin will assume the place of standard money. The second corollary, relating to the behavior of legal tender circulating notes, offers no serious difficulty. So long as such notes XXXII] THE MONEY STANDARD 399 are kept redeemable in standard money, they of course will be worth as much as standard money. When, however, the issuer of the notes suspends payment on them, their value inevitably declines, because, although people may expect them to be again made re- deemable at some future time, they are not willing to give as much for a probable future payment as for a certain present one. But when notes with the faculty of legal tender become less valuable than the money which has hitherto been standard money, this fact brings into operation Principle II, that is, these notes displace the money hitherto standard, and themselves usurp its office. The circumstance alluded to in the third corollary has repeatedly arisen in our history when a concerted suspension of payment on their notes by practically all banks has led the general public by tacit consent to treat those notes as a valid tender for debts. As a result, the notes behaved as if they were a true legal tender in other words, Corollary 2 was brought into operation. In a similar way, bank credit, deposit currency, as it is often called, has more than once been made the standard money by a concerted refusal of banks to pay in any form of money. At such times, the public has come to accept bank credit as a valid tender for debts, thus making bank credit the immediate standard, while all forms of money proper went to a premium. ILLUSTRATIVE PROBLEMS 1. In the United States in 1830, both silver and gold were freely coined at a ratio of 15 to i, when the market ratio was 15.8 to i. (a) Which metal did the mint overrate? Explain carefully. (b) Which of the two moneys, if any, must have been standard money ? 2. In 1830 France had a system similar to ours but its ratio was 15.5 to i. Answer the same questions for it as for the United States under i. 3. Why did the United States have the greenback as its standard money between 1862 and 1879? 4. In 1717 the British government decreed that a gold guinea should be treated as the equivalent of 21 silver shillings; though, judged by the 400 PRINCIPLES OF ECONOMICS [XXXII bullion in them, the guinea was worth 20^/2 shillings. Which must have become standard money ? Explain. 5. In the panic weeks of 1837, bank notes were the standard money. (See Problem 2, page 396.) How do you explain it? II Defining and Determining the Ultimate Standard Thus far our discussion has been concerned with standard money and the laws governing it. Two other principles of considerable importance have to do with defining and determining the ultimate standard. The first of these is the following: Principle III. // by any process whatsoever the standard money is kept constantly equal in value to a definite quantity of some outside commodity or group of commodi- ties, such commodity or group of commodities constitutes the ultimate standard of the system. This principle can perhaps be best illustrated by imagining a system in which there was no metallic money, some kind of paper money being the standard money, but in which that paper money was all the time kept equal in value to a certain amount of gold or silver or some other outside substance. In such a system, the principle tells us, the gold or silver or other outside substance to which the standard money was kept equal in value would constitute the ulti- mate standard. As a matter of fact, this particular method of realizing the condition indicated in our principle is not actually employed, though some very able economists have favored it. The plan generally pursued is to have, as our standard money, coins made of the very metal which we wish to use for our standard, in our own case, gold. These coins we keep equal in value to the quantity of gold (25.8 grains) desired for our ultimate standard by maintaining two condi- tions which insure this result : ( i ) the metal gold has free and gratuitous coinage the mint must turn into coin of full weight without substantial charge whatever gold is offered; and (2) under XXXII] THE MONEY STANDARD 401 ordinary conditions, free inciting of gold coin is permitted. When these conditions are realized, it is plainly impossible that the coin and the metal, being practically interconvertible, should have differ- ent values. No one would give more for the coin than for the metal, since he could have that metal turned into coin without charge ; so he would not give more for the metal than for the coin, since he could at will turn the coin into the metal by melting it. In the above illustration of our principle, we supposed that a certain amount of gold was chosen as the ultimate standard. But, of course, some other metal, for example silver, may be chosen, or something not a metal, say, wheat, or a group of things made up of many items : a ton of coal plus 10 yards of cotton plus 100 pounds of flour, etc. A standard of the latter sort has been advocated by many able men and is commonly known as a multiple standard. But, whatever the particular thing or things chosen, the idea is the same: if there is something outside the standard money which fixes the value of that standard money, that something is the ultimate standard. The principle needs little argument to establish its truth, since it is little more than the corollary from the definition of the ultimate standard. The ultimate standard is the something behind the im- mediate standard, standard money, which finally determines the value of that money, just as that standard money determines the value of the money unit. Now, it can hardly be doubted that the gold or silver or wheat or list of goods used in our illustrations answers to this definition of the ultimate standard. First, by hypoth- esis, the standard money is kept equal to such gold or silver or wheat ; and so, the latter is, in some sense, standard. Secondly, since this gold or silver or wheat is not, in turn, dependent on some- thing else for its value, such gold or silver or wheat constitutes the final, ultimate, standard. Perhaps a doubt may still linger in the student's mind. "It is plain that the value of our standard money, gold coin, and the value of the gold metal in that coin are equal. But are we sure that the value of the metal fixes the value of the coin rather than the reverse? Surely, gold as a metal has its value influenced by the value of the gold money." The last statement is no doubt correct: the value 4 02 PRINCIPLES OF ECONOMICS [XXXII of money influences that of the metal just as truly as the value of the metal influences that of the money. Nevertheless, one of these, the metal, must be looked on as, in the more ultimate sense, a de- terminant. The gold coin of any one country constitutes only a small fraction of the total gold coin of the world, and a still smaller fraction of the total gold metal coin, articles made of gold and gold bullion. Conditions tending to bring about a change in the money of a particular country independently of the gold stock of the world must, of course, tend to exercise some influence on the value of that gold stock. But, after all, the small fraction cannot be credited with determining the value of the whole. The total gold stock must have a value resulting from the action of number- less other forces as well as the causes which influence the value of the money of a single country; and, to the value of the total gold stock as thus determined, the value of the gold coin of any par- ticular country must tend to gravitate. As long as the money unit of a country is kept equal in value to a certain quantity of the metal gold, that metal must be recognized as the truly ultimate standard. ILLUSTRATIVE PROBLEMS 1. A few years ago, the United States remodeled the monetary sys- tem of the Philippines, making silver pesos coined only for the govern- ment the standard money, but providing that gold exchange on New York should be sold to any person wanting it in exchange for silver pesos at a rate of $i for two pesos. Such a system tended to establish what ultimate money standard in the Philippines? 2. Great Britain puts into every sovereign 113 grains of pure gold, coins these sovereigns for everyone free of charge, and does not attempt to hinder the melting of coins. Under these conditions what necessarily becomes the ultimate standard of Great Britain? Explain fully. 3. What must have been the ultimate standard of the United States in 1830? See Problem i, page 399. 4. What must have been the ultimate standard of France at the same date? See Problem 2, same page. Our second principle with respect to the ultimate standard has to do with a situation where the standard money is itself the ultimate XXXII] THE MONEY STANDARD 403 standard. Prior to 1893 British India had as its ultimate money standard 180 grains of silver; that is, the unit coin, the rupee, contained 180 grains of silver and was freely coined, thus making the metal itself the ultimate determinant of the value of the rupee. But, in the year named, the government stopped the free coinage of silver with the result that coins rose in value as compared with the metal in them, fluctuating from 32 cents down towards, but never to, their bullion value, 22 cents. Thus the silver rupee had nothing behind it to fix its value it moved up and down inde- pendently of anything else. Accordingly, the silver rupee fixed the value of the unit (the rupee) not only immediately but also ultimately; and hence was itself the ultimate standard. This illustra- tion alone would seem to furnish sufficient proof of the following principle : Principle IV. // the standard money is not kept con- stantly equal in value to a fixed quantity of some commodity or group of commodities outside itself, but varies in value independently of the variations of any other object, then such standard money is itself the ultimate standard of the system. ILLUSTRATIVE PROBLEMS 1. What was the ultimate standard of the United States between 1862 and 1879? Explain. 2. What was the ultimate standard of the United States during the panic weeks of 1837? See Problem 2, page 396. 3. Suppose that after 1893 the government of British India had so managed things as to keep gold exchange on London constantly at 20 rupees for i sovereign (123.27 grains of gold). What would then have been practically the ultimate standard of India? CHAPTER XXXIII PRINCIPLES GOVERNING THE CIRCULATION OF MONEY The second group of principles under our present subject con- cern the circulation of money the capacity of money to form a part of the monetary stock, the active medium of exchange. Will a particular money circulate at all? What kinds of money have the greater capacity for circulating the greater tenacity in circula- tion? To what part of the circulation is a particular kind of money likely to gravitate ? Will it tend to be used in the ordinary business of exchanging commodities or will it more probably lie most of the time in the banks, serving the purpose of a reserve fund ? These and other related questions are of importance because a government may in one case find it desirable to keep a particular money in circulation ; or in another case to drive a particular money out of circulation; or in still another to keep a particular kind of money down to a small stock, though not driving it out altogether ; or again to segregate a particular kind of money in some special part of the system. A government may, I say, at some time desire to do any of these things; but it can no more accomplish its desire by merely decreeing such a result than it can bridge a river by that process. The circulation of money is ruled by natural laws; and a government can accomplish its objects in that field only by estab- lishing such conditions that the natural laws which rule the cir- culation will automatically work out the results desired. It is of prime importance, therefore, that we should be familiar with the more influential of these natural laws. The first principle which we shall lay down runs as follows: Principle I. Under modern conditions, the full and continuous circulation of any kind of money in almost any 404 XXXIII] THE CIRCULATION OF MONEY 405 country of high commercial development requires a measure of legal authorisation from the government of that country. The most decisive proof of this principle is to be found in the fact that, in all but very exceptional cases, the circulation of a money is limited to the country where it is legally authorized. Even nations lying geographically side by side, closely connected in in- dustry and commerce and using the same monetary standard and the same system of denominations, even such nations do not usually circulate each other's money save along the border. Thus, despite the proximity and the intimate relations of Canada and the United States, Canadian money has no currency in this country outside Detroit, Buffalo, and a few other similarly situated places. This connection between the circulation of a money and its legal authorization by the home government is, of course, no mere accident. From early times governments have been wont to issue the money of their respective countries ; so that now, habit, if nothing more, would make the public chary of accepting any medium of exchange not authorized by government. Further, authorization by a government creates a presumption that that government will make some effort to insure the goodness of the money authorized. Such moneys, therefore, will naturally be more readily accepted in ordinary transactions than money which has nothing but private backing. Again, as between a money authorized by one's own government and one authorized by the government of some other country, men will naturally have more confidence in that authorized by their own. Finally, the government itself will usually discrim- inate against foreign moneys in certain relations, for example, in determining what shall be receivable for public dues or what shall be a legal tender for debts. This public discrimination will exercise more or less compulsion on private persons to take a similar attitude. We have seen that the power of a money to circulate usually depends on some degree of governmental recognition. Our next principle puts this case somewhat more strongly. Principle II. Under modern conditions, the power of any money to hold its place in the circulation in the fullest 406 PRINCIPLES OF ECONOMICS [XXX1I1 sense varies as 1 the extent to which it is given power to do the different kinds of money work. Thus, a money which will not be accepted by the government in payment of taxes or which cannot be used as bank reserves will have less tenacity in circulation than a money which enjoys these prerogatives. In part, evidently, the capacity of a money to circu- late depends upon the willingness of people to accept it in return for commodities and services. But some persons, anyhow, will need to use a part of the money, received in exchange for their goods, for the purposes indicated, to pay taxes and maintain reserves. They will, therefore, hesitate to accept, or perhaps absolutely refuse to accept, money which cannot be ultilized for these purposes. Further, if the money is one which they are not really free to reject in trade, they may yet be free, as in the case of the circulating notes of a bank, to return it to the issuer, getting in exchange some money which possesses the prerogatives lacking in the one in question. This course they are likely to take, and, in so doing, they put such money out of circulation. An obvious inference from the principle is that, if we wish to diminish the tenacity in circulation of any money, we can usually do so by depriving it of some prerogative ; 2 refusing to receive it for taxes, forbidding its use as bank reserves, or prohibiting bankers who receive it from paying it out over the counter. The two principles just set forth affirm that moneys of superior quality those having recognition by the government and possessing all money prerogatives remain more persistently in circulation than inferior moneys. We have now to remark on a principle which seems almost in flat contradiction of these. It affirms that inferior moneys have greater power in circulation. The formula "bad money drives out good," commonly known as Gresham's Law, is the one most in vogue. As thus stated, the doctrine was always inexact; 1 Remember that in Economics "to vary directly as" means only to vary in the same direction, not proportionately, and "to vary inversely as" means only to vary in the opposite direction, not proportionately. 1 This must be qualified by a consideration of the principle about to be commented upon. XXXIII] THE CIRCULATION OF MONEY 407 and, however stated, it is now true to a much smaller degree than in earlier times. Perhaps the facts are fairly well covered in the following : Principle III. Moneys which are inferior in respect to exchange or substance value commonly show greater tenacity in circulation than those which are superior in these respects. The truth of this principle has been amply confirmed in mone- tary history, in fact, the principle is one of the few in economic science which have been accepted primarily as inductions from ex- perience. Its explanation is easily found in the causes at work. The chief of these causes is the fact that, in the circulation proper the use of money in actual exchange transactions the superiority or inferiority of different kinds of moneys shows relatively little; whereas in various other uses, less strictly belonging to the circula- tion proper, or even quite outside the field of money, the superiority or inferiority shows relatively much. Take first the case of standard metallic money, gold coin in our system. Coins short in weight have no difficulty passing in trade. Only a careful test would prove that they are actually short ; and this test few people in the hurry of business care to make. Further, most people assume that, even if a coin is really short, no trouble will be experienced in passing it on to someone else. In active circulation, then, inferior coins serve as well as any. But not so in other relations. If a jeweler wishes to melt a gold coin to get the metal for use in this trade, he naturally chooses a ten- dollar piece of full weight, 258 grains, rather than one weighing somewhat less, say, 240 grains. The same is of course true of the exchange dealer who has occasion to send gold abroad in covering his drafts. Again, the peculiar position of the banker strengthens in another way the tendency of short-weight coins to stay in circula- tion. Governments and other institutions to which the banker makes payments will discriminate against inferior coins, so that, to save himself a loss, he must refuse to receive them extept at a discount. But depositors, in turn, anxious to escape this discount, studiously avoid presenting such coins for deposit, instead, keeping them for 4 o8 PRINCIPLES OF ECONOMICS [XXXIII their own use in trade, while they take to the bank full weight coin or other par money. The illustration just used concerns standard metallic moneys which show differences in substance value as well as in exchange value. But paper moneys, which differ in exchange value only, submit easily to the same principle. Thus, prior to 1863, the bank notes of this country issued by all sorts of institutions and under all sorts of conditions, circulated at different values measured in standard money, some worth 100 cents on the dollar, some worth 95, some 92, some 97. Of these notes the best ones usually showed less capacity to hold their place in the circulation than the inferior ones. Their acceptability in ordinary trade was not, indeed, as good as that of gold coin which was only a little inferior in weight. But, assisted by the ignorance of people in general, by the indisposition of tradesmen to displease customers by challenging money offered for goods, and by the anxiety of workingmen to keep their jobs, anyone who held such money could easily pass it on at a value greater than that recognized by banks and other dealers in exchange. On the other hand, the inferior notes were received at banks and public institutions only at a full discount. Accordingly, they were not taken in for deposit, but were sorted out for use in trade, while notes of the better grades went in. Further, the institutions in question, desiring to make room for their own notes, and to accumulate only moneys which would be useful as reserves, made a practice of sending home for redemption all the foreign notes they received; hence, the fact that the ones they received were chiefly the better ones, resulted directly in driving these better ones out of circulation. Thus, there were at work not only forces tend- ing to choose the inferior moneys for the circulation proper, but also forces tending positively to drive the superior out. It perhaps ought to be added that even when the inferiority or superiority among moneys is not openly recognized, though ad- mitted by the initiated, the inferior is likely to show a stronger hold on the circulation. Banking institutions being, as we have seen, in a position to discriminate by paying over the counter the less desirable forms of money and retaining for reserves the more desirable, can and do keep the former in more active circulation. XXXIII] THE CIRCULATION OF MONEY 4OOy The points made in the foregoing discussion apply in large measure to all kinds of money. The considerations now to be brought forward concern only credit money. Credit money, for example, a bank note, is simply a promise of the issuer to pay upon demand a stated sum of standard money or its equivalent; and such money is, by return to the issuer, retired from circulation. Accordingly, the degree to which such a money is able to maintain its hold on the circulation depends on the strength of the tendency to send it home. This in turn depends chiefly on two conditions: (i) the strength of the motive for returning it, and (2) the ease with which the operation can be carried out. As respects the first, if a bank note or other credit money is qualified to perform all the functions which the standard money that it calls for can perform, there will be little, if any, reason for sending it home. If, however, it is not receivable for public dues or is not a legal tender for ordinary debts, there will be some holders, anyhow, who have ample motive for sending it in to be exchanged for money more adequate for their purposes. The working of the second condition on which depends the strength of the tendency to send credit money home the ease with which the operation can be carried out may be seen from an imaginary illustration. If a noteholder lives in Boston while the issuing bank is located in Butte, Montana, and the noteholder has no way of securing redemption except by sending the note from Boston to Butte and bringing back the money at his own expense, there will probably be little of such sending undertaken. In such case, even though the note is not usable for the payment of taxes, the holder will content himself with retaining it for use in ordinary business. Thus, such notes tend to continue in circulation rather than go out by return to the issuer. They have tenacity in circula- tion just because there is difficulty in sending them home. Although the conclusion just reached was based merely on a consideration of the causes at work, its soundness has been fully confirmed in the history of bank note issues. Thus, in the United States in the early part of the last century, when the provisions for securing the "homing" of notes were quite inadequate, those notes which could be returned only at considerable trouble and expense 4 io PRINCIPLES OF ECONOMICS IXXXIII almost completely monopolized the circulation as against notes which could easily be returned. This was conspicuously illustrated in the city of Boston as between the notes of outlying towns and those of Boston itself, the latter being largely driven out by the former. The condition was remedied by providing for the redemption at par in Boston of the outside notes, and establishing an arrangement whereby the institution which performed this task became in effect a clearing-house for these notes. Under the complicated conditions of modern business, the money stock of a country naturally distributes itself, or is consciously distributed, into different parts called funds, each of which has a special function. Thus, a very considerable part of the stock is used as a medium of exchange in ordinary business. A second large quantity constitutes the reserves of the banks, especially those out- side of New York City. The New York bank reserves constitute a third fund, distinct from ordinary bank reserves because, for reasons too complicated for review in this place, the general bank- ing reserves of the country largely rest upon it. This fund also requires differentiation because it is the chief source from which must come the money employed in the settling of international balances. Another very significant fund is the 150 millions of gold reserved by law in the Federal Treasury for the redemption of treasury notes. Under the Federal Reserve system adopted a few years ago, the reserves of the so-called regional banks ought perhaps to be treated as constituting still another special fund. Now, it is a matter of some consequence that the proper sort of money and that sort only should find its way into each par- ticular fund; and the government takes pains so to manage the issue of different kinds of money that, as far as possible, proper distribution will be automatically effected. The result is largely brought about by issuing just the right denominations of the money which is meant for a given fund and for the appointed uses of that fund. Thus, if it is desired to keep a certain type of money out of banking reserves, especially out of the New York reserve, this is accomplished by putting out the money in small denominations. The XXXIII] THE CIRCULATION OF MONEY 4II principle which furnishes the basis for such a policy may be stated as follows: Principle IV. In the distribution of the monetary stock of a country, money of smaller denominations naturally gravitates to the Circulation Proper, the part which is being used directly as a medium of exchange; moneys of larger denominations gravitate to the Reserves, the funds kept by banks and other institutions to meet credit obligations. This principle has been utilized in the practical management of our silver certificates, and so may be said to have been estab- lished inductively. But it naturally results from the conditions and forces present. There is comparatively little need for money of large denominations in ordinary transactions, since persons engaged in those transactions usually pay by means of checks. If, then, we restrict the issue of any kind of money to large denominations, we are certain to keep the greater part of it out of the ordinary circula- tion. On the other hand, in the ordinary transactions of the market there is much need for small money, whether in effecting payments outright or in making change. In consequence, we can easily infer that money of very small denominations will remain in ordinary circulation and will stay out of the bank reserves, unless it is issued in greatly excessive amounts. As a matter of fact, experi- ence shows that it is extremely difficult to satisfy the everyday need for money of small denominations. The government of the United States has been obliged over and over again to expand its issue of fractional silver and of small bills from $i to $5. ILLUSTRATIVE PROBLEMS 1. In 1849, when the United States had free coinage of both gold and silver, a change in the relative values of the two metals sent silver coin to a premium, i.e., two silver half-dollars were worth $1.02. What naturally happened to silver coin? 2. During the Civil War, the government of the United States thought best to borrow money by paying soldiers, contractors, et al., with treasury notes. Yet it was desirous that these notes should not be 412 PRINCIPLES OF ECONOMICS [XXXIII added to the circulating medium, but should soon get into the hands of people who would lay them one side and hold them till they were due, in other words, treat them as bonds. The Treasury finally hit on a pretty good plan to accomplish this, namely, the issuing of these notes to bear interest, that interest to be compounded every six months but to be paid only at the end of three years. How would this plan tend to accomplish the end sought? 3. In 1862, when gold payment on treasury notes had already been suspended, the United States began the issue of legal tender notes. In consequence gold went to a premium, soon being worth $1.15 per dollar. What naturally happened to it ? 4. Experts consider it very desirable that the bank note circulation should be elastic, should expand readily when the need for money in- creases and contract promptly when the need diminishes. Of these two phases of elasticity, the second is in a sense the more important, in that it really provides for the first. In order to secure this power of prompt contraction, various provisions have been enacted or proposed: (a) Estab- lish a good many redemption agencies at convenient points throughout the country; (b) prohibit any bank from paying out in regular business the notes of another bank except in the city or district where the issuing bank is located; (c) prohibit the use of bank notes as reserves by banks outside the system; (d) take away the right of legal tender to govern- ment; and so on. Explain in each case why the provision set forth would naturally con- tribute to the contractility of the note circulation. 5. In 1894, on account of excessive issue of silver and paper money, as also on account of the marked decline in business activity, the United States had a great excess of circulating medium. This fact (combined, doubtless, with other causes) led to a considerable contraction by ex- port to other countries. What kind of money must have gone? 6. In 1886, Congress provided by law for the issue of silver cer- tificates of $i, $2, and $5 denominations, and in 1900 decreed that 90 per cent of the total amount of such certificates should be in denomina- tions from $10 down. What did they hope to accomplish by this legisla- tion? CHAPTER XXXIV PRINCIPLES GOVERNING THE MOVEMENTS AND DISTRIBUTION OF MONEY The monetary stock of any country, as also of the world, is constantly in motion. Scarcely a day passes without the shifting of considerable sums of actual cash between different districts of the same country; and even the movements between nations, though by no means so frequent, are in the aggregate very extensive. Interest in Money Movements. For various reasons these movements of money are of much interest and significance, both to the specialist and the general public. First, every money move- ment considered by itself tends to change the distribution of the money stock among different districts or countries; and, if for any reason the movement in one direction is long enough continued, it may cause an excessive supply at one point and a deficient supply at other points. As a matter of fact, this result is much less likely to occur than people commonly suppose, and even if it did occur it would probably be quite harmless. Occasionally, however, there may be changes of a 'really undesirable character ; and so a knowledge of the principles governing them is needed as a basis for a corrective policy. Moreover, it will be decidedly worth our while to have a knowledge of even the harmless changes in distribu- tion, lest, in thinking them pernicious, we should suffer needless anxiety and make ill-advised efforts to modify them. In the second place, there are some kinds of money movements which indicate diseased conditions in the monetary system, and a knowledge of these movements is pretty certain to prove useful when we are trying to locate the trouble. We shall, therefore, in the present chapter, set forth the natural laws regulating movements of money between different countries or districts, and regulating the territorial dis- tribution of the stock of money which results from these movements. 4 i 4 PRINCIPLES OF ECONOMICS [XXXIV A notable fallacy in connection with the subject of money move- ments is almost constantly and everywhere current. It assumes that buying any goods or services from another country naturally means losing some of our stock of money to that country. If we give up the production of some commodity for which we show comparatively little fitness, and commence buying that commodity from our neighbors, people at once condemn the trade as certain to draw away a portion of our money. They may even fancy that, if we allow perfect freedom of trade, all our money will be drained away. Trade and Money Movements. This error was fully, though indirectly exposed, under the Principle of Reciprocity, so a briefer statement, with a slightly different emphasis, will serve in the present connection. The dealings of one country with another, or, more exactly, of the people of one country with those of another, do not in themselves lead to net money movements. Even if interna- tional dealings were commonly effected with money directly, there would be few or no net movements, assuming that we have in mind intervals of at least a few months in length. The reason is plain. No sensible person wants money for the money's sake. Our neigh- bors are anxious to get money by selling their products, not because they wish to keep that money, but because they wish to use it again to buy our products. This fact appears clearly enough within the limits of our own town; and in no essential respect does the trade within a town differ from the trade between it and other towns, or from the trade between the country as a whole and other countries. Money naturally comes back as surely as it goes away. Again, under the credit regime which actually prevails in inter- local trade, no considerable movements of money ever take place except in very unusual circumstances. The reciprocal claims and obligations between the dealers of different countries which grow out of their trade dealings are transformed into claims and obliga- tions between the bankers or exchange dealers of those cquntries ; and, between these bankers, money itself actually flows only when their reciprocal claims fail to balance. Furthermore, this failure to balance must be of appreciable duration a few weeks at least; for XXXIV], MOVEMENTS AND DISTRIBUTION OF MONEY 415 usually an exchange dealer with an adverse balance will as a first resort borrow from his correspondent, sending money only when it becomes evident that the adverse balance will not be turned into a favorable one for a long time. Capital Movements and Money Movements. What we have thus shown to be true of trade relations, we can also show to be true of investment transactions the lending of capital by the people of one place to the people of another place. Transfers of capital between communities, like trade payments, primarily take the form of debts between the bankers of the different communities. A person in England who lends money to an American railroad by purchasing its bonds does not send over money to that railroad ; his payment, exactly like a payment for wheat or cotton, appears as a debt created against some London house and in favor of some New York house. It is thus plain that, at the outset anyhow, such a shifting of capital does not constitute a movement of money. But, someone may object, would it not necessarily mean a move- ment in the end? For transactions in capital, unlike trade trans- actions, are almost certainly one-sided; Europe might lend much to America while America lent little to Europe, and hence, to balance the claims against them which have grown out of buying American bonds, the European houses would apparently sooner or later be compelled to send money. But even here another alternative is possible. While America holds an abundance of claims on Europe and may use them to demand money if she likes, she probably will not do so, because it is not money that she wants. The borrowing railroads do not want money, but rails, cars and locomotives. And either they will buy these articles abroad with the borrowed money, or they will buy abroad some other articles in order to release American capital and labor which can produce the rails, etc., at home; in either case, America buys from Europe more goods than usual. Thus the debt of European exchange houses to American exchange houses arising out of the fact that Europe is lending us capital, is likely to be matched with a debt of American houses to European houses arising out of the fact that Americans have bought 416 PRINCIPLES OF ECONOMICS [XXXIV from Europe more goods than usual. The debts are accordingly cancelled and no money will flow either way. Circumstances Causing Money Movements, We thus see that neither trade nor investment transactions necessarily involve money movements. They may, however, involve such movements, if the circumstances happen to be of a particular character. Con- fining our attention for the moment to trade relations, let us examine what those circumstances are. Any fact which causes the total volume of goods or services bought by any community from other communities to remain for some time in excess of its sales to those other communities, will tend to bring about a net move- ment of money from the community whose purchases are in excess ; on the other hand, any fact making the sales of a community exceed its purchases, will tend to bring about a net movement of money into that community. The argument is too simple to need elaboration. The exchange dealers of a community which buys more than it sells will for a shorter or longer period be in debt to the exchange dealers of other communities. But the creditor dealers do not like to wait indefinitely for their pay, and so, if there is no promise of an early turning of the tide, they will probably order the money itself delivered. This principle is illustrated almost every year in the trade between America and Europe. The exports of America, being largely agricultural, are naturally "bunched" at cer- tain seasons; while its imports from Europe, being generally manu- factured products, are distributed more uniformly through the year. Consequently, temporary balances against Europe are almost sure to appear in the fall season and to lead to movements of money toward America. There are likewise conditions under which investment transac- tions may cause money movements. An exchange balance created against a lending country by the movement of capital is, as we have seen, usually offset through the natural readjustments of trade the expansion of imports into the borrowing country. But if the movement of capital from country to country is very large and rapid, the growth of trade may not be rapid enough, for an extended period, to restore the balance. In this event, the creditor country, XXXIV] MOVEMENTS AND DISTRIBUTION OF MONEY 417 unwilling to lose the use of its capital, if only for a few weeks, will probably order the gold shipped. Bringing the essential points of the foregoing discussion into a single statement, we have the following principle : Principle I. The dealings of one country (commun- ity) with other countries in respect to goods and capital do not in themselves naturally lead to net movements of money either to or from said country; but, if circumstances are such as to maintain a balance of claims for or against said country for a period of several weeks, a net movement of money to or from that country is probable. Based upon the above principle are five corollaries, each of which should, with only the briefest statement, explain itself. Corollary i. Money tends to flow to any country (community) where the rate of discount is exceptionally high, and vice versa. If the rate of discount in any country or community, let us say New York, rises to a point two or three per cent higher than in London or Paris, bankers having connections in New York will hasten to avail themselves of this opportunity to make exceptional profit by transferring funds to New York. Naturally, they will so far as possible use credit for this purpose. But, if the high rate persists and they continue to send funds, they will soon exhaust the available supply of credit and, thereafter, will send money. Corollary 2. Money tends to flow from a country where the stock is abnormally large as indicated by the state of the central reserves. This corollary is closely related to the last. An excessive money stock causes a fall in the rate of discount, which brings into opera- tion Corollary i. In extreme cases, an excess of money raises the prices of commodities; this naturally brings about an expansion of the import trade; and the latter, by creating a balance against the country, finally causes an outflow of money. PRINCIPLES QF ECONOMICS [XXXlV Corollary 3. There tends to be a continuous net flow of money from a country which is a producer of standard money metal. Corollary 3 remarks the tendency of money to flow from a country producing standard money metal. The reason for an out- flow of this kind is not far to seek. The natural and easy way to market standard money metal is to take it, directly or indirectly, to the mint, have it turned into money, and sell it as money that is, spend it for goods. By this process the money stock of a gold- producing country is constantly being augmented, and is constantly becoming excessive; and with an excess of money there come into operation the influences already cited under Corollary 2. This proposition needs emphasis chiefly because it shows the folly of undue anxiety respecting an excess of gold exports from a nation producing a large amount of gold. We should expect, as a matter of course, that the custom house reports of the United States or Australia would show them exporting more gold than they import. Gold is one of their important products which they naturally use to buy things they cannot produce so easily, just as they use wheat or wool. Corollary 4. Money tends to How from any country which has experienced a marked decline in industrial ac- tivity. When business slackens there is less money work to be done ; this makes the existing money stock excessive, and so brings into opera- tion Corollary 2. Corollary 5. // a full weight metallic money comes to command a premium, it tends to be exported from the coun- try. Full weight metallic money which comes to command a premium, is certain to be withdrawn from circulation almost completely ; since it will seldom be accepted in exchange at as high a premium as that given on the bullion market. But, being withdrawn from circulation, XXXIVJ MOVEMENTS AND DISTRIBUTION OF MONEY 419 it becomes mere bullion, a metal, not money. Again, changing such a quantity of money into bullion inevitably makes the stock of bullion altogether excessive for the uses to which it can now be put. In consequence, the value of the bullion in the home market is lowered as compared with its value in other markets ; to put it a little differ- ently, the premium which the bullion bears at home is not so great as the difference between its nominal value as money and its value in other countries. It will therefore be exported to those countries where its value is greater. Money Drains Self-Corrective. The discussion of Principle I and its corollaries must by this time have made it clear that pur- chase abroad does not necessarily mean a loss of money from the purchasing country. But, further, if we look more deeply into this subject, we shall find that money drains, when they do occur, can, in all but a few special circumstances, safely be left to correction by natural causes. Removes Its Own Cause. First, the movement may be stopped by the automatic reversal of that condition which is neces- sary to bring it about. That condition is a high rate of exchange, a rate on London, for example, of $4.89; for obviously, the exchange dealer could not afford to send gold unless he got out of the transac- tion the value of a sovereign $4.866-)- plus the cost of sending it, about three and one-half cents. But such a high rate of exchange will naturally set up an unusually strong tendency for the export of goods. If I am selling wheat to London, when claims against Lon- don which will be used to pay for my wheat are selling at several cents above par, my trade will be unusually profitable. I will there- fore be eager to sell as much as possible ; but so will other American exporters be eager to sell, and, competing against each other, we will shade our prices ; with prices lowered, our eagerness to sell will be met with eagerness of Londoners to buy, so that our export of goods will increase at a bound. But what, now, will be the conse- quence of the increase in exports due to the high price of exchange? Manifestly, those exports will put Londoners in debt to us, will increase the supply of claims, or exchange, on London. But when 420 PRINCIPLES OF ECONOMICS [XXXIV exchange becomes abundant, its price will inevitably be lowered. And, finally, since, as we saw at the outset, a high rate is necessary if gold is to be exported, the lowered rate will tend to check the ex- port. To put the whole argument in a sentence : Gold cannot go until exchange reaches a very high rate; but a high rate of exchange simulates exports; the increase in exports presses down the rate of exchange ; and the lowered rate of exchange stops the outflow of gold. Starts into Operation Corrective Processes. Not only is an outflow of money stopped by the automatic reversal of the condition which makes it possible, but, further, a persistent net movement of money tends to be stopped or even reversed by the action of condi- tions which its own continuance establishes. Three processes may be distinguished : First, a money drain from any country makes the surplus banking reserves from which money for export is taken, in the chief commer- cial centers (London, New York, etc.) relatively small. Depletion of the surplus reserve will raise the rate of discount interest collected in advance on short time loans ; since the rate on this kind of loan is almost entirely dependent on the size of the surplus reserve. A high rate of discount thus established will make the country a de- sirable market for lenders, and so will tend to draw in the floating capital of other countries. Ordinarily this process is adequate to stop an excessive drain of money; but, if it does not prove so, a new and slightly different series of reactions follow and usually effect the desired result. When the central banking reserve becomes scanty, the inclination of people to buy or hold international securities, the trade in which is usually based on borrowed capital, rapidly diminishes. With a fall in demand, the price of securities also inevitably falls. But a lower price for securities will encourage foreigners to buy them, thus giving New York an abundant supply of exchange on Europe. .Finally, since, as we have already seen, abundant exchange means a low rate of exchange, the condition necessary to further outflow a high rate of exchange is thus removed. There is yet a third chain of causation which comes into operation probably a little later than the others. The same high rate of dis- XXXIV] MOVEMENTS AND DISTRIBUTION OF MONEY 421 count which causes a fall in securities, if long enough continued, leads to a fall in the prices of the great export staples, such as cotton and wheat, which are speculated in like securities. This fall in price leads to increased buying by foreigners, which makes foreign ex- change abundant, thus lowering the rate of exchange, and checking the outflow of money. Finally, if the outflow went on long enough to produce a scarcity of money in the country as a whole, there would result a general fall in prices, which would stimulate foreign buying all along the line until the direction of the money movement was completely reversed. The foregoing arguments would seem to establish beyond ques- tion the following principle : Principle II. Every net movement of money tends to be stopped, or even reversed, by the automatic reversal of that condition "which is necessary to bring it about, or by the action of conditions which its own continuance sets up. From the above principle it is only one step to the following corollary : Corollary. There is never any danger that an outflow of money from a particular country will go on till tJiat coun- try is denuded of its monetary stock. Every net movement of money, even a moderate one, tends auto- matically to bring about its own stoppage. But, obviously, if this is true of every net movement, it would prove to be true of any move- ment so extensive that it threatened the complete exhaustion of the money stock. Automatic Distribution. Another important principle regard- ing the distribution of the money stock, and one which is little more than a corollary from the last may be stated as follows : Principle III. Generally speaking, the monetary stock of a country, or group of countries having the same stand- ard, tends to distribute itself according to relative need. 422 PRINCIPLES OF ECONOMICS [xxxiv If the need of any particular country, as compared with other countries, is less completely satisfied, this fact alone will tend to start a process of redistribution, which continues till the several needs are satisfied in equal measure. The explanation of this process has already been anticipated. If the stock of money in one country, as compared with another, is small relatively to the money work to be done, this fact will show itself in deficient bank reserves, and such a deficiency, causing the rate of discount to rise, will bring an inflow of money for investment. A high rate of discount will, moreover, cause the prices of securities and of the great staples to fall, again resulting in an inflow of money. The process by which an excess in any country is corrected by an outflow to other countries is simply the reverse of those described. There first results from the excess an expansion of the bank reserves; large reserves bring down the rate of discount, making investments unprofitable; and this will cause capital and, in time, money to be exported. The low rate of dis- count will, moreover, occasion a rise in the prices of securities and the great staples ; foreigners will then begin to sell freely on our markets, thus expanding our foreign debt ; and a large foreign debt, raising the price of exchange, will very quickly result in the export of money. The above argument treats of movements occurring between highly developed commercial nations having the ordinary economic relations. As between small communities where standard money metal is produced, for example, South Africa and the Klondike, on the one hand, and the rest of the world, on the other, the working of things is, if anything, more simple. The extraordinary abundance of money (for in such places gold, even in its raw form, at once becomes money) and the great scarcity of all other goods, make prices excessively high ; as a result, goods flow in at an extraordinary rate ; the community has constantly a large balance of indebtedness against it ; and money must constantly be sent out. Interference Sometimes Needed. Up to this point our dis- cussion has placed a special emphasis upon the self-regulative char- acter of monetary distribution. If taken in too absolute a sense, this might lead to a misunderstanding. The last of our principles XXXIV] MOVEMENTS AND DISTRIBUTION OF MONEY 423 governing the movements and distribution of money must, there- fore, be one which in some degree qualifies those heretofore laid down. Principle IV. While, in general, the proper distribu- tion of the world's monetary stock among the different nations can safely be left to the working of automatic forces, circumstances may arise under which it is desirable Consciously to control particular movements of money, in order to maintain the stability of the system of credit. In a typical monetary system of our day, a large part of the total monetary stock consists of representative or credit money and bank credit. Under such an order, the foundation of standard money is vastly more important than any other constituent of the circulating medium ; it is not mere money ; it is emphatically the basis of the whole system. This is particularly true of that portion of the stock of standard money which we call the ultimate reserve, the reserve kept by a great central bank or, as in the United States, by the government, to redeem credit money. To maintain this reserve in adequate volume is of the greatest moment, not because we need it as a medium of exchange, but because, if it proves inadequate, the whole system will fall in ruins. Accordingly, it is natural that every extensive movement of standard money should be jealously watched with reference to its possible bearing on the ultimate reserve of the system. When that reserve is being drawn down, it is not enough to say that, in the long run, an excessive drain will correct itself. We cannot afford to wait for the long run, serious consequences may overtake us in the meanwhile. The disappearance of the ultimate reserve would mean the overthrow of the standard ; and even the beginning of a depletion which threatened to be at all serious would excite such anxiety in the business world as gravely to injure industry and perhaps precipi- tate a panic. A nation may, for example, find itself experiencing the specie drain incident to a great war, a drain for which automatic regulation will not furnish a sufficiently strong or sufficiently rapid check. Or there may be a drain arising from the action of unwise 424 PRINCIPLES OF ECONOMICS [XXXIV statutes or other artificial conditions, which at the very best cannot be changed for a long time. In such circumstances, it might easily be the duty of the government, or the great central bank, to take active and vigorous measures to check an outflow of standard money, 1 ILLUSTRATIVE PROBLEMS 1. During the years 1853 to 1864, inclusive, when France had a system of bimetallism at a coinage ratio of 15.5 to i, while the market ratio was about 15.3 to i, the French circulation absorbed about $680,- 000,000 of gold, and ejected about $345,000,000 of silver. Explain these facts, using one of the corollaries of Principle I. 2. "Between America and Europe there is usually a net movement of money toward Europe during the second quarter of the year, toward America near the end of the third, and early in the fourth, quarter." Explain why you would expect this to be true. 3. "A country has never been despoiled of its money by the working of its international trade." Gide's Political Economy, page 120. Why does he feel so sure about this ? 4. A New York wheat broker sells 50,000 bushels of wheat to a Liverpool miller, and sells against it a sight bill of exchange for the proceeds, 8735 i6s. The wheat cost him 84 cents per bushel. (a) With exchange on London at $4.88, what would his profits be? (b) What would they be with exchange at $4.84? (c) What does this have to do with money movements? Explain carefully. 5. "Between New York city, as the banking center of the United States, and the country at large, there is usually a great money movement outward from New York during the summer and early fall, and an in- ward movement toward New York during the late fall or early winter." Explain why you would expect this to be true. 1 The most important device employed for this purpose consists in raising the rate of discount, and thus bringing into operation Corollary I of Principle I. CHAPTER XXXV PRINCIPLES GOVERNING THE VALUE OF MONEY Thus far in our discussion of money we have treated it as a thing apart from the general field of economic goods, a thing pecu- liar, and governed by laws of its own. Again, in our chapters on Price (Chapters XXIX-XXXI), we for the most part spoke of econo- mic goods as if money, the thing in which the prices of those goods is expressed, were not to be considered as one of them, essentially the same in kind and governed by the same laws. But these impli- cations are misleading. Money is in a sense an economic good, just as wheat and cotton are economic goods, and the time has now come when we must so treat of it. We must show that money, the thing in which the values or prices of most other goods are expressed, is itself subject to the laws of value and price. The chief defect in our earlier reasoning lay in the assumption that money was constant in value. This assumption was encouraged by our emphasis on the idea that the money unit is tied to a certain definite quantity of substance, say 25.8 grains of gold, just as a gallon measure is tied to 8.33 pounds of water. But, as a closer examina- tion will disclose, any such view is decidedly inaccurate. The analogy between the case of the money standard and that of the liquid-measure standard is not as perfect as we have assumed. In using 8.33 pounds of water as a standard of liquid measure, we need have no anxiety that the bulk of the water itself will change, and so cause that of our unit to change ; for we can make those con- ditions which would modify the bulk of water temperature and atmospheric pressure absolutely the same in all times and places. But we cannot parallel this operation with gold and its value. We cannot say that we will have as our money standard the value of 25.8 grains of gold under fust the same conditions as prevailed when it was finally adopted in 1873; for we can never reproduce 425 42 6 PRINCIPLES OF ECONOMICS [XXXV those conditions. All we can do, and all we try to do, is to keep the value of one dollar equal, at any particular time, to the value of 25.8 grains of gold at that same time. In doing this, we anchor the value of the dollar to a value which itself changes, and so, of course, the value of the dollar will change. Doubtless our policy in this matter is, on the whole, wise; for the value of gold changes very slowly, perhaps more slowly than that of any other single commodity, and, anyhow, we ought to have the same standard as the rest of the world, which is gold. But, whether wise or not, this policy anchors our money to something which changes in value, and so the value of our money changes, instead of remaining constant, as has all along been assumed. Measuring Money Value Changes. But, although changes in gold and money value do occur, it is not so easy to establish the fact of change or to measure its extent as the student might imagine. Gold, being the standard of all great commercial nations, there is practically no market where its value is expressed in terms of anything but the money unit. There is, therefore, prac- tically no place where the apparent value of gold and money alters at all. In the United States, 25.8 grains of gold is always worth one dollar and, conversely, one dollar is always worth 25.8 grains of gold. Hence, our only method of ascertaining changes in the value of gold and money is to study the movements of the prices of other things. If gold, and so money, should all at once greatly rise in value, their own price in terms of each other would remain constant, but that of goods and services in general would fall. Conversely, a sudden fall in the value of gold and money would show in a rise of the prices of all other things. It would seem, therefore, that we need only ascertain the changes in the general level of prices to know the changes in the value of money ; and, in large measure, this is what we try to do. Absolute and Relative Changes. But we scarcely begin an application of this formula when we run upon difficulties of a most serious nature. Changes in the value of money would surely express themselves in opposite changes in the level of prices. But the level XXXV] THE VALUE OF MONEY 427 of prices may also be affected by a sudden collapse of business de- mand or a great fall in cost of production. In other words, a change in the general price level may really be, not a change in the value of money, but a change in the value of goods. Or, to use a better expression, some changes in the general level of prices have their origin in causes affecting goods rather than money; and, if called changes in the value of money at all, these may be distin- guished as relative changes, while changes in the price level due to catises acting on money itself would be called absolute changes. A familiar instance of a relative change is the following: When, after a period of industrial stagnation, business begins to pick up, and people regain their faith in the future, there naturally takes place an expansion of demand for goods of all sorts, and in consequence a measurable rise in prices, starting among a few com- modities but gradually extending until it covers, if not the whole field, at least a large portion of it. As the boom advances, this movement becomes more and more pronounced. Every one, believ- ing prices will go higher, is eager to buy, that he may have something to sell at the higher prices; and, of course, his eagerness to buy means more demand and so contributes to the very price advance which he expects. This self-propagating movement continues until the expansion has passed all reasonable bounds, when suddenly some accident precipitates a general collapse of the boom, pricks the speculative bubble. At once all are eager to sell, no one wanting to buy ; and this sudden expansion of supply and contraction of demand causes a falling-off of prices, more rapid probably than the rise has been. These changes all take place, not because anything has hap- pened to money, but because something has happened to people or to goods. Take another illustration. If throughout a period of some length, say between 1850 and 1890, technical methods generally undergo a rapid improvement so that the costs of producing large numbers of commodities are much reduced, there naturally follows a decline in the prices of these commodities so great as to lower markedly the average, or general, price level. But such a lowering of the general price level could not properly be conceived as a real or absolute advance in money. In a very natural sense of the terms it is not a 42 g PRINCIPLES OF ECONOMICS [XXXV change in the value of money at all, but rather a change in the value of goods. So much for relative changes. In a study of money, however, it is of course not the relative changes, but the absolute changes which are really germane. Our reference to changes in the general price level have been made merely to guard against the danger of confusing them with genuine changes in the value of money. We turn now, therefore, to the real task of our present chapter, the analysis of these genuine, absolute changes. Quantity Theory. The principle governing the value of money which is looked on by the majority of economists as most truly fundamental is known as the quantity theory or principle. Principle I. The value of money in any country tends to vary inversely as the quantity of money in that country. The Proof. The argument for the quantity theory runs some- what as follows : If the quantity of money increases, people in general will have more to spend, will, therefore, demand more goods. But, if people demand more goods, no corresponding increase in such goods being provided for in the hypothesis, prices in general are certain to rise. Finally, such a rise in general prices is the same thing as a fall in the value of money. An analogous argument shows that a diminution in the quantity of money must tend to raise its value. Thus, if the quantity of money diminishes, people will have less money to spend, will, therefore, demand fewer goods, and so prices will fall ; that is, the value of money will rise. Confirmed in Experience. This argument, though an a priori one, has at times been strikingly confirmed in experience. Thus, in a community which contains only a few thousand inhabitants there may occur a great gold discovery, producing, in a few months, bul- lion to the value of hundreds of thousands of dollars. As this bullion can be almost instantly turned into money or its equivalent bank credit, the money demand for all sorts of goods will at once greatly expand. In the output of goods, on the contrary, there will be no XXXV] THE VALUE OF MONEY 429 corresponding increase. Consequently, the prices of goods in gen- eral show a rapid rise. And, since this rise is caused by the increase of money or its cheapening (in cost) or both, it constitutes a real or absolute fall in the value of money. In gold producing districts, such as California, Australia, and the Klondike, the new gold was generally used as money at once, in its bullion form, without waiting for coinage. The eager spending of this new metal to buy the necessaries and luxuries which the hitherto poor miners craved, naturally led to a swift advance of almost all prices, that is, a swift fall in gold. Application to Groups of Countries. The application of the principle in a small community is thus easily shown; but does it apply as well to an entire country, or to a whole group of countries? In such a country, or group of countries, will the value of money tend to vary inversely as the total quantity of money f The a priori argu- ment is, of course, still valid. An addition of 200 million dollars' worth of gold to the world's stock must surely tend to modify the gold, or money, demand for all goods other than gold, and so to modify the value of gold as measured in those goods. The new gold, or much of it, will be coined and pass into the monetary stock of the world ; this will mean a corresponding enlargement of the ulti- mate reserves to which gold money is mainly relegated ; and this enlargement in turn will lead to an expansion of bank credit, and so of general purchasing power. As a result, buyers will find it easier to get possession of purchasing power. If they are already disposed, on other grounds, to go into the market as buyers of wheat, cotton, machinery, etc., the increased control of buying power will increase the demand for those goods. Finally, the increased demand will tend to raise the prices of those goods or, in other words, to lower the value of gold. Nevertheless, in a large country or in a group of countries the complete working out of this process cannot be looked for with any- thing like the same degree of confidence as in a limited district. That the value of money, even in such cases, tends to vary inversely as money quantity, assuming that sufficient emphasis is laid upon "tends," would seem almost indisputable. The norm toward which 430 PRINCIPLES OF ECONOMICS [XXXV the actual value of money gravitates, about which it varies under the influence of more temporary causes, is in large measure determined under the principle noted. Nevertheless, this doctrine requires much qualification. Historical and statistical studies have seriously undermined it, and not a few economists have been tempted to reject it altogether. In the opinion of the writer, the doctrine contains a basis of truth which is of prime importance. But the limitations to which it is subject in actual experience and which seem at times to reduce its practical significance almost to nothing, must be clearly understood. Limitations. First, so far as gold, the standard money, is con- cerned, the quantity in existence changes relatively so little in a year, or even in a long series of years, that, however true the theory might be, we should have great difficulty in establishing a satisfactory proof of it. In the case of many commodities, as for example wheat, the output of a year constitutes almost the entire stock for that year, and a doubling of the output means almost a doubling of stock. But not so with gold. Its physical imperishability, its very high specific value, and its technical treatment as money make it, economically considered, immortal. It is almost never consumed in the sense of being irrevocably withdrawn from the market. The untold accumu- lations of the centuries are in large measure available to meet the needs of today. In consequence, an increase or decrease in the out- put does not cause anything like a corresponding increase or decrease in the stock. Another limitation, or set of limitations, upon the quantity theory grows out of the fact that in any modern monetary system, purchas- ing power, stated in terms of money, is not rigidly fixed by the quan- tity of money, but is almost indefinitely elastic. The whole point of the theory, as we have seen, lies in the assumption that if people have more money they will demand more goods, and that if they have less money they will demand less goods. It is easy, however, to show that many causes interfere with the prompt and effective working out of this process. First, a small quantity of money, frequently turned over, will demand as much goods as a large quantity of money circulating XXXV] THE VALUE OF MONEY 431 slowly. Money demands goods every time it is spent or offered in exchange; and when it is not being offered in exchange it is not demanding goods. Hence, as the saying is, the nimble sixpence may do the work of the slow shilling. In a word, rapidity of circulation may neutralize any tendency to a rise in value caused by scarcity of money, and slowness of circulation may neutralize any tendency to a fall in value caused by an abundance of money. In the second place, under modern conditions the monetary stock has a degree of elasticity sufficiently high to neutralize, at least temporarily, changes in quantity. Only a small proportion of the actual circulating medium, the buying power in money form, consists of gold. A much greater part consists of bank notes, secured by small reserves of gold, and the issues of these may be expanded or contracted almost at will. But there is an even more important consideration. The general course of wholesale prices is largely determined in the great ex- changes where wheat, cotton, iron, petroleum, and so on are dealt in. Now, the exchange medium employed at these markets is not money in the narrow sense, but rather credit. Cotton, wheat, and iron are paid for with checks, and these checks practically never lead to a call for cash the transactions are carried on almost entirely with deposit currency. But this sort of circulating medium expands or contracts virtually as it is needed, expands or contracts, indeed, with the expansion or contraction of the very business which employs it. Just because a dealer has bought 50,000 bushels of wheat, he can induce his banker to manufacture on his behalf say $30,000 in credit money, secured by that wheat, and ready to be used in buying more wheat. The new wheat, in turn, can be made the basis of additional bank credit, which again can be used in buying still more wheat. There must always exist, to be sure, a basis of real money ; every new bank loan must be secured by a certain reserve of standard coin or metal; but the possible expansion of the loan is several times as great as the necessary addition to the reserve. Hence if business prospects look favorable both to the would-be borrower and the bank, the purchasing medium can be and will be expanded almost indefinitely, with only the slightest dependence on the stock of money existing at the time. On the other hand, if prospects are not favor- 432 PRINCIPLES OF ECONOMICS [XXXV able, the buying medium, deposit currency, will not expand, no mat- ter how large the reserves of real money. Immediately it appears that the quantity of money has little to do with determining the demand for goods. Nevertheless, with all these qualifications, the quantity theory, as a statement of a general tendency, remains unshakable. In the long run, the general level of prices the value of money must be influenced by the quantity of money, particularly the quantity of standard money. Forces Acting through Quantity Principle. If the value of money varies inversely as the quantity, we should need little argu- ment to establish certain facts concerning the effect upon value of various forces that influence the quantity. Since the output of money metal increases the stock, it must tend to diminish the value of money. Since a high cost of production tends to diminish output, and a low cost of production to increase output, then the one must tend to raise and the other to lower value although, due to the highly speculative character of mining, this cause does not operate with anything like the promptness or certainty characteristic of many other industries. Finally, since the increase or decrease of money metal used in the arts must effect opposite changes in the amount of such metal available for use as money, they necessarily tend to increase or decrease the value of money. The facts just mentioned may all be briefly stated in a corollary of Principle I. Corollary. The value of money tends to vary inversely as the quantity of standard money available, and hence to vary inversely ats the output of metal, directly as the cost, and directly as the quantity used in the arts. Conscious Adjustment Changes. While the quantity prin- ciple is the basal doctrine for money value, special circumstances may arise in which one or two other principles have greater influence. Thus, the value of the substance used for the monetary standard may at times be determined quite independently of the quantity of money, XXXV] THE VALUE OF MONEY 433 and then the value of money be fixed in accordance with the value of this ultimate standard substance. Whenever the value of the ultimate standard changes, as measured in at least one important commodity, then the value of the money dependent on that standard will also change. Business men of experience, alert and shrewd, will certainly refuse to sell goods at the old prices for money which, as measured in an altered ultimate standard, has fallen twenty or thirty per cent. And if they proceed to raise prices, this will consti- tute a change in the value of money by adjustment to a changed ultimate standard. Suppose the standard of a country is a metal which has the status of a mere commodity in some great world market where the country in question maintains intimate trade relations. Thus before 1893, India had a silver standard. At that time, as now, silver was in London and other European centers a mere commodity, bought and sold like cotton or wheat. Naturally, it showed many fluctua- tions in price; and every marked fluctuation was followed by an opposite change in Indian prices, particularly of imported goods. When silver fell, Indian prices rose ; when silver rose, Indian prices fell, in a word, the value of Indian money was readjusted to varia- tions in the world price of silver. This result was, of course, the natural one to expect. If silver fell, the value of Indian silver rupees, as measured in English pence, would fall ; it would take more of them to buy the goods imported from Europe; and so the dealer would have to recoup himself by charging more for the, goods. But, if dealers in imported goods charged more, dealers in domestic goods would in the long run have to do the same, or else suffer a loss. Finally, if dealers in general charged more for their goods, laborers would presently have to begin charging more for their services. A rise in prices begun in the import trade would thus eventually be extended throughout all business relations. And this is merely to say that the value of the rupee was being adjusted to the value of silver. A second illustration : Suppose the standard money consists of irredeemable notes. Changes in the value of this money, as measured in the metal which was formerly standard, can be followed in the market price of that metal. Thus, during the American Civil War, 434 PRINCIPLES OF ECONOMICS [XXXV gold went out of circulation and was speculated in on the open mar- ket just as cotton, wheat, and copper are now. Every day, every hour, its price, measured in greenbacks, the standard money which had displaced it, rose or fell. But this, of course, is the same as saying that the value of greenbacks, measured in gold, moved in the opposite direction, fell or rose. Naturally, every seller of goods would note these changes in the greenback, since it was the measur- ing unit of the value of the goods he was selling. Naturally, too, he would sooner or later make some effort to guard himself against loss from the fall in greenback values. Doubtless he would not try to readjust his prices to every change, but we can be quite sure that great declines, especially if long continued, would lead to a remark- ing of goods, a readjustment of prices to correspond to the decline in standard money. As a formal statement of the points here illustrated, we have the following : Principle II. Whenever the conditions are such that it is possible for the general public to have fairly conclusive evidence that a change in the value of the ultimate standard, as measured in at least one important commodity, has taken place, there will almost certainly follow, more or less rap- idly, a direct readjustment of the value of money (and so of general prices) to the changed ultimate standard. Credit Fluctuation Changes. A third principle concerns the value of irredeemable paper money as affected by political or com- mercial uncertainty. Irredeemable paper money is merely credit money which has hitherto been redeemed freely on demand in the standard money, but on which, for the time being, redemption has been suspended. The type we have in mind is issued by the public treasury or a central bank closely allied to the treasury, for example, the Bank of England. When payment on such money has been suspended, it inevitably becomes the standard money as shown on page 398. Now, in normal times, when no public crises intervene, the value of money of this sort may remain at about the same point for months or even years. That point will be below the value of the XXXV] THE VALUE OF MONEY 435 standard displaced, but not necessarily much below, depending on the quantity out, the skill with which it is managed, etc. But if any period is marked by uncertainty in public and commercial affairs, for example, if the nation is engaged in a war characterized by greatly fluctuating fortunes, anxiety will naturally spread abroad lest the government will in greater or less degree repudiate its obligations. This failure of the public confidence will of course react on the value of the notes as measured in the old standard, causing that value to show extraordinary fluctuations even within the limits of a single day. 1 But this will not be the end of the matter. As brought out in discussing Principle II, dealers will more or less fully adjust their prices to the larger changes in the value of the irredeemable paper as measured in the old standard. The final result, then, will be that the value of such money, as measured in goods in general, will vary in a rough way with the degree of the public confidence in the certainty and proximity of its redemption. The following statement will formulate the conclusions of our argument. Principle III. During a period marked by much un- certainty, either political or commercial, the value of irre- deemable paper money is chiefly determined by public con- fidence in its ultimate redemption, varying directly as said public confidence. MISCELLANEOUS PROBLEMS UNDER MONEY 1. "I can't understand what people mean when they say that money has risen in value since 1873. Money is by common consent the measure of the values of all other things ; and so its own value must be fixed, cannot rise or fall." A Gold Advocate in 1896. Explain his mistake. 2. Why would changes in the total quantity of money in the United States between 1862 and 1879 naturally have had more influence on its value than equal changes would have had between 1850 and 1860? 1 As seen in opposite changes in the value of the old standard metal, quoted in terms of the irredeemable note. 436 PRINCIPLES OF ECONOMICS [XXXV 3. Extract from a speech in the campaign of 1896: "If any man in this community would offer to buy all the eggs at 25 cents a dozen and was able to make good the offer, nobody would sell eggs for less, no matter what the cost of production, whether one cent or five cents a dozen. So with silver. Free coinage would establish the market price of silver at $1.29, and nobody would sell for a cent less." There is doubtless a sense in which the italicized claim is true but this is not the sense which was intended. The speaker meant that silver would rise to $1.29, as measured in the present dollar; so that there would be no repudiation of debts in adopting the free coinage of silver. (a) Show that such a claim is not established by this argument. (b) In what sense is the statement true? 4. "We have altogether too. little money in the country ($2,600,000) not enough to pay the railway debt ($6,000,000), or even the debts of banks to depositors, let alone the business debts." Explain fallacy. 5. A few years ago Mexico had a silver standard. If at that time silver had risen in value, would the Mexican dollar have risen in value ? Would it have risen in price? Would the price of silver bullion have risen? 6. In 1856 the monetary system of France was bimetallism at the ratio of 15.5 to i. The market ratio at that date was about 15.3 to I. What must have been the monetary standard? Prove. 7. In the panic of 1893, when in America money was so scarce that business men and bankers had to resort to all sorts of substitutes, such as due bills, New York drafts, deposit certificates, etc., an eminent Amer- ican economist said in substance : "What do you think now ? Was I not right in contending that the stock of money is altogether insufficient?" Did the facts establish his contention? 8. Argument against Bryan in the campaign of 1896: "I can see how free coinage is going to increase the profits of the mine owners by doubling the value of silver; but I do not see how it is going to help the rest of us." Explain the fallacy in the words italicized. 9. During the sixth decade of the XIX Century when France had bimetallism at a ratio of 15.5 to i, though the market ratio was about" 15.3 to i, dealers to their surprise every now and then received silver five-franc pieces in payment for goods. Why should this have surprised them? XXXV] THE VALUE OF MONEY 437 10. "Unless the government redeems all worn coins at their face value, a coinage in active use always shows a strong tendency to de- terioration." Explain why this is bound to be true. 11. "I object to our buying outside anything which we can produce at home; for this means just so much money lost from our coin circula- tion." Show that this is unsound 12. About 1850, when the United States had bimetallism at a ratio of 16 to i, there took place a considerable fall in the silver price of gold, so that the silver in an American silver dollar was worth 2 to 3 cents more than the gold in a gold dollar. In consequence, silver coins gen- erally went out of circulation, only the much worn ones remaining. Explain (a) why most went out and (b) why some stayed. 13. What is meant by saying that our mint ratio between gold and silver was I to 15.98? 14. "New York, Dec. n, 1903. The banks gained from the in- terior this week $2,042,906." Newspaper. Was this normal ? 15. "London, Oct. 3. One hundred and fifty thousand pounds sterl- ing gold will be shipped tomorrow to New York." Was this normal? CHAPTER XXXVI THE PRESENT SYSTEM OF DISTRIBUTION The Problem of Distribution. In our very first attempt to describe the nature of the existing economic order, we emphasized the point that that order is one in which men cooperate in the proc- esses through which they seek to satisfy their wants, to make a liv- ing. That cooperation is, indeed, spontaneous, its working out auto- matic ; nevertheless it is very real and covers by far the greater part of our economic activities. Economically, we constitute a vast or- ganic complex into which the individual more or less skilfully fits himself, and from which he more or less successfully makes his living. Since we thus constitute a vast organism, it is natural to conceive the product income of us all as a totality, a social income which is broken up into the individual incomes of the members of society. Thus conceiving the income of us all, it is natural to in- quire : What are the processes and principles under the operation of which the amounts of these individual incomes are determined? This, then, is the chief problem suggested by the term Distribution as the economist uses it ; and we must now devote ourselves to its solution. The above account of the nature of the problem which distribu- tion, as a division of economic science, presents to us should make it clear that that problem is not concerned with the division of the product of a given factory or mine or farm among the persons who participate in the operation of such factory or mine or farm. In- stead, our problem is concerned with the division of the total product of the u'hole economic group in which is found that factory or mine or farm, as well as many other factories and mines and farms, and also many other industrial concerns, among all the members of the group. Our problem stated in the former way is not a legitimate one, 438 XXXVI] PRESENT SYSTEM OF DISTRIBUTION 439 for it implies that we may reasonably think of the sharing of the product of a single industrial concern as being determined inde- pendently of other concerns belonging to the same general economic group, a notion which is surely quite untenable. If we insist on using the word "shares" in this connection at all, we must mean by it, in the case of all participants but the entrepreneur, the sum or sums of money which are paid each one in exchange for his particular service. But this, obviously, is determined by multiplying the price of a unit of such service by the number of units rendered. That is, the fundamental determinant of the share of each is a price. But it surely is evident by this time that prices are things which are not fixed within the relations of a single concern, but over the industrial field as a whole. What the chief engineer of a particular factory gets may be determined in almost entire independence of his contribution in that factory: from the standpoint of that factory, his wages may be an absolutely fixed quantum which the concern has to accept from the general market, and in accord with which they have to adjust their conduct of the business. The Principal Kinds of Income Looking at the matter in a very general way, it may be noted that shares in the general social income may be either ( i ) economic or (2) non-economic. The former are such as are obtained through economic relations, processes, for example, wages from the sale of labor. Non-economic shares are any outside the above, for example, shares obtained by theft, cheating, governmental corruption, gift, and so on. Some incomes can with more or less reason be assigned to either class. Thus, many of the great incomes obtained in America from the exploitation of natural resources, such as lumber, copper, and oil, which we usually classify under one of the regular economic shares profits may also be conceived as in a sense non-economic, in that they often have their origin in the foolish or corrupt munifi- cence of government. Naturally, the study of incomes undertaken here will be concerned with those which can properly be called economic. 440 PRINCIPLES OF ECONOMICS [XXXVI The chief economic incomes or economic shares in the social in- come are wages, interest, profits, and rent. These terms need little definition. Wages are a form of income which men receive in return for personal services labor. Interest is the capitalist's remunera- tion for "carrying" the reserves of the community, supplying the service of waiting, and takes its purest form in loans where risks are practically eliminated. Profits, on the other hand, are the re- muneration paid especially for taking the risks or, better, for taking the responsibility of ownership. Rent is the hire paid for the use of unproducible or indestructible elements in land. Again, we should note as a general point that economic incomes are of two distinct classes personal incomes and property incomes. Personal incomes, which men receive in exchange for personal services, may in practically all cases be brought under the category of wages, though in ordinary speech remuneration for the higher forms of personal service is usually called salary. Property in- comes, those which men receive in exchange for services given by the property they own, fall into three classes, rent, interest, and profits. Functional Distribution. The above account of what we have called the economic shares suggests that distribution under the pres- ent order is primarily a functional process. Each member of society receives a share which is supposed to represent the effective social importance of the function which he performs directly or through some factor which society authorizes him to own. Such a system of distribution is not logically necessary. We could conceive an order in which shares were determined independently of function, for example, one in which all shares were equal, as is commonly advo- cated for communism. On such a plan, it would still be necessary to try to ascertain the effective social importance of each function, in order to have the information needed to enable us wisely to utilize our stock of the various primary factors. But that knowledge would not influence the community in distributing the social income. The present order, however, makes income correspond to function. This view of the matter explains how it is that the economist, when study- ing distribution, seems to busy himself almost entirely with what is XXXVI] PRESENT SYSTEM OF DISTRIBUTION 44! often called "functional distribution," the allocation of the social income to the several different functions which had to be performed in order to produce that income. Personal Distribution. In contrast to functional distribution as thus described, we have "personal distribution," meaning the allo- cation of shares to actual, concrete persons. Manifestly, these two distributions are not necessarily identical ; since any person may be in receipt of more than one functional share. Still the process of ex- plaining incomes compounded of two or more functional shares offers no difficulty, since such incomes are mere aggregates of the functional shares entering into them. Accordingly, the economist seldom feels called on to go much beyond mere functional distri- bution. ILLUSTRATIVE PROBLEMS i. Mr. Crane puts $3,000 into a grocery business and works him- self in the store from morning till night. His net return from the busi- ness is $1,500. Make an imaginary distribution of this income into the several eco- nomic shares which are probably involved. 2. My friend has eight houses and lots in Ann Arbor which he rents, getting for each, let us say, $360 a year. Try to break up this sum into the different elements which probably enter into it. 3. At a certain inland resort rowboats are let at $1.50 per day. Enumerate the different elements entering into this sum. 4. "Production is, so to speak, a synthesis ; distribution, an analysis." Explain what seems to be meant. II General Character of the Process Determining the Regular Economic Shares Distribution an Exchange Process. Generally speaking, the process whereby these regular economic incomes are determined is simply the price- determining process, which we have discussed at length. The correctness of this statement may be seen from a mere preliminary examination of the economic incomes which will 442 PRINCIPLES OF ECONOMICS [XXXVI show that the source of each is in reality nothing more than the price of something. Thus wages of all sorts whether those of a mechanic in the automobile factory, for example, or those of a sales- man, advertising writer, or general manager are nothing but the prices of labor services brought by the laborer to market. Interest also is plainly a price; for, as we have conceived it, the lender makes a sale of the service of waiting. Rent is the price paid for the use of land unmodified, or modified only by improvements which are indestructible. The case of profits, though on the surface less evi- dent, is at bottom not materially different. The entrepreneur sup- plies the service of responsibility-taking. From the very nature of this service, it cannot be sold directly; but it is virtually sold, in that the entrepreneur unites this service with the services which he buys from other agents in the productive process, and sells the total result- ant on the general market. Profits, therefore, are in effect a price received for a service supplied. Another less direct but not unimportant sense in which incomes are determined through exchange processes should perhaps be men- tioned in this place. The immediate income which most of us receive is of course an income of money or its equivalent. But to realize this income, to obtain gratification for our wants, we have to turn the money into commodities or services bread to eat, clothes to wear, rides on the train, etc. Now, obviously, the amount of such goods which we enjoy must depend in large measure on the money prices of those goods. But this, in turn, is a matter of exchange. Hence the amount of goods we can enjoy our real income depends, again, on the processes of exchange. But we need not be content with saying that the sources of the economic incomes are the prices of services, economic goods, which the income-receiver sells, and that those incomes are determined, through exchange processes, by the laws of price. We can be more specific. We can affirm that the particular services in question, the services of labor, land, capital, and responsibility-taking, belong to the class of economic goods which were earlier designated primary factors or cost-goods. A primary factor, as we remember, is one behind which economic analysis cannot reach, which can be traced to no more ultimate source ; and we should be able to see with little XXXVI] PRESENT SYSTEM OF DISTRIBUTION 443 effort that the factors under discussion answer completely to this description. The services of land are obviously primary factors, for they flow without man's assistance from a source which man has not made. Labor services again, for which wages are paid, flow from an unproducible source labor power. For, although labor power is, literally speaking, produced and continually reproduced by the nat- ural propagation of the human species, it is seldom, except under a slave regime, brought into existence primarily for market purposes; it occurs only as an incident to living and precedes the origination of economic motives ; and we may accordingly look upon labor as one of the ultimate things in our analysis, something behind which we cannot go. An equally clear case can be made out for waiting power and responsibility-taking. These factors are indeed supplied by men on their own free choice, and, unlike labor power, are sup- plied from preconceived motives of an economic sort ; but they are preceded by no factors of a strictly economic kind in reaching them we have reached a point beyond which economic analysis cannot penetrate. We have seen that the services of labor, land, capital, and respon- sibility-taking are primary cost-goods. In consequence, wages, rent, interest, and profits, being the prices of these different services, are prices of primary cost-goods. Naturally, then, the particular law of price operative in determining these distributive shares is the one which determines the prices of primary cost -goods. But the principle governing the prices of such goods has already been brought out in Chapters XXIX and XXX. It follows that the principle there set forth is in essence the principle which in the long run governs the regular economic incomes, wages, rent, interest, and profits. Formulated as a principle governing distribution, it may be stated as follows : Principle. Every economic income tends to approxi- mate that quantity of goods which constitutes an expression of the marginal significance to people at large of the actual output when competition is free, the natural output of the type of service rendered by the receiver of said income, 444 PRINCIPLES OF ECONOMICS [XXXVI and which also, in the case of free competition, constitutes an expression of the net marginal disutility involved in fur- nishing said type of service. Ill Explanatory Comments (1) The principle of distribution above laid down is manifestly a compound one, in that it asserts the coincidence of income both with the marginal significance of the service rendered, and the mar- ginal disutility of rendering it, provided there is such a disutility. The full title of the principle, therefore, would naturally be the "sig- nificance-disutility principle." It is possible, however, to treat the two parts as separate principles; and this is perhaps desirable at times, because the first is accepted by some economists who would demur at the second. At any rate, the first part of the principle, which is much the more important and oftener the subject of reference, will certainly require a separate title of its own. We shall therefore frequently allude to the "significance principle," which affirms that the price of any primary factor tends to be such as will express its mar- ginal significance ; or, in other words, that any economic income tends to be such as will express the marginal significance to people at large of the service rendered by the primary factor in question. Another designation occasionally used is the "service value principle," the principle that each person tends to get an income which represents the value of his service or contribution. (2) Our principle affirms that every economic income tends to approximate (not equal) that quantity of goods which expresses the marginal significance attaching to the service rendered. If the mar- ginal significance of a piece of land, for example, is $500, the rent paid for that land will approximate $500, but not necessarily equal it. If the labor of carpenters has a marginal significance of $5.00 per day, the wages of this class of workmen will tend to be $5.00 per day, but not necessarily equal to that figure. The reason for this statement will be evident on a moment's consideration of the prin- ciples of price as already presented. XXXVI] PRESENT SYSTEM OF DISTRIBUTION 445 We remember that there are four limits of price determination, the marginal demand price and the first extra-marginal supply price, above; and the marginal supply price and the first extra-marginal demand price, below. Since it is perfectly possible that there should be a considerable interval between these limiting prices, actual price may vary over a considerable range. This statement manifestly applies to the primary factors from which incomes are derived, just as much as to other economic goods. (3) The principle teaches that each person tends to get an in- come which represents the marginal significance of his services. A given employer might be willing to pay $8 a day for carpenter service. But, taking employers all together, those who are least de- sirous of having carpenter work done find the service is worth to them only $5.00 a day. Five dollars, in other words, expresses the marginal significance of that type of service. The employer who is willing to pay $8 will therefore need to pay no more than $5.00 per day. This is, of course, the same principle that applies in the purchase of bread, meat, coffee, and other ordinary commodities. Whether ethically right or wrong, there is nothing peculiar about it. (4) In the second part of our principle, it was said that every economic income tends to be one which constitutes an expression of the net marginal disutility of furnishing the type of service. The word "net" is introduced to provide for the following feature. The act of supplying certain services may involve advantages as well as disutilities; university teaching, for example, gives men opportunity for the pursuit of scientific investigation, and practicing law gives men standing in the opinion of their fellows. Now, evidently, in cases of this sort, the reward received by the man who supplies the service does not need to be large enough to express the full disutility of his task, but only large enough to express that disutility minus the incidental advantages. An artist, scientist, or missionary, however great his labor, may find such pleasure in the exercise of his talents or in contemplating the result he hopes to achieve, that he will con- sider himself well paid if he receives only the barest living. 44 6 PRINCIPLES OF ECONOMICS [XXXVI ILLUSTRATIVE PROBLEMS 1. One eminent economist heads the chapters in which he treats Dis- tribution with the title Exchange-Distribution. Argue that such a head- ing is legitimate. 2. "The economist commonly concerns himself too much with func- tional distribution, neglecting personal distribution." What is the point of this distinction? Argue that most that might be said under the head- ing of personal distribution is too evident to need much elaboration. 3. "Orthodox economics teaches that the natural laws regulating distribution assign to each owner of a factor of production that portion of the product which is economically necessary to evoke and maintain the efficient operation of his factor, and nothing more." Assuming that the doctrine taught in this text is substantially that of orthodox economics, show that orthodox economics leaves room for the notion that the owner of a given factor in production might get some- thing more than the amount "necessary to evoke and maintain the effi- cient operation of his factor." 4. "This contractor will lose $50,000 if his building is not completed September i. Bricklayers are worth $50 a day to him, yet he can get all he needs for $8 a day. How can you say that each of us tends to get an income which expresses the marginal significance of his service?" Point out the error. CHAPTER XXXVII THE GENERAL PRINCIPLE OF DISTRIBUTION: COROLLARIES Not Precisely Realized. In affirming the existence of the general principle of distribution which was presented in the pre- ceding chapter, it was not intended to claim that that principle is precisely realized in the phenomena of actual life. The lack of such realization appears in both aspects of the principle but is especially notable on its significance side. Few contributors to production receive sums which exactly correspond to their contributions. Some get much more ; a far larger number get less. But, in this respect, the significance principle is not materially different from any other economic law. Those hypotheses which we assume as the starting point of all economic reasoning, absence of force, fraud, favoritism, monopoly, and other conditions interfering with freedom of competi- tion and contract are far from being realized. Further, were none of these manifestly abnormal elements present, we should still have human ignorance, folly, and inertia, to hinder any precise realization of the principle. Sufficiently Realized to Be Important. But, while this and all other principles of economic science are nowhere rigidly opera- tive, economic phenomena do, in a broad way, come under their con- trol. This statement is more conspicuously true of some other prin- ciples than of the one before us, but it applies to this one also. Such being the case, it follows that our significance principle should not and cannot with safety be ignored in affairs of the practical world. It frequently is ignored, as we know ; for not a few well-meant but ill-advised reforms run directly counter to it. But the outcome of such reforms, just because they neglect the principle, is invariably a partial and sometimes a complete failure. To bring out the connec- 447 448 PRINCIPLES OF ECONOMICS [XXXVII tion between such failures and our principle, we will set down a few of its more important applications in the shape of corollaries. Most of these concern the significance side of our principle ; but the last relates to its disutility aspect. Corollary i. Attempts to fix- arbitrarily the amount of any economic share whether by governmental or private action without changing the demand for, or the supply of, the particular type of service involved can succeed only within the narrowest limits. Illustrations of such attempts are found in the Statute of Labor- ers (1351) designed to keep wages at the old level in spite of the diminution of laborers through the black death and, more recently, in minimum wage laws and usury laws. All these measures, we should note, are attempts arbitrarily to regulate the value of something without changing demand or supply. It is at times possible arbitrarily to change prices, but only on condi- tion that one accepts the consequences in the shape of changed de- mand or supply. Thus, a monopolist may arbitrarily raise his price, but only on condition that he reconciles himself to smaller sales. So the workmen in a particular trade, if very strongly organized, may put up the wages of their trade, but at the same time they must be content with fewer jobs. So, again, if government insists on estab- lishing a maximum price for some producible service below the cost of supplying that service, it will have to be satisfied with seeing the supply of the service fall off. If in any particular case the action taken to fix prices does not alter demand and supply conditions, it can, as the corollary affirms, seldom succeed at all. The corollary, as stated, really contains two elements : ( I ) An admission that the shares can be, in some degree, fixed arbitrarily by legislation, and (2) a claim that this is possible only within very narrow limits. Let us begin with the first point. Some Fixing of Shares Possible. (i) A share can always be arbitrarily fixed within the limits set by the significance principle, as XXXVII] DISTRIBUTION: COROLLARIES 449 against any departure to a point outside those limits caused by a failure of competition or the intervention of illegitimate elements. For example, rent is not seldom driven above marginal significance because of the ignorance or inertia of tenants; and government can then, without colliding with regular economic forces, bring it down to the proper level. (2) It is probable that there is nearly always some leeway between the marginal significance and the first extra- marginal one, in which case, our principle fixes, not the precise amount of each share, but only the limits within which it may range. But one point within these limits will reconcile supply and demand as well as another. Hence, within these limits, legislation can arbi- trarily fix on one particular point rather than another, without com- ing into collision with regular economic forces. For example, if wages anywhere from $1.20 to $1.40 would reconcile demand and supply, the law might fix them at $1.40, and not contravene our principle at all.. (3) It is admitted that the prices of labor services or capital services or land services can be fixed at points somewhat outside the limits set by the significance principle because of the inertia or weakness of buyers or sellers of those services. But this being true, it is surely reasonable to claim that government, when public policy demands it, can take advantage of similar weaknesses consciously to fix prices somewhat outside the limits set by our principle. Limits of Such Fixing Narrow. Such arbitrary fixing of the economic shares is possible only within very narrow limits. ( i) Law cannot long compel people to pay for anything more, anyhow much more, than it is worth to them. (2) Law cannot long hinder peo- ple from paying for anything as much, anyhow almost as much, as it is worth to the marginal buyer ; for this is the only way to insure that buyers at or within the margin will get the goods, as against buyers outside the margin. (3) Law cannot long compel people to furnish anything for a price much below that which expresses to them the disutility incurred in furnishing that thing. (4) Law can- not long hinder people from taking a price for their service sub- stantially as low as that one which expresses the disutility incurred in furnishing said service. 45 o PRINCIPLES OF ECONOMICS [XXXVII Corollary 2. Broadly speaking, the share per unit of each class of producing agencies varies inversely as the size of that class. Abundant land makes rent low; abundant capital makes interest low ; abundant labor makes wages low. This obviously results from the joint action of our significance principle and the law of dimin- ishing marginal significance (page 305). Each productive agent tends to get an amount which expresses the significance of the con- tribution made by the marginal member of his class. But, since the larger his class the smaller will be the significance of the contribution made by the marginal member, therefore the larger his class the smaller the income which each member will get. In saying this, as in stating any other scientific principle, we of course assume continuity of conditions. An increase in the volume of any factor would not necessarily lower the rate of return if accompanied by the introduction of new opportunities for employ- ing that factor. Corollary 3. Broadly speaking, the share per unit of each class of producing agencies varies directly as the size of other classes which cooperate with it. Increasing the size of one class of producing agencies increases the share of the others. For example, if capital increases in volume, not only does the rate of return to capital tend to fall, it is equally true that the rate of return to labor and land also tends to rise. The argument should be easy to follow. (i) According to the last corollary, the condition supposed lowers the rate of return to the changing factor. (2) Since the total going to said changing factor out of the product of earlier units of the combination is fixed by multiplying the number of units into the rate, said total will be smaller than before. (3) In consequence, the portion of the product of earlier units going to the other factors, being that product minus the total going to the changing factor, w'll be larger than before. Take a simple illustration : Ignoring capital, let us suppose that a certain piece of land will yield to one man's labor 14 bushels of wheat; to the labor of two men, 20 bushels; to XXXVII] DISTRIBUTION: COROLLARIES 45! that of three men, 24 bushels. When, now, laborers are so few that land needs to be worked in the first stage only, the whole product, 14 bushels, will go to labor. When it becomes necessary to put on a second man, he will add only 6 bushels, therefore will get only 6 bushels, and the first man also will get only 6 bushels, thus giving the landlord 20 minus 12 or 8 bushels rent. So when a third man has to go on, his significance and so his share will be represented by 4 bushels; the shares of laborers I and 2 will fall to the same figure, and the total of the landlord will become 24 minus 12, or 12 bushels. Thus, increasing the number of laborers lowers their share and raises that of the landlord. That diminishing the size of one class diminishes the shares of the others, may be shown merely by reversing the preceding argu- ments. Corollary 4. Increase of population in itself tends to lower all shares but rent, most of all common wages. This is really a sub-corollary from Corollaries 2 and 3. An in- crease in population means normally an increase in the size of all classes of producing agencies except land. Hence an increase in population would normally mean a diminution in the shares of all classes except those receiving rent. Further, this diminution would fall most heavily on wages for the reason that increase in population means a greater increase in labor power than in capital, that is, in the power to wait or assume the responsibilities of production. In opposition to the teaching of this last corollary it is sometimes argued that increase in population does not lower wages for the reason that each person brings into the world capacity to produce as well as capacity to consume. He adds, therefore, to the supply of goods just as much as to the demand. This merely shows that there is not ordinarily any danger that the new laborer will be unable to get any wages at all. It does not show that he will be able to get as high wages as before. Since the stock of natural factors in pro- duction and the stock of capital are not increased by the incoming of the new laborers, therefore the marginal significance of labor, and with it the wages of labor, must tend to be lowered. 452 PRINCIPLES OF ECONOMICS [XXXVII Again, it is sometimes argued that increase in population, in that it makes a larger market and so justifies the resort to extreme specialization, large-scale production, etc., really raises marginal significance rather than lowering it, and so raises the shares going to labor and capital. This is doubtless possible but not, in my opinion, probable. In most countries population has long since reached the size which would justify a resort to the most efficient methods. If a particular community is failing to take advantage of the possibilities of large-scale production because markets are too small to justify a resort to that method, this smallness of the markets is probably not due to lack of the population necessary to make a large market, but to the lack of those facilities for transportation and communication in general which are necessary to coalesce the different small markets into one large one. Corollary 5. Any cause which restricts competition among the persons who supply a particular type of service tends to increase the rate of income received by the said persons. It is of course a fact familiar to the student that producers in all lines are disposed to adopt measures to limit competition, each in his particular line. Monopoly in some form or degree is a condition of things which, consciously or unconsciously, almost everyone tries to see realized in his special field. Perhaps the entrepreneurs in some industry, for example, sugar production, form a trust, thus establishing a combination so wide-reaching as to approximate mo- nopoly. Or perhaps the men engaged in building houses in a certain city form an agreement whereby they promise not to compete in the fullest sense against each other. Or perhaps the painters combine to restrict their numbers by refusing to take on more thnn a fixed number of apprentices at any one time. Now, it is doubtless hoped in each of these cases that the action described will increase the returns of the persons interested; the entrepreneurs in sugar, and the building contractors will get larger profits, and the workmen in the case of painting will get larger wages. Further, it is doubtless true that the result thus hoped for is largely realized. Such re- XXXVII] DISTRIBUTION: COROLLARIES 453 strictions of competition do usually increase the incomes of the persons interested. The reasons are plain. Diminished competition means decreased output, therefore higher marginal significance, therefore higher price, for the service rendered. The principle, as stated, says "rate of income" rather than simply "income" in order to provide for cases where restricting of output might increase the return per unit of service performed but not per person. Thus, the whole body of laborers might unite to keep, say, one-fifth of their number idle, hoping thereby to increase the total income of their class, 1 while in fact they might thereby lower the total though increasing the rate that is, the income per unit of service or effort. Corollary 6. Any cause which restricts competition among the persons who supply a particular sub-class of services tends to lower the incomes of the persons who sup- ply related sub-classes of services. As we have seen, it is very common to try to limit the output of one's own type of service in order thereby to raise the price of it. It is less common, but by no means rare, to hear persons who have inaugurated this policy attempting to enlist the sympathy and sup- port of others as if the public in general or producers in general, were to gain by it. That persons sometimes succeed in this attempt does not alter the facts of the case. Their position is, generally speaking, quite untenable. We may sympathize with their aims, may even be glad to suffer some loss in helping them to realize those aims ; but we are bound to experience a loss the policy in question is against the immediate economic interests of all but the person* di- rectly concerned. The explanation of this fact, in so far as it concerns related workers, should call for no elaboration. Restricting competition within any sub-class of productive agencies, say painting, drives the persons shut out of that sub-class into related sub-classes, carpen- tering, masonry, etc., thereby increasing the size of said sub-classes. 1 It probably can be shown that as a mere matter of economic theory this is a possible res.ult. It does not, however, seem of sufficient importance to reward the effort. 454 PRINCIPLES OF ECONOMICS [XXXVII As a consequence, under the working of Corollary 2, the share per unit of those classes is lowered. Corollary 7. Broadly speaking, improvements in method through discovery and invention tend more espe- cially to increase interest and profits. Such improvements, by increasing opportunities for the employ- ment of waiting and risk-taking, increase the marginal significance of those factors, and so fulfil the conditions of the principle. This is not to say that improvements in method bring no advantage to laborers ; but any advantage the laborer gets comes indirectly in lowered prices and in the greater quantity of goods which lower prices enable him to buy. As already noted, the disutility part of our principle is of much less importance than the significance part. Still it is not altogether negligible in practical affairs. In so far as any class of persons depend for their income on supplying some primary factor which involves a disutility, we cannot arbitrarily cut down that income without more or less interfering with the supply of that factor. This is the old story of killing the goose that lays the golden egg. One good reason for not interfering with the freely made price of a primary factor and the income derived from it is that only so can we be sure that the stock of said factor will be assigned to its proper tasks. But if the factor has a disutility cost, there is an- other reason for not interfering with its price and the income derived therefrom, namely, that, by pursuing such a policy, we are liable to cut down the stock or output of the factor. This point may be formally stated in the following corollary. Corollary 8. // the primary factor from which an in- come is derived has a disutility cost, all artificial attempts to reduce that income are likely to reduce the supply of said primary factor. XXXVII] DISTRIBUTION: COROLLARIES 455 ILLUSTRATIVE PROBLEMS 1. Suppose that at a certain date, competition being free and general conditions normal, the rate of wages for ordinary labor is $1.50 per day; and suppose, further, that, under these conditions, the legislature passes a law forbidding anyone to pay or receive wages less than $5 per day. Do you believe that this would result in giving everyone wages of $5 per day? Why? 2. "The logic of their (the orthodox economists') teaching, has been that wages which were determined by free bargaining between capital and labor would be just or reasonable wages." Point out wherein the above is incorrect, or at least inadequate, as a statement of the real teaching of the economists. 3. Quite soon after her entrance into the war, Great Britain under- took to raise a large revenue by the exceptionally heavy taxation of the industries especially connected with war, that is, the industries engaged in producing guns, ammunition, etc. What argument could be made against that policy? CHAPTER XXXVIII RENT In Chapter XXXVI we presented the general principle under which the four economic shares in distribution are determined. In this and the three chapters following, we give a somewhat more detailed study to each of the shares taken separately. We begin with rent. The Nature of Rent As understood by the general public, the term rent commonly means the consideration paid for the use of any tangible object, such as a house, a horse, a boat, an automobile, or a piece of land. Eco- nomic usage is much narrower, for it includes, not hire in general, but only the hire of land. It does not include even the hire of build- ings, fences, or other removable or impermanent improvements standing on the land. When trying to be very precise, indeed, it speaks of rent as derived from the original, indestructible elements only of land, excluding all improvements wrought by man. even those of the most permanent sort. As a matter of fact, this usage is not perfectly feasible for the reason that some improvements are so indestructible, so irremovable, so altogether permanent, that they become in effect inseparable parts of the natural thing itself. Thus a tile ditch laid in a field becomes once and for all a part of it ; no one will ever take up the ditch, no one will need to give it more than an insignificant amount of repairs, and it will last indefinitely. Like- wise the increased fertility of the land resulting from its drainage is a quality which, though originally created as an improvement, can never again by any probability be extirpated, so long as the land itself endures. In consequence, the common practice is to interpret 456 XXXVIII] RENT 457 economic rent as paid, not only for unimproved land, but also for land improved in the ways indicated. The difficulty which is usually met in the way just indicated, is by some writers met by refusing to distinguish the hire of land from that of other goods, calling them all rents or hires. This practice has not become general, and, in my opinion, is of doubtful expediency. The chief reason is that, in connection with certain problems of value determination and particularly in connection with the incidence of taxes, strictly non-producible goods, fixed-supply goods, behave in a quite different way from ordinary producible goods, and improved land behaves generally like the strictly non- producible goods. II The Origin of Agricultural Rent Rent Originates Like Any Price. Rent is a price the price of the services given off by a piece of land during a given period of time. It follows that the most natural way to explain the origin of rent is that which is used in explaining other similar cases of price. Any appropriable thing will have a price, provided the demand for that thing at some price above zero is greater than the available sup- ply. Inadequacy of supply to equal the demand at any price above zero is sufficient to insure the existence of a price. Such inadequacy doubtless exists in the case of land services, anyhow in the ca.se of services of lands which are superior in respect to fertility or loca- tion. This is sufficient to give such services a price and, therefore, sufficient to explain the existence of rent. Special Explanation: Surplus Theory. But, while the existence of rent does not necessarily call for any explanation other than the one commonly given for the existence of price in other cases, it is customary, especially in the case of agricultural rent, to set forth some more specific and elaborate theory. Such theories are not to be conceived as inconsistent with the explanation of rent just given, but rather as explanations which go back a little further or in a little deeper, explanations which attempt to show the process whereby the conditions indicated come to be fulfilled. The particular 458 PRINCIPLES OF ECONOMICS [XXXVIII theory which most commends itself to the present writer may be called the surplus theory. First Hypothesis In explaining this theory, we will begin with the hypothesis that all the land is of one grade, and that its productive capacity is abso- lutely fixed with just the right expenditure of labor, waiting, etc., it can produce a certain amount of product, less expenditure will pro- duce nothing, more expenditure will add nothing. Such a hypothesis is, of course, in the highest degree unreal, but it will serve best in bringing to light the causation process through which rent comes into existence. At the outset, then, we take the small isolated island of classical convention. That island, we will suppose, contains just 1,000 acres of land of the same grade of fertility and the same de- gree of accessibility ; the sole agricultural product wanted is wheat, 1 each acre of land will yield to the proper expenditure just 20 bushels of wheat, no more and no less ; and the cost of the labor, waiting, and other factors necessary to produce these 20 bushels not in- cluding, however, the services of land is $6 or 30 cents per bushel. Starting from this hypothesis, what condition or conditions will be necessary to bring rent into existence? In the first place, it is certain that this result cannot be reached, rent cannot exist, so long as the demand for wheat at every price higher than 50 cents even one of only 31 cents is less than 20,000 bushels. The best way to demonstrate this, perhaps, is to make the contrary supposition, that, through some process or other, rent did actually come to exist in spite of the fact that demand at 31 cents was less than 20,000 bushels ; and then to show that this rent would inevitably be eliminated through the spontaneous working of economic forces. Thus, let us suppose that, though the demand for wheat at 31 cents is only 19,900 bushels, there has actually appeared on each acre in use a rent of 20 cents per acre, one cent for each bushel. Since, under this supposition, the farmer's outlay for each bushel amounts to just 31 cents, 30 for other costs and i for rent, the actual price must be at least at high as 31 cents, else production would not go on 1 Or wheat will be taken to represent agricultural products in general. XXXVIII] RENT 459 at all. But an actual price of 31 cents means that the effective de- mand will be only 19,900 bushels. As a result, only 995 out of the 1,000 acres of land will be wanted, since only that many are needed to raise the 19,900 bushels. But this fact will make 5 acres super- fluous; and the competition of these five acres for the 20 cents rent will reduce that rent to zero. Thus, the existence of rent is not possible so long as the demand for wheat at every price above costs other than rent is not as great as the total possible output. 2 We have seen that, under our present hypothesis, rent could not exist so long as the demand for wheat at some price above 30 cents, say 31 cents, had not come to be as great as 20,000 bushels, the total capacity of the land. The complementary proposition, that rent would begin to exist as soon as this condition was fulfilled, provided that, in addition, the demand at 30 cents were greater than 20,000 bushels this proposition is easily established. As soon as demand had become equal to 20,000 bushels at 31 cents, while greater at 30 cents, the buyers who were ready to pay 31 cents would have to bid the price up to that figure in order to exclude the excess of demand, thus establishing a price of 31 cents. But, at this price, producers would get a surplus of i cent on each bushel or 20 cents on each acre ; and, since prior to the increase in demand, the producers of wheat could afford to supply it at 30 cents, this surplus of 20 cents per acre would invite competition of producers from other indus- tries ; some part of the 2O-cent surplus would be offered to land- owners for the right to use the land ; and reciprocal bidding between possible tenants would go on till the whole surplus had been turned over to the landlord, or assured to him if he were his own tenant. 3 3 A theoretic complication is possible in which, though the demand at the above-cost price is not as great as the possible output, the demand at cost is greater than output. This case would be one of unstable equilibrium. Price must rise for a moment above cost in order to throw out a part of demand, and, in doing so, it would bring rent into existence. But this could be true only for the moment. The fact that demand fell below capacity as soon as price rose above cost would again bring down price and so annihilate rent. When this had happened, the excess of demand at cost might again send price up temporarily, creating rent temporarily, which would again be eliminated as before. And so this alternation might go on indefinitely. * The existence of rent does not require that a payment should be made from one person to another. The surplus over cost which goes to. or stays with, the landowner is itself the rent. 460 PRINCIPLES OF ECONOMICS [XXXVIII Summary. The above explanation of rent under our present very unreal hypothesis may advantageously be summarized before leaving it ; for it contains the essence of the explanation of rent un- der any set of conditions. The following will answer : When the demand for wheat at a price above cost has become as great as the capacity of the land, and demand at a price equal to cost has become greater than the capacity of the land, the actual price of wheat will rise above cost, this will create a surplus, and the competition of possible tenants will put this surplus into the hands of the land- owner, if tenant and landowner are separate persons, and fix it in the hands of the landowner, if these two are united in the same person. Putting the essence of the matter in still more compressed form, we may say that rent, at least under our present hypothesis, would come into existence when and because the possible output of the land proved inadequate to satisfy demand except at some price higher than cost of production. ILLUSTRATIVE PROBLEMS 1. On the basis of the hypothesis just used, what would rent per acre be under each of the following demand schedules for wheat? (a) 18,000 bushels at 36 cents; 19,000 bushels at 35 cents; 20,000 at 34 cents; 21,000 at 33 cents; 22,000 at 32 cents; and so on? (b) 18,000 at 39 cents; 19,000 at 38 cents; 20,000 at 37 cents; 21,000 at 36 cents; and so on? 2. In the earlier days of economic study it was thought by some very able men that the existence of rent proves that agriculture is an especially productive kind of industry. When the true explanation of rent had been given, a famous economist declared that rent is due, not to the bounti fulness, but to the niggardliness of nature. Defend that proposi- tion. Second Hypothesis We have seen how rent originates in the very simple, but very unreal, case furnished by our first hypothesis. Let us now change the hypothesis so as to bring it a step nearer to the facts of life. Let us suppose that the wheat land of our island is not all of one grade, there being only 100 acres of the grade which yields 20 bushels XXXVIII] RENT 461 per acre at a cost of 30 cents, while the rest is distributed into 3 parcels, one of 200 acres which will produce each 17 bushels at a cost per bushel of 35 cents ; another of 300 acres which will produce each 15 bushels at a cost per bushel of 40 cents ; and a third of 400 acres which will produce each 13^ bushels at a cost per bushel of 45 cents. In each case, greater expenditure would make no increase in output, while any smaller expenditure would produce no output at all. We will designate these different grades, 3O-cent land, 35-cent land, 4O-cent land, and 45-cent land, respectively. When, now, would rent appear under these new conditions? First, it is quite certain that there could be no rent so long as the demand for wheat at any price above cost on the 3O-cent land has not become equal to the possible output of that land, 2,000 bushels. This proposition is plainly analogous to the first one laid down under the previous hypothesis, though this time the crucial figure in de- mand is 2,000 bushels, the possible output of the best land, instead of 20,000, the possible output of all the land under the previous hy- pothesis. In substance, the argument for this proposition is the same as that used before. Any rent which might temporarily ap- pear under the conditions given would soon be reduced to zero by the spontaneous working of economic forces. The paying of that rent would necessitate an actual price for wheat of 31 cents; that price would reduce actual demand to less than the possible output of the 3O-cent land ; this reduction in demand would throw out of cultivation some of said 3O-cent land ; and the competition of the thrown-out acres would reduce rent to zero. Again, the conditions under which rent will appear and persist are substantially the same as before. Just as soon as the demand for wheat at some price higher than cost on the best land, say 31 cents, had become equal to the total possible output on that land, 2,000 bushels, while demand at the cost price, 30 cents, had become greater than 2,000 bushels, rent would begin to exist on the best land. For, under this condition, the price of wheat would necessarily be- come 31 cents; this would give a surplus over cost of I cent per bushel or 20 cents per acre; and the competition of possible tenants for this 20 cents would insure its being given to, or left with, the landowner. The explanation of rent is thus substantially the same 462 PRINCIPLES OF ECONOMICS [XXXVIII as under our former hypothesis. That is, rent comes to exist when and because the possible output of the best land proves inadequate to satisfy the increasing demand except when actual price has risen to a point above cost of production on that best land. Inferior Lands Not Cause of Rent. What, now, is to be said with respect to the relation of the inferior lands of our present hypothesis to the rent problem? If we have in mind the causation of rent, the most natural answer is that the inferior lands have no part in the matter. If they had been sunk under the ocean by an earthquake, if they had never existed, rent would have risen just the same and just as soon, that is, as soon as the capacity of the best land had proved inadequate to satisfy the increasing demand, save as that demand was reduced by the rising of actual price above the cost of production on the best land. But it is possible to interpret the affirmation that rent depends on the inferior lands, in a way that makes the proposition include an element of truth. These inferior lands are, after all, lands. If they were not inferior, we could count them right along with the best lands as adding so much to the total stock and so adding to the total possible output of wheat, with the result that the rising of the price of wheat, and so the ap- pearing of rent, would be much postponed. The reason why they cannot be so counted is that they are inferior. Their inferiority, then, counts indirectly as a limitation on the stock of best lands. This, however, seems like a very back-handed way of affirming the fact which really causes rent, namely : the fact that the supply of the best land is limited to 100 acres. Inferior Lands Check on Rent. The above paragraph brings out the point that the inferior lands have no part in the origination of rent. Those lands do, however, play a very important role in rent determination, namely: limiting the amount of rent, checking its growth. Thus, if there had been no 35-cent land available, then, as soon as the demand for wheat had so increased as to become 2,000 bushels at 36 cents, the price of wheat would necessarily have risen to that figure, and rent would have advanced to $1.20 per acre. Under the actual hypothesis, however, the result is quite different. XXXVIII] RENT 463 When the price of wheat reaches 35 cents, it becomes profitable to work the 35-cent land; as a result the possible output becomes 5,400 bushels instead of just 2,000; hence the price of wheat cannot rise to 36 cents, though the demand for wheat at that figure has reached 2,000 bushels, being kept instead at 35 cents as long as demand at 36 cents is under 5,400; and so the surplus and rent are kept from rising. ILLUSTRATIVE PROBLEMS 1. The existence of rent does not require that there should be differ- ences in the fertility or accessibility of the land. Defend that statement. 2. Why would rent come sooner under the second hypothesis than under the first? Third Hypothesis Let us now bring our hypothesis into closer accord with reality by supposing that the productivity of the land is variable, not abso- lute, being governed by the principles brought out in Chapters IX, X, and XL Accordingly, let us suppose that our best land does not show a cost for auxiliary factors as low as 30 cents till the land has been worked to the point of diminishing returns; and that, after this point has been reached, a new expenditure of 32 cents per bushel will add 10 bushels to the output per acre, and a further new expenditure of 34 cents per bushel will add 5 bushels. In short, after we have reached the point of diminishing returns in the working of the land, we shall have, on each acre of the best land, three legitimate productive opportunities: a 3O-cent opportunity, a 32-cent one, and a 34-cent one; and we shall also have three possible outputs: 2,000 bushels, 3,000 bushels, and 3,500 bushels. \Yould this change in conditions require us to change our explana- tion of rent? In essentials, No. As before, rent would emerge when and because the demand for wheat at a price higher than cost on the best land had come to be as great as the possible output on that land. This time, however, a more explicit statement would be needed. Rent would emerge when and because the demand at a price higher than cost on the best land, that land being worked only to the point of diminishing returns, had come to equal the possible 464 PRINCIPLES OF ECONOMICS [XXXVIII output of that best land worked only to the point of diminishing returns. The reason for this change of statement is fairly obvious. Of the three opportunities present on the best land, the best, that is, the cheapest, will be first utilized and will yield a surplus at a price which would be too low to justify utilizing the other opportunities at all. Thus an actual price for wheat of 31 cents would give, on each acre, a surplus, and so a rent, of 20 cents, though an actual price of 32 cents would be necessary to induce farmers to utilize the 32-cent opportunity. The relation of the inferior opportunities for the production of wheat, derivable from the more intensive working of the best land, to the rent problem are the same as that of those inferior oppor- tunities which are derivable from the poorer grades of land. In causing rent, they have no part. Rent would arise at the same time and for the same reason, if they did not exist. On the other hand, they play an important part in checking the growth of rent. Under our previous hypothesis, rent experienced no check until it had risen to $i an acre, that is, until the price of wheat had risen to 35 cents and so justified the working of the second grade land. Now, how- ever, there is a 32-cent opportunity on the best land, which oppor- tunity can be utilized as soon as actual price reaches 32 cents ; and, with its utilization, demand is temporarily satisfied, the rise of price is checked, and so the growth of rent is checked when it is only 40 cents per acre. Fourth Hypothesis The last of our three hypotheses has brought us much nearer the facts of the real world; but there is at least one very considerable point of difference left. Up to this time, the several costs of pro- ducing wheat which appear in the second and third hypotheses have been separated by considerable intervals. Under the second hy- pothesis, they differed by 5 cents, being 30, 35, 40, etc. Under the third, they differed less, but still by 2 cents most of the time, being 30, 32, 34, 35, etc. Now, it can scarcely be doubted that in real life, even these smaller differences are too great. Very likely the differ- ent costs really grade into one another almost insensibly. Since, how- XXXVIII] RENT 465 ever, producers would probably not be influenced in the amount they produced by changes less than one cent, let us suppose that, under the successively less favorable conditions of resort to poorer lands and more intensive cultivation, the costs of wheat are 30 cents, 31 cents, 32 cents, 33 cents, etc., making a supply schedule for our island something like the one given in the accompanying table. Would this change in our hypothesis compel a change PRICE SUPPLY in our explanation of rent? The true answer is 30 2,000 surely a negative one. ^ 2,500 33 3^500 Real Cause Unchanged. As before, the 34 4,ooo 1 f 1 r 1 1 1 35 4>5 real cause or rent is the fact that demand at 36 5,000 some price above the cost of production on the 37 5>5o and so on best land when cultivated to the point of dimin- ishing returns the least cost before rent exists is equal to the total possible output at that least cost, while demand at a price just equal to least cost is greater than the total possible output at that cost. The fulfilment of this condition causes actual price to rise above the least cost ; and thus is brought into existence a surplus on the best land, which is bound to go to the landowner. But, it may be said, under this new condition there will be a cost of production equal each time to the price which demand establishes ; may we not, therefore, say that price rises and so develops the rent surplus because the marginal cost has increased? The answer is a negative one. When demand increases till it is 2,000 bushels at 31 cents and 2,100 at 30 cents, the price rises to 31 cents, not because the latter becomes the marginal cost, but because no more wheat can be produced at the old cost of 30 cents. Were there no possibility of producing wheat at 31 cents, and, therefore, no chance that this could be the marginal cost, the actual price would just as certainly rise to 31 cents, and just as certainly cause rent to emerge. The correct statement of the case is this : actual price rises above the least cost and so rent emerges, because no more wheat can be sup- plied at the said least cost. But the appearance of the price which made rent also justified the raising of wheat at the next higher cost, which raising of wheat stopped the further rise of price and so the further rise of rent, thus bringing about a price for wheat, and so 466 PRINCIPLES OF ECONOMICS [XXXVIII a rent, in tlie fix-ing of which the demand for wheat and the cost of production both participated. Ill Rent and Disutility In Chapter XXVIII it was maintained that the disutility cost involved in supplying the three factors of human origin, labor, capital, and responsibility-taking, had a part in determining their price. Can the same be said of the price of the services of land, that is, rent? The answer is of course a negative one. In order to have a real disutility cost, a factor must be of human origin ; hence land, which is not of human origin, can have no disutility cost. A particular piece of land may, like any other factor in production, have an opportunity cost. If it is needed for one purpose and we desire to put it to another purpose, the advantage of the former will have to be sacrificed, and this fact will probably have a part in determining the price. But this sacrifice is net a true disutility cost. It follov.-s that rent is determined solely by the significance or utility of land or its services. This significance or utility is probably for one reason or another more easily ascertained for land than for any of the other factors; and so the significance or service-value prin- ciple is more fully realized for land than for labor, capital, or re- sponsibility-taking. But if land has no disutility cost, no disutility cost can influence its price. The disutility half of our principle has here no application. This matter, however, should not be left without further com- ment. While the furnishing of land services involves no original disutility, it does involve derivative disutilities. Under normal con- ditions, the market price of any piece of ground will approximately equal the capitalization of its net income. In consequence, persons desiring to become rent-receivers will be obliged to invest their capi- tal in the land, just as if it were a producible commodity, gaining the position of a rent-receiver will therefore mean assuming the ordinary capitalistic disutilities, abstinence, waiting, and risk-taking. Further, this process of capitalizing the income of land will almost certainly work itself out in such a way that the income pretty XXXVIII] RENT 467 closely expresses the disutilities created. In consequence, it might seem that we ought to affirm that rent must be so determined as to be an expression of the derived disutilities of supplying the land services for which it is received. This, however, would not be true. The disutilities follow rather than precede the appearance of the rent. Hence they have no share in determining the rent. It is rather the price of the land which must be so adjusted as to make the rent an expression of the disutilities involved in furnishing land services. CHAPTER XXXIX INTEREST The subject of interest has probably given rise to more theoretic analysis than any other part of economics. This is due partly to the serious inherent difficulties of the subject, partly to the fact that such theoretic analysis, in the case of interest, connects itself with certain great practical controversies. Of these controversies, the most important concerns the ethical legitimacy of interest. From the earliest times there has been much opposition to this particular source of income as being essentially immoral. This opposition, seek- ing to strengthen itself theoretically by showing that there are no valid grounds on which the existence of such an income can be justi- fied, has devoted enormous energies to the study of the nature and origin of interest. Thus a purely practical problem has given im- mense stimulus to studies purely theoretical. It seems best, there- fore, that we should here enter into some phases of the subject quite fully; though what we have to say will not be unfamiliar, since it has been, in great part, anticipated in previous discussions. The Interest Phenomenon Explicit Interest. Our first task must be to develop clear and definite ideas of what interest is. Its most familiar manifesta- tion is seen in connection with the ordinary money loan. A lender puts at the complete disposal of a borrower a sum of money; this money or an equivalent sum, is to be returned to the lender after a stated period ; and, in return for the advantages which are sup- posed to accrue to him from this operation, the borrower makes to the lender a special payment amounting to a small per cent of the sum loaned and proportioned to the length of time for which the 463 XXXIX] INTEREST 469 loan runs. This special payment is of course the interest we are talking about. Implicit Interest. The type of interest jus/t described is commonly called contractual, or, sometimes, explicit interest. It is open, avowed interest. But there are besides many business situa- tions in which interest, though just as truly present, is more or less concealed implicit interest. Consider for example the relation between the prices of ordinary producible goods and their costs in other goods, current labor, and risk-taking. Each unit of product has a price high enough to cover not only the items just enumerated, but also interest on the invested capital, the sum of money which the entrepreneur could get from the sale of his whole outfit. This must be so, the business man would say, because otherwise no one would devote his money to manufacturing commodities ; instead, everyone would lend it, getting contractual or explicit interest. This is inadequate if it is meant to be a complete explanation of interest ; for sums of money are, so to speak, merely formal capital ; and the deeper explanation must be found in the interrelations of those things which borrowed money is used to buy rather than in money relations as such. But it contains this much truth : It is in the market for money-loans that the various forces which are causing interest to exist and determining its rate, most completely manifest themselves. Accordingly, the business man's method of arguing at this point supplies a clue which will often tell us where to look for implicit interest. Wherever we find a person occupying an economic relation which deprives him of an opportunity to make money loans and receive explicit interest therefor, we may be sure he is in some way receiving implicit interest. ILLUSTRATIVE PROBLEMS 1. How does the interest phenomenon manifest itself in the price of a dwelling house? 2. In the hire (rent) of such a house? 3. In the price of a building site ? 4. In the fares charged by a steamship in the transatlantic service? 470 PRINCIPLES OF ECONOMICS [XXXIX II Essential Nature of the Interest Phenomenon The surface marks of the interest phenomenon have probably been shown with sufficient distinctness in the preceding discussion. When, however, we inquire as to the real inner nature of interest we find ourselves beset with more serious difficulties. Out of a rather confused mass of writing on this subject we may distinguish two principal theories : the use theory and the exchange theory. 1 The Use Theory. The use theory is almost universal in the business world and is still widely held by economists. According to this doctrine, interest is a payment for the use of capital ; capital be- ing conceived either as a sum of money or as money value embodied in some capital good. If a manufacturer borrows on his ninety-day note $600 to buy 200 tons of coal for his engines, he obviously gets all the uses of the coal but in addition he may be said to get a ninety- days' use of the $600 embodied in the coal. Similarly, if Mr. Elder buys a $1,200 automobile on a one-year note, he enjoys all the services which any cash buyer could realize from the machine and in addition he is thought of as having the use of $1,200 for a year's time. The Exchange Theory. In explaining the exchange theory, our best procedure perhaps is to begin by pointing out the fault in the use doctrine. No one denies, of course, that the borrower or the credit buyer gets some advantage, service, or utility, in addition to the services of the coal or the automobile; if he did not, he surely would not pay the interest. But the use theory, many thinkers affirm, errs in its method of characterizing this advantage. The advantage of the man who buys goods with borrowed money or on credit consists, not in receiving a greater sum of utilities than the 1 It is not uncommon to conceive these as two different ways of explaining interest. I do not consider this view justified. The real explanation given by writers from each of the two groups is, in most cases, substantially the same. XXXIXJ INTEREST 471 men who buy similar goods with their own money or for cash, but in paying what is to him a smaller price. He enjoys all the preroga- tives of a man who has acquired ownership in goods by the process of purchase, although he has not made the complementary sacrifice naturally involved in a purchase, has not in the deepest sense bought the goods at all. In short, his additional advantage over the non- credit buyer consists in postponing the sacrifice necessary to becom- ing the rightful owner of the utilities of the goods. The exchange theory as to the nature of interest will now be readily comprehended. Interest, it affirms, is in reality a bonus, a premium, a something to boot which the man who buys goods now but does not himself pay for them till some future time, gives to the person who enables him to effect this transaction. Or, looking at the operations from the lender's side, interest is a bonus or premium which the man who relinquishes his right to goods now but gets his pay only at a later date, receives for making this exchange. To put the theory in more conventional form : Whenever present goods are exchanged for future goods, a bonus or premium is paid by the party who brings to the exchange future goods, to the party who brings present goods; and this bonus or premium constitutes interest. Ob- viously, this description best applies to contract interest, where one particular kind of goods, especially money, is borrowed with the understanding that just the same kind of goods is to be returned after a stated interval. But the advocates of this phraseology hold that it describes the real nature of every transaction wherein interest figures at all, even to the most obscure cases of implicit interest. The entre- preneur who buys raw materials, machinery, and labor, and com- bines these to produce shoes is in effect exchanging present for fu- ture goods; for the raw materials, machinery, and labor, though literally existing in the present, are not truly present goods, but only future goods, shoes in the making, shoes to be. Into the real merits of this controversy between the use and ex- change theories, it will scarcely pay us to enter. In general, we shall asume that the antithesis between the two is not as great as their respective advocates imagine. The man who exchanges present for future goods must, as a condition of doing so, be in a position to wait, he must have a surplus of wealth which, measured in value, 472 PRINCIPLES OF ECONOMICS [XXXIX equals the goods he exchanges for future goods. Speaking figura- tively, such a man must be the owner of waiting power, carrying power; and, this will usually be in the form of general wealth, money or claims to receive money. To say that he sells the use of waiting power does not seem essentially different from saying that he exchanges present for future goods. Ill How Interest Comes to Exist Requisites of an Explanation. In beginning the explanation of interest, it is natural to make a remark similar to that with which we introduced the explanation of rent. Interest exists because the demand (at some price above zero) for a certain thing is in excess of the output of that thing in other words, because there is an extra- marginal demand for it. To explain the value of any object we have only to show that there are good reasons why there should be a demand for that object and good reasons why the supply should be limited. We are not called on to show that it must have value, but only to point out the conditions which, if fulfilled, will insure its having value. In the case before us, the thing commanding a price is the service of carrying society's stock of reserve goods. In gen- eral, then, our task is to show (i) why there would naturally be a demand for carrying power, of its equivalent loanable money funds, and (2) why the supply of this service would naturally be limited. Why Waiting Power is Demanded. Among the reasons why there would naturally be a demand for waiting power are the following: (i) Overestimate of the importance of present -wants (spendthrift borrowing), (2) anticipated increase in income, and (3) the superiority of time-consuming methods in the production of goods or services. The first of these reasons needs little comment. Overestimation of present as compared with future wants, the conviction that one's immediately pressing desires are important above all things else and must be satisfied this may be a foolish reason for borrowing, but XXXIX) INTEREST 473 it is plainly a very real one. The second reason is almost equally familiar. Many people, particularly the young, think themselves justified in borrowing, even if only to have a little more pleasure in the passing hour, because they confidently anticipate larger incomes in the near future. The third, and much the strongest, reason why there is a demand for carrying power, waiting power, is to be found in the fact that the control of such power enables us to increase enormously our productive efficiency. The chief reasons why this is true were brought out in Chapter V, when we were illustrating the function of capital as a factor in production additional to labor and land. High productive efficiency requires that we should maintain a vast fund of reserve goods, goods devoted to the service of the future. The desire to attain this efficiency leads us to come on the market as buyers of the right to use the surplus wealth which constitutes capital. Why Quantity of Waiting Power* Is Limited. I have dwelt on various reasons why there would naturally be a demand for wait- ing power, carrying power. It is equally easy to show that there would naturally be a limitation on the supply. As we already know, the ability to furnish this service of carrying depends on the ac- cumulation of a reserve fund of goods or money, and this accumu- lation can be made, in the last analysis, only through saving. But there are limits to the total saving capacity of a community. In the first place, the amount which a community could set aside for the future would of necessity always be limited by the total income; we could not conceivably save more than the total product of our efforts. But, again, we could not by any possibility devote even this total product to providing for the future, for some of our present wants can go unsatisfied only atthe cost of life. Further, it would be folly to sacrifice any present needs for the sake of future ones which were not of equal importance. Accordingly, a wise econ- omy would never build up the stock of carrying power for the satis- faction of future wants from that part of the current income which is needed to satisfy present wants of more, or even equal, impor- tance. 474 PRINCIPLES OF ECONOMICS [XXXIX The share of current income which can be devoted to the service of the future is further limited by the fact that future needs of a certain degree of intensity are not really as important as present needs of the same degree of intensity. For this there are two reasons, (i) Life itself is uncertain; the present we have, the future may for us never exist. A perfectly sensible and prudent person, therefore, will refuse to sacrifice a present want of a certain magnitude for a future one of the same magnitude. (2) Gratification of the present want is sometimes a condition necessarily precedent to the future want. Thus, the gratification of the present want may be essential to the continuance of life, or at least to the maintenance of that degree of physical and mental health which alone can fit us for the enjoyment of the future gratification. But, even if present and future wants of the same magnitude were equally important, we should still have a check on our pro- cesses of saving. This consists in the same tendency we have cited as a cause for the rise of demand for carrying power; namely, the almost universal overestimate of the importance of present wants, the almost universal underestimate of the importance of future wants. For the same reason that borrowers borrow, savers are dis- inclined to save anything to lend them. Not to gratify the want of today seems an unbearable hardship, while we contemplate without misgiving the deprivation of tomorrow. No doubt there are indi- viduals to whom these remarks do not apply ; some people accumu- late much even with small incomes. But most of us spend freely or even carelessly ; and, as a result, the supply of the carrying power, the savings of the community for the future, accumulates less rapidly than it would if prudence in such matters were universal. We have thus shown why it is natural that there should be, on the one hand, a demand for carrying power, and, on the other hand, a limitation of the supply. This does not prove that there must be interest. To prove that, we should need to show that the conditions tending to build up a demand for carrying power and those tending to limit the supply of carrying power are so potent that they neces- sarily make the demand at some rate of interest above zero greater than the supply at that rate. To prove anything of this kind would be from the nature of the case impossible. However, as was pointed XXXIX] INTEREST 475 out in an earlier paragraph, we are not called on to undertake such a task. Our business here is to explain interest. This does not re- quire us to prove that interest must exist, but only to name the con- ditions which, if fulfilled, will cause it to exist and this, plainly, we have done. ILLUSTRATIVE PROBLEMS 1. "That capital is productive has often been questioned, but no one would deny that tools and other materials of production are useful; yet these two propositions mean exactly the same when correctly understood." Show that those persons who object to calling capital productive would hardly be satisfied with the above proof. 2. Suppose that a fisherman could catch 21 fish a day without the aid of a net or boat or any other form of capital ; that to make a net would cost him 30 days' labor ; and that it would last only 30 days. (a) What is the smallest number of fish which the net must enable him to catch each day in order to make it possible for us to credit any portion of the product to capital as capital? (b) Supposing that the fisherman catches with the aid of the net 200 fish a day, what is the maximum productivity which could be credited to the capital as capital? (c) Under what circumstances would that maximum tend to be so credited to capital ? (d) Supposing that only 1,000 fish were actually credited to the net as its product, how would you explain the fact? (e) Can you imagine a condition of things under which no part of the catch would be credited to the net? 3. In order that we should impute productivity to capital, is it neces- sary that some part of the capital supplied have a cost of abstinence? IV Interest and the Significance-Disutility Principle Interest and Significance. We argued in the preceding chapter that the economic share known as rent is with special ease brought into correspondence with the economic significance of the service rendered by land. We might almost as well have chosen interest as being peculiarly submissive to our principle. Almost ev- erywhere the capital market is especially free from interference, is 476 PRINCIPLES OF ECONOMICS [XXXIX especially characterized by freedom of competition. If, then, the reasoning of Chapter XXX be accepted, the reasoning that under complete freedom of competition the price of each primary factor inevitably tends to be one which expresses the marginal significance of that factor we may be quite certain that this is true of interest, the price of the use of capital. There is, to be sure, probably no method of ascertaining directly and definitely the product-significance of a given unit of capital. Not a few writers believe such a method to exist, but I do not share their conviction. The economic significance of capital does not manifest itself in the same tangible way as does that of land. Nevertheless, the automatic process which we depended on in Chapter XXX to make the prices of primary factors express their marginal significance here operates freely and fully. On every side opportunities arise for the use of capital in order to substitute ma- chinery for labor. The advantage or disadvantage of such substitu- tion turns finally on the rate of interest, the price of the use of capital. Entrepreneurs compete or refuse to compete for the sup- plies of capital according as its price does, or does not permit a profit on its use. So, the owners of that capital openly compete against each other to insure its employment. If its price exceeds its mar- ginal significance, some portion of the supply will soon cease to be employed. If its price is below its marginal significance, marginal and intra-marginal users will have to bid it up to shut out the extra- marginal users. Entrepreneurs may be individually and collectively in complete ignorance as to the real marginal significance of capital ; but they have no difficulty ascertaining whether, at a given rate of interest, they can advantageously bid for more capital. Paying no attention to anything other than their own immediate profit, their spontaneous action finally brings the rate of interest to a point -where it expresses the advantage of the marginal opportunity for the use of capital. Interest and Disutility. Is the rate of return to capital gov- erned also by the disutility principle? Undoubtedly, as we have already argued more than once, the supplying of capital does necessi- tate some sacrifice or disutility. The question remains as to whether XXXIX] INTEREST 477 the marginal portion of this sacrifice is expressed by the rate of interest. Doubtless a negative answer is possible. The volume of capital accumulation is influenced by other conditions than the rate of interest. For example, some persons are in a position to save from the present income without appreciable sacrifice while, at the same time, they desire to provide a surplus for the future. Such persons would accumulate capital even if they were obliged to pay for the privilege. It is, therefore, conceivable that the amount of capital actually supplied to the market is not influenced to any great extent by a regard to the interest paid. If not strictly a fixed-output good, it would have its fluctuations of output determined through forces other than cost. The price of its use, therefore, would not have to conform in any degree to the sacrifice of saving it. But, while this state of things is conceivable, it surely does not exist in fact. One type of accumulation, certainly, is motived by considerations of direct economic gain. I mean the getting to- gether of a small sum to make a start in business or speculation. Doubtless we are not here dealing with pure interest the profit ex- pected is the more important item. Still the interest problem is also present, since the entrepreneur who puts his own capital into a busi- ness cannot help performing the waiting function as well as the responsibility-taking function. Now, every year a large amount of capital comes into existence in this way ; and it is hard to believe that such capital has no influence in determining the rate of interest. But, finally, the accumulating of that portion of capital which is devoted to earning interest only must be materially influenced by the immediate reward in the shape of interest. Surely there are not a few people in such a position that they naturally say : The rate of interest has fallen so low that it really is not worth my while to save any more ; I would better enjoy the present. If so, their de- cision for or against further saving must change the volume of capital sufficiently to modify its price. Putting the matter in a still different way, can we seriously doubt that a fall in the rate of interest to zero would diminish the stream of new capital, or that a rise to ten per cent would increase that stream? If not, then we must say that the price of the use of capital must tend to express the marginal disutility of supplying it. 478 PRINCIPLES OF ECONOMICS [XXXIX The Rate of Interest and the Quantity of Money In the Long Run. Besides the general theoretic questions respecting interest already considered, there are one or two of a more practical sort which claim our attention. A very persistent and troublesome popular fallacy makes the rate of interest to vary inversely as the quantity of money; whereas of course the more ultimate causes determining interest are found, not in the demand and supply conditions of mere money, but in those of real capital, such as engines, machines, and lumber. This fallacy seems to spring from a popular confusion of money and capital. It is not unnatural in view of the fact that capital is always marketed in the immediate form of money or the money equivalent, bank credit. As a matter of fact, we may, in the long run, safely take as our guide to the interest relations prevailing among real capital goods, the market for mere money capital. But this is only because in the long run those interest relations prevailing among the real capital goods find full expression in the market for money capital. In the actual determination of interest the quantity of money plays little part. The argument is simple. What the borrower really wants is not money but goods, engines, cars, rails, labor ; and putting out more coin or more paper money will not make these goods cheaper to borrowers, nor will the withdrawal of money make them dearer. Or, if we suppose the rate of interest to be lowered at first by an in- crease of money, the natural working of things will soon reverse the movement, (i) The lower rate will lead to extensive borrowing and buying of goods. (2) This will raise the prices of goods; since they have not increased though the money has. (3) This will com- pel borrowers to borrow more money in order to get the same amount of goods. (4) This will raise the rate of interest again to its former place. 2 Summarizing, we have the following principle: 1 In fact, it is generally held that, when the stock of money is increasing, the expected fall in its value rise in prices will cause lenders to hold back for a higher rate of interest in order to insure themselves against loss on the principal. XXXIX] INTEREST 479 Principle. In the long run, the rate of interest must be determined in substantial independence of the quantity of money. For Short Periods. But, while in the long run we cannot expect to influence materially the rate of interest by altering the quantity of money in circulation, we can for brief periods accom- plish this result. In fact governments and powerful banks at times consider it one of their functions to manipulate the money stock for l!:e express purpose of raising or lowering the rate of discount. Thus the Bank of England has in several instances contracted the circulation of London in order to force on the market a higher rate. The possibility of bringing about such results in the way indicated rests upon the following facts. Short-time loans largely connect themselves with the need for money, not to invest productively, but to meet money obligations. The demand is thus emphatically for money itself, not something which money will buy. Hence the short-time rate adjusts itself to the marginal utility of money capital, without much regard to goods capital. Emphasis rests also on the fact that the short-time rate adjusts itself to the marginal utility of money capital with little re- gard to the disutility of saving. This is simply the old case of short- time normals being determined without respect to cost of production. During a series of years, the price of wheat tends to equal its marginal cost of production. But between two harvests its price tends to be one expressing the marginal utility of the existing stock. Principle. For short periods (a few weeks or months}, the rate of discount (interest} tends to equal that rate which expresses the marginal utility of the stock of money capital without much regard to the marginal utility of goods capital or the disutility of saving. VI The Rate of Interest and Risk At any one time the rate of interest on capital used for the same general purpose differs greatly in different places, say Ann Arbor 480 PRINCIPLES OF ECONOMICS [XXXIX and Spokane ; and even in the same place at the same time it per- haps differs widely when the capital is put to different uses. The chief explanation of these differences is doubtless inequality in the matter of risk. The excess over, say, four per cent in a given time and place may be conceived as an insurance premium, necessary to cover losses from bad debtors, or perhaps as a payment necessary to overcome the natural indisposition of the lender to take chances. If we understand by "gross interest" the amount actually paid and by "pure interest" the rate to cover the simple use of capital, we may lay down the following principle, which though obvious and familiar, is unfortunately often overlooked. Principle. The amount by which gross interest in any particular case exceeds pure interest tends to vary roughly as the risk involved. CHAPTER XL WAGES As was the case with rent and interest, wages constitute the price of one of the primary factors. It follows that the general argument for the dominance of the significance-disutility principle over this share in distribution was implicit in Chapters XXVIII to XXX when we were showing that the prices of primary factors in general are determined by this principle. In the present connection, therefore, we need only to comment briefly on some facts which tend to modify more or less the workings of the general principle. We will comment first on matters which seem to interfere with the significance half of the price. Wages and Significance Labor Organizations. One of the most important obstacles to the complete domination of the significance principle in the case of wages is the fact that there is more or less restraint put on competition by those who supply labor services : in a good many occupations, something like a labor monopoly exists. Restriction is secured both by limiting the number of laborers in a given field and by limiting through various devices the natural output of those per- sons who do get into the field. As a result, the share of these persons tends to exceed that which would express the marginal significance of the natural output of their type of service. In short, society has to pay for many of the higher services more than would be expected in view of the amount of those services which would naturally be forthcoming. Laborers who supply the services get more than they earn, using the latter term in its ordinary sense. We need not, however, take this concession too seriously. In 481 482 PRINCIPLES OF ECONOMICS [XL this age of publicity, free education, and universal initiative, few combinations could, in the long run, be successful in shutting out the competition of the really fit. Further, the policy of the trades unions is to some extent though certainly not a large one offset by an analogous procedure on the part of employers. Adam Smith, the so-called father of Political Economy, said that there always exists a universal, though tacit, combination among employers to keep wages down. This was probably nearer the truth in his day (1776) than now. The vastly greater extent of the market within which labor is bought and sold now makes tacit combination almost im- possible; and formal combination for this end seems not to have been carried far. Still there is probably enough to offset in some measure the monopolistic combinations of labor. In short, it is probably safe to assume that the wages of even the higher forms of manual labor are not priced at a point materially above their natural marginal significance. Immobility of Labor. Another obstacle to the complete domination of wages by the significance principle is the lack of mo- bility among laborers. We have all noted that the mere competition of sellers will not secure the advantage of buyers unless the latter are themselves reasonably alert. A shop may advertise ever so con- spicuously the fact that it sells the same wares at prices below those of its rivals; but, unless buyers note the fact and act accordingly, they will not benefit from the favorable competition. But the con- verse proposition is also true. The mere competition of buyers will not insure good prices to sellers unless the latter are alert enough to become cognizant of the fact, and are in a position to profit by their knowledge. Ignorance, lack of means, inertia by all of which laboring men are too frequently hampered may combine to neutral- ize more or less completely the advantage which they might derive from the free competition of employers. Custom. Another reason often given for expecting wages to be different from what they would need to be to express the mar- ginal significance of labor, is that wages in many fields are fixed by custom. Thus we have been wont for years to pay housemaids $3 XL] WAGES 483 to $4 per week in one social class, $5 to $6 in another, $7 to $10 in another. Similarly, the wages of common labor range usually from $i to $1.50 per day. Now, without doubt, custom has some direct influence on the rate of wages; but that influence is, in the opinion of the writer, much exaggerated. In the first place, the facts do not display the degree of uniformity claimed. Within a few years a very marked change in the alleged customary standard has taken place. The amount which we commonly assume will have to be paid for one or another type of labor has changed three or four times in the memory of living men. Again, the uniformity claimed is not exact enough to show the effect of custom. Custom is nothing if not fairly inelastic. A custom which permitted men to wear at a formal dinner anything from a frock coat to a doctor's gown would not be called a custom at all. So, a custom which makes wages for one type of service range from $3 to $4 a week can hardly be called a custom. Again, if wages were so much under the influence of custom, we should see but little change in their rate due to inflation of the currency, rise in the value of the standard, immigration, booms in business, and other modifying conditions. But statistical investiga- tions have shown that wages, though moving somewhat slowly, do actually move in response to changed conditions. Finally, the con- siderations noted a few paragraphs back, publicity, general educa- tion and universal initiative, create a strong presumption against the belief that in our day mere custom can exert a marked influence in wage-determination. Bargaining. We have, finally, to remark a tendency rather pronounced with some present-day writers to put forward the in- fluence of bargaining in the determining of wages as a reason why wages cannot, and do not, express marginal significance. These writers usually set out with the idea that the sole downward limit of wages is what the laborer will take, much as the upper limit is what the employer can afford to pay. They thus overlook altogether the part played by employers in fixing another possible lower limit to wages, and hence insure that the supposed lower limit shall be a very low one indeed, one leaving ample room for bargaining. But 484 PRINCIPLES OF ECONOMICS [XL this analysis is certainly unsound. There is another lower limit 3 besides what the laborer will take, namely, the significance of labor to the first extra-marginal employer; and this limit is often much higher than the employee's minimum, so that the range of bargaining is much narrowed. Further, a good deal could be said for the con- tention that the laborer's minimum which really appears most of the time is the wage he believes he can get elsewhere ; it is not a true laborer's minimum but rather a minimum set by the extra-marginal employer. Generally speaking, then, bargaining does not seem to act upon wages with the force recently attributed to it, and does not seem to limit in any marked degree the dominance of the principle of mar- ginal significance. In so far as our principle is displaced by bargain- ing, this is probably true, not because bargaining as such can override the natural limits set by the marginal and first extra-marginal signifi- cances, but because the bargaining is, on one side, collective, monopo- listic. The individual employer has to deal, not with each workman, nor even with his workmen as a unit, but with the trade ; and the trade as a totality has restricted competition in one way and another so that bargaining can move wages outside the limits set by the marginal and extra-marginal significances of the natural output. But this was already provided for in admitting that monopolistic labor could set limits other than those which would be established by the marginal significance of the natural output. II Wages and Disutility Overtime Labor. An interesting confirmation of the con- tention that wages have to be such as to express the marginal dis- utility of supplying labor services, is to be found in the fact that everywhere laborers insist on higher rates of compensation for overtime work. The disutility attaching to an eleventh or twelfth hour of labor is greater than that attaching to the earlier hours, and "Oddly enough, the analysis is usually inconsistent at this point; for it does not ignore the part played by employees in fixing an upper limit which may be under that fixed by employers. XLJ WAGES 485 employers commonly find it necessary to offer higher rates for these extra hours to induce the desired supply of labor. Freedom of Action Lacking. It is sometimes objected, in this connection, however, that the laborer's freedom of action is too limited, under modern conditions, to make possible the easy opera- tion of the disutility half of our principle. Under a simpler order of things the laborer might cease working as soon as the added utility, in the form of wages or goods, fell below the marginal dis- utility of his labor. He would stop his day's work at the end of say ten hours, or nine, or eight, unless an additional hour would clearly add enough to his returns to offset his discomfort. But un- der modern conditions the length of the day is largely a fixity, de- termined by custom and by the necessities of business processes. The latter commonly require the coordinated working of great numbers of persons and large volumes of capital. The individual laborer cannot decide of his own motion to shorten his day to nine hours or eight hours, for he is only a small part of a vast and complicated mechanism. This shortening of the day can only be done concert edly by the common consent of many employees and employers. Still Much Freedom. This objection is not without point, yet it has much less weight than one might suppose at first sight. The disutility of labor can act upon the supply and so upon the price of labor, not only by altering the length of the working day, but also by diminishing the total number of working days and the total number of men who work at all. The decrease in the number of working days, as a result of disutility, is especially conspicuous in times when the demand for labor is very great and wages conse- quently very high ; but at all times it probably plays a greater part than is commonly supposed. A very considerable per cent of the men who are engaged in the ordinary trades which we have in mind when speaking of labor in general, work a few days, weeks, or months, and then loaf for a time, not hesitating even to give up the present job, confident in the knowledge that they can easily find another. 486 PRINCIPLES OF ECONOMICS [XL Only Freedom at the Margin Needed. Doubtless the num- ber of men who are ready to quit work altogether and thus reduce the supply of labor, when wages are inadequate to cover the dis- utility as rated by them, is smaller than the number who quit work temporarily. Men are more loath to become dependent upon rela- tives, or "take to the road." But this number is not, after all, neg- ligible. It helps to give the labor supply an elasticity sufficient to make disutility a real factor in the determination of wages. For we must remember that it is not necessary that all or a very large part of the supply should be ready to drop out it is sufficient that an appreciable margin should be in this attitude. Wages and the Standard of Living. The effect of disutility on the supply of labor, and hence on wages, is brought about not merely by a decrease in the supply of labor services from men and women already living, but it is reflected also in the size of laboring men's families, and, so, in the future supply of labor. While there is probably little direct regulation of the size of workingmen's fam- ilies because of economic motives, yet, through both conscious and unconscious processes, population tends so to adjust itself that the typical rate of wages is compelled to coincide roughly with the work- ingman's conception of what is essential to a decent living. This, of course, means merely that the result named is effected in the long run. Laborers cannot raise their wages here and now merely by deciding that more is needed to insure a decent living. At any mo- ment their numbers are fixed ; and comparatively few will take to the road for the difference between $1.50 and $1.40 a day. Their wages, therefore, must for the moment roughly correspond to the marginal significance of their labor. But a given standard of living insisted upon through a series of years will express itself in dimin- ished population ; this, in the end, will raise the marginal significance of lalor ; which, finally, will raise wages to the required height. A very practical application of the above principle is seen in the fact that the rate of wages can be altered by changing the ideals of the wage-earners. Adverse conditions may permanently lower actual wages, because those adverse conditions may hold wages be- low the old standard of living until the working classes have in- XL] WAGES 487 sensibly come to accept a new inferior standard. On the other hand, favorable circumstances may work the opposite result. In short, a new level of wages brought about, and for some time main- tained, by temporary causes, tends to persist. The points brought out above may be formulated in the follow- ing principle and corollary. Principle. Under the natural working of economic and social forces, the long-run rate of wages tends to be that rate which will enable the working classes to maintain that standard of living which, in the particular time and place, is looked on as necessary to a decent living. Corollary. In the long run the rate of wages can be altered by changing the ideals of the working classes as to what is essential to a decent living. ILLUSTRATIVE PROBLEMS 1. What bearing does our principle have on the question whether Chinese immigration should, or should not, be discouraged? 2. "No remedies for low wages have the smallest chance of being efficacious, which do not operate on and through the minds and habits of the people." Mill. Argue for the truth of this statement. (It probably needs qualifica- tion; but leave that for some other occasion.) 3. Argue that, though the restrictive policy in the trades unions temporarily injures lower classes of workingmen, in the long run it is likely to raise wages generally. Ill The Theory of Employment Employment and Say's Law. One aspect of the wages problem which has the greatest practical importance for every worker is employment. Some of the most important aspects of this matter connect themselves with a topic discussed much earlier in this text under the title of Say's Law. In our present connection, 488 PRINCIPLES OF ECONOMICS [XL we will merely enumerate some of the corollaries of that law apply- ing to employment. 1 i ) The destruction of objects of wealth which are bound to be replaced does not increase employment. (2) Private expenditure for extravagances, as contrasted with other forms of expenditure or even with hoarding, does not increase employment. (3) Governmental extravagance does not increase employment. (4) Producing for oneself, when it is done without decreasing one's output for the market, does not diminish employment. It might be well, perhaps, to give this last proposition the benefit of an illustration. A person who produces through his property or his efforts, say, $1,000 worth of products each year, does not diminish employment by putting in some spare time building himself a rowboat. Assuming that his outside production is not changed, his demand for goods on the market is the same as before, and therefore creates the same volume of employment opportunities. . (5) Broadly speaking, an increase in the supply of labor services creates opportunities for employment as well as absorbing them, though not usually in quite the same proportion. This proposition is not so evident as the preceding ; nor can it be accepted without larger qualifications. But it is still substantially true. If the whole producing group creates a demand for labor by producing, it follows that the labor part of the producing group cre- ates a demand for labor by its producing. Doubtless it must be ad- mitted that not all the demand created by labor's production will eventuate in a demand for other labor; since labor's demand for goods will be a demand for all the factors necessary to produce those goods, land and capital services, as well as labor services. But with the majority of commodities, the contribution of labor, direct or indirect, is by all odds the most important element. There is no intention here of asserting that the process described will have no adverse effect. Without doubt it will tend to cause some decline in the rate of wages, under the working of the principle of diminishing marginal significance. But this result is not to be confused with the question of employment. XL] WAGES 489 Employment and Foreign Trade. One of the most obstinate of popular fallacies is the notion that the employment opportunities of the people of a community are diminished by carrying on trade with other communities, that buying outside takes away jobs from one's own people. The unsoundness of this notion was brought out in the chapter on the Principle of Reciprocity. In this connection, therefore, only a word is needed. Foreign trade is necessarily re- ciprocal. If we are buying abroad, we must be selling abroad, must be delivering the foreigner some form of wealth, either goods or money. But, in producing the commodity or commodities with which we pay the foreigner for our purchases, we create opportuni- ties for employment just as truly as we should by producing the imported goods at home. There are some valid arguments for arti- ficially developing certain industries within our own borders ; but this "more employment" argument is not one of them. Employment Dependent on Land and Capital. In carrying forward the preceding discussion, it was assumed that, in demanding goods, the public create an almost equal demand for labor, and, so create an almost equal amount of employment. But this presents only a partial view of the matter, since production requires other factors besides labor. A demand for goods cannot constitute a de- mand for the labor needed to produce those goods, unless there are land and capital available to complete the combination. It is, of course, equally true that a demand for goods does not constitute a demand for the land necessary to produce those goods, unless there are available labor and capital to complete the combination ; and a similar affirmation may be made with respect to capital. In short, in a sense each kind of productive goods constitutes a demand for the others. Our concern here, however, is with the opportunities of labor rather than land or capital. A formal statement of the point just made gives us the following: Principle. Broadly speaking, satisfactory -opportuni- ties for employment vary with the abundance of natural resources and capital. 490 PRINCIPLES OF ECONOMICS [XL Limits of Possible Employment. In the preceding discus- sion we affirmed the reciprocal dependence of land, capital, and labor for opportunity. Rigidly interpreted, this doctrine would suggest that there is a definite limit to the opportunities for each of these factors, or, for our special purpose, to those of labor. Given a certain outfit of natural resources and capital, there will be oppor- tunity to utilize a definite amount of labor and no more. Such an interpretation would nicely support the popular notion that there are just so many jobs, no more and no less, so that giving a job to one person necessarily takes one from somebody else. To the trained economist, this view seems quite unwarranted. But possibly our present discussion may have given it some color of sense. Does not the affirmation that land and capital, as well as labor, are essential to production support the contention that labor opportunities are strictly limited? In answering this, we have to remind ourselves that all industry is, during some period, in the condition of returns increasable at diminishing rate. That is, even if the available quantities of land and capital are constant, yet increasing the amount of labor will in- crease the total return to the combination, though not proportion- ately. Since the increase in return is the contribution in the product which will be credited to the additional labor, and, as such contribu- tions will determine the price of labor, it follows that the new conditions will lower wages. Still, this will not alter the fact that the new labor has found employment. Accordingly, we may say that, under ordinary conditions, no one need lack employment if he is content to accept that wage which expresses the new marginal pro- ductivity of labor. As a basis for th6 foregoing argument, it was said that, during some period, industry is in the condition of returns increasable at diminishing rate. But this basis does not always hold, and so the principle laid down calls for qualification. It is possible that in- dustry should reach a stage where its returns are substantially fixed, where they have reached their maximum ; even if the efforts of an- other laborer could increase the output somewhat, still the additional amount would be so small that even with the extremest conceivable economy it would not furnish subsistence. ' Employment is so far XL] WAGES 491 dependent on land and capital, and the possibilities of industry are so limited that a time is always liable to come when opportunities for employment cannot experience any measurable increase, when no more laborers can be utilized. Further, in actual life the practical, effective limit to employment is usually reached somewhat short of the combination of maximum returns. The decline in the marginal productivity of labor does not go on till men could live on no less. Rather it stops where they will live on no less. In earlier times conquering migration and, more recently, peaceful emigration have brought relief ; and in our own day improvements in methods of production have repeatedly pushed far into the distance the point of maximum returns. Employment and the Rivalry of Capital. We have seen that in some sense and to some degree employment opportunities are de- pendent on the presence of a large volume of capital. It has to be added that the fulfilment of this condition may also bring an un- favorable reaction. Capitalistic methods are generally labor-saving methods, hence methods which in themselves decrease the need for labor as compared with the need for capital. Capital therefore ap- pears in some sense the rival or competitor of labor. This fact has naturally given rise to much controversy as to whether the intro- duction of improved methods does not diminish the total demand for labor. ( i ) All are agreed that immediately certain classes of laborers suffer by being thrown out of employment and compelled to make new adjustments. (2) Experience shows that, in any given industry taken as a whole, there is little, if any, decrease in employ- ment ; because the lowered price due to lowered cost so stimulates demand that the old workers are needed to meet that demand even under the new and more efficient methods. (3) The lowered price due to lowered cost, if it does not create new demand, releases buying power saved because of the lower price, which will be spent on new products, save on the almost inconceivable hypothesis that goods have become so abundant and their marginal utility so low that people no longer want more things. But supplying these new products will furnish employment opportunities for the labor dis- placed in the old industries. 492 PRINCIPLES OF ECONOMICS [XL These last remarks would not show that the introduction of improvements has no tendency to lower wages by making labor relatively more abundant and so lowering its marginal utility. We are here concerned only with opportunities for employment at some wage or other. CHAPTER XLI PROFITS I The Real Nature of Profits In the business world, profits were early recognized as a special share in distribution, though sharply distinguished from interest only when part of the capital was borrowed. This recognition was present also in the earlier theoretic discussions. The medieval churchmen, who sweepingly condemned interest usury as they called it seem to have considered profits legitimate, meaning by profits a share going to the capitalist who undertook the risks of enterprise. But, after economics had come to have some scientific development, profits largely failed, especially among the English and American writers, to receive any distinct and separate treatment. Even when in the middle of the last century the office of the entrepreneur began to get attention from English economists, there was a singular failure to recognize his true function. He was rep- resented as primarily the man who managed productive operations. And this happened in countries in which industry was rapidly pass- ing into the hands of entrepreneurs who hired men to manage their business rather than doing it themselves. This doctrine still shows a most astounding tenacity in the texts, though it is manifestly quite untenable. The peculiar function of the entrepreneur must surely be found in something which he only can do, which he cannot hire someone else to do. For anything coming under the latter category is plainly labor. Now, the only functions which seem necessarily to be left with the entrepreneur, are the assuming of final responsi- bility and performing certain types of management which cannot be delegated, for example, appointing those who shall direct the business. 493 494 PRINCIPLES OF ECONOMICS [XLI Gross Profits. Profits, as the term is frequently used by the general public, include the whole net return to the responsible owner of a business after money outlay has been deducted from money receipts. This whole return, which we might call gross profits, usually includes at least three elements, (i) wages of some sort, principally for management, (2) interest on capital invested, and (3) a remuneration for taking the responsibility of production, and making certain -final decisions which necessarily fall to the owner. The first element has come to be eliminated from profits even in the popular sense of the term because of the great extension of the corporate form of business in which the work of management is turned over to hired officials. The second element, interest, is still commonly included. That is, stockholders in a concern paying 7 per cent dividends would think of the business as yielding 7 per cent profit, rather than 4 per cent interest plus 3 per cent profit. In this sense, profit is contrasted with interest in being the return to the capitalist who bears the whole burden of ownership, waiting plus responsibility-taking; while interest is the return to the capitalist who assumes only one part of the burden, waiting. In strict eco- nomic analysis, however, profits ought to be limited to the third element, the taking of responsibility and making final decisions. From this point of view, profits in the illustration above would be only 3 per cent, the difference between what the capital would have received if lent to the company and what it actually did receive as invested in the business. Profits in this sense, we will call pure profits or profits proper. Pure Profits. Pure profits, then, are the remuneration for responsibility-taking, especially for the risk element in responsibility- taking. They include an infinitesimal amount of wages, in that the owner must make certain final decisions though in practice this tends to become negligible and perhaps other disutilities or sacri- fices. But the chief element in the case is the bearing of economic risk. Profits Risk a Special Type. That risk for the bearing of which profits are paid must not be confused with the regularly re- XLI] PROFITS 495 citrring, calculable losses of a business. Such losses simply increase the outlay for labor and capital goods. The remuneration received by the entrepreneur because of such losses would never be thought of as profits, but only as a fund to replace costs. The risk for which profits are paid is the risk of losses which cannot be recouped in the experience of the individual entrepreneur, risks of total failure, or some loss almost as great. Compare the breakage of bottles in the brewery business with the chance that temperance legislation will destroy the business. The former is covered by greater outlay. The latter is a not-to-be-compensated loss. To induce men to assume the risk of such a loss, they must be paid something, not of course enough to cover the loss if the risk should become a certainty, but enough to move their wills to face the possibility of loss. It is thus evident that profits must not be conceived as a contribution to an insurance fund from which losses are covered. There is no such fund; the losses are not covered. Profits Under Socialism. Under Socialism, /the sort of risk now remunerated by profits would in the main be covered by an in- surance fund ; since the state, having a complete monopoly of pro- duction, would pool in its own hands all risks, and, as well, all chances of occasional gain. The risk cost of production, therefore, except perhaps in the case of long-time enterprises undertaken for future generations, would become simply more capital and labor cost, instead of being as now, the price of the psychological disutility of bearing risks. It is probable that the state would charge each com- modity with the average cost of the whole output of that commodity, including successful and unsuccessful branches of the industry in- volved. Profits, as an element of cost, would not therefore be entirely eliminated under socialism, but would appear in another guise. II Do Profits Tend to Disappear? A noteworthy fact in recent economic discussion is a disposition to hold that profits pure profits tend to disappear. The argument for this contention moves along two general lines, (i) It is affirmed 496 PRINCIPLES OF ECONOMICS [XLI that pure profits, assuming them to be paid for risk-taking, will necessarily disappear with the elimination of risk from industrial affairs ; and such elimination is steadily proceeding through the in- crease of knowledge, forethought, and invention. (2) Secondly, it is claimed that the disutilities correlated to profits are disutilities which plenty of men, especially in America, are quite willing to assume without reference to an economic reward. The desire for power, the craving for better social standing, and the gambling spirit which eagerly improves the opportunity to take chances, all these unite to make men willing to undertake the responsibilities of pro- duction, even though they expect to get nothing more than ordinary interest on their capital and ordinary wages for their labor. Chance Not to Disappear. In reply to the first of these arguments, it seems sufficient to declare that the complete disap- pearance of risk, chance, uncertainty from industrial affairs, if not quite impossible, is certainly so remote that it cannot properly be made the basis for any affirmations with respect to the present order. Some centuries hence we may have become able to predict the weather for a year in advance with absolute precision ; but we shall still have to reckon with the uncertainties due to human folly and caprice. Motives Named Inadequate. The second argument is less easy to answer, yet will not, I think, carry conviction to most persons. The first two motives named, the desire for power and the desire for social position, affect only a small minority of our entrepreneur class, namely, the small individual or partnership entrepreneurs, who combine in themselves the functions of capitalist, manager, and entrepreneur. For most of our entrepreneurs, belonging to that class merely by virtue of being stockholders in some industry organized as a corporation, enjoy neither power nor prestige. Under the corporate organization of industry, salaried officials are the ones who wield power and the social position of capitalists (bond-holders) is surely as good as that of stockholders, assuming their investments to be equal. But, if there is any large section of the entrepreneur class with whom these non-economic motives would not suffice, XL1] PROFITS 497 who would insist on a greater economic return for taking responsi- bility than for simply lending their capital then, profits would surely have to be paid. Pure Risk Not Desired. The third consideration, the gambler's desire to take risks contains the old confusion of ideas which has already been commented on more than once. It is un- doubtedly true that men are so ready to take risks, when a possible prize is in sight, that they do not as a whole class have to be remu- nerated for taking that risk. If all the copper producers of the world spend 500 million dollars worth of labor and capital getting out the product, it is not necessary that the product should be worth 500 millions plus something for the risks taken. On the contrary, that product will probably be worth less than its labor and capital cost, say 400 millions. But all this is beside the point. The real issue concerns, not the whole class of entrepreneurs interested, but only those upon whose conduct depends the output actually supplied, the successful entrepreneurs. Do these persons have to get profits? Surely they do, else there would not be this gambler's eagerness to assume the risks of the business. The proper test for determining whether profits as a remuneration for risk-taking really exist, is this : Does society have to pay a higher price for a given commodity or service than it would have to pay if risk were eliminated ? Surely there can be but one answer to that question, the affirmative one. Ill Profits as Affected by Changes in the Value of Money In an earlier discussion, it was shown that the value of money itself may change, and so general changes in prices may take place without reference to the conditions ordinarily governing the value of each commodity. Thus, under the paper money standard of Civil War times, there was a general rise of prices, or, in other words, a fall in the value of money, in the United States. So, for many years following 1873 there was a general, though gradual, fall in prices, a rise in the value of money, affecting most or all of the western nations. Much more rapid ups and downs mark the 498 PRINCIPLES OF ECONOMICS [XLI periods immediately preceding or following commercial crises or panics. Common Fallacy. There has naturally been much debate as to how far such movements influence all shares in distribution and particularly profits. At first thought one is inclined to say that of course such changes influence profits. If a merchant has paid $100,000 for a stock of goods and because of a universal and simul- taneous fall in prices, their value declines to $60,000, how can anyone deny that the merchant is losing $40,000? This sounds plausible, but is in fact an undoubted fallacy. A universal and simultaneous fall in prices of 40 per cent raises the buying power of $60,000 till it is just as great as was the value of $100,000. Assuming, then, that no other element was involved, the merchant in question would neither gain nor lose as a result of the general fall in prices. That fall in prices does not of itself mean a fall in profits. Borrowed Capital. The above affirmation was qualified by the assumption that no other element was involved. But in actual life this condition is seldom fulfilled. In the first place, the merchant is usually carrying on his business in greater or smaller measure with borrowed capital. But the sum which he has promised to pay when borrowing does not change because the value of money has changed. If he is using $20,000 of borrowed capital, he will have to pay back, not three-fifths of that sum $12,000 but the whole $20,000. His debt has not shrunk though the value of his goods has. To pay his debt he will need so much of his goods as are now worth $20,000, which means so much of those goods as were worth five- thirds of $20,000, or $33,000. Hence he has lost the difference be- tween $20,000 and $33,000, or $13,000. It follows that, in so far as the dealer works upon borrowed capital, a change in the value of money causes an inverse change in his profits : If the value of money rises he loses proportionately, and if that value falls he gains pro- portionately. Unequal Rate of Price Changes. Another element in this situation which compels a qualification of our original statement is XLI] PROFITS 499 that general price movements do not take place at an equal rate all along the line. Some goods rise or fall more rapidly and more promptly than others. In particular, wages do not change as rapidly as general goods. It follows that a rise in prices, a fall in the value of money is likely to redound to the advantage of the dealer, in that he gets a larger return from the sale of his goods while his expenses for labor have not proportionately increased. And of course a reversal of the situation, that is, a general fall in prices, an increase in the value of money, works to the disadvantage of the dealer for precisely opposite reasons. IV Profits and the Significance-Disutility Principle The attempt to establish the validity of our significance-disutility principle for each of the economic shares meets the greatest difficulty in the case of profits. As already explained, we mean by profits proper the return going to the man who takes the responsibility of ownership. We usually distinguish several different sorts, the nature of which is perhaps sufficiently indicated by their names. The most important are : ordinary, enterprise, speculative, monopoly, and acci- dental profits. Profits and Significance. One has no difficulty showing that profits are in some sense or degree correlated to a service ren- dered, a significance in economic relations belonging to the part per- formed by the receiver of the profits. Further, profits are undoubt- edly in some sense or degree proportioned to the significance or magnitude of the service rendered. Thus, all must admit that those persons who initiate a commercially dubious, but socially important, enterprise perform a greater service than those who carry on the same in later years when success is assured ; and, undoubtedly, the profits must commonly be larger for the former persons than for the latter. But, admitting a rough correspondence between profits and the service rendered, it does not seem possible to affirm quite the same degree of correspondence as in the case of wages, interest, and rent. 500 PRINCIPLES OF ECONOMICS [XLI Where profits are accidental, the correspondence between services rendered and reward received is of course slight. Such profits do not tend to express the marginal significance of the receiver's con- tribution. Monopoly profits doubtless correspond rather closely to the marginal significance of the supply of service actually rendered, but not to the marginal significance of the supply of service which would naturally be rendered. The monopolist, by limiting the output of his product, raises its marginal utility, and so its price, above the mar- ginal utility which the product would naturally have. In doing this, he obviously raises his own profits above the amount which would express the marginal utility of his services, were no limitations set on their output. One qualification must, however, be added. The monopoly which temporarily exists may have been anticipated, and may have been one of the necessary conditions which induced capitalists to under- take the industry in question. Hence we may say that the monopo- listic output is after all the natural one and so that monopoly profit comes fully under the service-value principle. Cases of this sort are supplied by the legal monopoly of patents, copyrights and franchises, and by the quasi-monopoly of new enterprises. Here the extra profit does not correspond merely to the higher valuation by supra-marginal buyers of the service rendered, but also to the additional service. For, surely, there is an additional service when men undertake to try out the feasibility of a new enterprise, giving the public an opportunity to see the real utility of the service or commodity which the enterprise supplies. Yet in spite of this qualification of our first statement, economists are not generally disposed to affirm the service-value principle for monopoly. The presence of monopoly at any point more or less seriously interferes with the realization of the principle. Hence, assuming for the moment that the principle is a good one in an economic order, then monopoly, if necessary or permitted, ought to be regulated or controlled in the public interest. The argument for enterprise profits has been more or less antici- pated in the preceding paragraphs. Such profits somewhat resemble prizes. Many persons get nothing ; a few get large rewards. Under XLI] PROFITS 501 these conditions, we can scarcely expect profits to express with great precision the contribution of the profit-receiver. Yet we should not, on the other hand, imagine that the two are entirely divorced. Op- portunities for exploiting novel enterprises are constantly arising; competition for such opportunities is kept fairly brisk; the goods produced must command prices expressing their marginal utility ; the marginal contributions of the other factors are at the same time being more or less fully determined in other fields ; and it seems not unreasonable to assume that the residuum of product which consti- tutes profits is properly credited to the entrepreneur as his con- tribution. That ordinary profits, if they exist at all, tend to express the marginal significance of the entrepreneur's contribution, seems to need no further discussion. Here the elements of change and un- certainty are reduced to a minimum; so. that the economic processes which tend automatically to secure each factor a share representing its contribution to the joint product, meet little hindrance. Profits and Disutility. We have seen that the significance half of our principle does not very clearly dominate profits. How about the disutility part? It seems plain that disutility would have little influence on accidental or monopoly profits. Ordinary profits, however, it would seem, must express with fair precision the mar- ginal disutility of supplying the entrepreneur service. First, the demand of the public must insure for a product a price high enough to cover the disutility undergone by the entrepreneur ; since other- wise production will cease, supply will fall off, and so price will rise. Second, the competition of entrepreneurs will keep price from going higher than the above point ; since their numbers can be recruited at all times from those capitalists who merely furnish waiting power, who lend their capital rather than invest it. In the case of enterprise profits, also, correspondence between the disutility and its reward seems necessary from the same reasoning, though here the correspondence is less precise. The objection is sometimes raised that there is too much chance in these cases to insure any particular result. Thus the price of a product may fail to cover, not only the peculiar disutility of the entrepreneur, but even 502 PRINCIPLES OF ECONOMICS [XL1 the ordinary outlay for material, wages, and capital ; while on the other hand, it may cover all that outlay and give a surplus large enough to insure almost any conceivable risk several times over. This reasoning quite fails to recognize the real nature of the re- sponsibility-taking disutility. It consists, not of a chance of loss to be covered by insurance, but of a chance of loss not to be covered at all. To induce men to incur that disutility, a prize or bonus, of larger or smaller magnitude, must be attainable in the event of success. The size of that bonus is roughly proportioned to the risk, though the unit of variation is very different for different races; and, having been fixed, it must be covered in the price of the product. ILLUSTRATIVE PROBLEMS 1. "Profits are the wages of management." Criticize. What is the test of whether any particular function is an entrepreneur's function whether it is something for which profits are paid? What in the nature of the corporation as a form of business association makes "management" particularly inapt as a description of the peculiar function of the entre- preneur? 2. "Profits constitute nothing more than an insurance fund to cover the possible losses of the entrepreneur." Criticize. CHAPTER XLII CRITIQUE OF EXISTING SYSTEM : INTRODUCTORY A Critique of the Existing Order a Legitimate Task of Economic Science In the opinion of not a few persons, we have now reached the end of our proper task ; we have covered the whole field which can be legitimately included in a purely scientific study of Economics, the analysis of the existing economic order in respect to structure and functions. To go further and undertake to pass judgment on the satisfactoriness of the existing order, seems to these persons a plain transcending of our proper sphere. The title of the present chapter shows that the writer does not share that opinion. I consider it a very important part of the economist's task to study the present order in respect to its fitness or unfitness to realize the ends for which it must be presumed to exist. Argument. My principal reasons for holding this opinion are as follows : First, in dealing with the existing economic order, a^ with any structure to which the term "organism" can be applied, thj most strictly scientific study one which has no other end than a really adequate knowledge of the facts cannot properly omit a consideration of the fitness of the several organs to perform wel. their respective functions. What physiologist, after determining the function of some bodily organ, would consider his task completed until he had made an attempt to learn the degree of efficiency at- tained by the organ in performing its function? But the study of the working fitness or unfitness of the present economic organism has another and more practical justification. That organism, in both structure and function, is to a considerable 503 504 PRINCIPLES OF ECONOMICS [XLII extent the product of consciously free arrangement. At many points, it is what it is because we make it so. Doubtless, this aspect of the matter can easily be exaggerated; the power of individuals or of society as a whole to alter the system in fundamentals can be, and commonly is, overstated. But, so long as this power exists in even a small degree, the student of economics is surely called upon to consider the fitness of the system, as at present constituted, to attain its proper ends. For where he finds it fit, he will wish to exert his power in support of it, and where he finds it unfit, he will wish to have it changed. Rival Candidates for the Task. It may be objected that, while we have here a problem which imperatively calls for solution, the task is after all one which does not properly fall to the economist. The solution, of course, requires economic data; but the problem itself is essentially an ethical or political one. Logical consistency, therefore, requires that the economist, while furnishing the needed data from his own science, should leave the problem as a whole to the men who can claim to be authorities in ethics or politics. There is no doubt some force in this contention; but it does not seem de- cisive. First, we must always remember that there is a degree of deference to logical consistency which spells pedantry rather than any practical good. Secondly, there are many problems in which elements from different fields of study are closely commingled ; and a person who undertakes to solve these problems must weigh and pass upon the elements from every field. This means that such person must transcend in some measure the strict boundaries of his subject. But, if none of the persons interested can make an abso- lutely legitimate claim to the task, it would seem reasonable to turn it over to that particular one whose science furnishes the larger number and the more difficult of the data necessary to a solution. In the case before us, this condition is most certainly realized by economics. Superior Claims of Economics. Economics, then, would seem to be the science which would naturally essay the task of ascer- taining how far the present economic order is fitted to attain the XLII] CRITIQUE OF EXISTING SYSTEM 505 ends for which it must be presumed to exist. We do not mean to suggest that moralists, sociologists, ct al., should be stopped from discussing this subject, but merely that economists can also discuss it, and perhaps with more propriety than any other group of thinkers. In further support of this contention we may remark that such prac- tice is, on the whole, in accord with the best traditions of our science. Economists of standing, whatever their initial professions, have rarely failed to comment upon the workings of our system from the teleological standpoint and even to argue for or against proposed changes. And it is probable that the instructed public give more weight to the verdicts of economists regarding such matters than to those of any other class. II The Question at Issue In the preliminary account with which this course began, the existing order was represented as a coherent, rational whole, a system having different parts devoted to different functions, all co- ordinated into a great harmonious totality. At the same time, we saw that the organizing and regulating of this great totality was not conscious, but spontaneous, automatic; and that the particular eco- nomic process having most part in creating the great whole and regulating its operations, is exchange, and especially that element in exchange which we know as value, price. We explained, further, that it is price chiefly which determines what things shall be pro- duced, how things, when produced, shall be utilized, and what pro- portion of the total product shall fall to the different participants in socialized production. In the present and succeeding chapters we try to answer, not exhaustively, but with greater fulness than here- tofore, the question : How far is this automatically regulated economic system a suc- cess in attaining the ends for zvhich it exists? Does it accomplish in a fairly adequate manner its special task: namely, providing for the satisfaction of human wants in so far as this is dependent on economic goods? 506 PRINCIPLES OF ECONOMICS [XLII III Verdict of This Text Favorable. In view of the tone of many previous allusions to this question, it is hardly necessary to say that the answer here offered is on the whole an affirmative one. Broadly speaking, we look on the existing economic order as measurably realizing the ideals which, considering the limitations of human nature, it is reasonable to demand from such a system. Disclaimer. But in taking this position we wish to disclaim in the most emphatic language any intention of representing the present order as a perfect one, either theoretically or practically. Its ideals are below the highest, though necessarily so as we think ; and its practice is at many points far below its ideals. Many of its failures grow out of the limitations of human nature ; but not a few are needless can be avoided. Increased interference with the actual working of things, both through private and governmental initiative if for no other purpose than to eliminate elements which are, and always have been, inconsistent with the system is impera- tively demanded. Further, there can be no doubt that a degree of governmental interference going much beyond this, and limiting sharply the free working of those conditions which are most char- acteristic of the present order, ought to be, and will be, forthcoming in the near future. Whether in the interest of society as a whole or of those individuals on whom the existing system presses too hardly, we shall doubtless see a more extensive resort to governmental initiative, a greater limitation of the rights of property, a further restricting of the rights of inheritance and bequest, a distribution of tax burdens far more favorable to the poor, public provision for old age pensions, and so on. System in Main Outlines Satisfactory. In a word, when we defend the existing order we merely mean to affirm that that order is in its main outlines substantially sound, fitted to attain the reasonable ends for which such an order exists. Looked at broadly, XLII] CRITIQUE OF EXISTING SYSTEM 507 it shows itself to be highly efficient and as much in accord with our moral ideals as we could expect in view of human weakness, folly, and wickedness. The general plan of exchange-cooperation, in- volving private rather than public initiative, characterized by private property in capital and, for most purposes, in land, with production, consumption, and distribution regulated in general through a price resulting from free economic action, is more likely than any funda- mentally different scheme to work in a measurably satisfactory fashion. Increased regulation and a more liberal admixture of socialistic elements may improve things ; but the general system, the main framework, is sound and, as human affairs go, fairly adequate. IV Distribution Logical Starting Point of Critique What Wants Constitute the Economic End? In attempting to answer the general question concerning the satisfactoriness of the existing order, we begin a critique of that order in respect to distribution. The reason for this should readily be understood. Men's wants lie at the root of any economic order; and, presum- ably, the satisfaction of men's wants is the object of such an order. The ultimate test of an order, therefore, must be its success in satisfying these wants. But the phrase "men's wants" is ambiguous. Not all wants, surely, can be satisfied. As between lesser and greater wants, in the case of the individual, the satisfaction of the latter must take precedence. As between different individuals, we might set up any one of many standards. Thus, we might rate the importance of wants according to their absolute magnitude, sup- posing it possible to ascertain this. That is, we might treat any want, whether that of a person contributing much to the general advantage or contributing little, as having an importance exactly proportioned to its intensity. Again, we might recognize the total wants of every person as having equal importance with the total wants of every other person. Still again, we might treat the wants of different persons as having very different degrees of importance, according as the part played by these persons in economic matters is of little or of great importance. And many other standards mighf 508 PRINCIPLES OF ECONOMICS [XLH be imagined, determining just what are the wants which we have in mind when we declare that the end of economic action is the satis- faction of "men's wants." Function of Distribution to Answer. But, not only is the phrase "men's wants" an ambiguous one, needing definition before we can proceed to pass judgment on the fitness of an economic order to accomplish its task providing for the satisfaction of those wants, the process by which this defining is done, the process by which society determines what are the "men's wants" that should be satisfied, belongs to that part of economics which we have called distribution. We could, indeed, conceive an economic order in which the state directly determined the importance of different wants and directly provided for their satisfaction in accord with that determination. Such a system has been tried more or less ade- quately at different times, and is usually designated communism. It is more or less fully illustrated in the life of the family. But the present economic order, as also the much-advocated system of socialism, solves the problem by authorizing a system giving to each individual a certain money income which he uses to buy the commodities or services which constitute his real income. In doing this, the state determines the relative importance of the total wants of each individual over against other individuals and leaves the determination of the importance of the different wants of the in- dividual to be settled according to his own ratings. Hence Distribution Our Starting Point. But, if the good- ness of an economic order must be judged by its fitness to secure the fullest possible satisfaction, in their proper proportion, of that body of wants which society has decided are the ones that ought to be satisfied, and, if such deciding by society is effected by maintaining a particular system of distribution, it follows that said system is the necessary starting point of any critique of the economic order in question. Once we have determined whether the system of distri- bution is or is not reasonable, the rest of our task is comparatively easy. The remaining parts of the economic order are good or bad according as they do or do not contribute to the realization of the XLII] CRITIQUE OF EXISTING SYSTEM 509 ends implicitly approved in the system of distribution, according, in short, as they are or are not consistent with, complemental to, the system of distribution.' 1 Qualifications. This broad statement of the matter doubt- less needs various qualifications. Certain public or group wants are not provided for in the system of distribution, at least as we have treated it. But this qualification is manifest ; and the state has no difficulty making its wants supersede all others, either by coming on the market with a buying power vastly exceeding that of any individual, or by the exercise of its absolute sovereign authority. Another qualification is needed because the government, believ- ing that it is desirable to modify in some particular the working of the system of distribution and despairing of being able to do this by direct means, may make use of its power to guide the employ- ment of social resources in order to accomplish its object by indirec- tion. Thus, as was noted quite early in our study, a characteristic feature of the present order, in its actual working, is the govern- mental practice of producing certain necessaries and supplying them to the public either gratuitously or at a> price below what would be possible under private initiative. In spite, however, of these and other possible qualifications, the soundness of the general proposition laid down above is incon- testable. The system of distribution prevailing at any moment must be interpreted as embodying the decision of society in respect to the body of wants to be satisfied through the working of the economic order, and therefore embodying the decision of society as to what are the true social wants arranged in the order of their importance. If following the guidance derived from this system of distribution results in what seeme, on other grounds, to be a wrong use of our resources, this must be viewed as an indictment, not of the process whereby production is regulated, but rather of the system of dis- tribution which society has authorized. If amendment is needed, 1 This argument, when combined with that of the present and follow- ing chapters defending the present system of distribution, has been objected to on the ground that it involves circular reasoning. This objection will be commented on in Chapter XLVI. 510 PRINCIPLES OF ECONOMICS [XLII that amendment should, with few exceptions, be directed to the alteration of the source of the trouble, the system of distribution itself. Accordingly, our critique of the present economic order be- gins with a consideration of the reasonableness of the system of distribution embodied in that order. CHAPTER XLIII CRITIQUE OF PRESENT PRINCIPLE OF DISTRIBU- TION The general principle underlying the present system of distribu- tion, it will be recalled, runs somewhat as follows : When competition is free, each individual tends to get approxi- mately that income which expresses the marginal significance of the natural supply of the type of contribution made by himself or his property to the sum of utilities, and which, at the same time, ex- presses approximately the net marginal disutility involved in making that contribution. Is this principle, on the whole, wise and just? No adequate answer to this question can be made without con- trasting the principle to be judged with possible substitutes. It will perhaps be best, therefore, to begin our critique by examining some of the more plausible substitutes that have been suggested, reviewing their merits, and, if such exist, their logical and practical defects. Proposed Substitutes To Each According to His Need. One principle of dis- tribution often highly commended is that which we try to realize in family life, as also in the life of the state during periods of greatest social exaltation. I mean the principle that each shall receive of the common income in proportion to his need, having given in propor- tion to his capacity. This seems to have been, and to be still the formula of the highest type of communism. "From each according to his capacity; to each according to his need." To the present writer there seems no room for argument as to the ethical superiority of this distributive ideal over all others. If 5" 512 PRINCIPLES OF ECONOMICS [XLIII human nature were capable of maintaining it, no other formula would deserve a moment's consideration. But unfortunately there is reason, and perhaps quite conclusive reason, to doubt the suffi- ciency of human nature in this regard. Even those few hundreds of people who succeed in living somewhat near such an ideal in Amana and other communistic associations admit that their very limited success is made possible only because of certain intense religious sentiments which are common to all the members. And no one seriously believes that uniform sentiments of this kind exist, or can ever possibly exist, in more than a small minority of the hundred millions of men, women, and children who constitute the population of the United States. Labor Ideal. Another ideal which seems to have been more or less consciously held by many socialists of the earlier type, is that each person should share in the joint income in proportion to his labor. This of course can be differently interpreted. One may have in mind the sacrifice made or the results accomplished. And he may conceive the sacrifice as measured in a subjective standard or as measured in an objective 'one, like time. In general, the socialists seem to have had in mind primarily the sacrifice of labor as measured by the time spent in applying it. Yet they tried to avoid divorcing this completely from results, by in- sisting that the labor must be labor which produced things, and standardized labor at that, labor which in the given place and time was "socially necessary" to accomplish the result. Marx 1 further conceded that we could not treat all kinds of labor as exactly the same, though he would not admit qualitative differences. The labor of the artist and that of the mechanic must be treated as differing in intensity, or density, so to speak. That is, one hour of the artist's labor should be reckoned as the equivalent of, say, three of the mechanic's. The labor ideal as thus interpreted, though not without points of merit, has fundamental defects which render it unworthy of ex- tended discussion. Any scheme of distribution which can reason- 1 The most eminent of the theorists who laid the foundations of socialism. XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 513 ably ask for society's favor must in serious measure make economic reward conditioned upon economic significance, must make differ- ences of economic reward correlative to differences in economic significance. This Marx tacitly admits by refusing to reward labor which produces nothing useful, and by insisting that all labor must be standardized, reduced to "socially necessary labor." But differ- ences in the economic significance of the several kinds of labor often show no correspondence either to labor time or to labor intensity. It is therefore quite out of the question that labor as measured in labor time, even when corrected for intensity, should be accepted as the principle of distribution, Social Service Ideal. Another conceivable ideal of distribu- tion, more or less definitely held by many intelligent people, may be called the social service ideal. This idea differs from the one em- bodied in the present order in that, under the latter, each person receives a price which expresses the significance of his services to individuals graded according to the buying power they possess; while, under the social-service principle, a man would be paid ac- cording to the significance of his services to the group as a whole or to all individuals without any reference to their wealth or poverty. This ideal has at the first hearing an extremely plausible sound. There" is something particularly obnoxious in the fact that, under the present system, the power to furnish services of a very trivial sort, or even services highly immoral in their character, enables the owner to command a large income, because persons desiring such services chance to possess great buying power. It would seem much more equitable that one's income should depend upon the services of real worth which he renders direct to the humanity which is in all men alike, or to the worthiest needs and demands of the entire social group. But further examination shows this principle to be seriously deficient. First, in so far as it concerns the group as a whole, the new principle is already contained in the one which governs our present system. The group is fully organized and, through the use of the sovereign power of taxation, can insure that group wants are satisfied at whatever cost, can see in other words, that men are paid 514 PRINCIPLES OF ECONOMICS [XLIII in accord with the importance of the service they render to the group. Secondly, the proposed ideal, as applied to individuals, is self- contradictory. For a principle of distribution simply cannot pay according to the importance of the service rendered without paying according to the importance of the service to individuals graded according to buying power. ( i ) Since men are to be paid in accord with services rendered, they are to be paid unequally. (2) This means that the effective demand for commodities and services will be unequally distributed. (3) But the distribution of effective de- mand will necessarily determine in what proportions people will actually consume goods. (4) But the only importance which can signify anything is importance to actual consumers. (5) It follows, therefore, that to pay for services according to their importance to individuals without discrimination as to wealth or poverty, is to pay for those services in accord with their importance to persons who do not get them at all, a process which really amounts to paying for services without regard to their importance. Equality Ideal. The last ideal of distribution which we shall here discuss is that of equality. To each an equal share, but from all, service, is its motto. This is the more usual communistic ideal, and it is apparently favored by many socialists. Nor can we wonder at its popularity, for^there is indeed much to be said in its support. The greatest discomfort from poverty not the absolute want of the poor, but their contrast with more favored neighbors, would, under such a principle, be overcome. Further, equality would not fail to bring a degree of satisfaction to many people, those who descended as well as those who rose, even if the equality were one but little removed from misery. But, after all, this principle is quite impracticable. Equality in income, though serving well various sentimental considerations, would sacrifice to these the real, material welfare of all classes. Further, it would not even embody the ethical ideals which dominate practically the whole community. For, however people may feel toward interest, rent, and profits, they almost universally believe that wages and salaries ought to bear some relation to service. XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 5^ Need for Inequality. But the subject is too important to be so lightly disposed of. Are we right in saying that an attempt to enforce complete equality would sacrifice the real material welfare of all classes to mere sentimental considerations? In support of this view, there are three chief sets of facts. Efficiency in Important Functions. In the first place, giving some persons larger incomes than the rest of us may be directly required in the interests of the rest of us, in that the larger incomes are necessary to enable those persons to perform efficiently the im- portant tasks we have assigned them. Thus no thoughtful person would contend that the people of the United States could afford to have their chief executive live on $1,000 a year, even if he were perfectly willing to do so. To perform at all well his services to the people of the nation, he must spend, on matters more or less per- sonal in their nature, many times $1,000. What is true of the presi- dent of a great republic is true in only lesser degree of hundreds of other men. In fact, if we sufficiently narrow the circle of interested persons, it is true in a way for almost every male citizen. To the other members of his family, it is more important that the bread- winner, though the humblest of day-laborers, should be well fed than that the rest should be, because only so can he be fit to earn the income on which they all depend. But, of course, the point is more forcefully illustrated in the greater relations of society. To those men whose functions involve large responsibilities, intense mental activity, and great* nerve strain, we must, for our own sakes, give large incomes, in 'order that they may prove resolute, clear- sighted, well-poised, and in other respects fitted for their great tasks. The objector may say that we really have here a case not of better income, but rather of collateral expenses. Needs of this kind should be provided for as part of the outlay of the office which the man holds. If $1,000 is the best income the community can afford its members, the president, as a man must be satisfied with that in- come; though on his office we may spend $100,000. Doubtless some- thing, perhaps much, could be done along this line ; the writer heart- ily believes in employing such a policy wherever possible. But the whole difficulty could not be met in this way. A need is often so 5 i6 PRINCIPLES OF ECONOMICS [XLIII personal, so individual, in character that it cannot be provided for save through a fund placed at the disposal of the person interested. One person requires one sort of relaxation, perhaps a very inex- pensive one; another requires a very different sort, perhaps a very costly one. Further, the employing public (under socialism), whose opinion is greatly influenced by persons not in a position to judge of the personal needs attaching to the higher social functions, would commonly underrate those needs, as is shown in the niggardly sal- aries now paid public officials in democracies. In consequence, pro- vision for this kind of need, if made in a formal sort of way, would probably be far too small. Proper Assignment of Factors: Disutility. The preceding paragraph has named one reason why inequality of incomes is neces- sary in the interest of the very persons whose apparent incomes would be raised by the abolition of that inequality. A second is found in the fact that unless incomes are unequal, they will not even approximately express the relative sacrifices which men un- dergo in contributing different services, and, so will induce an over- supply of services which involve small sacrifices and an undersupply of the opposite kind. This difficulty has always been recognized by the creators of Utopias; and to meet it a great variety of ingenious schemes have been devised. Thus, some writers have proposed that conscripts from all classes should have to serve a certain length of time in objectionable trades. Others have reserved these occupations for the convicts. More, recently, we have had -much stress laid on (i) variations in the length of the labor day and (2) honor rewards. An undesirable occupation might be made less unattractive by reducing the day from 6 hours to 4, or 3. So, attractiveness might be given the occupation by attaching thereto decorations and official rank. Now, it seems highly improbable that these devices should have anything like the effectiveness which is anticipated from them. The honor device, especially, overlooks the fact that hc&iors, to be effec- tive as a stimulus to emulation, must not be too commonly employed. Gaining a prize is not worth while, if almost all the contestants gain prizes. Being a member of an academy which everyone can join XLIIIJ CRITIQUE OF DISTRIBUTIVE PRINCIPLE 5I7 by paying $5, will attract people only so long as they are ignorant of the facts. But, whether these schemes are practicable or not, there can be no doubt that they are inconsistent with real equality. Why do I object to my neighbor's having a better income than I, supposing mine to be enough for a decent life? Mainly, it is because the spectacle of his enjoying advantages which I cannot enjoy de- tracts from my peace of mind. Now, what matter as to the source of these advantages? To see him watching the great national game, or comfortably lying in the shade, while I toil and sweat in the sun, would surely awake in me an unpleasant sense of contrast if these privileges were granted him as a direct reward for accepting some task, just as truly as they now do, when they come as an indirect reward for that same service. So, again, one of the greatest objec- tions to the inequality of the present order is that it gives to the men of larger incomes a higher place in the estimation of their fellows, better social standing. Will this deeper sort of inequality be any less obnoxious when it is directly created than when, as at present, it is the indirect result of inequality in money income? Proper Assignment of Factors: Significance.- There is still a third reason and this is the weightiest of all why people gen- erally, considered as consumers, must in their own interest prefer that some other persons should receive better incomes than them- selves. There must be inequality of incomes, some contributions must command much higher prices than other contributions, because only in this way can it be made certain that society will make the best use of its resources, its productive capacities. In an earlier discussion it was shown that, in a world like ours where different kinds of primary factors, limited in amount and capacity, enter in different proportions into the production of differ- ent commodities, each of those kinds of factors unit have its own special significance or importance as determined by its contribution to the production of goods. Further, under the present system of free private initiative and exchange, insuring that each factor has a price which expresses approximately its true significance is accom- plished automatically. Now, by some process or other, the same task must be performed under any system of economic organization 518 PRINCIPLES OF ECONOMICS [XLIII communism, socialism, or what not. For,, otherwise, we could have no assurance that we were making the best use of our capacities. Proper Valuation of Services Necessary. First, the mere assigning to things of their proper prices would be necessary under socialism no less than under the present order, a& a part of the public system of bookkeeping. For, if the state were to become the sole landlord, capitalist, and entrepreneur, it would be obliged to carry on an elaborate and complete system of bookkeeping in order to have at hand the knowledge of conditions necessary to a reasonable conduct of economic affairs ; and, in this bookkeeping, the state would need to credit each primary factor with the true significance of that fac- tor, since, otherwise, it would frequently waste important factors on unimportant commodities. In short, whether or not men were actually to receive unequal incomes, they -would have to be credited with unequal contributions. Corresponding Income Probably Necessary. But when each person has been credited with the true value of his contribution, can it be doubted that, under any system which is in the remotest degree practicable, that value, or something approximating it, would have to be paid to the man who made the contribution ? We say "under any system which is in the remotest degree practicable"; for one might admit that a despotically organized communism, effecting and regulating cooperation through authority, could "exploit the work- ers" to use a socialist phrase could give equal remuneration for very unequal services. But surely no communistic plan yet proposed is to be taken seriously. We need, therefore, to consider only socialism. Would that system of economic organization be driven to pay men in proportion to their contribution? True Under Socialism. The answer is surely an affirmative one. We could, indeed, conceive a socialist state which at first thought would seem able to avoid the necessity of adjusting reward to contribution ; I mean a state conterminous with the earth and organized as a completely centralized despotism. Such a state might XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE seem to be emancipated from all necessity for paying its workers according to any standard other than its own will, because competi- tion would have been completely eliminated. As a matter of fact, however, I doubt if even this vast despotism would be able to exploit the capable in the way supposed, and that for two reasons: (i) the capable would probably be in power, and (2) whether or not, they would know their own importance and, by a refusal to work for less, would compel the authorities to raise their pay till it approximated the real value of their services. But it surely is wasting time to build upon the fantastic assumption of a cooperative commonwealth coextensive with the earth and organized as a completely centralized despotism. If we ever have a collectivist state, it will be one among many sovereign states, and one in which local autonomy, municipal and provincial, still exists. It will, therefore, be a state in which competition still exists. Different municipalities, different common- wealths, different sovereign states will more or less vie with each other in trying to attain the highest efficiency, and so will drive one another into paying the persons who supply the different kinds of productive services something like what those services are worth. But, in doing this, they will of course make the shares of these per- sons in the social income unequal. In short, while inequalfties in distribution need not always be so great as they are today, while they would be much reduced under a socialist regime and no doubt will be much reduced under the present regime still, inequality of some degree is inevitable. The ideal which would give to each citizen an equal share with every other is quite out of the question. The remuneration received by each must bear some relation to his contribution. Summary. Finally, as a general result of the discussion in this entire chapter, what do we have? We have examined all the chief substitutes for the existing principle of distribution that have been proposed ; and while we have found them commendable in many respects, and especially as regards their humanitarian purpose or intent, we have also found them one and all, on the whole, im- practicable, it is doubtful whether, for the present at least, they can be established. This being true, it is virtually certain that the 520 PRINCIPLES OF ECONOMICS [XLIII existing principle, with possible modifications, will for some time be continued. It therefore becomes of the first importance to determine whether that principle, since it needs must be endured, is any more defensible than these others. To that task we shall turn in the fol- lowing chapter. II Defense of Service-Value Principle We have tried to prepare the way for a defense of the existing system of distribution, especially in respect to its general principle or ideal, by showing the impracticability of the ideals which have been proposed as substitutes for the one dominating the present order. We now undertake a brief defense of the general principle of the existing system, leaving to the succeeding chapter a defense of the more prominent features of the system of distribution that appear in the working out of its principle. Service-Value Principle Necessary. That, under any social order which retained any degree of individual liberty and local self-government, the acceptance of the service-value principle or ideal would be practically necessary in the interest of mere economic efficiency, has already been established* in showing the impossi- bility of the equality of the ideal. Even under socialism, we should be driven to pay men for their services in substantial accord with the effective importance or value of those services; for only so could we assure the assignment of those services to their proper tasks. We shall now comment briefly on special objections to the dominance of this principle. Generic versus Specific Utility. There appears among many people a disposition to criticize the ruling principle of distri- bution because it pays men in accord with their effective or specific utility rather than their generic or class utility. Thus, the utility of coal miners as a class is surely far greater than that of high-grade singers as a class ; but society pays a miner for an hour's work, per- haps, 40 cents, while it pays the singer for an hour's work, perhaps, $2,000. This objection always arouses a sympathetic response in the popular mind ; but to the student who has acquired a fuller compre^ XLIII] CRITIQUE OF DISTRIBUTIVE PRINCIPLE 521 hension of economic relations, it is quite without point. A person who puts forward this objection really admits by implication that it is right to have men paid in accord with the importance of their services; he only complains that we set the wrong standard for judg- ing importance. But his complaint is of course a mistaken one. The real importance of any man is his effective importance, what we should lose if we lost him, not what we should lose if we lost his whole class. For usually the alternative facing us is, not keeping or losing the whole class, but keeping or losing an individual of the class. And what we lose by losing any individual of a class is only the utility of the least useful of the class, since the loss of any higher utility would be avoided by transferring the least important member of the class from his present task to the higher one. One's Own versus Marginal Utility. Another familiar ob- jection to the service-value principle is that it pays a man, not in accord with his o*wn specific utility, but in accord with the utility of the marginal member of his class. Thus, a man may be performing some service for which his employer is glad to pay him, and does pay him, $2 a day ; when, without any fault on his part, an increased supply of labor comes on the market and lowers the marginal utility of his class to $1.50 per day, with the final result that, though still performing the $2 service, he now gets only $1.50. Viewed from this man's standpoint the situation naturally makes a powerful appeal to one's sympathies. But what about the incoming man? He surely cannot be paid more than the $1.50 which he really earns. But, if the first man continues to get $2, while this second one who is working just as hard and is perfectly able to replace the former gets only $1.50, our sense of justice would be outraged just as much as in the former case. But, again, the objection is quite untenable logically. As we said above, if a man is to be paid in accord with his importance at all, the importance in question must be his real, effective importance. But the real, effective importance of a man is determined, not by the importance of the thing he accomplishes, but by the importance of the thing which the marginal member of his class accomplishes, 522 PRINCIPLES OF ECONOMICS [XLIII Justice versus Mere Economic Value. Probably the mis- giving which most persistently recurs to all of us concerning the service-value principle, is that to defend or even patiently accept it one must be somehow too cold-blooded, too insensible to considera- tions of sympathy, humanity, love of one's fellows. When one is exercising his logical faculties on mere abstractions or is dealing with mere things, he can recognize the working of an inflexible scientific principle without a qualm. But here the interests at stake are the incomes and, therefore, the happiness of living human beings. Is there not something inherently shocking to our moral sense, even to our sense of mere decency, in the advocacy or adoption of a principle which places interests like these at the mercy of so unmoral a thing as the law of supply and demand, or the law of marginal utility? Does not every right-minded man respond with full ap- proval to the belief expressed by Mill that a time will come when the division of society's product, instead of being a matter of automatic, mechanical, regulation, "would be made by concert on an acknowl- edged principle of justice?" In fact, is not this whole attitude of mind which conceives human beings as mere instruments, mere things, inherently wrong? Must we not rather at all times con- ceive human beings as ends in themselves? Now there is surely some force in all this. We saw in the pre- ceding chapter that it is at least possible to imagine a principle dif- ferent from, and higher than, the one now operative. We believe also that the working of the principle in the actual order can be greatly improved by changes which would better satisfy the de- mands of moral and humanitarian sentiment above alluded to. And we believe that its worst tendencies could be, and are, not a little offset by a secondary distribution through voluntary benevolence and the use of the taxing power, all this in obedience to the same moral and humanitarian sentiment. But, when all is said and done, we can only imagine a radically different system not really estab- lish it. We can only modify the working of the present principle, not overthrow it; we have no choice but to submit to the principle as it is. Whether the principle shocks our sentiments or not, there- fore, the least we can do as scientific students is frankly to recog- nize its reality. XLIII] CRITIQUE. OF DISTRIBUTIVE PRINCIPLE 523 But in fact there is no good reason why the existing principle of distribution should offend our moral sentiments. Rather, the contrary. If the service-value principle is the only one which can sustain society from falling into the poverty and misery of com- munism, then it would not be difficult to make out a case showing the principle to be positively humanitarian. Nor need we, in the second place, feel too keen a response to the notion that it is wrong ever to conceive of human beings as functioning in some relations like mere instruments or things. There is nothing per se unworthy or degrading in taking one's turn at being a mere thing in economic society. Doubtless we all ought to have our opportunity to live for living's sake, to be ends rather than means. But this is perfectly consistent with our being, much of the time, mere means to an end. Further, it is quite easy to overstate the case. Men are prone to overemphasize their right to be "ends in themselves." Most men of mature years have learned that, in the long run, scarcely anything is really worth while, even from the purely selfish standpoint, except to set oneself a suitable task and endeavor conscientiously to perform it. 1 1 By a curious inconsistency, people who emphasize this objection seem to have no sensitiveness on the matter, provided the station in -which one serves as a mere means is sufficiently dignified. We hear nothing in this vein when they are speaking of doctors, lawyers, professors, politicians, and others of the higher classes of workers, though of course these persons are, on the professional side, mere instruments, mere things, just as truly as the common laborer. CHAPTER XLIV THE PROPERTY INCOMES INDESTRUCTIBLE In the preceding chapter we defended the general principle or ideal of distribution embodied in the present system, as being necessary to social welfare, and, on the whole, reasonable and just. But this leaves much of our task unaccomplished. The service- value principle might be all right, abstractedly considered ; but it can be realised only under a concrete set of conditions. It must work itself out through definite institutions, legal prescriptions, customs, economic laws, and so on. As thus working itself out, is it de- fensible? The conditions in question, as we know, are very numer- ous and complex. To cover the whole matter thoroughly is of course quite beyond us. We must content ourselves with some consideration of the most important points. Primary economic distribution, as we have seen, depends chiefly on the kinds of shares or sources of income which are permitted and the natural laws determining the volume of these shares. The former of these two conditions depends largely on what kinds of property are permitted: especially whether private persons may or may not own capital or land. The latter is the general principle of distribution we have already considered. We shall consider mainly the legitimacy of the shares or sources of income by which primary distribution is determined, more especially the three property incomes. As preliminary to the defense of the existing system, I propose to use the present chapter to show that the three incomes in question are indestructible. They cannot be eliminated ; and they must af- fect the distribution of the total social income whether we believe in them or not. We may alter their destination, but we cannot annihilate them. In making the argument for this point, I shall assume the existence of a socialist order; since, if these incomes 524 XLIV] PROPERTY INCOMES INDESTRUCTIBLE 525 are bound to exist under such an order, few will doubt the propo- sition that they will continue under any order. We will first take up the case of rent. I The Maintenance of Rent Inevitable That rent would necessarily continue to exist under any eco- nomic order, supposing the condition necessary to create it the inadequacy of the land to meet the need for it to continue, is a proposition from which there is little, if any, dissent. Economists are apparently agreed on the point ; and even the reformers who deny the legitimacy of a system which permits private persons to appropriate this income, usually admit that it must exist, though they would transfer it from private landowners to the state. The reason for this unanimity is plain. Rent is a surplus arising, not through any act of man, but through the fact that the natural amount of land and its capacity to assist in the production of commodities is so limited as compared with the demand for those commodities that the latter necessarily have a value greater than their costs other than rent, and so a surplus is created. By no conceivable process can that surplus be destroyed, though, of course, its destination can be altered. Objection. But it is possible that someone might be in- clined to demur from this matter-of-course settlement of the ques- tion. "Whatever may be the ultimate condition necessary to create rent," the objector may say, "the condition immediately nec- essary is the existence of high prices for land products, prices higher than costs of production on the rent-bearing lands. But, under socialism, prices are things to be fixed by the government. Would it not be possible, therefore, for government to destroy rent by so changing the prices of land products as to destroy the sur- plus from which it springs? Thus, if the government were to fix for each parcel of wheat a price exactly equal to the cost of that parcel, instead of having just one price high enough to equal the marginal or greatest cost, there would be no surplus and so no rent," 526 PRINCIPLES OF ECONOMICS [XLIV Answer. This sounds well ; but it will not hold. The pro- posed policy would not destroy the surplus, but merely transfer it from the landlord under socialism, the state to consumers of those parcels of wheat which were raised on better lands. 1 If the marginal portion of the wheat crop costs $2 and continues to be produced and sold, it must be worth $2. But, if the marginal portion is worth $2, the other portions must also be worth $2, even those which cost only 50 cents a bushel. .Hence, the government which should charge a price of 50 cents for wheat which cost only 50 cents, would, in effect, make to the buyer of that wheat a present of $1.50, that is, would make him a present of the rent on the land from which his wheat came. There can be no doubt, then, as to the soundness of the common doctrine that rent must exist under any economic order as cm income divided in some way among the citizens. 2 II The Continued Existence of Interest Inevitable The contention that, under socialism and so under any system, interest must continue to exist as an income to be enjoyed by some person or persons, this contention has not been so generally ac- cepted as the analogous one with respect to rent; but it seems no less certainly true. Interest represents a real advantage, a real service, derived from the power to wait, which advantage or service has marginal significance or importance because the supply is not sufficient to satisfy all needs for this service, and, having marginal significance, therefore has value. This being true, only those products which had a marginal significance great enough to justify their having a value which included an allowance for interest the 1 The share going to each of these consumers would, of course, vary with the goodness of the particular piece of land on which their parcel of wheat was raised. a Most advocates of socialism would probably favor maintaining one price for wheat and having the state absorb the resulting rent. It is not unlikely, however, that a socialist government, which would almost of necessity be democratic, would manipulate prices somewhat in order to show special favor to the consumers having smaller incomes, supposing such a state to permit income differences. XLIV] PROPERTY INCOMES INDESTRUCTIBLE 527 value of waiting could legitimately be produced. That is, so long as the condition causing interest the inadequacy of the supply of waiting-power to satisfy all the need for that waiting power con- tinued to exist, 3 interest would continue to exist. It might be hidden, it might be consciously transferred from the owner of the waiting power to some one else, it might be ignored; but it could not be eliminated. Some person or persons would necessarily en- joy it. But possibly someone might bring forward an objection analo- gous to that remarked on in the case of rent. If interest under socialism would be implicit in the prices of commodities, could not the government destroy it altogether through its control over the fixing of prices? Thus, if the prices of products were lowered so as to cover only the costs other than interest there would be none of this interest implicit in prices. Quite true, but not germane. It would not be in the price, but it would still be in the value. Consumers would enjoy advantages for which they had not paid, that is, they would be the recipients of the particular income under consideration, interest. Further, the plan would involve much dis- crimination in the way in which this income was distributed among consumers. Those persons calling for goods in the production of which waiting plays a large part would get the lion's share of the interest income, the rest would get little or none. Thus, the plan proposed for eliminating interest would merely transfer it from the state to specially favored consumers. Ill The Maintenance of Profit Inevitable That profit must continue to exist under any economic order is somewhat less certain than the analogous proposition with respect to rent and interest. Some types of profit now familiar would 3 We are not here concerned with the question whether the situation which now insures the existence of interest would continue, but whether, even with that situation continuing, interest would necessarily continue, whether, in other words, interest could be eliminated by some arbitrary change in the system or in its management? The answer is an emphatic negative. PRINCIPLES OF ECONOMICS [XLIV probably disappear altogether. Further, the most important con- stituent of profit, the one growing out of risk, would be greatly diminished in amount, and what remained would in large measure be transformed into other types of income. As a result, the total of what may be called profit in the strict sense would be much di- minished. Nevertheless, the share now called profit would have its counterpart even under socialism, and, though a portion of this would be transformed into other types of income, there wottld remain a portion which retained its own distinctive character. The argument for this contention is substantially the same as in the preceding cases. Profit corresponds to a service which must be performed if production is to go on at all. If we are to have meat or clothes or shelter, someone must assume the responsibility of producing these, must use up his goods in the venture, accept- ing, in place of those goods, the resulting product. This function might be performed by the government, as under socialism, instead of by private persons, as at present. But performed by someone it must be. Further, the power to perform this function must ob- viously depend on the possession of surplus wealth, capital, and so must be limited in amount. No one surely would claim that our wealth could ever be so great that we could afford to undertake the production of anything men might desire, however great the risks of failure. There would always be wants clamoring for at- tention, provision for which would be impossible because, with our limited resources, we could not afford to take the chances. That is, the power to assume the responsibility of production would have extra-marginal significance and so would have value. In con- sequence, if the production of one of two given commodities in- volved greater risk than the other, though their costs in other items were the same, the one to which the greater risk attached would need to have more value than the other to justify its pro- duction instead of the other. In other words, there must be an element in the value of any product corresponding to, representing, the risk taken in its production. That element is the real profit, implicit profit we may call it. As a real value the presence of which is made necessary by the conditions of the case, its elimina- tion is impossible, if production is conducted as it should be, though XLIV] PROPERTY INCOMES INDESTRUCTIBLE 529 its destination can be changed. Thus, as in previous cases, we might omit from the selling price of a given commodity the part which would correspond to the profit element just described, and it seems probable that many advocates of socialism would favor such a procedure. In doing this, however, we should not be de- stroying profit, but only making a present of that profit to the consumers of the particular product in question. The above argument shows that, even under socialism, there would necessarily exist an income corresponding in a general way to what is profit in the present order. Under socialism, however, as was indicated at the outset, a considerable portion of this par- ticular income would naturally be transformed into the other types previously considered, namely : wages, rent, and interest. The reason is as follows: Since, under socialism, the state would be the sole entrepreneur, all losses of whatever character would im- mediately fall on the state. That is, the existence of such losses would merely mean that the total outlay of the sole producer in carrying on the industries of the community his outlay in labor, natural resources, and waiting-power had been made just so much greater than it would have been if the losses had not occurred. Doubtless, there would necessarily be a value, and so an income, representing this excess of cost. But such value and such income would be assignable, not to some new type of income, but to one or more of those previously considered : wages, rent, or interest. We have argued in the last paragraph that, though the income which now appears as profit would largely survive under socialism, it would after all survive, not as a distinct type, but rather as an addition to wages, rent, and interest. . To this, however, it ought to be added that there would probably remain under socialism a residuum of profit in the strict sense, an income not capable of as- signment to one of the other three. The reason for this is that, in the long run, the socialist state would insist on making a charge for products sufficiently in excess of probable losses to insure com- ing out even ; and, in doing this, the state would take to itself a type of income closely analogous to pure profit under the present regime, and one which could not be brought under any or all of the three other types. CHAPTER XLV THE PROPERTY INCOMES AS INCOMES OF PRIVATE OWNERS It has been shown in the preceding chapter that rent, interest, and even profit, in some degree, are bound to be present under any economic order as incomes enjoyed by someone. This quite ob- viously does not prove that they can legitimately be assigned to the classes of persons now receiving them. It does not even con- tribute any definite argument in support of such a contention. Nevertheless, the time spent establishing this point does not seem to me to have been wasted. In the first place, this aspect of the matter greatly impairs the force of a certain method of attacking the legitimacy of the present assignment of the incomes in question which has had much vogue in our day. That method consists in representing all economic institutions and arrangements as tempo- rary, provisional, almost accidental. Capital itself, and of course the incomes springing from it, are "historic categories." That is, they have no roots in the very nature of things they have not always existed they are the product of special, social, or legal arrangements. Such an account of the matter does not, of course, really constitute an argument against the present treatment of these incomes ; but it has a sort of dissolving effect on the con- victions which have been held on these points. If capital, interest, and profit are categories representing things altogether temporary, things invented and established by man, it is very easy to slip into the notion that the particular disposition of these which obtains in the present order has no presumption in its favor, that such dis- position is purely artificial and arbitrary, can be swept away with- out hesitation as having no claim to serious consideration. Against such a dissolving doctrine, this text has tried to guard the student from the very outset. There is nothing or next to nothing in it. 530 XLV] INCOMES OF PRIVATE OWNERS 531 Capital is not a historic category; interest is not; profit is not. With scarcely a shade of exaggeration, we may say that there never was a time in the history of civilization when they did not all exist. They have their roots in the very nature of things, not in the artificial enactments of men. Any weakening in our support of the present system derived from the opposite notion is unjustified. A second advantage to be derived from the establishing of the doctrine that the three property incomes are indestructible, cannot be eliminated, though their destination can be altered, is that it isolates sharply the real issue before us, that is, the question whether or not tne private appropriation of these incomes is legitimate. That question we must now attempt to answer. Doctrine Here Maintained. The conclusion on this point reached in the following discussion is on the whole favorable to the present order. In maintaining that position, however, I wish to disclaim most emphatically any intention of affirming that the present assignment of the incomes in question is the only reasonable or just one. There is no room for doubt that, if society should come to believe it expedient to abolish private ownership in land and capital, and so to abolish the private appropriation of the in- comes derivable from these sources, it would be entirely justified in carrying out such a policy. There are no private claims so sacred that they can stand against the claims of the general wel- fare. Again, I wish to disclaim any intention of affirming that all of the three property incomes and all types of each are equally defensible. It is easier to maintain the legitimacy of some than that of others. It would be easier to make a case for giving these incomes to the state in some cases than in others. In contrast with the more extreme claims for the present order which are sometimes made, what we here contend for is merely this : The present as- signnent of the incomes in question is not inherently unreasonable or unjust: the not uncommon contention of even moderate advocates of reform that the private appropriation of any income not derived directly from personal exertion is something very like robbery, thor- oughly wrong under any condition, this contention is entirely un- sound. 532 PRINCIPLES OF ECONOMICS [XLV It may perhaps seem that a defense of the present order which contends for no more than the proposition just laid down, would scarcely be worth while. If it be admitted that the state can with- out injustice take from private persons the right to receive the incomes in question, we may be quite sure, the objector might say, that would-be reformers would in time persuade themselves that there is ample reason for adopting such a policy. Personally, I am not in accord with this view. It has always seemed to me that the strength of the socialist movement largely consists in the ac- ceptance of a grossly unfair indictment of the present order. Men honestly believe that, from the very nature of present arrangements, the capitalist, however honest or benevolent, cannot help exploiting, or robbing, labor. The acceptance of such a doctrine makes the masses "see red." Convince them that it is an erroneous doctrine, and you will have done much toward eliminating their desire for a new regime. In any case, you will have diminished the intensity of the emotional forces working for the movement, and will have thereby contributed toward a more temperate and reasonable altera- tion of the existing order, if altered it must be. Criteria for Passing Judgment on the Legitimacy of a Particular Assignment of the Property Incomes In passing judgment on the legitimacy or reasonableness of any social institution or policy, it is obviously necessary to have in mind some standards or criteria of such legitimacy. Doubtless there is room for difference of opinion as to the true criteria for the case before us; but I shall assume with little argument that the follow- ing propositions are fairly adequate. (1) In determining the proper destination of so much of the value income as expresses the contribution of a given factor, there is a presumption in favor of the person responsible for the exist- ence of such factor, when such person exists. (2) When no person is responsible for the existence of a given factor, for example, in the case of the factors commonly covered by the designation, land, the presumption is in favor of men gener- ally, or the community as a whole. XLV] INCOMES OF PRIVATE OWNERS (3) The valid claim of any person can be completely alienated by that person and completely acquired by another person through an act of exchange, sale and purchase, it being assumed that said exchange was on equitable terms approved by the state. Thus, if a person catches a hundred fish, his claim to property in those fish because he caught them ceases to have any validity after he has sold them. (4) The state, as the guardian of the welfare of all and hold- ing in trust the residual claims of all which grow out of the contri- butions to production derived from factors not appropriable or not appropriated, for example, the fund of accumulated knowledge, the protection of government, etc., has the power and right to confirm, limit, or cancel all presumptive claims as may seem wise, and the power to alienate its own claims. Thus, if it seems on the whole best, the state can without injustice abolish the right of private persons to receive the interest income, even though it be admitted that such destination of interest has presumption on its side. On the other hand, granting that the state, as representing men in general, has the best presumptive claim to the rent income, still the state can, without wrong, alienate that income to private per- sons, if there seem to be adequate grounds in expediency for such procedure. Defense of These Criteria. Since the acceptance of these propositions would render needless any prolonged consideration of the reasonableness of the individual incomes, we must take a moment to comment upon them. The first would probably lead to little controversy, being a widely accepted doctrine of very an- cient origin, and one favored by the opponents of the present or- der, as well as its supporters. As to its general validity, there would seem to be no serious reason for doubt. To have been responsible for producing a thing, if it does not create an absolute claim to the services or contributions of that thing, must certainly create a presumptive claim of this character. The second proposition would seem equally certain. Doubtless man's need is, in some sense, the most ultimate ground of the right of property in things. But this ground : .s common to all men 534 PRINCIPLES OF ECONOMICS [XLV placed in the same situation ; and, in the absence of any presump- tion in favor of special persons, the state, as representing all, could surely set up the best claim. The third proposition is too evident to need argument. To have produced a thing could not continue to be a valid ground for claiming property in that thing after k had been relinquished in legitimate exchange. Controversy might always arise as to whether the price paid in the exchange had been a fair one; but this is a matter for regulation by itself. It ought not to be confused with the question of title to the thing sold. The fourth proposition would not receive so ready assent as the third. In fact, it would doubtless meet opposition from both con- servatives and radicals. The former would deny that the state can legitimately limit certain fundamental property rights at all, for example, the right of capitalists to control entirely the disposal of their capital. Radicals, on the other hand, would deny that the state could ever legitimately alienate its property rights in land and natural resources. Nevertheless, the proposition, as originally laid down, seems a necessary foundation for any adequate social order. It must always be the right and duty of the state to establish and maintain such social and economic arrangements as seem necessary to secure the best results for society as a whole. If, then, the state becomes convinced that, however natural and reasonable it may be to permit private property in capital and the private appropria- tion of the income thereof, yet, everything taken into account, such a system works much more evil than good, the state must surely be bound to abolish that system, in spite of the presumptions in its favor. 1 On the other hand, if the state becomes convinced that the best good of all demands the alienation of its claims on natural resources to private persons, such action is surely within its sov- ereign prerogatives and duties. 1 The. right of private persons to use any wealth to which they have a valid claim, in initiating and guiding industrial activities, is surely no mqre reasonable on its face than the right of the same persons to use that wealth in buying such consumption goods as they may desire. Yet practically no publicist of standing would deny that it is within the prerogatives of the state to limit the latter right, and, in some cases, to abolish it altogether. XLV1 INCOMES OF PRIVATE OWNERS 535 II The Legitimacy of a System Which Permits the Capital Incomes to Be Appropriated by Private Persons In view of the preceding discussions, little more seems needed to establish the proposition that there is nothing inherently un- reasonable in the present destination of the capital incomes, that is, their being appropriated by private persons; that, on the contrary, such destination has in its favor a most evident presumption. Cap- ital as capital the power to wait and to assume the responsibility of production is a product and one for the existence of which private persons are commonly responsible. In order that it should come into existence, someone must produce an income and, through saving from that income, accumulate a surplus. Nor is this rea- soning invalidated by the consideration that the particular person now enjoying its incomes obtained that capital through fraud or violence or inheritance. Such considerations are beside the issue. We are here concerned only with the reasonableness of the capital incomes per se. In affirming that the private destination of these incomes has a presumption in its favor, because the person receiv- ing those incomes produced the capital from which they spring, we are not called on to defend such a destination of profit and in- terest, when admittedly this reason was not present. Of course, no one contends that a man who has obtained capital through fraud or violence ought to be permitted the enjoyment of its incomes. As to whether there can be any legitimate bequest or inheritance, opin- ion is not unanimous. But, in any case, the matter does not con- cern us. In the typical case, the capitalist is responsible for the existence of the capital ; and the presumption is that, because of that fact, he has a right to its ffuits. The Laborer's Claim. But the opponents of private profit and interest would not be content without setting up some other claimant over against the capitalist himself. A fairly complete enumeration of possibilities would perhaps give us three, as fol- lows : (i) the laborer who works with, utilizes, the capital in 536 PRINCIPLES OF ECONOMICS [XLV question, (2) the consumer of the particular commodities in the production of which the capital in question is utilized, and (3) the citizen or member of society in general. The first of these, as everyone knows, is the favorite claimant. The basis of his claim is the doctrine that laborers only contribute to the production of commodities. I trust we may safely assume that this doctrine has been completely disposed of in preceding discussions. Capital as capital, not merely capital as the embodiment of previous labor and other factors, is a real factor in production, makes a contribution of its own to the total result ; and the importance of this contribution is more or less fully expressed in the price paid therefor. The laborers who have been engaged in utilizing said capital did not make the contribution in question, and have no more claim on the incomes expressing the importance of that contribution than have any other members of the community. The Consumer's Claim. The case against the second claim- ant, the consumer of the particular commodity, in the production of which the capital was utilized is equally plain. As was ex- plained on page 527, such destination of the capital incomes could be brought about by omitting these elements from our cost calcu- lations when deciding what price should be charged for any given product. But against such a policy two strong objections would present themselves. First, there is nothing whatever in the status of the consumer as such on which to base a claim to these shares. On the contrary, the very nature of his position naturally calls on him to pay rather than receive. He enjoys the utilities derivable from the product; he should fully make good its costs. In the second place, distributing the incomes in question to consumers by omitting profit and interest from prices would necessarily involve a wholly baseless discrimination among consumers. For waiting and risk enter into the production of different commodities in quite different proportions, and these commodities enter into the con- sumption of different citizens in quite different proportions; hence, some persons would be large consumers of products costing much waiting and risk, and so would gain much from the generosity of XLV] INCOMES OF PRIVATE OWNERS 537 the state, while others would consume but little of such commodi- ties, and so would be small gainers from this policy. The Citizen's Claim. There, then, remains only the third possible rival to the capitalist as the legitimate claimant of interest and profit, that is, the citizen in general. As against the claims of either of the other two rival claimants, this one of the citizen in general is surely the best. The claims of the laborer and consumer have no foundation ; for that of the citizen in general, some very slight basis may be discovered. The citizen in general is the residuary legatee of all rights, advantages, for which a truly legiti- mate claimant cannot be found ; for he stands for humanity in general, is the inheritor of the knowledge and skill brought down from the past, and the maintainer of the political and legal institu- tions essential to all economic life. Nevertheless, it is surely little short of absurd to argue that the claim to the capital incomes set up by the mere citizen who has had no share in producing that capital is as good as that of those persons who are just as much citizens as himself and, in addition, have really produced the capital. Surely the claims of the latter have a strong presumption in their favor, though, as so often admitted, they may be overridden by weighty considerations of public advantage. ILLUSTRATIVE PROBLEM The medieval church attempted to eliminate completely the taking of interest, but thought it right for capitalists to gain a profit from the con- duct of business enterprises. Can you see any reason why the case for profit would seem to be better than that for interest? Ill The Legitimacy of Rent as a Private Income It is manifest that the right to receive rent, the income which represents the marginal importance of the contribution made by the land, cannot be defended on the ground brought forward in the case of the capitalistic incomes, the ground, namely, that the receivers of the income in question are responsible for the existence 538 PRINCIPLES OF ECONOMICS [XLV of the source from which that income springs; for, broadly speak- ing, land is not producible. Again, this fact that land is not pro- ducible means that the presumptive title to this factor belongs to the community, the state. It follows that private persons can ob- tain a valid title, if at all, only through the grant of the state. The real question, therefore, is this : Can the state legitimately alienate its title to the land, or, anyhow, its title to the income of the land? An affirmative answer to this question seems inevitable. Alienation and Social Expediency. First, it is scarcely to be doubted that the state could make such renunciation of its rights on non-economic grounds, grounds of political or social expediency. Thus, it may be argued that an almost indispensable means for insuring stability in the social order is the presence of a consider- able class rendered peculiarly interested in the maintenance o such stability, and peculiarly likely to develop the habits and dis- positions which render it well fitted to maintain that stability; and that one of the best methods of developing such a class is to es- tablish a system of private property in lands used for farming purposes. Such an opinion has long been held and has long in- fluenced powerfully the action of governments. Whether sound or not, this opinion would seem to justify the corresponding action on the part of the state ; for the state has no choice except to act in accord with its best judgment in trying to secure the best good of all. ILLUSTRATIVE PROBLEM The policy pursued by the leaders who reorganized society after the dissolution of Roman political civilization of making huge grants of land to their chief subordinates doubtless contained the seeds of many abuses. Nevertheless, much is to be said in favor of the legitimacy, almost the necessity, of instituting such a policy. Defend the latter statement. Alienation and Economic Services. But, again, it seems plain that the state could legitimately renounce its natural right to the land and its income, in return for economic advantages or services which, in the opinion of the public, were worth the price. XLV] INCOMES OF PRIVATE OWNERS One of the most familiar and universal cases of this kind is fur- nished by the practice prevalent in all ages of granting a more or less complete property right in land to persons who opened up, cleared, or otherwise brought into a productive state lands hitherto unused. Scarcely distinguishable from this case is one which arises when governments make grants of lands in order to develop the country as a whole, swell its population, expand the market for the manufacturing and commercial industries of the older parts of the country, and so on. Alienation and Efficiency. Another case of alienating the nation's property in the land in exchange for supposed economic advantages appears when land is granted to private persons in or- der to secure the highest efficiency in its utilization. This has played no inconsiderable part in initiating and maintaining the right of private property in this fundamental factor of production. Ex- perience is believed to have shown that, in farming, ownership will yield far better results than any sort of tenancy. In this connection, it is interesting to note that advocates of socialism have in later years felt almost obliged to hint at excepting agriculture from their system of universal undertaking by the government. 2 This notion that the private control of the land, on the whole, works for su- perior efficiency, has been brought forward even in the case of lands used as sites for the manufacturing and commercial industries. Not a few advocates of a single tax on land have given up the plan of making this tax cover the whole rent, on the ground that this policy would lead owners to relinquish their rights to the public, a result which would substitute expensive and inefficient public man- agement of these sites for a private one which is fairly free from these defects. Alienation and Capital Burdens. A final, and even more strictly economic, advantage of turning the land of the community over to private ownership is found in the fact that thereby the public 3 It was reported this winter (1921) that the communistic government of Russia had decided to release the peasantry in large measure from the operation of their system. 540 PRINCIPLES OF ECONOMICS [XLV escapes various burdens incident to occupying the position of land- owner. It has already been fully explained that the price-making forces give to a non-producible income-bearer such as land a price equal to the capitalization of its income. It follows that every per- son owning a piece of income-bearing land must consciously keep invested in that land a sum of general value equal to the amount which at current rates of interest would yield an income equal to the one given off by said land. In doing this, he necessarily makes two sacrifices : ( i ) foregoing the present control and use of the amount invested, and (2) taking the risk that, through the decline in the income of said land, he will suffer more or less loss on the capital sum. In the language of the business world, the land has to be "carried." Now the bearing of these two burdens of ownership would doubtless be less onerous to the socialist state than it is at present to private owners. But it could not help being present, par- ticularly the first of these. Circumstances might easily arise under which it would be greatly to the advantage of the state, or anyhow would be so considered, to exchange the right to receive an endless series of small future incomes for the right to have now a lump sum equal to, say, twenty times one of those small incomes. That, under such circumstances, the state would be justified in relinquish- ing to private persons the right which naturally belongs to it as the representative of men generally seems incontestable. Such a con- clusion follows inevitably from any doctrine of sovereignty: the state has the right to do, ought to do, whatever it believes to be on the whole most conducive to the general good. Considerations of Equity. As a final comment of some weight in the situation, we may call attention to a fact implicit in what was just said with respect to the capitalization of the income of the land. This process means that the rent is in effect trans- formed into interest and profit, quasi-interest and quasi-profit. When a system of private property in land has been maintained for any considerable time, persons can put themselves into the position of rent-receivers only by parting with an amount of money capitr 1 equal to the value of the property in question. It follows that, from the standpoint of abstract justice, if only these persons are XLV] INCOMES OF PRIVATE OWNERS 54! taken into account, the rent received is as truly justified as interest and profit received from any ordinary capital. The public interest may sometimes require a complete disregard of the claims thus created. But this is true of all rights. Until such a situation arises, the presumption holds that what the citizen has obtained through exchange for an equivalent sum of general wealth he has a valid right to enjoy. IV Further Modifying Conditions of Actual Life In the preceding defense of the existing system of distribution, we began by arguing for the general reasonableness of the principle which is supposed to be realized more or less fully in that system, that is, the principle that each tends to get an income correspond- ing to the social value of his services his contribution to our eco- nomic life. We next undertook to maintain the thesis that said principle is still reasonable even under the specific conditions which enter into the actual economic order. In doing this, however, we have merely taken into account one set of conditions, namely, that legal system which permits private property in land and capital arid so recognizes the contribution of these factors as being virtu- ally contributions of private persons, and which, therefore, recog- nizes rent, interest, and profits as legitimate sources of private income. If we were trying to make a truly complete critique of the ex- isting system of distribution, we should be compelled to test the legitimacy of our service-value principle in the presence, of many other modifying conditions. To carry out this test, however, would take us far beyond the scope of the present volume. We shall therefore content ourselves with mentioning some of these condi- tions, without attempting more than the briefest comment. Defects of Human Nature. In the present chapter we have merely attempted to argue for the general, abstract legitimacy of interest, profits, and rent as private shares, haznng no regard to the weaknesses of human nature, Taking those well known weak- 542 PRINCIPLES OF ECONOMICS [XLV nesses into account, can the shares named still legitimately go to private persons ? We recognize this question as a really serious one. We see much force in the contention that, however reasonable it may be on general principles to permit the private ownership of capital and land and the private undertaking of industry, the evils which inevitably results from such a policy in the actual working of things make its continuance impossible of justification. Still, in view of the great superiority, in other respects, of private, to public, ownership, and in view of the fact that its worst evils can be gradually removed without overturning the system, we believe that the system of private ownership should be maintained. At the same time, however, regulation of private initiative should un- doubtedly be carried much further than it has been, limitations of the property right should be increased, and at some points, how many and what only experience will show, public ownership and initiative should be substituted for private. Rights of Inheritance and Bequest. A second supplemental question of much importance is whether the present system is justi- fied in permitting private individuals to acquire possessions through inheritance or bequest. Personally, I am disposed to answer this question in the affirmative but only with very emphatic qualifica- tions. I would greatly reduce these rights both directly by legisla- tion and indirectly by a taxation which, for the excess of larger estates over a certain minimum, would amount to practical con- fiscation. Social Opportunities. Still another question is whether law should permit private persons to enjoy the extraordinary profits which flow from the exploitation of natural resources, public fran- chises, consolidations, etc. We can only say in this limited space that such permission is of very doubtful justice, and should at least be carefully guarded. Secondary Distribution. Finally, how far can society afford to modify the primary distribution of property and income through a secondary distribution effected by taxation? It would seem XLV] INCOMES OF PRIVATE OWNERS 543 that, if the dominance of the present principle of distribution to each in accord with the value of his service is necessary to insure the proper conduct of economic affairs, we should spoil everything by arbitrarily contravening the working of that principle, even though we do this after distribution in accord with the principle has once been effected. For what interest would a man have in earning ten times as much as his fellows, if he is to be reduced to their level by taxation? Doubtless, if it were to go so far as this, he would have no interest in seeking the better income. But, on the other hand, there can be no doubt that a tax much heavier than that levied on his poorer neighbor would not influence in any material degree his economic efficiency. The whole problem is one of degrees. Its solution probably can be reached only through ex- periment, and for that we shall have to wait. ILLUSTRATIVE PROBLEM The chief justification for the retention of a system which permits private ownership in property and private receipt of property incomes is based, in the last analysis, on the ground of expediency. Such a system works fairly well. Practically, the individuals in whom are vested the legal titles to property and to the incomes derived from them, act as stewards for society in the care and utilization of these properties, and in the disposition of a large part of the incomes derived from them. Argue in support of the thesis contained in the second sentence. CRITIQUE OF THE PROCESS WHEREBY PRODUC- TION IS REGULATED The chief characteristics which we can reasonably require in a productive system are : ( I ) that the right things shall be pro- duced; (2) that the quantity of product shall be reasonably large; (3) that the quality of product shall be reasonably good; and (4) that these results shall be realized as continuously as pos- sible, in other words, that production as a whole shall be as free as possible from marked irregularities. In the present chapter we take up the first of these requirements, that the right thing shall be produced, or The Regulation of Production. It has by this time become a commonplace that, under the pres- ent order, the selection of what shall be produced is almost entirely effected through freely-determined prices. Now, as the earlier economists taught, if the present system could realize fully the con- ditions which are assumed as fundamental to it, this regulative mechanism would probably be an almost perfect one. The spon- taneous working of free competition would result in prices which would insure production of the things called for by the general advantage, the things which a wise dictator dealing with the same conditions would think it expedient to produce. Further, the earlier economists commonly believed that, even under the condi- tions actually existing, price-guided production in the main worked out results as near the ideal as could reasonably be expected. In our day, this opinion is probably still held by the majority of economists. But a not inconsiderable minority take radical ground on the other side. A few even insist in unqualified terms that there is no truth whatever in the older doctrine, that there is not even a tendency for production to follow the channels which social or general advantage would dictate. In view of this disagreement, a 544 XLVI] CRITIQUE OF PRODUCTION REGULATION careful and rather full treatment of the matter seems called for. We ask, then : Do the principles governing price promise to secure a reasonable guidance of productive activity f In answering this question, we will first comment briefly on the standard to be set up in judging whether a particular guidance of production is reason- able ; after which we will pass in review the leading principles of price, and try to determine the fitness of each to meet this test. What Is a Reasonable Regulation of Production? The answer to this question has already been made in introduc- ing our critique of Distribution in Chapter XLII. The general ob- ject of an economic order of any kind is to secure the satisfaction of human wants in so far as this depends on economic goods. Just what wants shall be included under this general category, and the comparative order of their importance as between different persons, are determined by the system of distribution. It follows that production, like all other economic processes, should be so regulated as to correspond to the system of distribution, to provide for the satisfaction of wants according to the scale which is in effect em- bodied in the system of distribution. This means that, broadly speaking, no wants are recognized as social wants except those of persons having incomes under the existing system of distribution, and that the wants of different persons have a social importance corresponding to the size of their incomes. Finally, it means that the general demand schedules made up of the different individual demand schedules, composite as they are, express the social im- portances of wants. Objections: Absolute Magnitude. The objection to this method of rating wants, that it does not rate them according to their real or absolute magnitude, has been answered directly or by implication in the argument for the general reasonableness of the present system. The social magnitude of wants is the only one in which society at large is interested ; and the social magnitude of wants is bv no means identical with their absolute magnitude. In 546 PRINCIPLES OF ECONOMICS [XLVI the spring of 1918, the wants of a French private soldier may have had as great absolute magnitude as those of Marshal Foch; but, quite obviously, they had much less social magnitude. Circular Reasoning. Another and somewhat more serious objection to the doctrine before us is that, taken as a whole, it in- volves circular reasoning. "On the one hand, letting ordinary de- mand prices mere composites of heterogeneous individual schedules represent the social importance of wants is said to be legitimate, because this is the necessary complement of the system of distribu- tion. On the other hand, the system of distribution is said to be legitimate, because it gives each person what his services are worth as indicated by the general demand schedule. The system of dis- tribution establishes the legitimacy of the demand schedules; the demand schedules establish the legitimacy of the system of dis- tribution." Now, this sounds plausible ; but it will not, after all, bear exami- nation. It would be true only on condition that all large incomes were obtained by catering to the demand of persons of large incomes only. We should then be defending the power of a particular group of persons to influence unduly the course of production, on the ground that this was the necessary complement of a system of dis- tribution which gave persons of that group large incomes because those persons supplied services which were accounted very impor- tant, because persons of that same group, having large incomes, were able to rate those services highly. But I hardly need say that no such relation exists between large incomes and their source. The great majority of persons in receipt of large incomes get those in- comes from industries which cater, not to the demands of large- income persons only, but rather to the demands of all classes. The circularity complained of is not, therefore, characteristic of the ac- cepted reasoning, but only of special cases to which that reasoning may be applied. Recapitulation. In order to emphasize the entire course of reasoning on this matter, let us recapitulate it in a series of proposi- tions as follows : XLVIJ CRITIQUE OF PRODUCTION REGULATION 547 (1) The kind of importance in respect to wants with which society is really concerned and which, in the interest of the social welfare, should be treated as the proper guide of economic action is social importance. If this is not identical with individual or abso- lute importance, the latter must yield. (2) The social importance of the wants "of different individuals depends, not primarily on the absolute magnitude of those wants, but on the relative importance of the different social ends the attain- ment of which may be conditioned on the satisfying of those wants, and the degree to which their attainment is so conditioned. 1 (3) One important way in which the attainment of social ends is conditioned on the satisfying of individual wants is found in the fact that the getting of efficient service from individuals is dependent on providing for the satisfaction of their wants in certain propor- tions. If we do not provide for their wants in these proportions, we do not get the service called for. (4) On account of the great inequalities in human capacity and the consequent inequalities in the importance of the services different men can render, it is practically indispensable that this satisfying of their wants on which their efficient service is conditioned, should have some reference to the importance of those services, and so this satisfying of wants should be unequal as between different persons. (5) Under the present system, society elects to attain the end by making the money incomes of different individuals unequal and roughly adjusted to the importance of their services, leaving those individuals themselves to put a rating on the relative importance of wants. (6) In doing this, society necessarily recognizes these indi- vidual ratings of the importance of wants as social ratings, express- ing the true, though indirect, social importance of those wants. (7) It thus follows that, broadly speaking, the demand prices of the ordinary demand schedules are, in a very real sense, expres- sions of the social importance of the wants involved. Qualifications. Having so roundly emphasized the point that the demand schedules resulting under the existing system of distri- 1 See Note 10, Appendix. 548 PRINCIPLES OF ECONOMICS [XLVI bution represent broadly comparative social wants, let me once more remind the reader that this must be qualified if it is to be an entirely true account of the matter. At several points, other indices of the true social importance of wants are needed. The state must find other criteria when the wants of the group as a whole come into conflict with those of individuals ; when the needs of future genera- tions conflict with those of the present ; and when the most funda- mental needs of many individuals are opposed to the trifling needs of the few. In short, the general position here taken, that we must accept the demand prices of individuals as indices of social impor- tance is in general perfectly sound; but, as in other cases, it is not always valid : these indices must at times give place to others better adapted for the particular case in hand. ILLUSTRATIVE PROBLEM It may be socially more important that a great executive enjov a week's outing on which he is willing to spend $1,000, than that a common laborer get a winter's supply of coal on which he can afford to spend, say, $150. Defend that statement. II Are Prices Which Are Determined Under the Law of Single Price Proper Guides of Production? Having now so definite a criterion as to what constitutes a proper regulation of production, our review of the different laws of price which participate in this process ought to prove a relatively easy task. First, then, we ask : Is the law of single price a suitable element in the mechanism which has the function of regulating economic production? The answer is surely an affirmative one. First, it is manifest on a little reflection that singleness of price is necessary to the realization of the system of distribution authorized by society. If incomes were equal, while the same goods had dif- ferent prices, the equality of incomes would be defeated by indirec- tion. One man could not get as much real income as another man though their money incomes were equal. On the other hand, if society decrees inequality of income, singleness of price is necessary XLVI] CRITIQUE OF PRODUCTION REGULATION 549 both from the standpoint of the man of small income and from that of the man of large income. If prices were lower to the rich man this would increase the inequality, make it greater than the social intention. If prices were higher to the rich man this would neu- tralize the superiority of his income. But there is another reason and if anything a more fundamental one why the law of single price is a proper element in the system guiding production. It is logically essential to having price act as a guide at all. Guidance, like sovereignty, must be indivisible. One price for each product or each factor can guide us in the production of that product or the use of that factor; but many prices for each could not guide at all. Thus, if the relation of supply and demand is such that common sand is at the margin worth 50 cents while moulding sand is worth $i, these prices can perform their function in showing us that common sand can properly be put to uses as low as 50 cents while moulding sand must be reserved for uses rated as high as $i, only on condition that the one price of common sand is 50 cents and the one price of moulding sand is $i. If at the same time common sand has prices of 50 cents, 75 cents, $i, $1.25, $1.50, and so on, we should have no guidance whatever from this source, prices would have no significance as respects the importance of the things involved. Ill Are Prices Which Are Influenced by Demand Prices and the Forces Behind Them Proper Guides of Production? We have seen that the law of single price constitutes not only a legitimate, but also a necessary, element in an economic order which entrusts the regulation of production to freely determined prices. What now is to be said of those principles zvJiich impute to demand prices and the forces behind them, significance, utility, a share in the fixing of actual prices, and therefore in the regulation of produc- tion? Do these constitute a legitimate element in the regulative mechanism ? Is it reasonable that actual prices which approximately equal demand prices, and approximately express marginal utilities or significances should participate in the guidance of production? 550 PRINCIPLES OF ECONOMICS [XLVI The Case of the Individual. In giving an affirmative answer, the majority of economists have probably had in mind the analogy of the individual guiding his own economic life in accord with his individual demand schedules. With respect to the reasonableness of his conduct in doing this, there has been no serious difference of opinion. Those schedules consist of money expressions of utility or significance for different commodities. These money expressions are fairly accurate indices of the comparative importance to the indi- vidual of the utilities in question, and so of the goods which yield the utilities. And the function of such money expressions of utilities or significances is to guide the individual in the rational utilization of his income or resources from which to secure an income. Speaking broadly, each person should, as far as possible, employ his income of purchasing power in such a way that the marginal utilities derived from equal portions of that income would be equal; and, when this is not possible, should employ said income in such a way that utilities or significances of higher rank would never be sacrificed for utilities or significances of lower rank. The practical wisdom of such a rule of conduct is plain, for it surely is the part of good sense to provide for the satisfaction of our wants in proportion to their importance. The Case of Society. Is there a true analogy between this case of the individual and that of society as a whole? Is there a rule analogous to that just laid down for the individual which can rea- sonably be applied to society as a whole? Is it reasonable that we should, generally speaking, so use our resources that marginal utilities, as these appear to be when judged by the general demand schedules, shall be substantially equal all along the line ? That such a rule for society at large actually obtains is evident enough. That is, society's use of its income or income-bearing resources is in fact guided by the market demand schedules which were studied in earlier chapters. Through the guidance of these schedules, re- sources are so employed that the marginal want satisfied in any one of many different lines is equal, when measured by the persons interested, in a unit which is at least nominally the same, to the marginal want satisfied in any other of those different lines. In other words, if we recognize demand prices as a true index of the XLVI] CRITIQUE OF PRODUCTION REGULATION 55! size of wants, then I dollar's worth of resources are used to satisfy what seem to be $i wants, not 5o-cent wants nor $2 wants. But, while such a rule does obtain for society in general, the question remains whether this rule can be interpreted and justified as the analogous rule is in the case of the individual. Are these demand prices of the general demand schedules a true index of the real social magnitude of wants ? Do they express comparative social or general importances in anything like the same way that the demand prices of the individual schedule express comparative individual im- portances? If they do, and only if they do we may say that the guidance of production effected through them in a rough way secures the gratification of wants in proportion to their importance, and is, therefore, a reasonable one. Affirmative Answer. This question has already been an- swered in the affirmative on pages 507-510. Given a system of dis- tribution approved by society (and a system of distribution cannot exist without this approval), the general demand schedules are social schedules, schedules representing social significances or importances, as these are determined by the vast complex of conditions which at any moment prevails. To this broad statement, there are several qualifications, as already brought out ; but the statement is, after all, substantially true. The objection, that, on account of the differ- ent meanings of the money measure to different persons, the prices of the general demand schedule do not represent the absolute mag- nitude of wants, has already been sufficiently answered. The rea- sonable, the proper, guide to the use of the resources belonging to a social group is not the absolute magnitude of wants but their social magnitude. Production should be so guided as to secure the greatest social, not individual, advantage. We are not, therefore, concerned with absolute magnitudes. If the objection is to be interpreted as really directed against the use of the term "utility" and the phrase "marginal utility'' in this connection, the matter, like other verbal controversies, is not of great moment. The general point, however, is important. In ac- cepting the guidance of ordinary demand schedules in the use of its resources, society, broadly speaking, insures that those resources 552 PRINCIPLES OF ECONOMICS [XLVI shall be used in a way which provides for the satisfying of wants in proportion to their social significance. IV Are Prices Which Follow Cost Proper Guides of Production? Among the most important of the principles through which prices are determined are those which affirm some kind or degree of causal connection between price and cost of production. Broadly speaking, in most cases prices have to equal marginal cost of production ; or, anyhow, the prices of different goods have to show the same ratios as their costs of production. A commodity costing twice as much as some other commodity must have a price approximately twice as high. Is such a principle as this a suitable element in the mechanism which regulates production? Does it tend to insure that our re- sources shall be most wisely utilized ? Here, again, the answer is certainly an affirmative one. Prices which have the regulating of production, which are called on to utilize our resources to the best advantage, can do this only on con- dition that they are, generally speaking, coincident with marginal cost. Correct prices, prices fitted to guide production rightly, must be adjusted, not only to demand prices and the forces behind them, but also to supply prices. If the price of any particular commodity, as compared with those of other commodities, was higher than its cost, this could be only because that price was being held up by a marginal significance or utility abnormally high as compared with that of other commodities having the same cost. But, since it is our business so to use our productive resources that a given unit of those resources yields equal or almost equal marginal utilities all along the line, the abnormally high marginal utility of our special commodity would mean that too little of our resources was being used in the production of that commodity, too much in the production of other commodities. On the other hand, if the price of any particular commodity, as compared with those of other commodities, was below its cost of production, this could be only because that price was being held down by a marginal significance or utility which was abnormally low as compared with that of other commodities having XLVI] CRITIQUE OF PRODUCTION REGULATION 553 the same cost. But, in view of our rule of equal marginal utilities, this abnormally low marginal utility of our special commodity would mean that too much of our resources was being used in its produc- tion, too little in the production of other commodities. ILLUSTRATIVE PROBLEM "Our attitude on the matter of pay to teachers is simply absurd. We pay less for this function which has such supreme importance to society than to the least skilled mechanic working in an automobile factory. But we shall be brought to our senses one of these days by learning that we simply will not be able to get teachers at the beggarly wages we pay." Of these two reasons for paying higher wages to teachers, the former is from the standpoint of economic science a worthless one; the latter a good one. Defend that statement. CHAPTER XLVII CRITIQUE OF PRODUCTION IN RESPECT TO EFFICIENCY In beginning the last chapter we said that a satisfactory economic order might reasonably be expected to produce the right things, to produce them in large quantity, to produce them of excellent quality, and to produce them without marked irregularities. We have thus far seen that the existing order, governed as it is by the laws of price, meets the first of these conditions the production of the right things reasonably well. It is the task of the present chapter to make a similar, though briefer, test of the three remaining conditions. I The Present Order and a Large Volume of Products To the question whether the present order is fitted to make the volume of products large, almost all students of our subject give a favorable answer. In general, abundance of products must depend chiefly on three conditions : ( i) a large volume of productive factors, (2) high efficiency in those factors, and- (3) most profitable utilizing of those factors. Let us consider these in order. Volume of Capital. As respects the volume of resources, no system can alter this as far as it depends upon nature. But the fac- tors dependent on human choice all forms of labor, waiting, and initiative or responsibility-taking may be supplied in small or in large volume according to conditions. As regards the second and third, the present order promises to do much better than any substi- tute ever seriously considered. A large volume of capital, which is the sole condition for an abundant supply of waiting power and the principal one for an abundant supply of initiative, is surely 554 XLVII] CRITIQUE OF PRODUCTION EFFICIENCY 555 more likely to be realized under the present order than under social- ism. With the present order, the accumulation of capital is left to private initiative, and a reward offered, in the shape of interest and profits, makes possible the attaining of a competency with its free- dom from labor. Under socialism, private capital, anyhow private interest and profits, would be eliminated. Society would, therefore, have to depend on something akin to taxation as a means for accu- mulating capital. But in a democratic state, with inequalities of income eliminated or much reduced, it is hard to believe that capital could be largely accumulated by such a method. Volume of Labor Services. Turning to the labor factor, we must admit that a socialistic order would show less difference ; but it would after all give smaller resources than the present order. One of the leading aims of socialism is to diminish individual responsi- bility in economic things. It does not, indeed, plan to go as far as communism, treating all members of the community as if they were members of one common family, insuring them a livelihood any- how. But it does propose to go a long way in this direction, to insure everyone a job and a so-called living wage, to relieve every- one of much of the anxiety which characterizes the present order. Now, this may be on the whole very desirable ; but it can scarcely fail to reduce the energy, industry, alertness, and prudence which men bring to their tasks under the present order, where the liveli- hood and the economic position of each individual are conditioned on the contribution he makes to the supposed welfare of his fellows. Efficiency. What has been said concerning the volume of the factors available applies in considerable measure to their effi- ciency. That feature of the present order which makes the share of each person dependent on his contribution as measured by others, stimulates him assuming free competition to raise the efficiency of the factor in his control as high as possible, in other words, to furnish efficient services. Finally, the system of private initiative probably promises to give greater efficiency in the utilisation of the factors ; though it is doubtless true that governmental action can contribute much at this point, particularly by the discovery of better 556 PRINCIPLES OF ECONOMICS [XLVII methods in industries where private initiative seems backward. In general, then, we may conclude that under the present order all the necessary conditions are fulfilled for securing 'a large volume of products. Objections. The above verdict is concurred in by almost all economists. Yet perhaps a moment should be given to the oppos- ing contention of certain critics that the present order is not pro- ductively successful. In support of this idea they bring forward three considerations chiefly: the wastes of competition, the idleness of the parasitic classes, and the sacrifice of utility to value. The first of these points is easily answered. There are undoubt- edly wastes in a system of free private initiative, though their amount is grossly exaggerated, but, in the opinion of the econ- omist, this so-called waste is merely the cost of a rarely efficient initiative, and a low cost at that. For all students of business or- ganization agree that the monopolistic and quasi-monopolistic busi- ness units are much less efficiently organized today than are the units exposed to free competition. Again, we cannot take more seriously the talk about the wasted productive capacities of the parasitic classes. To start with, their number is extremely small. A large proportion of the persons often designated as parasites are in fact performing functions essential to high productive efficiency. In the second place, it seems certain that, if they all were to become producers in the socialist sense, the amount they would add to the income of each person would be scarcely appreciable. Finally, the third objection of the socialist seems to economists to be a serious error. There is no doubt the possibility of a contra- diction between utility and value. One who is seeking only to increase values may find himself in a position where he would better diminish output and so diminish utilities ; and, since the immediate return to producers is a value return (purchasing power in the form of money) rather than a utility one, it naturally follows that pro- ducers may at times gain most by reducing, or at least checking, the increase of utilities. But the pursuit of such a policy is possible onlv through concert of action among producers; since values can XLVII] CRITIQUE OF PRODUCTION EFFICIENCY 557 be increased by limiting output, only provided it is the total output which is thus limited, not merely that of some producers. But concert of action among producers is in contradiction to the very essence of the present order of which untrammeled private initiative is the dominant feature. Accordingly, it is quite illegitimate to represent this order as one in which producers will inevitably seek to increase values to the neglect, or even the destruction, of utilities. Increase of values is doubtless the natural goal of the producer as producer ; but, under a regime of free competition, the only path by which that goal, generally speaking, can be attained is the increase of utilities* II The Present Order and Qualitative Excellence in Products The third requisite of an effective regulative mechanism for an economic order is fitness to insure that products should be of high quality as well as abundant in quantity. Is this requisite likely to be present in a regulative mechanism which consists of freely de- termined prices? At this point, it seems to me, our verdict cannot be so favorable. Doubtless the discriminating demands of buyers will secure high quality in some few products, through the natural competition of producers. But with the majority of products this rule will not apply. Unless government steps in to supplement the control effected by freely-determined prices, we almost everywhere meet with adulteration, poor materials, bad workmanship, etc. This might be remedied if buyers became more alert, better-informed, and more insistent with regard to their rights. But the likelihood of any such change is very remote. At many points buyers would find great difficulty fitting themselves to guard their interests even were they disposed to take the trouble ; at some others they are pretty 1 The last objection is perhaps given too little weight in view of the present trade-union policy of encouraging or requiring the limitation of output, a policy which would probably be less pronounced under socialism than it is today. Doubtless the diminution or disappearance of the open approval of soldiering would tend to result in a considerable increase in out- put. On the whole, however, I believe that this would be more than offset in a socialist order by the diminution in motive for effort due to the much less rigid connection between wage received and service rendered. 558 PRINCIPLES OF ECONOMICS [XLVII likely to be misled despite their efforts. Much evil may thus result both to individuals and the community ; so we cannot afford to leave regulation to the working of spontaneous forces. It should be added, however, that the partial failure of price control in this respect does not constitute a very serious defect in the present order, because the needed supplemental action of government is compara- tively easy to work out, as has been shown by the experience of the last sixty years in England. Ill The Present Order and Continuity of Production An economic order in which the regulative mechanism was effi- ciently operative for short periods only, being every now and then completely thrown out of gear so that a highly disordered state of things ensued, would be considered by everyone seriously de- fective, if not almost unendurable. An economic order to be really satisfactory, ought to show steadiness, regularity, dependableqess, ought to be free from all marked perturbations. Now in this respect, our system unfortunately does not work so well or we might desire. It is a familiar fact that production is subject to marked, almost violent, fluctuations, which naturally group themselves into the so- called industrial cycle; depression, recovery, increasing activity, normal activity, over-trading, crisis, collapse, depression, and so around again. The claim of the socialist that public initiative would almost, if not quite, eliminate this sort of thing is without doubt a fairly reasonable one. At all events, socialism would be certain to work better at this point than does the present system. The fact, however, is that the industrial cycle, in its serious forms, is a com- paratively modern disease, little more than a century old ; and much has already been done by our system to bring it under control. America, for reasons easy to trace, is still much subject to attack. But England, the original home of great panics, has had no serious crisis since 1866. In short, the leaders of industry are learning to control things sufficiently to safeguard this trouble or to palliate greatly its evils. Accordingly, while the present order cannot be cleared of blame, we should surely be unjustified at the present time XLVII] CRITIQUE OF PRODUCTION EFFICIENCY in pronouncing a final verdict against it on account of the defect in question. IV Conclusion We set out upon this discussion by asking whether the system of regulating production through freely determined prices works out reasonably satisfactory results. What answer may we draw from the facts presented above? We may, and apparently are compelled to draw an affirmative answer an affirmative qualified, but still an affirmative. The results are certainly below the best conceivable. Nevertheless, while great improvements are needed, are possible, and ought to be effected, we must still hold that a verdict for the substantial soundness of the system is practically inevitable. We may add that a thoroughly humane despot with power to substitute any other system thus far proposed, might very probably if he took all the facts into consideration decide that the system now opera- tive was on the whole the very best one possible. CRITIQUE OF CONSUMPTION In concluding our study, let us consider for a moment the satis- factoriness of the present order with respect to consumption. Con- sumption, sometimes treated as one of the main divisions of econom- ics, coordinate with production, exchange and distribution, has for various reasons been given little prominence in this volume. Nevertheless, our critique of the present order ought not to end without a brief comment on the way in which the price regulative feature affects consumption the use which is made of wealth and without some attempt to determine whether the result is satis- factory or the reverse. As respects the regulation of consumption, a satisfactory system needs to show three results chiefly: (i) Those natural resources which belong to society as a whole and to posterity must not be sacrificed to the selfish greed of the individual and the present; (2) the satisfaction of immediate wants must not absorb all our pro- ducing efforts to the neglect of that building of capital on which great productive efficiency depends; and (3) the best utilization of a stock of consumption products already existing should be assured. The first of these demands, we must admit at once, is very im- perfectly provided for in the present order. Under the free working of private initiative, the vast resources of a continent in lumber, coal, iron, etc., are being rapidly dissipated, and that in too large measure for the benefit of very small classes. Even the race itself has been threatened with serious deterioration through an unbridled use of liberty in the employment of women and children; so that everywhere governmental interference has proved a necessity. All this is natural enough. When we are dealing with the interests of the remoter future, it is only within quite narrow limits that we can trust the forces which ordinarily prove efficient and safe regulators 560 XLVIII] CRITIQUE OF CONSUMPTION 561 of economic action. The safeguarding of those interests is. a duty which from its very nature rests upon the group, rather than the individual. Unfortunately, the group too rarely rises above the standpoint of those individuals who are economically most powerful and greedy ; so that the duty of the group in this respect is too fre- quently neglected. Still it cannot be doubted that our only hope lies in this direction. Government must put great and rigid limitations on private initiative if the social patrimony is to be saved at all. As regards the second requisite of a system which properly regu- lates consumption that it should not permit the satisfaction of immediate wants to absorb all our productive efforts to the neglect of capital-building our present system can give an excellent account of itself, a better account, probably, than could be given by any system depending on public initiative. Capital increases at an amaz- ing pace. The increase is doubtless not a little due to a feature of the system which is, in many respects, undesirable, the extreme inequality of incomes ; for this concentrating so much in the hands of a few makes the task of saving relatively easy. But there is another explanation. The present system powerfully stimulates accumulation in that it offers to those who save, great rewards, not so much in the shape of interest, as in the shape of those profits which may be obtained by the skillful use of a small initial sum. A further reason is found in the fact that the present system supplies highly convenient and efficient machinery for assisting the process of capital-building, in the shape of savings banks, insurance com- panies, bond exchanges, and the like. The third requisite the best utilization of an already existing stock of consumption products is easily met by the present system, save under quite exceptional circumstances. It belongs to the very nature of the laws of exchange to establish a price which adjusts demand to stock : reducing demand, if stock is deficient, by raising price; increasing demand, if stock is excessive, by lowering price. But here, again, we are confronted with the "rich-man-poor-man" objection which was brought forward against the present regulation of production. "Demand," it is said, "is doubtless adjusted to stock by being cut down through higher price; but unfortunately this means that the demand of the poor is reduced while that of the rich 562 PRINCIPLES OF ECONOMICS [XLVIII remains at its old level." Now, there is doubtless some truth in this; the burden of curtailing consumption will often fall more on the poor than on the rich. Further, just as in production, circum- stances may arise where the discrepancy between the real magnitude of wants and their effective magnitude as expressed in price is so great that it becomes the duty of society to interfere with the auto- matic regulation and determine by authority the destination of its resources. Thus, when a famine of food, fuel, or other fundamental necessary threatens, it usually becomes the duty of government to intervene, even perhaps to the extent of taking upon itself the task of distributing these commodities. But, while extraordinary circumstances may arise which call for some other method of regulating consumption, the regulation by freely-determined price is on the whole fairly well adapted to most needs of human society. In the first place, it is easy to exaggerate the seriousness of the objection that in times of stock-deficiency, regulation through price throws the entire burden of curtailing con- sumption on the poor. Save with respect to a very few commodi- ties, indeed, the number of families who do not reduce consumption at all when price rises is very small, so small that its continuance of the old scale cannot materially alter the result; and here the government should, and usually does, step in and adjust the matter. In the second place the maintenance of a consumption policy which treats wants as having a social importance corresponding, not to their absolute magnitude, but rather to their apparent magnitude as expressed in the demand schedules of individuals, is a necessary complement to the system of distribution which is permitted to obtain. If incomes can legitimately be unequal, and we have argued that they really must be unequal, the needs of persons having unequal incomes, needs which are, absolutely considered, equal, must, after all, be treated as having unequal social impor- tances. For any other policy would destroy the inequality of in- comes which by hypothesis is necessary. APPENDIX . EXPLANATORY NOTES Note i A somewhat different solution of the difficulty which in the text was met by the use of the concept "capital as capital" makes the essence of capital to reside in the fund of value embodied in the goods commonly called capital. This is real capital, pure capital, value capital. In contrast, the goods are concrete capital or goods capital or capital goods. Closely allied to the last distinction is one which contrasts money capital with real or goods capital. The former is the fund of money which is accumulated and then used to purchase the goods capital ; or, better, perhaps, which is conceived as having been put into the goods capital. This in turn suggests the distinction of invested capital and free capital, a distinction which the terms suffi- ciently explain. A distinction which is sometimes useful is that between formal or money capital and real or goods capital. The former is the fund of money or bank credit which the capitalist accumulates; while the latter consists of the actual goods, the engines, machines, coal, etc., which are elsewhere produced to be bought with the money capital. This distinction emphasizes the point that the things which we are really trying to get are the engines, machines, etc., the fimd of money being only a go-between. The distinction must not however, be taken too seriously. In a very important sense, the nan who ac- cumulates the mere fund of money is responsible for tnc existence of the engines, etc. He it is who supplies the waiting power which makes possible this particular employment of our productive re- sources. Among older ways of distinguishing different forms of capital is one which contrasts fixed and circulating capital. The former is 563 564 PRINCIPLES OF ECONOMICS capital, like a tool or a machine, which gives off more than one service, while the latter is capital, such as the raw material used in making a wooden box or the coal burned in a steam engine, which does its part in a single use, gives off but one service. An interesting contrast is often drawn between specialised and general capital. Specialized capital is the kind which is fitted for one purpose only or for a very few purposes at most, for example, a planer, a copper steamer, or a printing press. Generalized capital on the other hand is something like .coal, or pig iron, or most of all, money, which can be put to any one of many uses. Most people broaden the concept of capital as "products devoted to further production," making capital synonymous with income- getting goods, or all goods which serve their owner indirectly by supplying him with other goods. If we take the word in this sense, it is necessary to recognize a distinction between social capital and private or acquisitive capital. Social capital, which is virtually the same as that discussed in the foregoing paragraphs, produces other products, and is therefore income-giving even from the social point of view. But private, or acquisitive capital for example, a gasoline launch rented to a summer resorter does not increase the total volume of goods and so is not income-bearing from the social stand- point ; it yields an income to its owner only. Some writers include under the term capital all durable products, not only those devoted to production, but those, such as a dwelling house occupied by its owner, which are devoted to consumption as well. While the older usage is preferred by most authorities, there is much to be said in favor of the new. Indeed, the emphasis we have laid on "carrying" as the distinctive mark of capital as capital makes such an extension of the field to which the term is applied almost necessary. Durable goods are, as such, goods which give off their uses on the installment plan, 1 that is, only a part of the services which they are capable of yielding can be enjoyed this year, 1921 ; we must wait for some of them till next year, for others till 1923, and so on. We can afford to resort to the use of such durable or instalment-service goods, e.g., brick houses instead 1 1 sometimes call such goods "installment-service" goods. EXPLANATORY NOTES 565 of wooden ones, only on condition that we have the necessary power to wait, to put into the house a great amount of productive resources which will in large measure yield its returns only after the lapse of a long period. A very natural extension of the term capital makes it to include such facilities and constructions as highways, canals, and bridges, which are usually maintained by the government. These things manifestly show the characteristics of being produced and devoted to further production. They are not, however, subject to private ownership, and so do not have a price ; hence they are not wealth in the usual sense, and, if capital is to be restricted to wealth in that sense these things are not capital. A natural compromise is to call them public capital. A less legitimate broadening of our term takes in the body of knowledge handed down from generation to generation which plays a very large part in economic production. In a sense, this has been and is being produced ; and it is obviously being used to assist pro- duction. It is not, however, included among the things which possess exchange value, command a price. It is not, therefore, wealth ; and, not being wealth, it can be called capital only in a figurative way. It is sometimes designated social or public capital. Finally, it is sometimes convenient to speak of personal capital, in reference to the bodily or mental capacities and aptitudes of human beings. Most economists, however, consider such language figurative. Capital is only a particular kind of wealth, or wealth looked at in a particular way. But personal capacities are not wealth because, not being transferable, they have no exchange value; and if they are not wealth, they cannot be called capital in the economic sense of the term. Note 2 In connection with the concept of "marginal product" discussed on page 131, a possible misunderstanding should be guarded against. The propriety of this designation for the addition to output conse- quent upon the addition of a unit of the changing factor is ques- tionable, but conforms to the common usage of current economic 566 PRINCIPLES OF ECONOMICS writing. In saying that, in combination n, the marginal product of the L's is 15, that is, that the 2 L's added in that combination "produce" the 30 units of additional output, we do not mean that these 2 L's are alone responsible for bringing into existence those 30 units of product. Such a contention would be absurd. When each of several factors must necessarily be present, if a given result is to be brought about, no one of them taken by itself can be physically or technically credited with the production of that result, or any assigned part of it. The whole 266 units of product resulting from combination n are produced by the union of all the N's and all the L's entering into the combination. The 2 new L's could produce nothing if the 20 N's were not present. That is, the N's are just as necessary to the production of the additional 30 units of product as the additional L's; for there is no degree in necessity. In short, it cannot be too much emphasized that there is no possi- bility of isolating any portion of the product and saying that it was produced by any particular unit or units of any of the factors in any physical sense. What, then, do we mean by crediting a particular portion of the product to a particular pair of L's ? Simply this : that, in view of all the circumstances, it is reasonable to act as if those L's were alone responsible for the added units of product. These circum- stances may arise in several different ways. One of the best cases, perhaps, is met when a particular unit of some factor, say a piece of land, is superior to other units in actual use, which, however, are so numerous that they can be ignored in economic reckoning, are in effect free goods. Since these units of the superabundant grade can be treated as non-economic factors, no part of their product, say 20 bushels per acre, will be credited to them. The farmer as a laborer, or as a laborer and capitalist, will receive the whole product. But, if a man can afford to expend his efforts getting only the 20 bushels yielded by the non-economic land, he can afford to pay some- thing for the control of a piece of land which would yield, with the same effort, 24 bushels. He can without impropriety affirm that such control would add 4 bushels to his output. He may, without being led into any practical error, conceive these 4 bushels to be the product of the land alone, though they are really no more the product EXPLANATORY NOTES 567 of the land than the other 20 bushels; and none of the 24 bushels are the product of the land any more than they are the product of the farmer. In a word, the real fact is this: from the economic standpoint, we act reasonably when we conceive that the land alone is responsible for the extra four bushels given off by this better grade of land. In the case just considered, we were enabled to ignore the share of the farmer in producing four bushels of the total product and to treat those four bushels as the special product of the land, because the maximum share going to the farmer was already determined as the product which he could get on the non-economic land. Substan- tially all that he could get beyond that he must regard as due to the special piece of land and, so doing, he can reasonably offer to pay to the owner for the privilege of using that piece of land anything less than four bushels of product. Another case wherein it is legiti- mate to ignore one of the factors and treat a particular part of the product as due exclusively to the other factor, arises when for any reason such other factor is conceived by the producer as fixed in amount. Thus we might suppose a farmer who was possessed of a piece of land which he could not or would not alienate, even in part, and to which he could not or would not make any addition, to be considering how much he could afford to pay a farm hand who was applying for a job. If, under such conditions, the laborer could add 200 bushels of wheat to the farmer's crop, the farmer could afford to treat his services as worth substantially 200 bushels of wheat, that is, he might reasonably act as if the laborer were alone the producer of these 200 bushels, though of course this would not be true in any literal sense those 200 bushels would be, like all the other bushels, the joint product of the several factors involved. Note 3 The discussion on page 295 brought out the point that 4 differ- ent prices of the demand and supply schedule play decisive roles in the immediate fixation of price. To avoid some rather persistent misunderstandings, it is perhaps desirable to note some differences in the processes by which these different limiting prices operate. 5 68 PRINCIPLES OF ECONOMICS The marginal demand price as a check on the upward movement of actual price, and the marginal supply price as limiting the falling of price are mere indices of the presence of the real causes rather than themselves the forces accomplishing the results. Thus, when, in the silver schedule on page 281, the actual price refuses to rise above 55 cents lest it should exclude the 10,000 ounces of demand which came in only when price was as low as this, the fact really bringing about this result is the absence of that 10,000 ounces of demand at the higher figure, 56 cents, not the presence of that in- crement of demand at 55 cents. This is seen from the fact that, had there been no new demand at 54, or 53, or 52, or any lower price whatever, the price would still have come down to 55 cents, even, in fact, to 54 cents. Analogous statements must be made with respect to the marginal supply price. As a limit to the falling of price from 55 to 54 cents, it is little more than an index of the presence of the real cause, that is, the failure of supply at the lower price, 54 cents. If no wheat whatever could be supplied at 55 cents, the price could not have gone down to 54 cents just the same, in fact it could not have gone down even to 55. In contrast with this status of the marginal demand and marginal supply prices considered as upper and lower limits, respectively, the first extra-marginal demand and supply prices are themselves active causes in fixing the position of actual price. That price cannot go up to the first extra-marginal supply price just because it is that price, that is, because it of itself will let in too much supply. So the actual price cannot go down to the first extra-marginal demand price just because it is that price, that is, because it will of itself let in new increments of demand. Note 4 As remarked on page 316, some economists hold that profits are not even at the present time an element in cost. Two of the considerations brought forward in support of this opinion will be briefly commented upon. First, it is sometimes remarked that, especially in the industries which involve much risk, for example, gold mining, the total ex- EXPLANATORY NOTES 569 penditure the expenditure over the whole industry is probably much greater than the total return: some surpluses are gained, but more deficits are incurred. The answer to this is easy. That any- thing should be a cost does not require that every unit of that thing should be remunerated. The only question is this: Is the forth- coming of supply dependent to an appreciable extent on the covering of a particular item which is alleged to be a cost? Are there en- trepreneurs who will continue to supply commodities only on con- dition that they get from the business a return on their capital in excess of the interest which they could get simply by lending that capital ? and is the supply which is so dependent on the action of these entrepreneurs of sufficient volume to make its withdrawal from the market significant ? The correct answer is surely an affirmative one. Another way of maintaining the proposition that profit is not a true cost is to say that, although some entrepreneurs may earn profits, the marginal ones commonly do not ; and since it is marginal cost in which we are interested, this shuts profits out of costs alto- gether. The real ground for this contention is that there are always producers who are hardly able even to cover their cost of production, who go on year after year running more and more behind, gradually using up their capital ; and because their cost is the greatest of all so great as to deprive them of any profits the objectors in ques- tion look on these producers as the real marginal ones. The answer to this objection is that the persons in question are not true marginal producers. The true marginal producer of any service or com- modity is the man -who would first quit production should price fall; like the marginal seller (page 276), he is the producer whose presence is conditioned on the appearance of the marginal price. Now this plainly has no application to the class of persons described above. They are not brought into the market by the marginal price; they will not drop out of the market should the price fall still lower. They will continue to produce because they have no alternative. They are perhaps too old to change to some other employment, hence keep on for the opportunity to employ them- selves, gradually consuming the little capital which they have in the business. 570 PRINCIPLES OF ECONOMICS Note 5 A special exception to the statement that rent is usually a part of the cost which determines the normal supply price may arise in this way. As indicated in the text, the reason we usually have to include rent is that the entrepreneur is driven to pay that rent because of the competition of persons who wish the use of the land for other purposes : that is, rent is what is called an opportunity cost. But cases arise in which the entrepreneur is compelled to pay a certain amount of rent for a particular piece of land, not because it is wanted in some other industry, for some other purpose, but only because it is wanted by other producers in the same industry. Thus, let us suppose that a given piece of land is wanted for a par- ticular purpose in which its use would be worth $1,000 a year ; while for the best of all other purposes its use would be worth only $800 a year. In such a case, rent forms no part of the cost of the product, the cost which determines the supply price. The tenant has to pay $1,000 for the right to use this piece, not because it would otherwise be devoted to raising some other product, but because, in being used to raise this product, it gives off a surplus of $1,000, and the competition of other producers of this same product compels him to turn over that surplus to the landowner. When in doubt whether or not to consider rent in a particular case a cost, the simple test is this: Is the tenant driven to pay the rent he does pay through the competition of producers in other fields or through that of producers in his own field. In the former case, rent is a cost ; in the latter it is not. Note 6 The untenable character of the doctrine that each product has its price fixed by its own marginal utility solely, is easily shown. On such a theory, the hypothetical case treated on page 389 would give the results represented in the accompanying diagram (Fig. i). The marginal significance of P x being $120, would make its price $120, which would make the price of the 12 L's entering into it $120, which would make the price of I L $10; so the marginal significance of Po being $80, would make its price $80, which would make the EXPLANATORY NOTES 571 IP1 $I20< M S P! $120 IP, $ 8(X M S P 2 $ 80 I PS $ 48* M S Pa $ 48 IP. $ 24< M S P 4 $ 24 I P 5 $ I2< M S P 5 $ 12 IP. $ 4< M S P 6 $ 4 12 L's $I2CK 10 L's $ 8o< 8 L's-$ 48* 6 L's $ 24< 4 L's $ I2< 2 L's $ 4< Figure I. price of the 10 L's entering into it $80, which would make the price of each L entering into it $8 ; and so on. But obviously, this result would be impossible; we should have in the same market at the. same time, 6 different prices, $10, $8, $6, $4, $3, and $2, for the same commodity, I L. Note 7 The theory as to the process of final price determination brought out on page 390 is in a general way that of the Austrian school. It may be represented in schematic form by the diagram in Figure 2. Stock") oi L L'sf Money Value of Cost Goods Price of Products f Significance G 1 Schedule of P, P 2 , P,, P<- P,, PC Marg. Significance^ of Products 12 L's =$24. -* IP, =$24. MSP, = $120.*- 10L's= 20. -*-IP 2 = 20. MSP 2 = 80.* / 8L's= 16. IP 3 = 16. MSP 3 = 48.* * / 6L's= 12. IP 4 = 12. MSP 4 = 24.* -_/ 4L's= 8. -* lp 5 = 8. MSP 5 = 12.*- IL=$2.*-2L's = 4.- V IP,- 4.- ^MSP 6 = 4. fOut-1 f fSig.l p;Jl'ij Figure 2. Austrian Theory In this diagram, L's are supposed to represent the single primary factor or cost good, while P x , P 2 , P 3 , etc., represent the different products arranged in the order of their marginal as well as their 572 PRINCIPLES OF ECONOMICS generic significance or value. Our stock of L's is supposed to be such that we can fairly satisfy our need for products ranging from P^s down to P 6 's, but no further. The utility schedules of all of these except P 6 are supposed to be highly inelastic, so that when production is economically carried out the marginal utility of P t stops at $120, that of P 2 at $80, that of P 3 at $48, and so on, as indicated in the third column of the diagram. At the top of the diagram, left and right, we have the two fundamental elements in the process of price determination : the stock or output of L's on the one hand, and the significance or utility schedule of products on the other. These are, so to speak, the springs from which flow all the forces that are in any way concerned in the process of price determination. The arrows leaving these two starting points, going around the main part of the diagram, and meeting at the lower right- hand corner bring out the point that, however complicated the processes by which the result would be reached, under our present hypothesis, the price-determining forces would come to a focus in the marginal significance of the marginal product. The remainder of the diagram shows that, after equilibrium has been reached, the reaction which is logically first among the reactions set up by the interaction of the stock of L's and the several significance schedules is the fixing of the marginal significance of the marginal product, P 6 . That, being finally fixed at $4, would cause the price of P 6 to be $4, as indicated by the arrow going from right to left between these points. This price of $4 for P 6 would, in turn, make the money value of the 2 L's contained in it $4, and, so, would make the price of i L $2. This price of $2 each for the marginal L's would now be communicated to all other L's, namely, to those L's which are used in the higher products. In consequence, the money value of that quantity of L's which is used in each of the several products would remain as many times $2 as the number of L's used in pro- ducing said product. Finally, the money value thus established for the L's contained in each product would be communicated to the products themselves ; that is, to P D , P 4 , P 3 , P 2 , and P lf as indicated by the five horizontal arrows running from left to right. As a result P x would have a price of only $24, though its marginal utility or sig- nificance was $120; P 2 would have a price of only $20, though its EXPLANATORY NOTES 573 marginal significance was $80; and so on. That is, for all these supra-marginal products, cost, not utility, is the determining ele- ment, though more remotely the decisive thing is utility, only it is the utility of the marginal product, determining the price or value of the primary factor, and, through it, the prices of all supra-marginal products. Note 8 In explaining the Austrian theory of final price determination, it is almost impossible to avoid letting in some misleading implications. Thus, it is almost impossible to avoid giving the impression that the marginal utility of P 6 would be first determined independently of everything else; that this marginal utility would thereupon determine the price of P 6 independently of everything else; that the price of P thus determined would then fix the price of L's devoted to its production independently of everything else; and so on. Now, it is surely quite impossible that anything like this should take place. No one of these things, whether the marginal utility of the marginal product or the price of any one of the various products or the price of L's, could be determined independently of the determination of every other one of them. The marginal significance of P 6 could not be determined until the output of this product had been finally determined. In turn, the output of P c could not be determined until the question of the number of L's available for this purpose had been determined. Again, the question of the L's available for pro- ducing P 6 's could not be determined until it had been decided how many of the higher products, P 1? P 2 , P 3 , P 4 , were to be produced. Still, again, it could not finally be determined how many of these higher products were to be produced until it was known what price they were to have and, therefore, what demand there would be for them. But, since their price would be dependent on the price of the L's entering into them, and the price of L's would be dependent on the price of P 6 , and the price of P 6 would be dependent on its mar- ginal utility, we seem to be in a position where we are obliged to say that nothing could be determined until everything else had been determined. That is, we seem to be trying to break into a com- pletely closed circle. And this is of course true. Nothing could be 574 PRINCIPLES OF ECONOMICS finally determined until everything else had been determined. As in so many other fields, reaction as well as action is present and the result must be influenced by both. Nevertheless, it is legitimate to represent the real order of causation, when everything is finally settled, in the way we have done. When at last equilibrium would have been reached, the starting point of this causation the point where the fundamental price-determining forces break into the circle would be in the marginal significance of the product. Note 9 The modification of our diagram made necessary by the intro- duction of the element of disutility is easily effected. As before there are two sources from which are derived the forces ultimately determining prices, and these appear at the top, one at the left, the Disutility Schedule of L's [Significance Schedule of Marg. Disutility of L's Money Value of Cost Goods 12L's=$24.- 10L's = 20.- 8L's= 16.- 6L's= 12- 4L's= 8.- 2 L's= 4.= Price of Products IP, = $24. IP 2 = 20. -IP 3 = 16. IP 4 = 12. IP 5 = 8. :IP e = 4. Marg. Significance of P's MSP, = $120.* MSP 2 = 80.* MSP 3 = 48.* MSP 4 = 24.* MSP 5 = 12.* =: MSP 6 = 4. r Sig.l Sch.K 1 P 6 S J fOut- Jput (Pis JL *MDL's= 1.10 *MDL's= 1.20 -MDL's= 1.35 __/ -MDL's= 1.50 IL=$2. MDL's= 2.00 4)isutl f Ibem 5ch.H*^f L's J U's Figure 3. Significance-Disutility Theory other at the right. The one at the left, however, is different from the old one. This time it is the disutility schedule of the single pri- mary factor, L, or, what is the same thing, the supply schedule of that factor. Again, as in the former case, we have a process of causation which starts from the marginal utility or significance of EXPLANATORY NOTES 575 the marginal product, moving thence to the price of that product, thence to the value of 2 L's, then to the price of I L. At this point, however, utility or significance finds itself obliged to recognize the influence of another force, the disutility of producing L's. For the existence of that disutility makes it impossible for equilibrium to be established until the price of each L is great enough to cover that disutility. Accordingly, we have this time in the lower left-hand corner a reaction between the disutility schedule of L's and the demand for them from which is determined the marginal disutility of supplying these L's, which in turn compels the price of I L to be what is needed to express this marginal disutility. That is, the price of I L is $2 not only when and because $2 is the marginal significance of the marginal product of L's, but also when and be- cause $2 is the marginal disutility of supplying L's. Note 10 The point brought out in the text that it is not the absolute mag- nitude of wants but rather the results conditioned upon their gratifi- cation which determines their social importances seems obvious enough, yet is constantly disregarded by not a few writers. In con- sequence, it seems desirable to give it the emphasis derivable from diagrammatic presentation. In the accompanying figure, the open space to the right of the vertical line represents the field of social advantages or importances, while the enclosed space to the left of the vertical line represents the field of individual or private importances estimated as absolute magnitudes. The upper right-hand circle represents one-fifth of the social importance of the contribution of some person, Mr. A we will call him, the whole of his contribution being assumed to have an importance represented by $5,000. The outer one of the two concentric circles at the left and above the broken-line one represents some want of the man contributing the $1,000 worth of service, which want the subject himself estimates at $1,000. The inner one of these two concentric circles the con- tinuous-line one represents the real or absolute magnitude of the want in question which is assumed to be only $100. The heavy line connecting the $1,000 circle of social importance with the $1,000 5/6 PRINCIPLES OF ECONOMICS circle of individual importance as estimated by the individual im- mediately interested signifies that the getting of the $1,000 worth of service, represented by the upper right-hand circle, is conditioned upon giving the man who contributes that service the volume of grati- fication represented by the outer one of the two concentric circles named. This brings out the relation among the wants and contribu- tions of Mr. A. Of the lower circles, the right-hand one shows the INDIVIDUAL GENERAL SERVICES $1,000 o Figure 4. Social versus Individual Importance social importance of one-fifth of the service of a second person, Mr. B. The inner one of the two lower left-hand circles the broken- line one represents the estimate which B, in view of his money income, puts upon a certain want of his, while the absolute magni- tude of that want is represented by the larger outer circle the continuous-line one with the $1,000 mark. The heavy line con- necting the $100 circle of social advantage with the $100 circle of individual want the dotted one signifies that the forthcoming of said social advantage is conditioned on the satisfying of this want EXPLANATORY NOTES 577 only so far as $100 will do it. Under these conditions, it is mani- fest that if A and B come into competition for the disposal of social resources, A's want which has an effective magnitude of $1,000, though having an absolute magnitude of only $100, will outweigh the want of B which has an effective magnitude of only $100 though its real or absolute magnitude is represented by $1,000. Now, to the unthinking, all this looks very unreasonable, not to say very wicked. The trifling want is treated as if it were the great one ; the great want as if it were the trifling one. But there is, broadly speak- ing, nothing in this view of the matter. The social importances in- volved are represented by the circles to the right of the line, the circles located in the social field. It is on these that our eyes should be fixed. A's contribution has a social importance of $1,000; the supplying of that contribution is conditioned on the gratification of a want which A estimates at $1,000; said want, therefore, has a social importance of $1,000. B's contribution on the other hand, has a social importance of only $100 ; the supplying of that contribution is conditioned on the satisfying of a want which is formally expressed by only $100; said want, therefore, has a social importance of onlf $100. y r4t .Jj i > c*/>- I / o - Date Due JUN 7 1972 HIM Q 1079