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Title: Supply and Demand
Author: Henderson, Hubert D., 1890-1952
Language: English
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By Hubert D. Henderson M.A.

With an Introduction by J.M. Keynes M.A., C.B.



The Theory of Economics does not furnish a body of settled conclusions
immediately applicable to policy. It is a method rather than a
doctrine, an apparatus of the mind, a technique of thinking, which
helps its possessor to draw correct conclusions. It is not difficult
in the sense in which mathematical and scientific techniques are
difficult; but the fact that its modes of expression are much less
precise than these, renders decidedly difficult the task of conveying
it correctly to the minds of learners.

Before Adam Smith this apparatus of thought scarcely existed. Between
his time and this it has been steadily enlarged and improved. Nor is
there any branch of knowledge in the formation of which Englishmen can
claim a more predominant part. It is not complete yet, but important
improvements in its elements are becoming rare. The main task of the
professional economist now consists, either in obtaining a wide
knowledge of _relevant_ facts and exercising skill in the application
of economic principles to them, or in expounding the elements of his
method in a lucid, accurate and illuminating way, so that, through his
instruction, the number of those who can think for themselves may be

This Series is directed towards the latter aim. It is intended to
convey to the ordinary reader and to the uninitiated student some
conception of the general principles of thought which economists now
apply to economic problems. The writers are not concerned to make
original contributions to knowledge, or even to attempt a complete
summary of all the principles of the subject. They have been more
anxious to avoid obscure forms of expression than difficult ideas; and
their object has been to expound to intelligent readers, previously
unfamiliar with the subject, the most significant elements of economic
method. Most of the omissions of matter often treated in textbooks are
intentional; for as a subject develops, it is important, especially in
books meant to be introductory, to discard the marks of the chrysalid
stage before thought had wings.

Even on matters of principle there is not yet a complete unanimity of
opinion amongst professors. Generally speaking, the writers of these
volumes believe themselves to be orthodox members of the Cambridge
School of Economics. At any rate, most of their ideas about the
subject, and even their prejudices, are traceable to the contact they
have enjoyed with the writings and lectures of the two economists who
have chiefly influenced Cambridge thought for the past fifty years,
Dr. Marshall and Professor Pigou.

J.M. Keynes.






























































































§1. _Theory and Fact_. The controversy between the "Theorist" and the
"Practical Man" is common to all branches of human affairs, but it is
more than usually prevalent, and perhaps more than usually acrid in
the economic sphere. It is always a rather foolish controversy, and I
have no intention of entering into it, but its prevalence makes it
desirable to emphasize a platitude. Economic theory must be based
upon actual fact: indeed, it must be essentially an attempt, like all
theory, to _describe_ the actual facts in proper sequence, and in true
perspective; and if it does not do this it is an imposture. Moreover,
the facts which economic theory seeks to describe are primarily
economic facts, facts, that is to say, which emerge in, and are
concerned with, the ordinary business world; and it is, therefore,
mainly upon such facts that the theory must be based. People
sometimes speak as though they supposed the economist to start from a
few psychological assumptions (e. g. that a man is actuated mainly by
his own self-interest) and to build up his theories upon such
foundations by a process of pure reasoning. When, therefore, some
advance in the study of psychology throws into apparent disrepute such
ancient maxims about human nature, these people are disposed to
conclude that the old economic theory is exploded, since its
psychological premises have been shown to be untrue. Such an attitude
involves a complete misunderstanding not merely of economics, but of
the processes of human thought. It is quite true that the various
branches of knowledge are interrelated very intimately, and that an
advance in one will often suggest a development in another. By all
means let the economist and psychologist avoid a pedantic specialism
and let each stray into the other's province whenever he thinks
fit. But the fact remains that they are primarily concerned with
different things: and that each is most to be trusted when he is upon
his own ground. When, therefore, the economist indulges in a
generalization about psychology, even when he gives it as a reason for
an economic proposition, in nine cases out of ten the economics will
not depend upon the psychology; the psychology will rather be an
inference (and very possibly a crude and hasty one) from the economic
facts of which he is tolerably sure.

But the purpose of economic theory is not merely to describe the facts
of the economic world; it is to describe them in their proper sequence
and true perspective. It must begin with those facts which are most
general and which have the widest possible significance. Those are not
likely to be the facts which our practical experience forces most
insistently upon our notice. For it is the particular and not the
general, the differences between things rather than their
resemblances, that concern us most in daily life. Nor are we likely to
find the universal facts which we require in the sphere of public
controversy. We must rather look for them in the dark recesses of our
consciousness, where are stored those truths which are so obvious that
we hardly notice them, which are so indisputable that we seldom
examine them, which seem so trite that we are apt to miss their full

§2. _The Division of Labor_. There is one such truth in the economic
sphere which it is essential to appreciate vividly and fully, with the
widest sweep of the imagination and the sharpest clarity of
thought. Man lives by cooperating with his fellow-men. In the modern
world, that cooperation is of a boundless range and an indescribable
complexity. Yet it is essentially undesigned and uncontrolled by
man. The humblest inhabitant of the United States or Great Britain
depends for the satisfaction of his simplest needs upon the activities
of innumerable people, in every walk of life and in every corner of
the globe. The ordinary commodities which appear upon his dinner table
represent the final product of the labors of a medley of merchants,
farmers, seamen, engineers, workers of almost every craft. But there
is no human authority presiding over this great complex of labor,
organizing the various units, and directing them towards the common
ends which they subserve. Wheel upon wheel, in a ceaseless succession
of interdependent processes, the business world revolves: but no one
has planned and no one guides the intricate mechanism whose smooth
working is so vital to us all. Man, indeed, can organize and has
organized much. Within a large factory the efforts of thousands of
work-people, each engaged on the repetition of a single small process,
are fitted together so as to form an ordered whole by the conscious
direction of the management. Sometimes factory is joined with factory,
with farms, fisheries, mines, with transport and distributing
agencies, as one gigantic business unit, controlled by a common
will. These giant businesses are remarkable achievements of man's
organizing gifts. The individuals who control them wield an immense
power, which so impresses the public imagination that we dub them
"kings," "supermen," "Napoleons of industry." But how small a portion
of man's economic life is dominated by such men! Even as regards the
affairs of their own businesses, how narrow, after all, are the limits
of their influence! The prices at which they can buy their materials
and borrow their capital, the quantities of their products which the
public will consume, are factors at once vital to their prosperity and
outside their own control.

A great business, like a nation, may cherish visions of
self-sufficiency, may stretch its tentacles forward to the consumer
and backwards to its supplies of raw material; but each fresh
extension of its activities serves only to multiply its points of
contact with the outside world. When those points are reached, the
largest business, like the smallest, is out on the open sea of an
economic system immeasurably larger and more powerful than
itself. There it must meet--the better perhaps for its inherent
strength and accumulated knowledge--the impact of rude forces, which
it is powerless to control. Beneath the blasts of a trade depression,
or some other tendency of world-wide scope, the authority of the
mightiest industrial magnate, and equally of any Government, assumes
the same essential insignificance as the pride of a man humbled by
contact with the elemental powers of nature.

§3. _The Existence of Order_. The parallel can be pursued further with
advantage. Just as in the world of natural phenomena, which for long
seemed to man so wayward and inexplicable, we have come gradually to
perceive an all-pervading uniformity and order; so there is manifest
in the economic world, uniformity, order, of a similar if less
majestic kind. Upon the cooperation of his fellowmen, man depends for
the very means of life: yet he takes this cooperation for granted,
with a complacent confidence and often with a naive unconsciousness,
as he takes the rising of to-morrow's sun. The reliability of this
unorganized cooperation has powerfully impressed the imagination of
many observers.

"On entering Paris which I had come to visit," exclaimed Bastiat some
seventy years ago, "I said to myself--Here are a million of human
beings who would all die in a short time if provisions of every kind
ceased to flow towards this great metropolis. Imagination is baffled
when it tries to appreciate the vast multiplicity of commodities which
must enter to-morrow through the barriers in order to preserve the
inhabitants from falling a prey to the convulsions of famine,
rebellion, and pillage. And yet all sleep at this moment, and their
peaceful slumbers are not disturbed for a single instant by the
prospect of such a frightful catastrophe. On the other hand, eighty
departments have been laboring to-day, without concert, without any
mutual understanding, for the provisioning of Paris."

The theme may well excite wonder. But wonder should always be watched
with a wary eye; for he is apt to bring in his train a hanger-on
called worship, who can do nothing but mischief here. It is a short
step from a passage like that quoted above to a glorification of the
existing system of society, to a defence of all manner of indefensible
things; and a cross-grained attitude towards all projects of
reform. It is a short step; but it is one which it is quite
unjustifiable to take. For the evils of our economic system are too
plain to be ignored; too many people have harsh personal experience of
the wastefulness of its production, the injustice of its distribution;
of its sweating, its unemployment and slums. And when the attempt is
made to plaster over evils, such as these with obsequious rhetoric
about the majesty of economic law, it is not surprising that the
spirit of many men should revolt and that they should retort by
denying the existence of order in the business world, by declaring
that the spectacle which _they_ see is one of discord, confusion and
chaos. And then we are engulfed in a controversy as stale, flat and
unprofitable as that between the "theorist" and the "practical man."

The truth is that the language of praise and obloquy is quite
inappropriate. In the first place, it may be well to note that the
order of which I have spoken manifests itself not merely in those
economic phenomena which are beneficial to man, but hardly less in
those which work to his hurt. Even in those alternations of good and
bad trade, which spell so much unemployment and misery, there is
discernible a rhythmic regularity like that of the process of the
seasons, or the ebb and flow of the tide. This is not an elegance to
be admired. Furthermore, in so far as the order comprises adjustments
and tendencies which are beneficial (as, indeed, is mainly true),
there is no warrant for assuming that these are either adequate to
secure a prosperous community or dependent upon the social
arrangements which happen to exist. Let us, therefore, refrain from
premature polemics and examine in a spirit of detachment some further
aspects of the elaborate, but yet unorganized, cooperation of which so
much has been already said.

§4. _Some Reflections upon Joint Products_. A quite inadequate idea of
the complexity of this coöperation is obtained by dwelling on the
numbers of people who participate in it, or the immense distances over
which it extends. The deficiency can be partially supplied by
referring to some of the more obvious of the many subtle
interconnections which exist between different commodities and
different trades.

There are innumerable groups of commodities (which it is customary to
term "joint products") such that the production of one commodity
belonging to the group necessarily implies or very greatly facilitates
the production of the others. Wool and mutton; beef and hides; cotton
and cotton-seed are a few familiar illustrations. The important
feature of these "joint products" is the fairly precise relation which
must exist between the quantities in which the different products are
supplied. If you plant a certain crop of cotton, it will yield you so
much cotton lint and so much cotton-seed. You can, of course, if you
choose, throw away part of the seed, as indeed at one time planters
used to do; but unless you do this, you cannot vary the proportions of
the two things which you will have for sale. Similarly, if you keep a
flock of sheep, or a herd of cattle, you will obtain wool and mutton
in the one case, or beef and hides in the other, in proportions, which
indeed you can vary within certain limits by choosing a different
breed,[1] but which you cannot radically transform. When, however, we
turn to the uses to which these products are put, no similar relation
is to be discovered. Cotton lint is used chiefly for making articles
of clothing; cotton-seed for crushing into oil, on the one hand, and
cake for cattle fodder on the other. There is no apparent connection
of any kind between the demands for these different things, and still
less is there any obvious reason why these demands should bear to one
another the particular proportions which characterize their respective
supplies. It is very much the same with wool and mutton; with beef and
hides; with all "joint products." Why should we consume mutton on the
one hand and woolen clothing on the other, in a ratio at all
commensurate with that in which they are yielded by the sheep?

[Footnote 1: These possibilities of small variation are of very great
importance as will be shown in Chapter V, but they do not affect the
present argument.]

What, then, might we expect to find if order was nonexistent in the
economic world? Surely that some things such as wool would be produced
in quantities many times in excess of the demand for them, quite
possibly five, ten, or twenty times in excess; while conversely the
supplies of others such as mutton might fall far short of what was
required. But in practice we find nothing of the sort. Somehow it
comes about that an equilibrium is established between the demand for
and the supply of every commodity; and that this applies to wool and
mutton, to beef and hides, as surely as to commodities which are
produced quite independently. It is true that this equilibrium is a
rough, imperfect one; and it may happen that what is called a "glut"
of wool may co-exist for a short period with what is called a scarcity
of mutton. But qualifications of this nature are in the strictest
sense of the phrase, the exceptions which prove the rule. For the
departures from equilibrium which gluts and scarcities represent are
always transient and are usually confined within narrow limits. A
strong prevailing trend towards an adjustment of demand and supply is
unmistakably manifest amid all the vagaries of changing circumstance.
Let me carry the argument a step further for the benefit of any reader
who is restrained by a repugnance too deep and instinctive to be
readily overcome, from admitting fairly to his mind that conception of
order which I am endeavoring to emphasize. He will in all probability
be one who, cherishing ideals of a better and fairer system of
society, looks forward to a time when an organized coöperation will be
substituted for what he regards as the existing chaos. Let us suppose
that his visions were fulfilled as completely as he could desire; and
that an immense system of Socialism were in existence, embracing not
one country only, but the whole world. Suppose all the difficulties of
human perversity and administrative technique to have been surmounted
and a wise, disinterested executive to be in supreme control of our
business life. Let us suppose all this, and ask only the question: How
would this executive treat the humdrum case of wool and mutton? How
would it decide the number of sheep it would maintain?

Shall we suppose that it is inspired by the ideal "to each according
to his need," and that it resolves accordingly that the commodities
which people require for a decent standard of life shall be supplied
to them as a matter of course? How, then, would it proceed? It might
estimate the amount of woolen clothing which a normal family requires,
allowing for differences in climate, and possibly indulging somewhat
the caprices of human taste. On this basis, a certain number of sheep
would be indicated. It might perform a similar calculation for mutton,
and again a certain number of sheep would be indicated. But it would
be an extraordinary coincidence if the numbers which resulted from
these independent calculations were nearly equal to one another, or
were even of the same order of magnitude; and, if they differed
widely, what number would our world executive select? Would it decide
to waste an immense quantity of either wool or mutton; or would it
decide that it could not, after all, supply the full human needs for
one or other of the commodities?

Of course, if the executive were sensible it could solve the problem
satisfactorily enough. It could retain the monetary system we know
to-day and it could supply the commodities to the consumers, not as a
matter of right, but by selling them to them _at a price_. This price
it could then move upwards or downwards, raising, say, the price of
mutton and reducing that of wool, until it found that the consumption
of the two things was adjusted in the required ratio. But if it acted
in this manner, what essentially would it be doing? It would be
seeking by deliberate contrivance to reproduce, in respect of this
particular problem, the very conditions which occur to-day without aim
or effort on the part of anyone at all.

The moral of this illustration must not be misinterpreted. It does
not show the folly of Socialism or the superiority of
Laissez-faire. What it does show is the existence in the economic
world of an order more profound and more permanent than any of our
social schemes, and equally applicable to them all.

§5. _Some Reflections upon Capital_. Another aspect of the great
cooperation is of even greater significance. It embraces not only a
multitude of living men, but it links the present together with the
future and the past. The goods and services which we enjoy to-day we
owe only in part to the labors of the week, the month, or the year,
only in part even to the efforts of our contemporaries. The men, long
since dead and forgotten, who built our railways, or sunk our coal
mines, or engaged in any of a great variety of tasks, are still
contributing to the satisfaction of our daily wants. The expression is
not altogether fanciful; for, had it not been reasonable to expect
that those labors would be of use to us to-day, many of them in all
probability would never have been undertaken. It was to meet our
present wants, and even our future wants, that many men toiled on
monotonous tasks ten, twenty, thirty years ago. And yet, of course, we
should deceive ourselves if we supposed that this was the motive of
these men, that our welfare was the centre of their heart's desire. We
in our turn dedicate to the future, and often to a distant future, an
immense portion of our energies. Let any reader who doubts this, study
the statistics of the occupations of the people, and reflect on how
long a period must elapse before the labors of this trade or that can
fulfil their ultimate function. How long would the period be in the
case of a man making bricks, which will later be employed in the
erection of a factory, where machinery will be made, to equip an
electrical generating station designed to supply, over a period of
many years, light, heat, and power to people living in a remote
Continent? A longer time, it may be hazarded, than he is accustomed
to look ahead.

Like the daily cooperation of living men, this cooperation of past,
present and future is essential to the well-being of mankind, and yet
it is undesigned and unorganized. As private individuals, men do,
indeed, deliberately provide for their own future, and for that of
their kith and kin: as the directors of businesses, they try to
forecast the trend of demand. But such conscious calculations and
deliberate acts would avail little if they stood alone. They are
hardly more than the necessary spokes in the great wheel which
regulates the relations of past, present and future. The hub of the
wheel is an elaborate system of borrowing and lending, essentially
similar to the buying and selling of commodities. The private
individual in order to provide for his family or for his old age
"saves" and "invests." But what exactly does this mean? It means that
he transfers so much purchasing power, which he might have spent on
his personal pleasures, to some one else in return for the expectation
of receiving, year by year in the future, he and his heirs after him,
a certain smaller quantity of purchasing power. The other party to the
transaction will be, we may suppose, a business man who enters into it
because he sees the opportunity of a promising industrial development,
to undertake which he requires more purchasing power than he himself
possesses. And, because this transaction is entered into, a smaller
number of us will shortly be engaged in making motorcars, or
gramaphones, and a larger number of us in making factories and
machinery, which will later enhance the world's productive power.

Many transactions of the kind take place daily in modern communities,
and their multiplicity gives rise to a mass of phenomena with which we
are all tolerably familiar. We recognize a short-loan market, a stock
exchange, a number of "markets" where lenders and borrowers are
brought together by the aid of various intermediaries, such as banks,
bill brokers, and stock jobbers, who correspond to dealers in
commodities. Between these different specialized markets, we are
aware of an interconnection so close and strong that we speak more
generally of a Capital Market, of which the stock exchange, the
short-loan market and so forth, are the component parts. Now, "market"
is a word which was originally used to denote a place where tangible
commodities were bought and sold; and the more closely we examine the
phenomena of the Capital Market, the more closely do we perceive the
profound resemblance between the mechanism of borrowing and lending,
and that of buying and selling. Corresponding to the price of a
commodity is the rate of interest (in the short-loan market we
actually call the rate of Discount "the price of money," and speak of
money being cheap or dear); and between the rate of interest, the
demand for and the supply of capital there exist relations precisely
similar to those between price, demand, and supply in commodity
markets. Above all there is the same strong prevailing trend towards
an adjustment of demand and supply.

This fundamental resemblance between two such apparently
incommensurable things as the buying of material commodities and the
borrowing of capital is highly significant; it is another instance of
that order in the economic world, of which the reader may now be
growing weary. But so difficult is it to see clearly and fully
something which one sees, as it were, every day of one's life, that a
few more moments of reflection on the special case of capital will be
time well spent. Let us revert then to our fantasy of a world
socialist commonwealth; and humbly submit another poser to its supreme
executive. The question this time will be whether some great
constructional work, such, let us say, as the recently mooted Severn
barrage scheme, should or should not be undertaken. Let us suppose
that the costs and future benefits of the undertaking can be estimated
accurately; and that the problem reduces itself to one of expending
now a sum, let us say, of $100,000,000, with the prospects of
obtaining in the future an income of power, or whatever it may be,
worth $5,000,000 per annum. I have assumed for the sake of simplicity
that we shall still be reckoning in terms of money, though possibly
the executive may have substituted Marxian labor units; but it is
quite immaterial to the present argument what the measuring rod may
be. The point to be observed is, that it is impossible to tackle the
problem at all without the conception of a rate of interest. For
suppose that you tried to do without it, and said, "We shall take a
long view. The interests of the future are no less our concern than
those of the present; we shall not discriminate between them. We shall
regard as an enterprise worthy to be undertaken whatever promises to
yield in the course of time a return larger than the outlay." Where
will this lead you? The particular proposal set out above would
clearly pass the test; for in twenty years the resultant benefits
would have added up to a figure equivalent to the initial cost. But
equally clearly, the cost might have been more than $100,000,000; it
might have been $250,000,000, $500,000,000, whatever figure you care
to take, and if you extend the period similarly to fifty or one
hundred years, sooner or later the gains would top the cost. Now there
is no limit to the enterprises which would pay their way on this
basis; and it would be quite impossible to undertake them all. For
they would swallow up all and more than all your labor and your
materials, and would leave you with no resources with which to meet
the recurrent daily wants of men. Clearly, then, in some way or other,
you must pick and choose, you must reject some enterprises as
_insufficiently_ worth while. But how would you proceed to choose?
Without a clear principle, a simple criterion to guide you, you would
be plunged in utter chaos. You could not say, "Let all proposals
involving capital expenditure be submitted to a central committee, who
shall compare them with one another in a sort of competitive
examination and, after deciding the number of applications they can
pass on the basis of the volume of resources which they can devote to
the future, award the places to those which head the list." Such a
prospect is a nightmare of officialism and delay. You would be driven
to formulate a simple, intelligible rule or measure, and leave that
rule to be applied by the unfettered judgment of innumerable men to
individual problems, as and when they arose. And for such a rule or
measure, you could not do better than a rate of interest; you would
have to lay it down that only those projects should be approved which
promised a return of 6 per cent, or whatever it might be. Even in
deciding what it should be, the limits of your choice would be
narrowly confined. If, for instance, you fixed on 1 or 2 per cent,
you would probably discover that you had not achieved your object,
that the undertakings for distant returns which passed this test,
still consumed far more resources than you could spare. You would be
compelled then to raise the rate until it had cut these enterprises
down within manageable limits. But, once more, what essentially would
you be doing? You would be using the instrument of the rate of
interest to adjust the demand for and supply of capital, though indeed
the interest might not be paid away as now to private individuals. You
would be reproducing by the method of deliberate trial and error, the
adjustments which occur automatically as things are, in the actual
world. Once again the most perfectly contrived Utopia would be
compelled to pay to the unorganized coöperation of our epoch the
sincerest flattery of imitation.

§6. _The Fundamental Character of many Economic Laws_. But again
perhaps a word of warning may be desirable. There is much controversy
in these days about something called "Capitalism" or "The capitalist
system." When these words are used with any precision, they usually
refer to the arrangement so prevalent at present, whereby the
ownership and sole ultimate control of a business rests with those who
hold its stocks and shares. There is much to be said upon the merits
and demerits of this system; something will perhaps be said upon the
matter in the fifth volume of this series; but I shall not discuss it
here. Nothing that I have said so far has any real bearing on it
whatsoever; to suppose that it has, is indeed to miss the whole point
of this chapter.

The order, which I have sought to reveal, pervading and moving the
most diverse phenomena of the economic world, would be a far less
noteworthy and impressive thing were it merely the peculiar product of
capitalism. Merchant adventurers, companies, and trusts; Guilds,
Governments and Soviets may come and go. But under them all, and, if
need be, in spite of them all, the profound adjustments of supply and
demand will work themselves out and work themselves out again for so
long as the lot of man is darkened by the curse of Adam.



§1. _Preliminary Statement of Three Laws_. The recognition of order in
any branch of natural phenomena is but the prelude to the formulation
of a set of laws, the simpler as the order is more universal, which
describe, and as we say, explain it. Thus the perception of the even,
elliptical courses of the heavenly bodies led to the statement of the
law of gravitation and the laws of motion.

In economics, similar laws have long since been enunciated, and have
proved themselves such valuable instruments for the understanding of
the daily problems of the workaday world, that they have been woven
into the texture of our ordinary speech and thought. I have already
touched upon them in the preceding chapter. But it is now desirable to
set them out in order, in the most concise and formal manner possible.

LAW I. When, at the price ruling, demand exceeds supply, the price
   tends to rise. Conversely when supply exceeds demand the price
   tends to fall.

LAW II. A rise in price tends, sooner or later, to decrease demand and
   to increase supply. Conversely a fall in price tends, sooner or
   later, to increase demand and to decrease supply.

LAW III. Price tends to the level at which demand is equal to supply.

These three laws are the cornerstone of economic theory. They are the
framework into which all analysis of special, detailed problems must
be fitted. Their scope is very wide. I have purposely refrained from
introducing into my statement of them any reference to commodities;
for they extend far beyond commodities. Subject to an important
qualification, they apply to capital, the price paid for the use of
capital being what we call the rate of interest. They apply hardly
less to "services," to the remuneration of labor of every kind and
grade. People sometimes protest warmly against the idea of treating
labor "like a commodity." If this indignation expresses no more than
a belief that in matters concerning conditions of work, and relations
between employees and the management, the sensibilities of human
nature should be taken into due account, it is based on elementary
decency and commonsense. But if, as sometimes appears, it is directed
against the fact that the remuneration of labor is controlled by the
laws of supply and demand, it is a mere baying at the moon, with
singularly little provocation. For these laws are in no way peculiar
to commodities, and it is no one's fault that they include commodities
too within their scope.

But let us go back to the laws themselves, and probe them and dissect
them, and turn them this way and that, so that we may perceive their
full content, and grasp it firmly in our minds. The third law implies
a prevailing tendency for demand to be equal to supply. This
tendency, as was suggested in Chapter I, can be verified by anyone
from his experience and observation (provided he is a reasonable
person, and not the tiresome kind who would dispute the law of
gravitation because he sees that a feather falls to the ground more
slowly than a stone). But it can also be deduced as a corollary from
the two preceding laws; and to regard it in this way will help us to
appreciate its significance. Start, for instance, by supposing that
demand is in excess of supply. Then the price will tend to rise. After
the price has risen, the supply will become larger, while the demand
will fall away. The excess of demand with which we started will thus
clearly be diminished. But if there remains any portion of this
excess, the same reactions will continue; the price will rise further,
and for the same reason; demand will be further checked and supply
further stimulated. In other words, these forces must persist until
the entire excess of demand over supply is eliminated. If we start by
supposing supply to exceed demand, the converse chain of sequences
will operate. Now these very simple steps of reasoning illuminate the
nature of the normal equilibrium of demand and supply. They reveal
that the equilibrium is established and maintained by the agency of
_changes in price_, and they enable us to lay it down as perhaps the
most important thing that can be said about the price of anything that
it will tend to be such as will equate demand and supply. But that is
not all that they reveal. They reveal also the extreme dependence of
both demand and supply upon price.

Now this is a fact which it is most important to realize vividly. It
is apt to be obscured by customary modes of speech. In ordinary times
the prices of most commodities and services do not change by very
much, unless indeed over a long period of years; the amounts demanded
and supplied may therefore seem to maintain a fairly constant level;
and we may be tempted to speak of Great Britain producing so many
million tons of coal, or America consuming so many millions of
motor-cars per annum, almost as though these quantities were
independent of price considerations. But we should never forget that
there is no service or commodity produced by man, however essential it
may seem, the demand for or the supply of which might not be reduced
to nothing, if the price were sufficiently raised on the one hand, or
lowered on the other. How easy it is sometimes to forget this simple
truth may be seen from the mistake so commonly made of supposing,
because the peoples of Central Europe were left, on the cessation of
the war, starving and destitute of the means of life and the materials
of work, that they must necessarily become heavy purchasers of
imported goods; without pausing to consider whether the prices were
such as they could afford to pay.

§2. _Diagrams and their Uses_. It will help to prevent mistakes like
this and more generally to make sharp and clear the fundamental
relations which exist between demand, supply and price, if we exhibit
them pictorially in the form of a diagram. Such diagrams are of great
service in many parts of economic theory, not because they can prove
anything which could not be proved otherwise, but because, being
really a simpler medium of expression than words, they enable the mind
to grasp more readily and to retain more vividly the essential facts
of complex relations.

Figure 1:

       |                                            S'
       |                                          *
     D |                                         **
       |*                                       **
       | **                                    *
       |  **                                  *
       |    *                                *
       |     **                            **
       |      **                          *
       |        **                       *
       |         **                    **
       |           **                 *
       |            **  Q           **
    _l_|--------------*------------* R
       |              |***       **
       |              |   ** P **
       |              |  *** |***
    _k_|--------------***----+---** _r_
       |          _q_*|      |     ***
       |          *** |      |        ****
       |       ***    |      |           ****
       |    ***       |      |               ***
     S |****          |      |                  ****
       |              |      |                      ** D'
       |              |      |
       |              |      |
       |              |      |
       |              |      |
      0+-------------------------------------------------------- X'
                      N      M.
                              Figure 1

In Fig. 1 the curve DD' represents the conditions of demand. It is
supposed to be drawn in such a way that if any point, Q, be taken on
the curve, and the perpendicular QN be drawn to meet the base line, or
axis OX, then ON will represent the amount that will be demanded at a
price represented by QN (or O_l_). In other words, distances measured
along OY represent prices, and distances measured along OX represent
quantities of the commodity, or service, or whatever it may be.
Clearly, then, the demand curve, DD', must slope downwards from left
to right, since the lower the price asked, the greater will be the
amount demanded.  Similarly the curve SS' represents the conditions of
supply. It is supposed to be so drawn that if any point _q_ be taken
upon it, and the perpendicular _q_N be drawn to meet OX, then ON will
represent the amount that will be supplied at a price represented by
_q_N (or O_k_). Equally clearly this supply curve must slope upwards
from left to right, since the higher the price obtainable, the greater
will be the quantity offered. Take the point P where the two curves
meet, and draw the perpendicular PM to meet OX. Then the third law
enunciated at the beginning of this chapter corresponds to the
statement that PM or O_m_ will represent the price at which the
commodity or service will be exchanged.

It can readily be seen that no other price could be maintained. For
suppose the price to be less than O_m_, suppose it to be O_k_, then,
at this price, ON (or _kq_) will be the amount supplied, and _kr_ the
amount demanded. The demand will thus exceed the supply, and the
price will tend to rise, i.e. to move upwards towards O_m_. Similarly
if we suppose the price to be O_l_, which is larger than O_m_, the
supply (_l_R) will exceed the demand (_l_Q) and the price will fall
downwards towards O_m_. Thus, again, we have deduced Law III from Laws
I and II with the form and precision of a proposition in Euclid. Now,
when once the eye has become familiar with this diagram, it ought to
be impossible for the mind to lose even momentarily its grip on the
fact that demand and supply are both dependent upon price. For these
curves do not represent any particular amounts; they represent a
series of _relations_ between amount and price; if the price is QN the
amount demanded is ON, and so forth. The terms demand and supply in
the sense, in which I have been using them, of the respective amounts
demanded and supplied are, indeed, strictly meaningless without
reference to some particular price. The reference may sometimes be
implicit; but, whenever there is a chance of ambiguity, it should be
explicitly made.

§3. _Ambiguities of the Expressions, "Increase in Demand," etc_. It is
the more important to be precise upon this point, in that there is a
further possible confusion which we have now to consider. Demand and
supply, as we have seen, are dependent upon price; but equally clearly
they are dependent upon other things as well. Demand depends upon the
needs, tastes and habits of the people, as well as upon the length of
their purse; supply depends upon such things as the cost of production
in the case of commodities. None of these things are constant
factors, all of them are liable to change, and it may well happen that
we shall want to consider in some concrete problem the probable
consequences of such a change. Now the most usual and natural way of
describing such changes in the medium of words is to use the
expression "increase" or "decrease in demand," and "increase" or
"decrease in supply," the same expressions, which we employed before
to describe the consequences of a change in price. This identity of
language conceals a fundamental distinction between the phenomena
described; and to make this distinction plain we cannot do better than
revert to our diagrammatic presentation of the laws.

Figure 2:

    Y |
      | .
      |  .                                         _s'_
      |   .                                       .
    D |    .                                     .
      |**   .                                   .    * S'
      | **   ..                                .    *
      |  **    .                               .   *
      |   **    .                            ..   *
      |     *    ..                         .    **
      |      **    .                       .    **
      |       **    ..                   ..    **
      |         *     .                 .     *
      |          **    .               .     *
      |           **    ..            .    **
      |             **    ..        ..    **
      |              **     ..    ..    **
      |                **     . ..    **
      |                 ** p' ..     **
      |                   **..  .. **
      |                  ..|**p  **._p_
      |                ..  | **** | ..
      |             ...    |**|** |   ..
      |           ..      *|  |  *|     ..
      |      .....     *** |  |   |**     .
   _s_|......       ***    |  |   |  **    ..
      |          ***       |  |   |    **    ...
      |     *****          |  |   |      **     ...
    S |*****               |  |   |        **      ..
      |                    |  |   |          ***     .._d'_
      |                    |  |   |            ***
      |                    |  |   |               **
      |                    |  |   |                 **D'
      |                    |  |   |
      |                    |  |   |
                          M'  M  _m_
                            Figure 2

In Fig. 2 we start as before with our demand curve, and supply curve,
cutting one another at the point P. We then suppose that some
alteration takes place in the conditions of demand; there has been a
growth in the general taste for the commodity or service, and the
demand, as we say, has increased accordingly. How is this fact to be
represented in the diagram? Plainly not by taking another point on
the curve, DD', at a further distance from OY. For this would merely
indicate the larger amount that would be taken, if the conditions of
demand had remained unaltered but the sellers had reduced their
prices. The correct way of representing the change we have supposed is
to construct a new demand curve (in the figure, the dotted curve
_dd'_), lying at every point above the old demand curve. For this
indicates that larger quantities will be purchased at the old prices,
which is exactly what we want to represent. Similiarly if we wish to
represent a change in the conditions of supply, such as might result,
in the case of a commodity, from a tax imposed on its production, we
must draw a new supply curve, _ss'_, which in the case supposed, must
lie everywhere above the old supply curve. On the other hand, the
decrease or increase in demand or supply, _resulting_ from a change in
price, is represented simply by a shifting of the equilibrium from one
point to another on the same curve. The striking pictorial contrast
between a movement from one curve to another, and a movement along the
same curve should help to make vivid to our minds the fundamental
distinction between a change in the _conditions_ of demand, arising
from new tastes, enhanced purchasing power, etc.; and a mere change in
the amount purchased resulting from an alteration in the price which
the sellers ask. Words, as this necessarily cumbrous sentence shows,
are a clumsy instrument for the expression of abstract relations; it
is not very easy to see which words in a sentence are the significant,
commanding ones, and which are performing, as it were, ordinary
routine duties. A diagram is not exposed to similar ambiguities of

The particular distinction, to which attention has been called, is
important. The reader who has grasped it clearly will be able to
perceive many instances of the confusion arising out of its neglect in
the ordinary discussions of economic questions which take place in the
press and on the platform. It is not uncommon, for instance, for an
argument to run something like this: "The effect of a tax on this
commodity might seem at first sight to be an advance in price. But an
advance in price will diminish the demand; and a reduced demand will
send the price down again. It is not certain, therefore, after all,
that the tax will really raise the price." A glance at the diagram
will keep us out of such a bog of sophistry and muddle. For if we
suppose the amount of the tax per unit of the commodity to be
represented by S_s_, the curve _ss'_ (drawn, as it is, roughly
parallel to SS') will represent the new conditions of supply after the
tax has been imposed. The new position of equilibrium will be given by
the point P', where _ss'_ cuts DD', the demand curve. Now P' lies to
the left of P the old point of equilibrium; hence, since DD' _must_
slope downwards from left to right, it is clear that, if, as it is
fair here to assume, the _conditions_ of demand have remained
unaltered, the new price P'M', must be greater than the old.

§4. _Reactions of Changes in Demand and Supply on Price_. Having now
made clear the meaning that must be attached to the terms, let us
consider the question which naturally arises, whether we can lay down
any general propositions or laws as to the effect upon price, of an
increase or decrease in demand or supply. Another glance at the
diagram suggests that we can. An increase in demand is represented in
Fig. 2 by a movement from DD' to _dd'_, which cuts the supply curve,
SS', at _p_, to the right of P. Since the supply curve (drawn, as it
is best to draw it, to represent the amount which will be supplied in
response to a given price) must always slope upwards from left to
right, the new price, _pm_, must be greater than the old, PM.
Conversely a decrease in demand is represented by a movement from
_dd'_ to DD', and the new price is seen to be less than the old. We
have already seen that a decrease in supply, which is represented by a
movement from SS' to _ss'_ results in a higher price; and it is the
obvious converse that an increase in supply will have the opposite
effect. It would seem then that we might lay down quite generally that
an increase in demand or a decrease in supply will raise the price
while a decrease in demand or an increase in supply will lower it.

But here it is necessary to be cautious. All conclusions as to the
effects of causes are necessarily based, implicitly, if not
explicitly, upon the assumption "other things being equal." This
method of reasoning, which some people appear to find so irritating in
the economic sphere, and as they say so "theoretical" and "unreal," is
one which they adopt readily enough in every other department of
life. No one, for instance, objects to the statement that the sun,
when it comes out, makes a room warmer, although it may very well
happen, if a fire is dying at the same time, that the room grows
colder in point of fact. For in our general statement we assume
implicitly that "other things" such as fires, are unchanged. But
assumptions of this kind are legitimate only when there is no reason
to suppose that the cause, the effects of which are being studied,
will itself produce a change in the "other things." If (as I have
often been told; I really do not know if it is true) the rays of the
sun help to put a fire out, the statement made above would be the
better for some qualification.

Now we can only say that an increase in demand raises price if we
assume the conditions of supply (as represented by the supply curve)
to remain unchanged. But in practice, an increase in demand may cause
a change in the _conditions_ of supply. An increase, for instance, in
the demand for a commodity may give rise to a revolution in the
methods of production, to the introduction of labor-saving machinery
and so forth, which will eventually result in the commodity being
produced more cheaply. It will certainly take a considerable time
before reactions of this kind can exert an appreciable influence; and
we can, therefore, feel reasonably sure that over a short period an
increase in demand will raise the price. But we cannot be sure what
the ultimate effect will be. A similar alteration in the condition of
demand is less likely to result from an increase or decrease in
supply; but it may conceivably occur. We must, therefore, be careful
to qualify any general propositions which we lay down in this
connection, by explicit reference to a short period of time. We can
add the following to our body of laws:--

LAW IV. An increase in demand, or a decrease in supply will tend to
   raise the price for a short period at least. Conversely a decrease
   in demand, or an increase in supply will tend to lower the price
   for a short period at least.

This law, like the others, applies to commodities, services, capital,
to anything which can be said, literally, or by analogy, to have a
price. "A short period" is, however, a vague expression and, since
precision is the hallmark of an important law, we must accord to this
one a status inferior to that which the preceding three can rightly

§5. _Some paradoxical reactions of price changes on supply_. Let us
turn, though, once more to these earlier laws, and with a heightened
critical sense let us submit them to the test of the whole gamut of
our experience, and see if in any of them we can find the smallest
flaw. The first of them will pass through the ordeal--let each reader
prove it for himself--unscathed. The second will emerge with a few
hairs, as it were, singed. It tells us, for instance, that a rise in
price will tend to augment the supply. Now there are some things the
supply of which cannot possibly be augmented; these are the capital
resources of nature, of which land is the most important for our
present purpose. Land is bought and sold, it commands a price. In a
certain sense, it may be said to be possible to increase the supply of
land, in response to a rise in price, by drainage and reclamation
schemes; and it will certainly happen that a rise in the price which
land can command for any particular purpose will increase the amount
which is devoted to that purpose. But, speaking broadly, the supply
of land available for purposes of every kind is a fixed unvarying
factor, with an inertia which the cajolery of price-changes is
powerless to disturb. This is a most important fact, and it gives rise
to some peculiar features of the price and rent of land, which we
shall have to consider later as a separate problem. It constitutes a
limiting case rather than an exception to the general law. But we have
not yet done with the reactions of price upon supply. In the case of
capital, the nature of those reactions has been much discussed as a
highly controversial question. That a rise in the rate of interest
will cause some people to save more than before, is generally
admitted; but it is pointed out that the effect upon others may be the
exact opposite, because it means that they do not need to save so much
to acquire the same future annual income. It is unwise to say
dogmatically that the former tendency outweighs the latter; though
upon the whole it seems highly probable that it does. We cannot,
therefore, in this case feel confident that a change in price will
react upon supply in the manner which our law indicates. Similarly it
is possible to argue that a rise in the general level of real wages
may reduce the supply of labor, even, or some might say particularly,
if the term is used to denote not the number of workpeople, but the
quantity of work done. For there may be a tendency for workpeople,
when more comfortably off, to work less regularly or less hard. Here
again we cannot be sure. In none of these cases, however, including
that of land, is there any reason to doubt that a rise in price will
diminish _demand_, or conversely that a fall will increase it. Since,
therefore, in the reasoning by which we deduced the third law, the
conclusion will hold good, even if the effects of price-changes on
supply are of the above paradoxical kind, provided that they do not
continually outweigh the effects upon demand, there is no reason to
cast doubt on the solidity of Law III, which, indeed, as we suggested
before, commends itself directly to experience. But Law II seems now,
perhaps, somewhat the worse for wear.

The damage, however, is not considerable. For in each case the
uncertainty arises only when we are dealing with one of the factors of
production, land, labor or capital, _regarded as a whole_. If we are
dealing with the capital available for a particular industry, a rise
in the rate of profit in that industry will certainly increase the
supply of capital available there; for it will tend to attract savings
that might otherwise have been employed elsewhere. We can even be
fairly sure that an increase in the general rate of interest
prevailing in any particular country will increase the total supply of
capital available for the businesses of that country, since capital
has in modern times acquired a considerable migratory power. In the
case of labor, we cannot go so far as this; but here, too, there is no
doubt that an increase in the remuneration offered in any particular
occupation will attract an increased labor supply (always supposing,
of course, that "other things are equal"). No similar difficulty
arises for land, labor or capital, as regards the effect of
price-changes on demand; while for ordinary commodities there is no
such difficulty on the side either of demand or of supply. Hence the
only qualification which the strictest accuracy would require us in
this connection to attach to our statement of Law II is the

   "Except that, in the case of land, the aggregate supply is
   unalterable; while in the case of capital or labor we cannot be
   sure how price-changes will affect the aggregate supply."

Much significance attaches to these exceptions, as later will appear.

§6. _The Disturbances of Monetary Changes_. But let us still keep a
critical eye on Law II, and submit it to another flashlight from our
practical experience. The recent world war made us all acutely aware
of a remarkable rise in the price of almost everything, which yet did
not seem to diminish appreciably the demand. The explanation of this
paradox is not difficult to find. There was an immense increase in the
volume of nominal purchasing power, due to a complex set of causes, of
which "currency inflation" may be taken as the symbol. Now perhaps we
are entitled to assume the absence of such currency changes as part of
the "other things being equal" which is always understood as
implied. But it is rash to take this particular assumption for
granted, more especially in these days. Already people are too apt to
speak as though the trade depression (which as these pages are written
holds us in its grip) cannot pass away until pre-war prices are
restored, ignoring altogether the great and probably permanent
increase in nominal purchasing power which the war has left behind
it. It would be safer, therefore, to add explicitly to Law II the
reservation, "Assuming that there is no change in the general volume
of purchasing power."

Monetary and allied questions will form the subject of the second
volume of this series. It must not be supposed that our general laws
have no bearing on them. On the contrary, Law I, which all this time
has remained serene and undisturbed by the occasional discomfitures of
Law II, is the gateway through which all questions of currency,
banking and the foreign exchanges should be approached. It is well to
note, as an inexorable corollary of Law I, that prices can rise _only_
if demand exceeds supply, and fall _only_ if supply exceeds demand;
and hence that it is only through the agency of changes in the demand
for and supply of commodities and services that an inflation or
deflation of the currency can influence the price level. Further,
since a condition of things in which supply generally exceeds demand
spells what we know and fear as a trade depression, it may be well to
note at once that falling prices and unemployment are inseparable
bedfellows. For we are far too apt to shut our eyes to these
unpleasant truths. But we cannot pursue them further here; and in the
remainder of this volume we shall not be concerned (except, perhaps,
incidentally) with questions affecting the general level of prices or
of purchasing power; but rather with the relation which the price of
one commodity bears to that of another, with the rate of interest
(which being a rate per cent is not essentially dependent on the price
level), with "real" wages (as distinct from money wages) and the like.

§7. _The Trade Cycle_. But our reference to trade depressions suggests
a final comment on Law II. One small qualification was embodied in our
original statement of it, namely the words "sooner or later." A rise
in price may not check the demand immediately (even if the printing
presses are standing idle in the Treasuries); it may actually
stimulate it for a time. For people may fear that the price will rise
further still, and hasten to buy what they _must_ buy before very
long. Sellers may share the same opinion, and be reluctant on their
side to part. When prices are falling the roles are reversed, and we
are likely to see the sellers tumbling over one another in a frantic
eagerness to sell, the buyers wary and aloof. Sooner or later, indeed,
these tendencies must dissolve and disappear; but they may persist for
a longer period than might seem probable at first. For the raw
material of one trade is, as we say, the finished product of
another. The demand for one thing gives rise to a demand for other
things, for the labor with which to make them, and so on in an
expanding circle. A sympathy, subtle and intense, unites the business
world, and a wave of depression or animation arising in any quarter
may spread itself far and wide, heightened by the gusts of human hope
and fear, and continue long before its influence is spent.

Here we are upon the threshold of one of the most striking and
formidable of economic facts, the regular alternation of periods of
good and bad trade, each very widespread, if not world-wide, in its
range, each comprising certain regular phases of acceleration and
decay, and each infallibly yielding sooner or later to the other. The
details of these phenomena are highly complex, some of them obscure;
an immense literature has already been devoted to the subject, yet its
systematic study is hardly more than begun. The account given in the
preceding paragraph is incomplete and meagre. It is inserted here in
the hope that it will impress the reader with a sense both of the fact
of these alternations and of the deeply rooted nature of the causes
from which they spring. They take a heavy toll of human happiness and
wealth; and there is no object that more urgently calls for concerted
human effort than that of mitigating them, and of alleviating the
misery which they bring in their train. Still better, of eradicating
them if that is possible; but let none suppose that it can be lightly
done. Meanwhile, let us always remember that they form the atmosphere
and medium in which the enduring tendencies of the business world must
work themselves out. It is often convenient to speak of "normal
conditions" in this trade or that; but hardly ever can it be truly
said of a particular moment that conditions are normal. The normal is
rather a mean level about which oscillations to and fro, round and
about, are constantly taking place, but which itself is reached only
by accident, if at all. Whenever we say that some new factor should in
the long run lower the price of this or that commodity or service, the
picture which these words should convey to our mind is one of the
price rising less on times of boom, and falling more in times of
depression than is the case with other things. And if ever our faith
in some honored economic law is shaken by the apparent ease with
which, perhaps, in times of active trade, sellers are able to advance
their prices to whatever figure (so it almost seems) they choose to
name, let us rally our sense of economic rhythm, and reserve our
judgment until the trade cycle has run its course.



§1. _The Forces behind Supply and Demand_. The laws enunciated in the
preceding chapter constitute the framework and skeleton of all
economic analysis; but they do not carry us very far. It is only
through the agency of these laws that any influence can affect the
price of anything: but what influences may so affect it is a question
which we have still to consider.

Let us begin with ordinary commodities and ask ourselves, in the light
of experience and common sense, upon what factors their price seems
mainly to depend? Two factors spring to mind at once; their cost of
production and their usefulness. As regards the former, the case seems
clear enough. We may indeed sometimes grumble that the price of this
or that commodity is unconscionably high in comparison with its cost;
but this only goes to show that we conceive a relation between price
and cost as the normal, governing rule. If one commodity cost only a
half as much to produce as another, we should think that something had
gone very wrong indeed, if the former commodity were sold for the
higher price. But, when we turn to the usefulness of commodities, the
case is not so clear. Usefulness has some connection with price, so
much is certain; for an entirely useless thing, fit only for the
dust-bin (and known to be such, it may be well to add) will fetch no
price at all, however costly it may be to produce. But it is not easy
to express the connection in quantitative terms. It seems reasonable
enough to say that the prices of commodities are roughly proportionate
to their costs of production. But directly we contemplate saying a
similar thing of their usefulness, we are pulled up short. As we look
round the world, and enumerate the commodities which by common consent
are the most useful, salt, water, bread, and so forth, the striking
paradox presents itself that these are among the cheapest of all
commodities; far cheaper than champagne, motor-cars or ball-dresses,
which we could very well get on without. As things are, of course, a
ball-dress, or a motor-car costs more to produce than a loaf of bread
or a packet of salt; and the common-sense explanation of the paradox
seems, therefore, to be that the cost of production is a more weighty
influence than the usefulness, or utility, as we will henceforth call
it (so as to include the satisfaction we derive from not strictly
useful things). We are thus tempted to conclude that, provided a
commodity possesses some utility, its price will be determined by the
cost of production, the degree of utility being unimportant. This was
exactly how the position was gummed up for many years in systematic
treatises upon Political Economy; and it was not until fully half a
century after the _Wealth of Nations_ that a discovery was made which
threw a fresh light on the whole matter.

First of all, let it be clearly observed how very unsatisfactory is
the above account. In Chapter II where we were treading surely, with a
sense of solid ground beneath us, we drew no such invidious
distinction between supply and demand. They seemed then to possess an
equal status. But cost of production is the chief factor which, in the
case of commodities, ultimately determines the conditions of
supply. Utility, similarly, is the chief factor which ultimately
determines the conditions of demand. Must not then the symmetrical
relations between demand and supply be reflected in a corresponding
symmetry between the utility and the costs which underlie them? Demand
springs obviously from utility; the only motive for buying anything is
that it will serve some real or fancied use. Can we then accord to
demand so dignified and to utility so subordinate a place? There is
here an inconsistency which we must somehow reconcile. It will not
serve as a solution to distinguish between different periods of time,
and to say, as economists used to say not very long ago, that price is
governed over a short period by demand and supply, but in the long run
by the cost of production. This still leaves our sense of symmetry
unsatisfied. Moreover, the conception of cost of production, when we
consider it as ruling over a long period, frequently seems to lose any
precision, as an independent factor, which it may otherwise
possess. Motor-cars, we have agreed, are more costly to produce than
loaves of bread; but, as we know well, the cost of producing
motor-cars varies enormously, accordingly as they are produced on a
small or a large scale. By the methods of mass production they can be
turned out at a relatively low cost per car. But this requires that
they should be purchased in large numbers and this in turn throws us
back to the demand for motor-cars, and plainly enough, to people's
judgment as to their utility. In some cases, the opposite phenomenon
occurs. In the case of British coal, for instance, the average cost of
production would be much lower than it is if the output were reduced
to a fraction of its present volume, and if only the richer seams of
the more fertile mines were worked. Once again, therefore it is
difficult to measure the cost of production until we know the
magnitude of the demand, which in a manner, which we have still to
elucidate, clearly depends upon the utility.

If we take the problem of joint products, the conception of cost of
production fails us still more conspicuously. For what is the cost of
producing wool, or the cost of producing mutton? We can speak of the
cost of rearing sheep: but it is hardly possible to allot this cost,
except quite arbitrarily, between the two products. How, then, can we
explain the separate prices of these things by reference to cost
alone? Instances of joint production are becoming so common in the
modern world, or at least, with the growing attention to the
utilization of by-products, are assuming so much more heightened a
significance, that an explanation of price, which does not apply to
them, is a very feeble one indeed.

§2. _The Law of Diminishing Utility_. Let us turn back, then, to the
factor of utility, and see if we cannot put on a more satisfactory
basis the relation between utility and price. The clue to the puzzle
is to be found in a brief reflection on the implications of the second
general law propounded in Chapter II. A rise in price, it was there
stated, will sooner or later diminish the demand. This was asserted as
a matter of fact, observed from and confirmed by experience. But what
does it signify? To what causes is this familiar fact to be
attributed? The first stage of the answer is very ample. The many
individuals, whose purchases make up the demand for the commodity,
will buy smaller quantities now that the price is higher. Possibly
some of them may cease to buy it altogether; but as a rule it would be
reasonable to suppose that most people continue to buy a certain
amount though a smaller amount than hitherto. Let us turn our
attention, then, to the individual purchaser, and ask ourselves why he
(or let us say she) acts in the manner indicated. The obvious answer
is that the more she already has of anything, the less urgently does
she require a little more of it. If she buys 6 pounds of sugar every
week when the price is 7 cents a pound, but only 5 pounds when the
price is 8 cents, she shows by her action that she does not consider
that the additional utility she will derive from buying 6 pounds a
week rather then 5 pounds is worth as much as 8 cents. But she shows
at the same time that she thinks it worth 7 cents. For, when the price
is 7 cents, no one compels her to buy that sixth pound. She could
stop, if she chose, at five; and it may serve to make the point quite
plain if we suppose her actually to hesitate before she buys the
sixth. She has hitherto, let us say, been buying 5 pounds a week at 8
cents. To-day she enters the shop and finds the price is down to 7
cents. She asks for her customary 5 pounds; then she pauses, and a
minute later turns her order into six. What are the alternatives which
she has been weighing one against the other in that momentary pause?
Not the utility of the whole 6 pounds of sugar against the total price
of 42 cents. For she has already ordered the first 5 pounds; and the
decision to buy the sixth is taken independently and subsequently. She
has been sizing up the _increment_ of utility which a sixth pound
would yield, and she decides that this is worth the expenditure of a
further 7 cents. Again, when the price was 8 cents she need not have
bought as many as 5 pounds. She could have stopped at 4 had she
chosen, and the fact that she did buy 5 pounds shows that the
increment of utility derived from buying a fifth pound, when she might
be said already to have 4, was worth at least 8 cents in her judgment.

This trite illustration enables us to lay down two important laws
relating to utility. To state them shortly, it is convenient to employ
one or two technical terms, which, unlike every term employed
hitherto, are not very commonly used in their present sense in
everyday life. Their adoption is desirable not merely for the sake of
convenience, but because they help to stamp clearly on the mind a most
illuminating conception, that of the "margin," which supplies the clue
to many complicated problems. The last pound of sugar which the
housewife purchased, the fifth pound when the price was 8 cents, or
the sixth pound when the price was 7 cents, we call the "marginal"
pound of sugar. And the increment of utility which she derives from
buying this marginal pound we call the "marginal utility" of sugar to
her. We are thus able to state the fact that the more a person has of
anything the less urgently does he require a little more of it, in the
following formal terms:--

LAW V. The marginal utility of a commodity to anyone diminishes with
   every increase in the amount he has.

The total utility will, of course, increase with an increase in the
amount, but at a diminishing rate. This law is usually called The Law
of Diminishing Utility.

§3. _Relation between Price and Marginal Utility_ But this is not
all. We are now in a position to perceive the true relation between
utility and price. The relation is one which exists not between price
and total utility, but between price and marginal utility. If we know
only that a housewife will buy weekly 5 pounds of sugar at 8 cents per
pound, but 6 pounds at 7 cents, we know nothing of the total utility
of sugar to her. We do not know how much she might be prepared to pay
rather than go without 3 pounds, 2 pounds, or any sugar at all. But we
do know that, when she buys 6 pounds, the marginal utility of sugar is
in her judgment worth something which does not differ greatly from the
price. We can, therefore, say in general terms that the price of a
commodity measures approximately its marginal utility to the

This statement is perfectly consistent with the paradox noted above
that the most useful commodities such as bread, salt and water are
very cheap. For when we say that these commodities are supremely
useful, we mean only that their total utility is very great; that,
rather than do without them altogether, we would offer for them a
large proportion of our means. But we would not value very highly a
small addition to the bread, water or salt that we habitually consume;
nor would most of us feel it as a very serious deprivation if our
consumption of these things were curtailed by a small percentage. In
other words, their _marginal_ utilities are small, and it is only the
_marginal_ utility that has any relation to price.

§4. _The Marginal Purchaser_. A possible objection to the preceding
argument deserves to be considered. Some readers may find the picture
I have drawn of the hesitating housewife entirely unconvincing. They
may declare that her mind does not work at all in the manner I have
indicated. She will have formed certain habits in regard to her weekly
purchases of sugar, which are connected very vaguely, if at all, with
any conscious processes of thought. She will buy so many pounds of
sugar weekly without troubling her head over the specific utility of
the last pound she buys. When the price falls she may, indeed, buy
more; but it will not be because she separates out and considers by
itself the extra utility of an additional pound. She may buy more,
because she has formed the habit of spending so much money on sugar;
and now that the price has fallen, the same amount of money will
enable her to buy more pounds. Or, perhaps, she may be moved by
instinctive and irresistible attraction to buy more of a thing when it
is cheaper, similar to that which inspires so many people to face with
ardor the horrors of a bargain sale. In any case the fine calculations
I have imagined convey a fantastic picture of her state of mind. And
how much more fantastic, the critic may continue, of the state of mind
in which things of a different kind are bought by less careful
people. When, for instance, one of us happy-go-lucky males (more
liberally supplied, perhaps, than the housewife with the necessary
cash), decides to buy a motor bicycle, or to replenish his stock of
collars or ties, does the above analysis bear any resemblance to the
actual facts? In the case of the motor bicycle, the purchaser may,
indeed, weigh the price fairly carefully against the pleasure and
benefit, though contrariwise he may be a rich enough gentleman hardly
to bother about this. But, one motor bicycle is as much as he is at
all likely to buy, and what becomes, then, of the distinction between
total and marginal utility? In the case of the ties and collars, the
vagueness of many of us about the price will be extreme. We probably
have been uneasily conscious for some time of an inconvenient shortage
of these troublesome articles and eventually will go off (or perhaps
will be sent off with ignominy) to the nearest suitable shop to make
good the deficiency. How can we speak here with a straight face of the
relation between marginal utility and price?

These are very pertinent criticisms; but they do not make nearly as
much nonsense of the notion of marginal utility as may seem at
first. The last point, indeed, serves rather to give it a fresh aspect
of much significance. Those of us who do not bother about the price we
pay for our ties and collars owe a debt of gratitude, of which we are
insufficiently conscious, to the more careful people who do; as well
as to the custom which prevails in shops in Western countries (as
distinct from the bazaars of the East) of charging as a rule a uniform
price to all customers. If _we_ were the only people who bought these
things, an enterprising salesman would be able to charge us very much
what he chose. He could put up his price, and we would hardly be aware
of it. And, as by lowering his price he could not tempt us to buy any
more, price reductions would be few and far between. But fortunately
there are always some people who do know what the price is, even when
they are buying collars and ties; and who will adjust the amount they
buy in accordance with the price. It is these worthy people who make
the laws of demand work out as we well know they do. It is they who
will curtail their consumption if the price has fallen and it is they
who constitute the seller's problem, and help to keep down prices for
the rest of us. The rest of us--it is well to be quite blunt about
it--simply do not count in this connection. We have no cause then to
plume ourselves that we have disproved the truth of economic laws when
we declare that we seldom weigh the utility of anything against its
price. All that this shows is that our actions are too insignificant
to be described by economic laws since they exert no appreciable
influence on the price of anything. And this in turn shows the extreme
importance of grasping clearly the conception of the margin. Just as
it is the marginal purchase, so it is the marginal purchaser who
matters. It is the man who, before he buys a motor bicycle, weighs the
matter up very carefully indeed and only just decides to buy it, whose
demand affects the price of motor bicycles. It is the utility which
_he_ derives that constitutes the marginal utility, which is roughly
measured by the price.

As to the housewife, I am not prepared to concede that my picture is
in essentials very fanciful. She may be a creature of habits and
instincts like the rest of us, but most habits and instincts affecting
household expenditure are based ultimately on _some_ calculation, if
not one's own, and reason has a way of paying, as it were, periodic
visits of inspection, and pulling our habits and instincts into line,
if they have gone far astray. I am not satisfied that the housewife
does not envisage the utility of a sixth pound of sugar as something
distinct from the utility of the other five; she may buy it, for
example, with the definite object of giving the children some sugar on
their bread, and she may have a very clear idea as to the price which
sugar must not exceed before she will do any such thing. Possibly I
may exaggerate. I have the profound respect of the incorrigibly
wasteful male for the care and skill she displays in laying out her
money to the best advantage.

§5. _The Business Man as Purchaser_. But if the reader still finds the
picture unconvincing, let us shift the scene from domestic economy to
commerce, and substitute for the careful housewife an enterprising
business man. Now, as anyone who has a business man for his father
will have often heard him say, the vagueness and caprice which
characterize our personal expenditure would be quite intolerable in
business affairs. There you must weigh and measure with the utmost
possible precision. You must be for ever watching the several channels
of your expenditure, careful to see that in none does the stream rise
higher than the level at which further expenditure ceases to be
profitable. You will not even engage typists or install a telephone in
your office without weighing up fairly carefully the number of typists
or the number of switches that it is worth your while to have. And in
deciding whether to employ say, five typists, or six, you will not
vaguely lump the services of the whole six typists together, and
consider whether as a whole they are worth to you the wages you must
give them. You will, in the most direct and literal manner, weigh up
the _additional_ benefit you would derive from a sixth typist, and if
that does not seem to you equivalent to her wage, you will not engage
her, however essential it may be to you to have one or two typists in
your office. If on the other hand, the utility of having a sixth
typist seems to you worth much more than her pay, the chances are that
you will be well advised to consider the employment of a seventh. And
so, where you stop employing further typists, the utility to you of
the last one, of the "marginal typist" as it were, is unlikely to
differ greatly from her pay.

Now this is not a fancy picture of some remote abstraction called an
"economic man." Allowing for the over-emphasis which is necessary to
drive home the central point, it is a bald account of the aims and
methods of the actual man of business. To ascertain the margin of
profitable expenditure in each direction, to go thus and no further,
is the very essence of the business spirit, as the business man
himself conceives it. When he condemns the extravagance of Government
departments, it is their lack of just this marginal sense that he
chiefly has in mind. "The lore of nicely calculated less or more" may
be rejected by High Heaven and Whitehall, but no one can afford to
despise it in the business world.

The transition from household to business expenditure involves an
extended use of the word utility, which is worth noting. Commodities
like bread, sugar, or privately owned motor-cars are sometimes called
"consumers' goods" in contrast to "producers' goods," which comprise
things such as raw materials, machinery, the services of typists and
so forth, which are bought by business men for business purposes. The
line of division between the two classes is not a sharp one, and we
need not trouble with fine-spun questions as to whether a particular
commodity should in certain circumstances be included under the one
head or the other. But, broadly speaking, things of the former type
yield a direct utility; they contribute directly to the satisfaction
of our pleasures or our wants. Things of the latter type yield rather
an indirect utility. Their utility to the business man who buys them
lies in the assistance they give him in making something else from
which he will derive a profit. The utility of these things is
therefore said to be _derived_ from that of the consumers' goods or
services to which they ultimately contribute. This conception of
derived utility leads to certain complications which we shall have to
notice later.

§6. _The Diminishing Utility of Money_. But one important point must
be emphasized in this chapter. The utility which a business man
derives from the things which he buys for business purposes is the
extra receipts which he obtains thereby. Derived utility, in other
words, is expressed in terms of money, and the idea of its relation to
price presents no difficulty. But the utility of things which are
bought for personal consumption means the _satisfaction_ which they
yield, and this is clearly not a thing which is commensurable with
money. When, therefore, it is said that the prices measure their
respective marginal utilities, what exactly is meant? What was it that
the argument of §3 went to show? That the utility of the marginal
pound of sugar would seem to the housewife just worth the price that
she must pay for it; in other words, that it would be roughly equal to
the utility she could obtain by spending the money in other ways. The
respective marginal utilities which _she_ obtains from the different
things she buys will thus be proportionate to their prices. But if she
were to receive a legacy which gave her a much larger income to spend,
she might buy larger quantities of practically every commodity; and,
though she would obtain a greater total utility thereby, the marginal
utility she would obtain in each direction would be smaller, in
accordance with the law of diminishing utility. The prices might not
have changed; the respective marginal utilities to her of the
different things would again be proportionate to their prices, but
they would constitute a smaller satisfaction than before.

Thus we can only say that the prices of commodities will be
proportionate to their real marginal utilities, when we are
considering the different purchases of one and the same
individual. The amounts of money which different people are prepared
to pay for different consumers' goods are no reliable indication of
the real utilities, the amounts of human satisfaction which they
yield. Here we must take account not only of varying needs and
capacities for enjoyment, but of the very unequal manner in which
purchasing power is distributed among the people. The cigars which a
rich man may buy will yield him an immeasurably smaller satisfaction
than that which a poor family could obtain by spending the same amount
of money on boots, or clothes or milk. When, therefore, we compare
commodities which are bought by essentially different consuming
publics, their respective prices may bear no close relation to their
_real_ utility, whether marginal or otherwise. Thus the law of
diminishing utility applies to money or purchasing power, as well as
to particular commodities. The more money a man has the less is the
marginal utility which it yields him; and, where the marginal utility
of money to a man is small, so also will be the real marginal utility
he derives in each direction of his expenditure. The extreme
inequality of the distribution of wealth gives immense importance to
this consideration. Its practical implications will be discussed in
Chapter V. Meanwhile, we may express the conclusions of the present
chapter by the statement that the price of a commodity tends to equal
its marginal utility, _as measured in terms of money_, i.e. relatively
to the marginal utility of money to its purchaser.



§1. _An Illustration from Coal_. We have already had occasion to note
the symmetry which characterizes the relations of demand and supply to
price. This symmetry was apparent throughout the argument of Chapter
II, and it was a striking feature of the diagrams which we employed to
illustrate the argument. We shall do well to cultivate a lively sense
of this symmetry, for it will frequently save us from ignoring factors
which have a vital bearing on the problems we are considering. We
should never leave an important feature of demand without turning to
see whether it has a counterpart on the supply side, though indeed we
may not always find one. In the last chapter we examined the relation
between utility and price, and found that the true relation was
between the price and what we termed the marginal utility.
Corresponding to utility on the demand side is cost of
production on the supply side. The question should thus at once
suggest itself--"Can we speak appropriately of the marginal cost of
production, and will this serve to make clear the relation between
cost and price?" To answer these questions, let us take one of the
instances in which we found that price could not be explained
satisfactorily by the bare phrase "cost of production."

An important feature of the coal industry, which recent events have
brought into sharp prominence, is the great diversity of conditions
between different coalfields and different collieries. We speak of
rich seams and poor seams, of fertile and unfertile mines, and we are
aware that the costs of raising coal to the surface differ very widely
in accordance with these diverse natural conditions. Nor must we
confine our attention to the cost price at the pit-head. If we wish to
speak of cost of production as a factor determining price, we must use
the term in a broad sense to include the transport and other charges
necessary to bring the coal to market.

In this respect also one coalfield differs greatly from another. Some
are well situated close to a large market, or within easy reach of the
seaboard; others must incur very heavy transport charges to bring
their coal to any considerable centre of consumption. These varying
conditions lead, as we well know, to great variations in the financial
prosperity of different colliery concerns. In Great Britain, under the
abnormal conditions which prevailed during the war, and subsequently,
these variations were so huge as to constitute a most formidable
embarrassment and to contribute, more perhaps than any other single
factor, to the unrest and instability by which the industry has been
afflicted. But they are always with us, if usually upon a more modest

What, then, is the normal relation between price and cost in the case
of coal? Should we direct our attention to the average costs over the
whole industry, or the costs incurred by the richer and better
situated mines, or, lastly, that of the poorer and worse situated?
Now, as things are, it is clear enough that no concern will continue
indefinitely producing at a loss. It may do so for a time, rather than
close down altogether, hoping to recoup itself later when the market
has taken a more favorable turn. But, in the long run, taking good
years with bad, it must expect to obtain receipts sufficient not only
to cover its necessary expenditure, but to provide also a reasonable
profit on the capital employed. Of course, once the capital has been
sunk and embodied in plant and buildings, which are of little use for
any other purpose, a business may continue for many years, with a rate
of profit far below what it had anticipated. But plant and buildings
gradually wear out, and need to be replaced; the course of technical
improvement calls continually for fresh capital outlay, which a
business in a bad way is reluctant to undertake. The tendency,
therefore, when profits rule low over a considerable period, is for
the plant to fall gradually into disrepair and obsolescence, and
finally for the business to disappear. We can thus include an
ordinary rate of profit under the head of cost of production, and say
with substantial accuracy that for no business can this cost for long
exceed the price if the business is to continue to exist. If then the
relatively poor and badly situated mines are to be worked, the price
of coal, taking good years together with bad, must cover the costs at
which these mines can produce. If the price rules lower than this,
sooner or later they will close down, and we will be left with a
smaller number of mines, among which great variations of conditions
will still prevail. Once more, the price must cover the cost incurred
by the least profitable of these remaining mines, unless their number
is still further to be diminished. Thus we can conceive of a "margin
of production" which will shift backwards to more profitable or
forwards to include less profitable mines, according as the demand for
coal contracts or expands. But, wherever this margin may be, there is
no escaping the conclusion that it is the cost of production of the
"marginal mines," of those that is to say which it is only just worth
while to work, to which the price of coal will approximate.

It follows that there is no real connection between price and cost of
production throughout the industry as a whole. It follows incidentally
that those concerns which can market their coal at an appreciably
lower cost than the marginal concerns, are likely to reap more than an
ordinary rate of profit, though royalties may absorb part of the

§2. _The Various Aspects of Marginal Cost_. This relation cuts much
deeper than the particular system under which the mines are at present
owned and worked. If, for instance, we supposed that the various
mines were amalgamated together in a few giant concerns, each of which
comprised some of the richer and some of the poorer mines, the
preceding argument would need to be recast in form, but its substance
would be unaffected. For though a great coal trust could in a sense
_afford_ to sell at a price lower than the marginal cost, setting its
losses on the poorer against its gains on the better pits, is it
likely it would do so? Why should it dissipate its profits in this
way? It is clearly more reasonable to suppose that it would close down
the poorer pits (unless it could advance the price of coal), and
thereby maintain its profits at a higher figure. If, indeed, the
mines were nationalized the deliberate policy might be pursued of
selling coal at a price which left the industry no more than
self-supporting as a whole. Some coal might thus be sold at less than
its cost price, and the selling price would conform roughly to the
_average_ cost. But such a policy, though in special circumstances it
might be justified, would represent a very dangerous principle, which
could not be applied widely without the most serious results. Nothing
could be more fatal to any enterprise, whether it be in the hands of
an individual, a joint-stock company, a State department, or a Guild,
than that the management should content themselves with results which
in the lump seem satisfactory, and regard losses here or there with an
indifferent eye. That way lies stagnation, waste, progressive
inefficiency and ultimate disaster. To inquire searchingly into every
nook and cranny of the business, to construct, as it were, for each
part a separate balance-sheet of profit and loss, to expand in those
directions where further development promises good results, and to
curtail activity where loss is already evident, is the very essence of
good management. Here, it will be observed, we are using language very
similar to that in which we described the principles which govern a
business man's expenditure. The resemblance is inevitable and
significant, for we are dealing here with what is essentially another
aspect of the same thing. The object is to secure that nowhere does
expenditure fail to yield a commensurate return. This we express, when
we consider a business in its aspect as a consumer, by saying that its
consumption of anything will not be carried beyond the point at which
the marginal utility exceeds the price it will have to pay. When we
consider it as a producer, we say that its production of anything will
not be carried beyond the point at which the marginal cost exceeds the
price it will obtain.

§3. _The Dangers of Ignoring the Margin_. This at least is the general
rule. A business may decide deliberately to sell part of its output
below cost, because, for instance, this will serve as an
advertisement, bring it connections, and enable it to obtain a larger
profit at a later date, or immediately on other portions of its
sales. In so acting, it recognizes that the price obtained for a thing
may be an inadequate measure of the real return it yields. In the same
way, though for different reasons, a nationalized coal industry might
conceivably be justified in selling some coal below cost price,
because, let us say, it held that the price which the immediate
purchasers were willing to pay was an inadequate measure of the
utility of coal to the community as a whole. But in all such cases it
is essential to be very clear as to what exactly you are doing; so
that you may be at least moderately clear as to whether the policy is
well advised. It may be sound enough to lose on the swings and make
good this loss on the roundabouts, but only if your loss on the swings
_helps_ you to a larger profit on the roundabouts. If you would get
the same return on the roundabouts in any case, it would be better to
cut the swings out altogether. So, if you are directing the policy of
a nationalized coal industry, and decide to make a loss on a portion
of your sales, you will need to know that the indirect benefit which
the community will derive from this particular part of your coal
output is worth the loss which you incur. You will certainly come to
grief, if you pursue a vague ideal of lumping all results together,
and regarding a profit somewhere as a sufficient excuse or a positive
reason for making a loss elsewhere.

It is quite true that in big undertakings, where there are large
standing charges, and where the organization possesses some of the
characteristics of an integral whole, it is not easy to measure
accurately the specific costs which should be assigned to any
particular portion of the output. But this difficulty is one of the
most serious weaknesses of large undertakings; precise detailed
measurement is the great prophylactic of business efficiency, and,
where it is lacking the bacilli of waste will enter in and
multiply. So clearly is this recognized, that the development of large
scale business has led to the evolution of new methods of accountancy,
designed to make detailed mensuration possible. We have most of us
heard of them vaguely under such names as "comparative costings," but
too few of us appreciate their full significance. It is hardly too
much to say that the issue as to whether the size of the typical
business unit will continue to become larger and larger, or whether it
has already overshot the point of maximum efficiency will turn largely
upon the capacity of accountancy to supply large and complex
undertakings with more accurate instruments of detailed financial

§4. _A Misinterpretation_. The price, then, of a commodity tends
roughly to equal its marginal cost of production; and this marginal
cost (in perfect symmetry with what we observed as regards marginal
utility), may be conceived as applying either to the marginal producer
or to the marginal output of any producer. In the former aspect it is
open to a misinterpretation, against which it will be well to guard.
Some advocates of socialism have argued, as one of the counts in their
indictment of the present industrial system, that the price of a
commodity is determined by the cost at which the least efficient
concern in the industry can produce. They say, in effect, "Under the
present competitive regime, you have to pay for everything you buy a
price which far exceeds the necessary cost to a concern which is
managed with ordinary ability. For, as economic theory has shown, it
is the cost of the _marginal_ concern, i.e. the concern managed by the
most incompetent, and half-witted fellow in the trade; it is the cost
incurred by him, together with a profit on his capital, that the price
has got to cover. The producer of no more than average capacity is
therefore making out of you a surplus profit, which would be quite
unnecessary in any well-arranged society." Such an argument is a gross
caricature of the marginal conception. The half-witted incompetent
will, as we know well enough, speedily disappear under the stress of
competition, and his place will be taken by more efficient men. There
is an essential difference between him and the "marginal coal mine" of
which we spoke above. For the probabilities are that of the coal
resources, whose existence is clearly known, the more fertile and
better situated parts will already be in process of exploitation; and
there is not likely, therefore, to be a supply of substantially better
seams which can be substituted for the worst of those in actual use.
There _is_ likely, on the other hand, to be available a supply of
decent business capacity which can be substituted for the most
inefficient of existing business men. The marginal concern, in other
words, must be conceived as that working under the least advantageous
conditions in respect of the assistance it derives from the strictly
limited resources of nature, but under average conditions as regards
managerial capacity and human qualities in general. Thus in
agriculture we can speak of a marginal farm, which we should conceive
as the least fertile and worst situated farm which it is just worth
while to cultivate (of which more will be said when we come to the
phenomenon of rent), but we must assume it to be cultivated by a
farmer of average ability.

§5. _Some Consequences of a Higher Price Level_. The foregoing
controversy will be of service to us, if it makes clear the manner and
the spirit in which the marginal conception should be handled. It
should be regarded not as a rigid formula which we can apply to
diverse problems without considering the special features they
present, but rather as a signpost which will enable us to find our
way, a compass by which we may steer between the shoals of triviality
and sophistry to the crux of any problem with which we have to deal.
Let us illustrate its practical uses by an example which is of great
interest and far-reaching practical importance at the present day. As
has been already observed, the war has left behind it in all countries
a great and almost certainly permanent increase in nominal purchasing
power. Since the armistice prices have moved upwards and downwards
with unprecedented violence; and it would be very rash to prophesy the
precise level at which they will ultimately settle (using that word
with considerable relativity). But, for reasons for which the reader
is referred to Volume II in this series, it is safe enough to say that
the general level of post-war will greatly exceed that of pre-war
prices. Now this will apply not only to consumers' goods like milk and
clothes, or to raw materials like pig-iron and cotton, but in very
much the same degree to things like factories and machinery. Things of
this last type are sometimes called "capital goods," because it is in
them that a large part of the capital of a business is embodied. Now
the fact that it will cost much more than it did before the war to
construct fresh capital goods, has a significance which very few
people appreciate. An existing factory cost, let us say, $500,000 to
build and equip with machinery before the war. To construct a similar
factory to-day would cost, let us assume (it is probably a moderate
assumption) $1,000,000. Suppose 10 per cent to be the gross profit
that is necessary to attract capital to the particular industry. Then
it will not pay to construct this new factory unless the trade
prospects point to the probability of a profit of about $100,000 per
annum. But if the old factory is equally well managed, it too should
be able to earn this $100,000, which upon the capital actually sunk
would represent a rate of 20 per cent. The particular figures given
are, of course, purely illustrative; the conclusion to which they
point is that, if new enterprises are to be undertaken, pre-war
enterprises are likely to yield a rate of profit, on their fixed
capital at least, increased in rough proportion to the price-level. Of
course, in years when trade is bad, the factory which dates from
pre-war times will not earn a profit of this kind, it may very likely
make an actual loss. At those times it is very certain that few new
factories will be erected. But it is difficult to reconcile a
condition of trade activity, in which the constructional industries
are busily employed, with a rate of profit to pre-war businesses on
the fixed part of their capital of a lesser order of magnitude than
has been indicated. It makes no difference, it should be observed,
whether we suppose the new enterprises to take the form of starting of
new concerns or extending old ones; in neither case will they be
undertaken, unless there is reason to expect an adequate return on the
capital which they require at post-war constructional prices. High
profits (taking always good years together with bad) on capital sunk
before the war in buildings and machinery are thus a likely
consequence of an increase in the price-level.

This fact is, indeed, the counterpart or complement of another
phenomenon with which we are more familiar. While prices are actually
rising, profits, as we have come to recognize, necessarily rule high,
because every trader or manufacturer is constantly in the position of
selling at a higher price-level, stock which he purchased, or goods
made from materials which he purchased at a lower level. He thus
acquires an abnormal profit on his circulating capital, which is
essentially similar to the profit on fixed capital, which we have just
examined. The difference is that the former profit is crowded into the
years when prices are actually on the increase, and thus is very
noticeable indeed; while the latter profit continues to accrue in
smaller instalments after prices have settled down, as it were, at the
higher level, and is not exhausted until the buildings and machinery
have become obsolete. But the two profits are essentially similar,
and in the long run should be commensurate. In the one case, stock can
be sold for a large profit, because it cannot be replaced except at a
higher price; in the other case, plant and buildings yield a higher
income because _they_ cannot be replaced except at a higher
price. Indeed, if the owners choose, the plant and building can, like
the stock, be sold at their appreciated value, as has been widely done
by the owners of cotton mills in Great Britain since the armistice.

There is nothing in these considerations that should surprise us, or
even shock our moral sense. For what they have indicated is an
increase of money profits in rough proportion to the price-level, so
that the aggregate profits will represent about as much real income as
before.[1] The conclusion therefore amounts to no more than this, that
you cannot alter fundamentally the distribution of wealth between
labor and capital by merely inflating the currency, or otherwise
juggling with the price-level. And this is only what we should expect,
if there are any laws of distribution of sufficient importance and
permanence to justify the many volumes which have been devoted to

[Footnote 1: Assuming that the rate of interest has remained
unaltered. In fact it has greatly increased since pre-war days, and
this points to a still further increase of money profits, and an
increase in the real income which they represent. See Chapter VIII,

But this somewhat tame conclusion does not make it any less important
to grasp clearly the significance of the appreciation in the value of
capital goods. A failure to realize it lies at the root of our
bewildered muddling of many crucial problems of the day. In the matter
of housing, for instance, we know we cannot build houses at less than
two or three times their prewar cost, and yet we cannot endure to see
the owners of pre-war houses obtaining a commensurate increase of
rent. And so, in Great Britain, we pass Rent Restriction Acts, and
Housing Acts, and then, in a fit of economy we suspend the latter, and
let the former stand, while the housing shortage becomes steadily more
acute. When we hand the railways back from State control to private
hands, our horror at the idea of the companies receiving larger money
profits than they did before the war leads us to lay down principles
for the fixing of fares and freight charges, which take no account of
post-war construction costs; and then, in alarm lest we may have
thereby made it unprofitable for the companies to spend a single penny
of fresh capital upon further development, we seek to provide for
capital expenditure by cumbrous and dubious expedients. Doubtless we
shall muddle through somehow with such policies: and, public opinion
being what it is, they may perhaps have been about the best policies
that were practicable. But the problems would have been easier to
handle, if the public generally were a little less disposed to think
in terms of averages, and a little more in terms of margins, if we all
of us instinctively realized that the cost that really matters is the
cost at which additional production is profitable under the conditions
ruling at the time, or in the immediate future.

§6. _General Relation between Price, Utility and Cost_. Let us
conclude this chapter by summing up the conclusions which have emerged
as to the relations of utility and cost to price.

The price of a commodity is determined by the conditions of both
supply and demand; and neither can logically be said to be the
superior influence, though it may sometimes be convenient to
concentrate our attention on one or other of them. The chief factor on
which the conditions of demand depend is the utility (as measured in
terms of money). The chief factor on which the conditions of supply
depend is the cost of production (again as measured in terms of
money). The prevailing trend towards an equilibrium of demand and
supply can thus be expressed as follows:--

LAW VI. A commodity tends to be produced on a scale at which its
   marginal cost of production is equal to its marginal utility, as
   measured in terms of money, and both are equal to its price.



§1. _Marginal Cost under Joint Supply_. Several references have been
made above to joint products, a relation which it will be convenient
now to describe as that of Joint Supply. Our sense of symmetry should
make us look for a parallel relation on the side of demand; and it is
not far to seek. There is a "joint demand" for carriages and horses,
for golf clubs and golf balls, for pens and ink, for the many groups
of things which we use together in ordinary life. But the most
important instances of Joint Demand are to be found when we pass from
consumers' to producers' goods. There, indeed, Joint Demand is the
universal rule. Iron ore, coal and the services of many grades of
operatives are all jointly demanded for the production of steel; wool,
textile machinery and again the services of many operatives are
jointly demanded for the production of woollen goods (to mention in
each case only a few things out of a very extensive list). Now we have
already noted that, when commodities are jointly supplied, there is an
obvious difficulty in allocating to each of them its proper share of
the joint cost of production. There is a similar difficulty in
estimating the utility of a commodity which is demanded jointly with
others. Thus, the utility of wool is derived from that of the woollen
goods which it helps to make. But the utility of the factories, the
machinery and the operatives employed in the woollen and worsted
industries is derived from precisely the same source. How much, then,
of the utility of woollen goods should be attributed to the wool and
how much to the textile machinery? Can we make any sense of the notion
of utility as applying to one of these things, taken by itself? And,
if not, how can we explain the price of a thing like wool in terms of
utility and cost, since we cannot disentangle its cost from that of
mutton, nor its utility from that of a great variety of other things?

Here the conception of the margin enables us to grapple with a problem
which would otherwise be insoluble. For, while it is impossible to
separate out the total utility and cost of wool, it is not impossible
to disentangle its marginal utility and its marginal cost. The
proportion in which wool and mutton are supplied cannot be radically
transformed; but it can be varied within certain limits, by rearing,
for instance, a different breed of sheep. Variations of this kind have
been an important feature of the economic history of Australasia,
where sheep farming is the leading industry. Before the days of cold
storage, Australia and New Zealand could not export their mutton to
European markets, though they could export their wool. Wool was
accordingly much the most valuable product; the mutton was sold in the
home markets, where, the supply being very plentiful, the price was
very low. In the circumstances, the Australasian farmers naturally
concentrated on breeding a variety of sheep whose wool-yielding were
superior to their mutton-yielding qualities. The development of the
arts of refrigeration led in the eighties to an important change. It
became possible to obtain relatively high prices for frozen mutton in
overseas markets. There was, therefore, a marked tendency, especially
in New Zealand, to substitute, for the merino, the crossbred sheep
which yields a larger quantity of mutton and a smaller quantity of
wool of poorer quality. Now if we calculate the cost of maintaining
the number of merino sheep which will yield a given quantity of wool,
and calculate the cost of maintaining the larger number of crossbred
sheep which will be required to yield the _same_ quantity of wool
(allowing for differences of quality) the extra cost which would be
incurred in the latter case must be attributed entirely to the extra
mutton that would be obtained. This extra cost we can regard as
constituting the marginal cost of mutton. So long as this marginal
cost falls short of the price of mutton, it will be profitable to
extend further the substitution of crossbred for merino sheep. The
process of substitution will in fact be continued until we reach the
point at which the marginal cost is about equal to the price.
Similarly by starting with the numbers of merino and crossbred
sheep which would yield the same quantity of mutton, we can calculate
the marginal cost of wool; and again the tendency will be for this
marginal cost to be equal to the price.[1]

[Footnote 1: It may be found difficult to grasp this point when stated
in general terms. The following arithmetical example may make it

Suppose a merino sheep yields 9 units of mutton and 10 units of wool.

Suppose a crossbred sheep yields 10 units of mutton and 8 units of

Suppose, further, that a merino sheep and a crossbred sheep each cost
the same sum, say, for convenience, £10, to rear and maintain; and
that there are no special costs assignable to the wool and the mutton
respectively, as, of course, in fact there are.

Then 10 merino sheep, yielding 90 units of mutton + 100 units of wool,
cost £100; while 9 crossbred sheep, yielding 90 units of mutton + 72
units of wool, cost £90.

Hence you could obtain an extra 28 units of wool for an extra cost of
£10, by maintaining 10 merino sheep rather than 9 crossbred sheep. The
marginal cost of wool is thus £ 10/28 per unit.

Similarly 8 merino sheep, yielding 72 units of mutton + 80 units of
wool, cost £80; while 10 crossbred sheep, yielding 100 units of mutton
+ 80 units of wool, cost £100.

Hence you could obtain an extra 28 units of mutton for an extra cost
of £20, by maintaining 10 crossbred sheep in place of 8 merinos. The
marginal cost of mutton is thus £ 20/28 per unit.

So long as the price obtainable for wool exceeds £ 10/28, and that
obtainable for mutton does not exceed £ 20/28 per unit, it will pay to
substitute merino for crossbred; and conversely. If the price of wool
exceeds £ 10/28 and the price of mutton also exceeds £ 20/28, it will
be profitable to expand the supply of both breeds, until as the result
of the increased supply, one of the above conditions ceases to
obtain. Conversely, if the prices of both products are less than the
figures indicated, sheep farming of both kinds will be restricted.
The resultant of the processes of expansion or restriction, and
substitution, will be that, unless one of the breeds is eliminated,
the prices of mutton and wool will equal their respective marginal
costs. These marginal costs may, of course, alter as the process of
substitution extends. For the relative cost of maintaining merinos and
crossbreds will not be the same for every farmer. Here again it is the
costs at the "margin of substitution" that matter.]

§2. _Marginal Utility under Joint Demand_. On the side of demand there
exist as a rule similar possibilities of variation. _Some_ machinery,
_some_ labor, _some_ materials of various kinds, are all indispensable
in the production of any manufactured commodity. But the proportions
in which these factors are combined together can be varied, and are
frequently varied in practice as the result of the ceaseless pursuit
of economy by business men. To produce pig-iron, you need both coal
and iron ore; but, if coal becomes more costly, it is possible to
economize its use. Machinery and labor must be used together, in some
cases in proportions which are absolutely fixed. But there is in
nearly every industry a debated question as to whether the
introduction of some further labor-saving machine would be worth
while, or some improved machine which would represent the substitution
of more capital plus less labor for less capital plus more labor. A
farmer can cultivate his land, to use a common expression, more
intensively or less intensively; in other words, he can apply larger
or smaller quantities of capital and labor (the proportion between
which he can also vary) to the same amount of land. The problem is
essentially the same as that of the substitution of the crossbred for
the merino. We can take the various possible combinations of the
factors of production, and contrast two cases in which different
quantities of one factor are employed, together with equal quantities
of the others. The extra product which will be yielded in the case in
which the larger quantity of the varying factor is employed can then
be regarded as the marginal product (or marginal utility) of the extra
quantity of that factor; and we can say that the employment of this
factor will be pushed forward to the point where this marginal product
will be roughly equal to the price that must be paid for it. We can
thus lay down the most important proposition that the relation between
marginal utility and price holds good generally of the ultimate agents
of production; that the rent of land, the wages of labor, and, we can
even add, the profits of capital tend to equal their (derived)
marginal utilities, or, as it is sometimes expressed, their marginal
net products.

Whenever, therefore, the proportions in which two or more things are
produced or used together can be varied, the relations of joint supply
and joint demand are perfectly consistent with a specific marginal
cost and marginal utility for each commodity.

§3. _A contrast between Cotton and Cotton-seed, and Wool and
Mutton_. But it sometimes happens that such variations cannot be
made. Thus, it has not been found possible (so far as I am aware) to
alter the proportions in which cotton lint and cotton-seed are yielded
by the cotton plant. Roughly speaking, you get about 2 pounds of
cotton-seed for every 1 pound of cotton lint (or raw cotton), and
though this proportion may vary somewhat from plantation to
plantation, it is upon the knees of the gods, and not upon the will of
the planter that the variation depends. We cannot, therefore, speak
with accuracy of the separate marginal costs of raw cotton and
cotton-seed. It is true that some plantations are so far distant from
any seed-crushing mill that it is not worth while to sell the seed as
a commercial product; and it might seem, therefore, as though we might
regard the entire costs of cotton growing on _such_ plantations as
constituting the marginal costs of raw cotton. But planters, so
situated, derive a considerable value from their cotton-seed by using
it as fodder for their live stock or as a manure. You can, of course,
argue that proper allowance is automatically made for this factor, as
a deduction from the costs of raw cotton, when you add up the expenses
of the plantation. In the same way you can deduct the price which a
planter who sells his cotton-seed obtains for it, from the total costs
of the plantation, and call the remainder the costs of the raw
cotton. But this is really to reason in a circle. For in either case
the magnitude of the deduction depends on the marginal utility of the
cotton-seed. And the notion of the cost of anything becomes blurred
and blunted if we so use it that it must be deduced from the utility
of something else, which is not an agent in the production of the
thing in question.

This point is not merely an academic one. It means that we cannot
explain the _relative_ prices of cotton lint and cotton-seed in terms
of cost at all, whether marginal or otherwise. The influence of cost
will be confined to the _sum_ of the prices of the two things. Upon
this sum it will exert precisely the same influence as it exerts upon
price in general, by affecting the total quantities of the two things
that will be supplied. But upon the distribution of this sum between
lint and seed, cost will exert no influence whatever, because it
cannot affect the proportions in which they are supplied. It may
assist some readers if I state the matter in more concrete terms. Cost
of production will be one of the factors which will result in the
production of an annual cotton crop in the United States of, let us
say, 10 million tons of seed cotton. This crop will yield roughly
6-2/3 million tons of cotton-seed, and 3-1/3 million tons (or rather
more than 13 million bales) of lint. The combined price received by
the planter of (let us say) 14.4 cents for 1 pound of lint plus 2
pounds of seed should correspond roughly to the marginal joint costs
of production. But the factor of cost has no influence at all in
determining that this combined price is made up of a price of 12 cents
per pound for lint, and only 1.2 cents per pound (or $24 per ton) for
cotton-seed. To account for this we must rely entirely upon demand. We
can say, shortly, that the respective prices must be such as will
enable the demand to carry off 6-2/3 million tons of seed, and 3-1/3
million tons of raw cotton. Or we can go further and say that the
marginal utility of a pound of raw cotton, when 3-1/3 million tons are
supplied, is ten times as great as that of a pound of seed when 6-2/3
million tons are supplied.

If accordingly the demand for cotton-seed were to expand considerably
owing, say, to the discovery of some new use for the oil, which is its
most valuable constituent; the effect would be first a rise in the
price of cotton-seed, and, subsequently, by stimulating cotton
growing, a more plentiful supply and a lower price for raw cotton. And
so far at least as the increased supply is concerned, this must
necessarily be the effect, "other things being equal"; though, to be
sure, it might be outweighed and obscured by other influences such as
the boll-weevil. But it is _not_ the case that an increased demand for
mutton must necessarily increase the supply or lower the price of
wool; and it is most unlikely to do so in any similar degree. For,
here, the separate marginal costs of the two things exert their
influence. An increased demand for mutton will stimulate sheep
farming, but it will also stimulate the substitution of crossbred for
merino breeds; and the resultant of these two opposite tendencies upon
the supply of wool is logically indeterminate. As a matter of history
we know that the development of cold storage in the eighties (which we
may regard for the present purpose as equivalent to an increased
demand for Australian mutton) caused considerable perturbation in the
woollen and worsted industries of Yorkshire. They were faced with a
dwindling supply and a soaring price of merino wool; and the
adaptability with which they met the situation, and won prestige for
the crossbred tops, and yarns and fabrics, to which they largely
turned is a matter of just pride in the trade to-day. The fact,
however, that this alteration in the supply of wool was a matter not
only of quantity but of quality, while it takes nothing from the
substance of the preceding argument, makes it difficult to draw a
clear moral, bearing on the present issue, from this incursion into

§4. _The Importance of being Unimportant_. The above contrast between
cases in which variation is possible, and those in which it is not
possible, is reproduced with a heightened significance when we turn
back to joint demand. The cases are perhaps less common in which it is
_impossible_ to alter the proportions in which different commodities
are jointly demanded, but there are many cases in which it is not
nearly worth while to do so (and this amounts to very much the same
thing). Cases of this sort are especially likely to occur when we are
dealing with a commodity which accounts for only a tiny fraction of
the costs of the industry which is its chief consumer. Sewing cotton,
for example, is jointly demanded, with many other things, by the
tailoring and other clothing trades; but the money which these trades
spend on sewing cotton is so small a part of their total expenditure,
that no ordinary variation in its price is likely to make it worth
while to study the ways and means of using it in smaller
quantities. When sewing cotton is bought by the domestic consumer,
considerations which are fundamentally the same, though somewhat
different in form, point to a similar conclusion. It is thus very
difficult to assign to sewing cotton a specific marginal utility. This
difficulty is of great importance in connection with the possibilities
of monopolistic exploitation. For it means that the demand blade of
the scissors upon which we rely to cut off excrescences of price is
blunted, and if accordingly the producers constitute a strong enough
combination to control the supply blade, they will possess an unusual
power of advancing their selling prices as they choose. I am far from
suggesting that Messrs. J. & P. Coats are to be condemned as an
extortionate monopoly. On the contrary, during 1919, when the profits
in highly competitive industries like the main branches of the cotton
and woollen trades, soared exuberantly, the record of this concern
seems to me one of distinct moderation. But the present point is that
they possess an exceptional _power_ to fix the price of sewing cotton
as they choose, and that this is attributable in no small degree to
the fact that sewing cotton constitutes an essential but relatively
trifling item in the expenses of the processes in which it is

Perhaps the point will be made clearer if we turn from the selling
prices of commercial products, in regard to which there is a strong
and not ineffective public sentiment against "profiteering," to the
remuneration of different classes of labor. With an instinctive
disposition towards megalomania, it is often claimed in Great Britain
that the miners, being a very numerous and well-organized body of
workpeople, were in a stronger strategic position than most workpeople
for exacting the remuneration they desire. It is quite true that a
stoppage of work in the coal industry causes us a high degree of
inconvenience, and temporary concessions may thereby be obtained which
might otherwise have been refused. But this is a dubious advantage,
and we grossly exaggerate its real importance. The truth is that the
strategic position of the miners in regard to wages questions is by no
means strong. For their wages constitute a very large percentage of
the cost of coal; and the price of coal in its turn is a most
important element in the costs of many of the industries which are its
principal consumers. Great Britain, moreover, is far from possessing
a monopoly of coal. If, accordingly, the wages of the miners are
temporarily pushed up to a high point, the result will certainly be a
diminished demand for British coal, which will lead before long to
their fighting a losing battle to maintain the concessions they have
won. Contrast their position with that of the steel smelters, whose
wages (high though the wage rates are) constitute a very small
percentage of the costs of steel production, and we must agree I think
that we have in this distinction the main reason why the steel
smelters, though they hardly ever go on strike, have as a rule been
able to do so much better for themselves than the miners.

When a commodity or service is such that an appreciable alteration in
its price has only a slight effect upon the quantity demanded, the
demand is said to be _inelastic_. Conversely, when a small change in
price greatly alters the quantity demanded, we call the demand
_elastic_. In the former case, it is worth nothing, a larger aggregate
sum of money will be spent upon the thing when its price is high than
when it is low, while the opposite is true in the latter case. This
distinction is of considerable importance in connection with many
problems (e.g. of taxation); and the terms, elastic demand and
inelastic demand, are worth remembering. We may thus express the
above conclusions by saying that the demand for sewing-cotton is
highly inelastic, and that the demand for coal miners is more elastic
than that for steel smelters.

§5. _Capital and Labor_. Cases in which it is impracticable to make
any variation in the proportions in which different things are used
together are, however, the exception rather than the rule. Where
variation is possible, we are confronted with an uncertainty as to the
way in which an increased supply of one thing will react on the demand
for another, similar to our uncertainty as to whether an increased
demand for mutton would augment or diminish the supply of wool. It is,
for instance, of the highest importance to give a clear answer, if we
can, to the question whether an increased supply of capital will
increase the demand for labor. The chief effect of an increased
supply of capital is to facilitate the extended use of expensive
machines: to some extent these machines will increase the demand for
labor; to some extent they will be substituted for it. Which of these
two tendencies will outweigh the other we cannot be absolutely
sure. But fortunately we can be far more nearly sure than was possible
in the analogous case of wool and mutton. An increase in the supply of
capital increases the demand for the commodities, from which the
demand for labor is derived, in both the senses discussed in Chapter
II. First it makes them cheaper to buy, and thus increases the
quantity that will be bought. It is this that is parallel to the
effect of an increased demand for mutton in making it more profitable
to breed sheep. But it also serves to increase the purchasing power
with which to buy commodities, because it increases the aggregate real
wealth of the community, and it thus serves to raise the whole demand
curve. This last consideration is so important as to make it
overwhelmingly probable, apart from the evidence of history, that an
increase in the supply of capital (and the same may be said of an
increase in the supply of the other agents of production) will on
balance increase the demand for labor. The evidence of history points
to the same conclusion. The history of the last hundred years displays
an unprecedented accumulation of capital, and an unprecedented
extension of machinery, associated with an unprecedented improvement
in the standard of living throughout the whole community. This is
powerful testimony in favor of the view that an increase in the supply
of capital and the use of machinery will usually enhance on balance
the demand for labor. Moreover, though this is not conclusive, there
is little room for doubt that an obstructive attitude towards the
extension of machinery in a particular country, or a particular
district, is misguided. For its effect must be to make production
more costly there than it is elsewhere, and to lead, slowly perhaps,
but very surely, to the transference of the industry to other regions.

§6. _Conclusions as to Joint Supply and Joint Demand_. Here, however,
we are beginning to digress. Let us sum up in a general form our
conclusions as to the way in which changes in the supply or demand of
a commodity react upon the demand or supply of the other things with
which it is jointly demanded or supplied. Everything turns, as we have
seen, on the possibility of variation in the proportions in which the
things are used or produced together; and this, it is also clear, is a
matter of degree. Our conclusions, therefore, had best take the
following form:--

LAW VII. When two or more things are jointly demanded, in proportions
   which cannot easily be varied, the tendency will be for an increase
   (or decrease) in the supply of one of them to increase (or
   decrease) the demand for the others. These results will be more
   certain, and more marked, the more difficult it is to vary the
   proportions in which the things are used.

   Similarly, when two or more things are jointly supplied, in
   proportions which cannot easily be varied, the tendency will be for
   an increase (or decrease) in the demand for one of them to increase
   (or decrease) the supply of the others. These results again will be
   more certain and more marked, the more difficult it is to vary the
   proportions in which the things are supplied.

§7. _Composite Supply and Composite Demand_. Joint Demand and Joint
Supply do not complete the list of relations between the demand and
supply of different things. Between tea and coffee, or beef and mutton
there is a relation of a different kind. These things are in large
measure what we call "substitutes" for one another. An increased
supply, and a lower price of mutton, will probably induce us to
consume less beef. This relation it is convenient to describe as
Composite Supply. Beef and mutton make up a composite supply of meat;
tea and coffee a composite supply of a certain type of beverage. For
any group of things, between which the relation of Composite Supply
exists, we can say, with complete generality, that an increased supply
of one of them will tend to diminish the demand for the
others. Parallel to the relation of Composite Supply is that of
Composite Demand. There are frequently several alternative uses in
which a commodity or service can be employed; and these alternative
uses make up a composite demand for the thing in question. Thus
railways, gasworks, private households and a great variety of
industries contribute to a Composite Demand for coal. It is worth
noting that there is frequently an association in practice between
Joint Demand and Composite Supply on the one hand; and between Joint
Supply and Composite Demand on the other. Wool and mutton, for
instance, we have described as an instance of Joint Supply; but, in so
far as the proportions of wool and mutton can be varied, we can regard
these things as constituting a Composite Demand for sheep. And this
conception may help us to retain a clearer and more orderly picture of
the problems we have discussed above. We can regard the fact that wool
and mutton are produced together as their Joint Supply aspect, and the
fact that these proportions can be varied as their Composite Demand
aspect; and the question as to whether an increased demand for mutton
will increase the supply of wool turns upon whether the former aspect
is more important than the latter. Similarly labor and machinery,
employed together for the same purpose, form an instance of Joint
Demand; but in so far as they can be substituted for one another, they
constitute a Composite Supply of alternative agents of production.

These four relations of Joint Demand, Joint Supply, Composite Demand
and Composite Supply are well worth remembering and distinguishing
from one another. They are of immense importance in every branch of
economic affairs. There are hardly any economic problems upon which we
are fitted to express an opinion, unless we have a lively sense of the
far-reaching ramifications of cause and consequence, of the subtle and
often unexpected interconnections between different industries and
different markets. To gape at these complexities in a confused stupor
is as foolish as it is to ignore them. But confusion and stupor are
only too likely to represent our final state of mind, if we attempt to
deal with these complications, one by one as they occur to us, in a
piecemeal and haphazard fashion. We need a clear method, a systematic
plan by which we may search them out, and fit them into place. The
four relations which we have enumerated supply us with such a plan and
method. For they represent something more than a series of pompous
names for familiar notions. They constitute a classification of the
various ways in which the demand and supply of one thing can affect
the demand and supply of others; a classification which is exhaustive
when we add the relation of derived demand, and an analogous relation
on the supply side which we must now notice.

§8. _Ultimate Real Costs_. Just as the utility of "producers' goods"
is derived from that of the "consumers' goods" which they help to
make; so the cost of any commodity is derived from the cost of the
things which help to make it. Moreover, just as we recognize that the
utility of "consumers' goods" lies at the back of all demand, and
constitutes the ultimate end of all production; so we cannot but feel,
however obscurely, that behind the phenomena of money costs, there
must lie certain ultimate costs, of which all money costs are but the
measure. But when we try to explain what the nature of these real
costs may be, we are plunged in difficulty. Wages, it may indeed seem
at first sight, present no trouble. There is the effort and the
fatigue, the unpleasantness of human labor, to represent real
costs. But can we suppose that these things are measured with any
approach to accuracy by the wages which are paid in actual fact? Is it
true, even as a broad general rule, that the services which are most
arduous and most disagreeable command the highest price? And wages are
not the only ingredient of money costs. There are profits: to what
real costs do profits correspond? More difficult still, to what does
rent correspond? These plainly are not questions upon which he who
runs may read. It will be necessary to devote the next four chapters
to their elucidation.



§1. _The Special Characteristics of Land_. In the great process of
co-operation by which the wants of mankind are supplied, Nature is an
indispensable participant. She renders her assistance in an infinite
variety of ways, of which the properties of the soil which man
cultivates form only one; but the sunshine and rain which enable the
farmer to grow his crops; the coal and iron ore beneath the surface of
the earth, can be regarded for our present purpose as forming part of
the land with which they are associated. We can thus concentrate upon
land as the representative of the free gifts of nature, which are of
economic significance. Land in modern communities is for the most part
privately owned. It can be bought and sold for a price, and acquired
by inheritance. Moreover, it is a common practice, particularly in the
United Kingdom, for an owner who does not wish himself to cultivate or
otherwise use the land, not to sell it to the man who does, but to
lease it to him for a term of years for an annual payment which we
term rent. It is therefore natural and convenient to envisage the
problems, which we shall consider in this chapter, as problems
concerning the price and rent of land. But, once again, the laws and
principles which we shall state and illustrate in terms of the current
systems of ownership and tenure, possess a much deeper significance
than this terminology might suggest.

The fact that land is a free gift of Nature distinguishes it in
various ways from commodities which are produced by man. The
peculiarities which are most important from the economic standpoint
are (1) that the supply of land is, broadly speaking, fixed and
unalterable, and (2) that its quality and value vary, from piece to
piece, with a variation which is immense in its range, but fairly
continuous in its gradation. These are thus two aspects from which
the phenomena of price and rent can be regarded; aspects which it is
usual to call, (1) the scarcity aspect, (2) the differential aspect.

§2. _The Scarcity Aspect_. The fact that the supply of land is fixed
has the following significance. If the demand for land increases, the
price will tend to rise. This is also true, for a short period at
least, of an ordinary commodity. But, in the latter case, there would
ensue an increase in supply which would serve to check the rise in
price, and possibly, if production on a larger scale led to improved
methods of production, bring the price down eventually below its
original level. In the case of land, no such reaction is
possible. There is nothing, therefore, to restrain the price (and the
rent) of land from rising indefinitely, and without limit, if the
demand for it should continue to increase. Conversely, if the demand
for land falls off, there is nothing to check the consequent fall in
price and rent. In the case of ordinary commodities, the supply would
be diminished, because most things are either consumed by being used,
or wear out in the course of time, and a regular annual production is
therefore necessary to sustain their supply at the existing level. But
land remains, whether it is used or not; and its supply is, broadly
speaking, just as incapable of being diminished, as it is of being
increased. Changes in the demand for land in either direction are thus
likely to affect its price in a much greater degree than that in which
the price of an ordinary commodity will be affected by a corresponding
change in its demand.

For most purposes, however, it is of more interest to compare land
with other agents of production, especially with capital and labor,
rather than with ordinary commodities. Now, as we have already noted,
there is some doubt as to the manner in which the supply of capital or
labor is likely to be affected by alterations in demand price. But the
supply of capital and the supply of labor, even if we suppose them to
be as entirely unresponsive to price changes as is the supply of land,
are at any rate not fixed. Not only _may_ they vary for many reasons,
but they are in fact likely to vary in direct proportion to the
population. An increase in population implies an increase in the
supply of labor; and it is likely to be accompanied by an increase in
the supply of capital; in other words, the supply of these agents will
expand, as the demand for them expands. But the supply of land will
remain what it was. This fact is enormously important in connection
with the broad problem of population, which will form the theme of
Volume VI.

But it is important also in other connections. It has been the
dominating factor in many absorbing controversies upon high policy
regarding the ownership of land, or the taxation of land values, upon
which we can touch but lightly here. It has seemed to many writers a
reasonable proposition to lay down, that the ordinary course of the
progress of society, the increase of population and industry, must
mean, as a broad general rule, a constant increase in the demand for
land. And, if that be granted, it seems to follow that the price and
rent of land will tend constantly to increase. John Stuart Mill,
accordingly, in the middle of the last century, asserted that "the
ordinary progress of a society, which increases in wealth, is at all
times tending to augment the incomes of landlords; to give them both a
greater amount and a greater proportion of the wealth of the
community, independently of any trouble or outlay, incurred by
themselves,"[1] and upon the strength of this assertion, he justified
the policy of imposing a special tax upon what we have come to call
the "unearned increment" of land. But how far does actual experience
bear his assertion out? In Great Britain we have seen in the last
half-century an undoubted increase in urban rents; but over long
periods at least, there was a marked fall in both the prices and rents
of agricultural land, despite the fact that the country was
"increasing in wealth" as rapidly as ever before. This was due, of
course, in the main to the increased supplies of wheat and other
foodstuffs coming from the New World: and if, accordingly, we choose
to lump together not only our own urban and agricultural land, but the
land of other countries as well, and to speak vaguely of the demand
for land as a whole, it might seem as though we could argue that
Mill's generalization still holds good. But even this is by no means
certain and in any case such a generalization is of very little
service: what the illustration should rather suggest to us, is the
danger of speaking of land vaguely as a whole, and the importance of
turning our attention to the variations in value between different
kinds and different pieces.

[Footnote 1: _Principles of Political Economy_, by John Stuart Mill.]

§3. _The Differential Aspect_. Most ordinary commodities are not
produced on a single, uniform pattern. As a rule there are many
variations of grade and quality, and consequently of price. But these
variations are usually designed to meet the differences of taste among
the purchasers, and we do not expect to find that any variety of an
ordinary commodity will be produced, which is so poor in quality as to
be entirely valueless. But since it is nature which has produced the
land, without any assistance or guidance from man, there are many
pieces of land which are so unfertile, or are otherwise so unsuitable
for productive purposes, as to be quite valueless from the economic
standpoint. Even in a densely populated country like Great Britain,
there are considerable tracts of land which it is unprofitable to
employ for any economic purpose whatsoever, and which possess no
further value than what the mere pride of ownership may give
them. This fact makes it possible to apply the conception of the
margin to the case of land with particularly illuminating results.

In the first place, however, it should be observed that the value of
any piece of land does not depend solely on the intrinsic fertility of
the soil. The fact that land is an immobile thing makes its
_situation_ a factor of great importance. In the case of urban land,
situation is, of course, the only thing that counts. The value of a
site in Bond Street or the City is entirely unaffected by its capacity
or incapacity for potato-growing purposes. But even for agricultural
land, situation is a most important matter. A farm, which is so remote
that considerable transport charges must be incurred to bring its
produce to market, will be less sought after, and less valuable, than
one which is much better situated though somewhat less fertile. In
what follows, therefore, we must speak of the "quality" of a piece of
land in a broad sense to include advantages of situation, as well as
of fertility. Let us now, imagine the different pieces of land in
Great Britain to be arranged in order of quality, so that we have a
long series, with land of the best quality at one end, and of the
poorest quality at the other. At the latter end, we will have such
land as is found near the top of Snowden or Ben Nevis, which it
clearly does not pay to cultivate at all. Somewhere, then, between
these two extremes, we shall come to a point where the land is just,
but only just, worth cultivating, or where, to revert to a form of
words we previously employed, it is a matter of _doubt_, whether the
land is really worth using for a productive purpose. Such land we can
regard as the "marginal land"; and since the variety of nature is at
once infinite and fairly minutely graduated we shall probably find
that on one side of this margin there is much land which is only
slightly superior, and on the other, much which is only slightly
inferior, to the marginal land itself. What, then, is likely to be the
value and the rent of this marginal land, this land which is just on
the "margin of cultivation"? Some readers may find the answer
startling. The rent of the marginal land will be nil, because it will
not pay to cultivate it, if any appreciable rent is charged. A piece
of land for which it is worth a tenant's while to pay an appreciable
rent, will not be the marginal land, because there will be land just
slightly inferior to it which it will also pay to cultivate if a
somewhat lower rent is charged. And so we can pass to poorer and
poorer qualities of land, with an ever diminishing rent, until at the
margin of cultivation the derived utility of the land is negligible
and the rent vanishes.

This certainly is a somewhat abstract conception; but it is by no
means so remote from reality as may at first sight appear. The reader
may protest that in the course of an extensive and varied acquaintance
with landowners, he has not yet run across this peculiar marginal
type, who lets his land for no rent at all. But there, if his
experience is really extensive, I think he is mistaken. It so happens
that the ordinary agricultural landowner leases out his land, not by
itself, but together with a variety of other things such as farm
buildings, which it costs him a considerable sum of money to
provide. He will not as a rule be willing to go to this expense,
unless he sees his way to obtain for the farm an annual payment, which
represents at least a fair return on this capital outlay, as big a
return as he could have got, for instance, by investing the same
amount of money in some gilt-edged security. This annual payment
will, it is true, be called rent; but the significance of this is that
what we term rent in ordinary life is usually a complex thing, made up
of two essentially distinct elements, viz. the normal return on the
capital goods supplied together with the land, and what we may call
the "net rent," or the "pure rent" attributable to the land
itself. Now will any reader make so bold as to say that there is no
land under cultivation, in respect of which this net rent is either
nil or negligible? The landowners will not agree with him. It is not
a question, it should be observed, as to whether the rent obtained
represents more than a fair return on the purchase price paid for the
land; that is quite another matter. The question is whether the rent
obtained exceeds a fair return on the capital sum spent on the
buildings, etc.; with which every farm must be equipped to let at
all. In fact there are not a few farms where there is no such excess,
and where accordingly there is no "net rent" or "pure rent" which can
be attributed to the land.

The question whether it would be profitable to cultivate any piece of
land, turns upon whether the receipts which would be obtained by
selling the produce would exceed the costs of cultivation: and under
these costs of cultivation we must include, of course, the
remuneration of the farmer's services. Farmers, like other people,
have to live; and they would not take on the troublesome job of
farming, unless there seemed a prospect of making a living out of
it. The remuneration of the farmer takes, of course, the form not of a
salary, but of profits: and these profits vary very much from year to
year, and from place to place, and from man to man. But they are
essentially payment for work done, and an ordinary profit must be
regarded therefore as part of the necessary costs of farming. Thus it
will not be worth while to cultivate a piece of land, and the land
will in fact lie unused, upon which a careful farmer might obtain a
profit in the ordinary sense, of no more than $50 or $100 a year. The
marginal land will be land which yields a decent profit to a decent
farmer, as well as a gross rent to the landowner, sufficient to
compensate him for his capital outlay, but nothing further.

What, then, will be the rent of a fertile and well-situated farm,
about which there is no doubt that it is well worth cultivating? Part
of the gross rent which the landowner receives must again be regarded
as merely a return for the capital expended in equipping the farm for
use; but in this case, there will be a residue left over, which
constitutes the net rent of the land. The net rent will measure the
derived utility of the land to its occupier, and will in general
represent (very roughly, of course, in practice) the differential
advantage of cultivating the land in question rather than land on the
"margin of cultivation." This differential advantage may take either,
or both, of the forms, of a larger produce per acre, or a lower cost
of production and marketing. But, in any case, the extra profit,
which, if no rent were charged, a decent farmer could obtain by
cultivating the farm in question, rather than a marginal farm, will be
roughly equal to the net rent which his landlord can exact from him,
if his landlord so chooses. The landlord may, of course, not choose to
exact a rent as high as this; and as a matter of fact, in a country
like Great Britain landlords often content themselves with less. The
traditions associated with the ownership of agricultural land, and
with the relations between landlord and tenant serve to soften the
edge of economic law, and to subject the rents which are actually
fixed to the control in no small measure of the general sense of what
is fair or customary. In such cases the landlord makes the farmer a
present, for the time being, of part of the economic rent. On the
other hand, as Irish agrarian history well illustrates, the landlord
may sometimes expropriate under the name of rent, permanent
improvements which are due to the labors or the expenditure of the
tenant. This is, of course, particularly likely to happen, whenever it
is the custom to leave to the tenant the obligation of providing the
capital equipment of the farm, which in Great Britain is, for the most
part, the recognized duty of the owner. Again, in the case of urban
land in the South of England, expropriations of this kind are an
essential and well-understood feature of the leasehold system. The
owner grants a lease for a long period of time, usually ninety-nine
years, for a ground rent, which is notoriously below the true economic
rent of the land, subject to the condition that the leaseholder must
erect upon the land and keep in good repair certain buildings, which
on expiry of the lease will become the property of the ground
owner. Here the nominal ground rent is only part of the total rent
which is really paid; the ultimate transference of the buildings
representing often the more important part. There is, in fact, a great
variety of systems of land tenure, some of which are highly complex,
the respective merits of which vary greatly, and which constitute a
most important problem for statesmen and legislators. Considerations
of this kind in no way diminish the importance of the general analysis
of rent, which we are pursuing in the present chapter. Rather they
make it the more important, because we cannot properly weigh the
merits of any system of land tenure, until we have grasped clearly the
principles governing the rent of land in the purest form. But
certainly we must never forget that the rent we are discussing may
differ very greatly from, though it will vitally influence, the money
payments which are called rent in actual life. It is the pure economic
rent, the rent which represents the _full_ annual payment which it
would be worth paying to obtain the use of the land alone, which will
measure, as we have said, the differential advantage of the land in
question over land on the margin of cultivation.

A clear grasp of this relation helps us to perceive that an increase
in the prosperity of the community may sometimes influence rents in an
unexpected way. It all depends on the causes which have given rise to
the increased prosperity. An advance, for instance, in agricultural
science will facilitate a more abundant supply of foodstuffs; but it
will not necessarily increase the aggregate rents of agricultural
land. For if it takes the form, say, of the discovery of some new
artificial manure, it will very likely facilitate production on the
less fertile soils far more than it will on the more fertile soils
where artificial manures are not so necessary. It will thus tend to
diminish the differential advantages of working on the more fertile
farms, and their rents will accordingly fall, possibly by much more in
the aggregate than any increase in the rents of the farms near the
margin of cultivation. The point may, perhaps, be better understood if
we pass from agricultural to urban land, and ask what would be the
effect on site values of a great improvement in the facilities of
internal transport. Push the case to an extreme, and suppose passenger
transport to become so cheap and so quick that there ceases to be any
advantage in living in a town so as to be near your place of work.
Urban landlords would no longer be able to obtain the high rents they
now receive for the sites of houses in or near a town. For most people
would prefer to move out into the country where sites can be obtained
at little more than an agricultural rent. The country covers so large
an area relatively to the towns that the supply of rural sites would
be still very plentiful as compared with the demand. Their rents would
not, therefore, rise by very much, although the rents of the housing
sites in towns would fall heavily. Of course, there are other factors
to be taken into account before we could pronounce upon the effect on
aggregate rents. Central sites for shops might, for instance, fetch a
higher rental than before. The purpose of this discussion is not to
generalize but to show the danger of generalizing about rents in the
aggregate, or land as a whole.

§4. _The Margin of Transference_. The last illustration may serve,
however, to remind us of an obvious fact which we must now take into
account. The same piece of land may be used for a variety of purposes.
It may have been used for growing corn, and later it may be devoted to
the building of houses, or, as at Slough, to a repair depot for motor
vehicles. It need hardly be said that the land will, as a general
rule, be put to the use in which its value is greatest; or to speak
more strictly, in which the biggest rent, or the biggest selling price
can be obtained. But the notion of the differential advantages which a
piece of land possesses over the marginal land becomes decidedly more
complicated when we take account of this variety of uses. Let us turn
our attention, for instance, to the sites used for shop and office
purposes, and consider what we can regard as the marginal site in this
connection. Clearly it will not be the marginal land of which we
spoke above, which it only just paid to cultivate, and which yielded
no rent at all. For this will probably be agricultural land in an
out-of-the-way district, where no one would dream of setting up an
office or a shop. Any site upon which a sane man would contemplate
setting up a shop will certainly possess value for other purposes,
such as house-building. Hence the marginal site for shopkeeping
purposes will not be like our marginal farm, a site which yields no

As regards many pieces of land, there is no doubt as to the purposes
for which they can most profitably be used. This piece will command a
much higher rent as a shop site than in any other capacity; for that
piece house-building is the obvious employment; for another,
agriculture. But in quite a number of instances there is considerable
uncertainty. It is not clear whether upon this site it will be better
to erect a house or a shop, or if the latter, what kind of a shop. It
is not clear whether it will pay to use that farm land for a building
scheme; and, within the domain of agriculture, which of course
comprises an immense variety of really different industries, it is
often a very moot point indeed whether a certain field should be left
under grass, or brought under the plow. Cases of this sort are not
phantoms of the imagination; they emerge on every side as concrete
problems with which some one or other is dealing every day, and it is
these cases which constitute the marginal land for the purposes of a
particular occupation. The marginal sites for shops are the sites for
which it is only just worth while to pay rents sufficient to entice
them away from houses. And the rent for a site in Bond Street, or
elsewhere, which is so much more suitable for shop purposes that no
alternative use would be worth considering, will exceed the rent paid
for one of these marginal sites by, roughly speaking, the extra
advantage it possesses for shop purposes. Or will fall short of it, it
may be well to add, to the extent of its comparative disadvantage. For
there may be many such marginal sites, some of which will fetch low
rents, and others very high rents indeed; the same site being often of
great potential utility for a large variety of occupations. Between
any two occupations there will thus usually be a _margin of
transference_, which we must conceive not as a point, but as an
irregular line, upon or near to which there will be many pieces of
land, differing greatly in the rents which they fetch. These
variations of rent will correspond to the differences between the
advantages or derived utilities which the sites possess for _both_ the
occupations in question. The position of such margins of transference
will of course alter as industrial conditions change, and, when they
alter, the rents of sites which are not near any margin of
transference will be affected also. Thus an increased demand for the
products of any particular industry will make it profitable for that
industry to offer higher rents, and thus draw land away from other
occupations. This will have the effect of raising, though possibly to
a very slight extent, the rents of sites which still remain in other
uses; for there will be fewer of them available; and their derived
utilities will consequently be increased.

But here, as everywhere, it is upon the margin that our attention
should be focussed, because it is round about the margin (wherever it
is found) that the changes are taking place which really matter for
society. When Mr. Mallaby-Deeley buys an estate in Covent Garden from
the Duke of Bedford, the transaction hardly deserves the degree of
public interest it excites. Nothing has happened which is of material
consequence to anyone except the two gentlemen concerned; the various
sites are still used for the various purposes for which they were used
before; nothing has occurred that really matters. But when houses are
pulled down for the erection of a cinema, or when a field is diverted
from tillage to pasture, something has happened which affects for good
or ill the interests of the whole community. Conversion from tillage
to pasture represents, indeed, a tendency which has been very marked
in Great Britain during the last generation, and has aroused
misgivings in many public-spirited observers. Possibly for a variety
of reasons, these misgivings may be justified; certainly the problem
is well worthy of attention. But when in this way the issue is raised
of tillage versus pasture, it is essential, if we are to discuss it
rationally, that we should envisage it clearly as applying only to a
limited portion of agricultural land, to the portion which lies
somewhere near the margin of transference, as things are now, between
the two forms of agriculture. It might be socially desirable to bring
under the plow a field which the farmer finds it only _slightly_ more
profitable to lease under grass; but this would be highly improbable
in the case of a field where the balance of argument to the farmer in
favor of pasture is overwhelming. The position of the margin of
transference between different uses may, in other words, be somewhat
out of place from the social point of view, and it may be desirable by
appeals and propaganda, even conceivably by the devices of State
subsidy and compulsion, to push it forwards or backwards in greater or
less degree. But it will be necessarily a matter of degree, and
nothing could be more foolish than to speak as though there was, or
could be, some ideal method of cultivation equally applicable to all
lands, without regard to their climatic and other conditions. Needless
to say, none of the agricultural experts who sometimes deplore the
decline of arable farming are guilty of such foolishness. But the
sense of the diversity of nature which is very vivid to them may
sometimes be lacking in people who live in towns, and a firm grasp of
the marginal notion may serve best to keep the latter from forgetting

§5. _The Necessity of Rent_. Behind all such detailed applications
there lies a more general consideration which deserves attention. The
way in which the land of a country is used, the way in which it is
apportioned between the countless alternative employments that are
possible, is a most important matter, more important perhaps than any
questions as to the size of the incomes which particular landowners
receive by virtue of their rights of ownership. How is this
apportionment effected as things are now? The answer is clear: mainly
by the agency of either rent or price. The business which finds it
worth while to offer the highest rent or the highest price for any
piece of land will, as a rule, be able to command its use. And, with
this as the governing principle, an apportionment is secured between
shops, offices, factories, agriculture, between the immense variety of
different employments covered by each of these broad headings; not a
rigid unvarying apportionment, but one which constantly changes as
economic circumstances change, and as the margin of transference
between different occupations moves hither and thither. This
apportionment takes place at present as the result of the independent
decisions and bargains of many private individuals, who are thinking
mainly of their own interests, and not of those of the community. But
this state of affairs might be altered. The land might be nationalized
and allocated to its various uses by the co-ordinated labors of a
great State department, or some other agency of the collective
will. However improbable such a change, it is perfectly conceivable.
But what is not conceivable is that any State department should handle
the job with a success even approaching that of the present system,
unless it continued to use, as its main instrument, the criterion of
either rent or price. That a piece of land would yield a higher rent
in one occupation than in any other is not conclusive evidence that it
is best to devote it to the former purpose, but it is very good
evidence, and it should be allowed to prevail unless it is
demonstrably outweighed, as it possibly might often be, by
considerations of a different kind. That it would not be well for the
community to employ land in the city of London for corn-growing
purposes, however desirable might be a revival of home agriculture, is
so obvious that it may seem to have no bearing on the present issue.
But it is only an extreme indication of the absurd and wasteful use of
our natural resources, which would grow up slowly but surely, if we
dispensed with ideas of rent and price as sordid irrelevancies, and
allocated our land on the basis of a balancing of the loftiest
arguments of a vague and sentimental character. If you are prepared
for the distribution of land to become stereotyped, for each piece to
continue indefinitely in its present use, then indeed you might
dispense with rent, as primitive societies very largely do. That would
mean stagnation and, for an industrial country, decay. But if changes
are ever to be contemplated, a simple quantitative measure is the only
safeguard against utter chaos. Thus rent, like interest, will be found
indispensable as a measure under any efficient system of society, even
if it might not always represent the payment of sums of money to
private individuals. And that is why the principles governing rent
possess, as I indicated at the outset of this chapter, an importance
more fundamental than our present system of ownership and tenure.

§6. _The Question of Real Costs_. But we must not forget the
preliminary question that started us upon our analysis of the agents
of production. The rent which a manufacturer or farmer has to pay for
his land he naturally includes in his cost of production. But does
this money cost to the individual correspond to, and measure, any real
cost to the community as a whole? Here let us note in the first place
that if only we could disregard the variety of uses to which land is
put, if we could suppose that all industry was agriculture, and that
agriculture was a single industry with a single product, we could
argue that rent does not enter into marginal costs at all. For we
could regard the marginal producer as the one working on a marginal
farm, whereas we have seen there is no pure rent. The rent which other
producers have to pay would thus represent merely the destination of
the surplus profits which arise wherever actual costs fall short of
marginal costs. This way of looking at the matter has proved
attractive to some thinkers, not in the least because of a desire to
palliate the effects of landlordism, but because it fits in so well
with our general sense of rent as a "surplus," and a surplus as
something distinct from a necessary price. But it is clearly
illegitimate in an economic theory which professes "to describe the
facts." The marginal land for many purposes fetches, as we have seen,
a considerable rent; and this rent is certainly part of the marginal
costs and of the necessary price of the products of the particular
industry. The answer to our question is, however, not now very
difficult to see. Land, greatly as it differs in many respects from
the other agents of production, resembles them in the very important
respect that, being used for one purpose, it is not available for
other purposes, and that the productive powers of the community in
other directions are thereby diminished. This is the real cost to the
community, which attaches to the products of any industry, in virtue
of the land which it occupies; not any human labors or sacrifices
required to produce the land itself, but the curtailment of the
natural resources available for productive use elsewhere. This is the
real cost of which rent is the money measure, and generally speaking
an accurate measure at the margin of transference between one
occupation and another. A somewhat fanciful use of the term cost, this
may seem perhaps, one not quite in accordance with our instinctive
sense of what real costs should be. But possibly the real costs
represented by wages and profits may turn out to be not so very
different, and we had best leave the matter there, until we have
examined the nature of these other costs.

§7. _Rent and Selling Price_. In this chapter we have spoken mainly of
the rent rather than the price of land: the relation between the two
things is fairly obvious and well understood, but it will be well not
to close the chapter without a brief account of it. The price of any
piece of land is affected by all the considerations on which its rent
depends, but it is also affected by another factor which has no
influence whatever upon rent. This factor is the rate of
interest. The higher the rate of interest, the higher the return which
a man could obtain by buying gilt-edged securities, the lower will be
the price that he will pay for a piece of land which yields a given
rent. We can express the relation more precisely by the formula Price
= (Rent * 100)/(Rate of Interest), though we must be careful, in
applying this formula in practice to allow for the possible deviations
between the nominal and the true rent, and similar complications. The
price, it must be observed, is derived in this way from the rent, not
the rent from the price.[1] Rent is thus logically the simpler, price
the more complex thing. It is well, therefore, to analyze in the
first instance the principles of rent, if we live in a country where
the practice of leasing land for annual rent is less common than it is
in Great Britain, even if, for whatever reason, it is the price of
land with which we are concerned in practice. The problem of price
contains two distinct elements which it is not easy to handle when
mixed up together. For the rate of interest represents in itself an
important branch of economics, which will require a separate chapter
to itself.

[Footnote 1: In this the rent of land differs fundamentally from that
of other things, such as houses. For the price of a house is largely
influenced by the costs of construction of new houses, and should
correspond closely to them in the long run. The same relation between
rent, price and rate of interest will hold good; but the rents will be
affected by changes in the rate of interest, owing to the reactions of
such changes on the supply of houses.]



§1. _Profits and Earnings of Management_. The profits of a business,
as they are ordinarily reckoned, whether for the purposes of income
tax or of a balance sheet, comprise several elements which are
fundamentally distinct. The relative importance of these various
elements varies greatly from one type of business to another. The
profits of a private business include, for instance, the remuneration
of the work of management, which in the case of a Joint Stock Company
is mostly paid for by salaries or directors' fees. It is to their
profit that farmers, small shopkeepers, and the partners of a private
firm look not merely for a return upon their capital, but for the
reward of their own labors. "Earnings of Management," as they are
usually termed (though in truth they often cover other and humbler
forms of labor) are thus frequently one of the ingredients of profits.

§2. _The Payment for Risk-bearing_. There is another element of great
importance about which our ordinary ideas are apt to be so vague that
it will be well to devote a chapter to its examination. This is the
element of payment for risk, or rather the reward of risk-bearing.
Risk is inherent in all business, as it is inherent in all life. The
vagaries of nature and the vagaries of man are alike responsible. The
farmer may find his harvest ruined by a drought or by a deluge; the
coal or the gold, for the extraction of which you have perhaps set up
an extensive mining plant, may come to an end which is unexpectedly
abrupt. You may put your money into roller-skating rinks and find that
cinemas have become the rage with the fickle public; sometimes "the
market" may decline for causes which remain obscure but with
consequences which are disagreeably plain. But while risk is always
present in some degree, the degree varies enormously from one industry
to another. Now, it is obvious enough that in an exceptionally risky
industry, where there is a considerable possibility that the capital
invested will yield no return at all, the profits of those concerns
which succeed are likely to exceed the rate of interest on gilt-edged
securities. But what is likely to be the magnitude of this excess? Is
risk-taking rewarded if there is any such excess, however small? Or
will it suffice that the gains and losses should average out to a fair
rate of interest over the whole industry? To enable us to think
closely let us suppose for a moment that we can measure accurately
what the chances are.

Suppose, then, that there were a precisely equal chance of success on
the one hand and failure on the other in any enterprise, failure
involving a complete loss of all the capital invested. Suppose,
further, 6 per cent to be at the time a fair return on a perfectly
secure investment. What would be the return which must be expected
from the risky enterprise, in the event of its succeeding, before it
will be undertaken? The reader may be tempted to answer, 12 per cent.
But 12 per cent would not suffice. An equal chance of 12 per cent or
nothing, as compared with a certainty of 6 per cent, does not mean
that the risk in the former case is paid for to the tune of 6 per
cent. It means that it is not paid for at all. In each case what a
mathematician would call the _expectation_ is a return of 6 per
cent. The odds are evenly balanced; in the long run, over a large
number of cases, if the law of averages works as we assume it does,
you would get just as much from the one type of investment as the
other. Now, risky enterprises will not, as a rule, be undertaken on
terms like these; investors and business men will not take risks with
the odds precisely equal; they must have them, or believe that they
have them, in their favor.

§3. _Monte Carlo and Insurance_. To assert this is not to ignore the
strength of the appeal which the gambling instinct makes to many, if
not to most of us. The taste for gambling is, indeed, so deep and
widespread that it would be foolish to leave it out of account in this
connection. It is clear enough that at places like Monte Carlo people
are prepared to have the odds unmistakably against them, apparently
for the sheer pleasure and exhilaration of taking risks. Moreover,
though for most people play at Monte Carlo represents a mere holiday
indulgence, it would be unsafe to assume that what appeals to them
there will not also appeal to them in their business affairs. But what
exactly is the secret of the charm of Monte Carlo? It is the great
attractive force of a small chance of a large gain, as compared with
the deterrent force of a large chance of a small loss. People will
readily pay $5 for one chance in a hundred of making no more, perhaps,
than $400 or $450. And it is very likely that this holds good in the
world of business. If, for example, we were to suppose that the
promoters of a new enterprise were confronted with one chance in fifty
of a profit of 50 per cent per annum on their capital, as against
forty-nine chances of a profit of 5 per cent, this might well prove a
more attractive prospect than a certain return of 6 per cent, although
the strict _expectation_ of profit would be smaller in the former
case. But the risks of business enterprise are not often of this
type. They conform more usually to the opposite type of a large chance
of a relatively small gain, balanced by a small chance of serious loss
or entire failure. Now for almost everyone the possibility of a great
loss will count as a deterrent (just as the possibility of a great
gain may count as an attraction) for much more than its strict
actuarial value.

The truth of this proposition is demonstrated by the existence of
institutions more impressive than Monte Carlo--the Insurance
Companies, which play so large a part in the economic life of modern
times. Every year, and upon an ever-growing scale, both private
individuals and business concerns pay sums of money, which reach in
the aggregate a colossal sum, as premiums to insure themselves against
loss by Fire, Shipwreck, Burglary, Death, Death Duties, against every
risk which Insurance Companies will cover. Now Insurance Companies
are not, as we say, in business for their health. They find their
business profitable, and pay good dividends to their shareholders.
Moreover, they incur a considerable expenditure on offices, on
clerical staff, on agents, and the like. All these payments must be
defrayed out of the premiums they receive; so that it is plain that
the premiums greatly exceed the _expectation_ of the risks insured.
The odds are heavily in favor of the Insurance Company--of that the
stupidest person can have no shadow of doubt. Yet we continue to
insure, as private individuals and as business men, and so far from
being ashamed of our proceedings as a weak and nerveless folly, which
somehow we are unable to resist, we blazon them forth in the strong
accents of conscious pride. We preach insurance to our neighbors as
the core of self-regarding duty, and, if ever we feel a twinge of
uneasiness, it is lest we, too, may have omitted in some particular to
practice what we preach.

The significance of this is unmistakable. Be our psychology what it
may, however deep and irrepressible our taste for derring-do, however
inadequate the scope which the dull routine of modern life affords for
our adventurous impulses, we are most of us anxious to avoid the risk
of great financial loss. We are very glad to find someone to take it
off our shoulders if we can; so glad that we are prepared to pay him
for the service, to pay him a sum which covers not only the actuarial
equivalent of the risk, but something substantial over and above. In
this we are entirely rational. Our conduct is justified by the law of
the diminishing utility of money, which was noted at the end of
Chapter III. It would be plainly foolish, for instance, to substitute
for the certainty of an income of $2500 per annum an even chance of
$5000 or nothing, since the utility to us of $5000 is not twice as
great as that of $2500.

The majority of business risks are not of a kind against which it is
possible to insure. Insurance companies confine themselves to risks
which are mainly a matter of what we call objective rather than
subjective chance, i.e. risks in respect of which knowledge of
detailed facts peculiar to the individual case is of minor
importance. But such knowledge is of paramount importance in the case
of ordinary business risks. If, for example, a new enterprise is to be
undertaken, the special knowledge and experience which its promoters
possess is a vital factor in determining their estimate of the risk
involved. An outsider with no special knowledge would necessarily
require to estimate the risk far more highly if we were to form a
rational opinion on the basis of _his_ knowledge. So great, indeed,
would be the risk to him, that we can lay it down as a sound maxim
that people are extremely rash who invest their money in risky
undertakings about which they know very little. This subjective aspect
of business risk has a significance to which it will be necessary to

But, though most business risks are not and cannot be a matter for
premiums and policies, the principle, which the practice of insurance
illustrates, applies none the less. In the light of their knowledge
and experience, the promoters of a new undertaking must weigh up the
chances of failure and success, though they will not do so by the
precise methods of an actuary. They will require that any chances of
serious loss should be balanced by such chances of exceptional gain,
as would raise the _expectation_ of profit well above the normal
return on secure investments. The more risky the project seems the
greater, generally speaking, must be the _expectation_ of profit
required to induce people to undertake it.

If we suppose business men to calculate reasonably, it follows that
the average profits in any industry over a long period of years,
reckoning in the losses of the concerns which disappear altogether,
are likely to be higher, the more risky is the industry. Such a result
will not, of course, occur in every case. Even when the calculations
are reasonable, they may be entirely falsified by the event. Moreover,
business men may not calculate reasonably on the information which
they have. But, unless we suppose their judgment to be subject to a
prevailing bias in one direction, i.e. to be unduly optimistic as a
general rule, _we_ should expect, and in any case _they_ must expect,
profits above the ordinary in a risky industry.

This conclusion is sufficiently important. Far too many people, though
they admit it when it is expressly stated and dismiss it even as a
tiresome commonplace, are apt to neglect it when the occasion for
applying it arises. For example, the great importance to any industry
of good management is generally recognized, and the consequent
desirability of paying adequate salaries to the managerial staff. The
importance of securing a supply of capital is very widely recognized,
and the practical necessity of paying a fair rate of interest is thus,
however grudgingly, conceded. But the "residuary profits," as they
are called, which accrue at present to the owners of a business, are
denounced in some quarters in a sweeping fashion, which seems to
ignore altogether the all-pervading element of risk. People speak as
though you might appropriately limit profits in every industry to some
uniform percentage on the capital employed, without making it clear
whether you would even be allowed to make up in good years for the
losses incurred in bad. The effect of introducing any such crude
device into our present industrial system could only be to paralyze
enterprises of an unusually risky kind, which, so far from being
pushed to an excess at present, are more probably curtailed unduly
from the standpoint of what is socially desirable. Like the fixing of
a low maximum price for a commodity it would cause the supply to
wither up and disappear.

§4. _Risk under Large-scale Organization_. While this is true of the
present economic system, the question is worth considering whether it
represents a fundamental necessity, whether, for instance, under our
world socialist commonwealth the factor of risk-bearing need play so
important a part as it does in the actual business world. This
question cannot be answered with a conclusive simplicity; opposing
considerations present themselves, between which it is not easy to
strike a balance. On the one hand, in accordance with the law of
averages gains and losses tend to cancel out over a large series of
transactions, _when reasonable calculations have been made_. Thus
Insurance Companies, while they take heavy risks off the shoulders of
policy-holders, incur relatively trifling risks themselves; they can
predict the aggregate sums which they will be called upon to pay
within a small margin of error. In the same way it might seem that
every enlargement of the scale of business would make for an automatic
insurance and a consequent economy of risk; and thus that if all
businesses were comprised in a single financial unit, gains and losses
would cancel out over so wide a range that the degree of risk
remaining would be almost negligible.

This might indeed happen, if business risks were mainly of that
objective kind in which the insurance companies specialize; for then
we could assume that the chances of success or failure would be
estimated reasonably. But, in fact, most business risks, not being of
this kind, must be estimated by processes of human judgment, which are
very fallible. And here we must take account of the law of averages in
another aspect, with a different bearing on the argument. When an
industry comprises a large number of separate concerns, and the
decisions accordingly are taken by many men, acting independently of
one another, the errors of calculation will tend to some extent to
cancel one another out. The undue optimism of one man will be balanced
by the undue pessimism of another; and, if there is no prevailing bias
in either direction, the errors of judgment will not affect the
results for the industry as a whole. But where the effective decisions
are taken by very few men, the chances are far greater of a
preponderating balance of error in one direction. The risks dependent
on the factor of human judgment tend therefore to increase.

This truth can be illustrated by a phenomenon which is fairly
familiar. It is recognized by intelligent persons that the risks of
speculation in a particular commodity market or stock market increase
more than proportionately to the scale of operations. A man who sets
out as a "bull" upon a small scale can buy without sending up the
price against him in the process, and, if he decides later that his
judgment is mistaken, he can at any time cut his losses and sell out
without much difficulty. But a "bull" on a very large scale cannot
complete his purchases except at a price which has been raised in
consequence of his own action, and he cannot count on being able to
"unload" at or near the market price, should he decide to do so. If,
accordingly, he miscalculates, he cannot save himself from serious
loss as a smaller man might do by a prompt discovery of his error. His
difficulties spring from the fundamental fact that the effects of his
calculations are too great to be offset by those of the different, and
often opposite, calculations of other men.

Upon the issue whether a growth in the size of the business unit is
likely to diminish risk, the law of averages thus cuts both ways. The
risks arising from the element of pure chance are more likely, those
arising from miscalculation are less likely, to cancel out. Upon
these grounds alone, it would be unsafe to conclude that there would
be on balance an economy of risk under any system of national or world

§5. _The Entrepreneur_. There remains, however, an aspect of the
problem which is perhaps more important than those discussed above. It
is probable that risks would be estimated and undertaken more wisely
or less wisely under a different system of society or of industrial
organization? Upon this issue, methods of precise analysis are out of
place, but we may have something to learn from the emphatic testimony
of tradition. It has become an axiom of business men that, while
Governments can manage with more or less competence a safe and routine
business like a Postal Service, their success would be unlikely to
prove conspicuous in undertakings where the element of risk is
great. There, it is said, we owe everything in the past to the
enterprise of individual men (for even joint-stock companies have not
been notable as pioneers) adventuring their own fortunes in accordance
with their own unfettered judgment. This contention, however much we
may desire to qualify it, has unquestionably a large measure of truth,
and the explanation is not difficult to discover. For the wise taking
of risks in industrial development of an experimental character,
peculiar conditions and special qualities are required. First, it is
necessary to envisage distinctly the promising though risky
opportunity, and this calls not infrequently for imagination of a none
too common order. Then it must be studied with insight and expert
knowledge and weighed by processes which are as much intuitive as
intellectual. The reasons for or against taking a particular business
risk are seldom such as can adequately be expressed in terms of
arithmetic, or even by clear arguments the soundness of which is
proportioned to their logical cogency. The mysterious faculty of
judgment enters in; and from mental processes which defy analysis
there emerge ultimately conviction and the will to act. But it is
precisely here that Government Departments are apt to fail. It is here
that the individual, who need consult no one but himself, has a pull
over any form of organization, where decisions are reached by the
method of debate and agreement among a heterogeneous committee. Hence
it is that we have come to regard exceptional risk-taking as the
peculiar province of individual enterprise. It is probable that these
deficiencies of corporate organization are tending to diminish, and it
is an interesting question how far it may be found possible to
eliminate them in the future.

Meanwhile the above considerations have an important bearing on the
rewards which can often be obtained from risky enterprises. The number
of individuals who are in a position to envisage a business
opportunity, and to assess with some confidence the chances of success
and failure is very limited. Not only must they possess special
knowledge, ability, imagination, confidence in their own judgment, and
the capacity to act on it; they must also have at their disposal
considerable financial resources. To combine all these advantages
represents a union of circumstances which is distinctly rare. The
fortunate few, who do combine them, are thus generally able to extract
in the form of profits a high price for their services, a price which
covers not only the strict reward of risk-bearing, and the necessary
remuneration of their own service, but a handsome payment for the
special qualities and advantages which have been indicated. Profits,
moreover, may vary between one industry and another, not only in
accordance with the real risk which is entailed, but with the degree
to which the supply of special knowledge, etc., is scarce or abundant.

This consideration goes a long way to explain the large fortunes which
enterprising business men are often able to amass. It also throws some
much-needed light upon the functions which such men discharge. They
perform to a large extent the work of management; they supply capital
on what may be a considerable scale; but it is the taking of business
risk which is perhaps their most characteristic function. It is the
union of these functions which distinguishes them as an essentially
different type from the salaried manager who has invested his savings
in rubber or in oil. In other languages there is a specific name for
the man who combines all these three functions; in French he is called
an "entrepreneur," in German an "Unternehmer." It is much to be
regretted that in English we have no clear corresponding word. The
word "capitalist" is not uncommonly employed to do duty in this
connection, but this is a source of much confusion. For the word is
also used, and more appropriately, to include all investors, whether
or not they are active business men.

§6. _Risk-taking and Control_. But there is an allied confusion of
more importance. We commonly suppose it to be a leading feature of our
present "capitalist system" that the control of industry rests in the
hands of those who supply the capital. Nor, as a general statement, is
this untrue. But it conceals the essential point. Strictly speaking,
it is risk-taking with which control is associated. The mere lending
of money carries with it no title to control. Governments and
municipalities concede no such title to the subscribers to their
loans; nor does a company to its debenture holders. The shareholders'
ultimate control is based upon the fact that they bear the financial
risks of the concern. Nor is this a matter of mere legal form. It is
not uncommon for ordinary shares to carry with them a greater voting
power than the preference shares of a corresponding value. The
principle which such arrangements endeavor to express is clear:
control should rest with him who bears the risk. It is with this
principle rather than with a mulish insistence on the rights of
property, that advocates of "workers' control" and the like have got
to reckon. It is upon this ground that (as they may quite conceivably
do) they must make good their case.

§7. _General Analysis of Profits_. Let us conclude this chapter by
clearing the ground for the next. Earnings of management, payments for
risk-taking and for the special knowledge and advantages associated
with it, are ingredients of the gross profits of a business. The chief
element that remains is that of interest on capital. Frequently,
indeed, it is not the only one. As we saw in the last chapter, a
farmer may not be required by his landlord to pay the full economic
rent for his farm; and he may therefore make profits above the normal
level, above the ordinary return for his own services, his own capital
expenditure, and the risks to which he is necessarily exposed. In such
a case the farmer is really the recipient, as we have already
suggested, of part of the economic rent of the land; and an element of
rent accordingly enters into his gross profits. But profits may
include a surplus element which may arise in a great variety of other
ways. A business may possess some decided advantage which is not open
to competitors; and it may reap high profits accordingly. You can,
for instance, if you choose, regard the high money profits, which, as
was suggested in Chapter IV, are likely to accrue in future to the
owners of pre-war factories, as a surplus profit of this kind. But
while, as this illustration indicates, the phenomenon of surplus
profits becomes of very great importance when we seek to study the
distribution of wealth, it need not detain us here. For the surplus
element arises only in so far as the costs of a business are lower
than the marginal costs; and it is the marginal costs, which, with
good reason, we are now endeavoring to analyze. The marginal costs
must include a normal profit, i.e. a profit which will cover earnings
of management, the reward of risk and enterprise, interest on capital,
but nothing further. It remains, then, only to consider this last
element of interest.



§1. _A Reference to Marx_. Interest is the price paid simply for the
use of capital. But what is capital, and in what does its use consist?
What claim has it to be regarded as an independent factor of
production? Our very familiarity with the term, our habit of employing
it with the rich looseness of every-day life is an obstacle to the
clearness of thought, which is again essential. We recognize, most of
us, clearly enough that capital, although we reckon it in terms of
money, consists, like income, of real things; factories, machinery,
materials and the like. It is quite obvious that these things are of
use, are, indeed, indispensable for production; what more natural than
that capital should command a price? It almost seems as though we
might pass, without further ado, to a detailed discussion of the
forces which determine the amount of this price.

But this account does not bring out the essential point as brief
reference to a very famous controversy will show. Some ingenious
writers in the last century, the most notable of whom was Karl Marx,
set out to prove that, in our modern society, workpeople are
"exploited," robbed of the "whole produce of their labor," to the full
extent of the return which accrues to capital. The argument was
exceedingly complex in detail; but it boils down to this: The
factories and machinery which are admittedly essential to production
were themselves produced in exactly the same way as consumable
goods. They were produced by labor, working with the assistance of
nature, and, again, if you choose, of capital in the form of further
factories, machinery, etc. But these further capital goods can in
their turn be regarded as the product of labor, nature and capital;
and so we can proceed until it seems as though the element of capital
must disappear in the last analysis, as though labor and nature were
the sole ultimate agents of production, and the reward of capital
represented no more than the exercise of the exploiter's power. In one
form or another this argument still dominates the minds of a large
proportion of the so-called "rebels" against the existing social

If we are to meet this argument, if, which is perhaps more important,
we are to understand the true nature of capital, we cannot rest
content with saying that it consists of factories and machinery, and
that these are essential to the worker. Just as it was well to get
behind the money terms, in which we often think of capital, to the
real goods; so we have now to get behind the real goods to something
else. What this something else is, the first chapter may have already
done something to reveal.

§2. _Waiting for Production_. Between production and consumption there
is an interval of time. All productive processes take time to
accomplish. The farmer must plow the soil and sow the seed months
before he can reap the harvest which will reward him for his
efforts. Meanwhile, he must live, and in order that he may live he
must consume. If he employs laborers he must pay them wages, that they
too may consume and live. For both purposes he requires purchasing
power, which represents of course command over real things; and if he
has not sufficient purchasing power of his own, he must borrow from
someone else who has. In either case it is not enough that the farmer
and his laborers should work; no less essential is it that someone
should _wait_. The farmer must wait till he has sold his crops, both
for the reward of his own labor and for the repayment of the wages he
advances in the meantime to his laborers. Or, if he cannot afford to
wait, and borrows in anticipation of the harvest, then the lender must
wait, until the farmer, having sold his crop, is able to repay
him. Thus the period of time involved in all production gives rise to
a demand for _waiting_, which someone or other must supply, if the
production is to take place. It is this waiting which is the essential
reality underlying the phenomena of capital and interest. It is really
this which constitutes an independent factor of production, distinct
from labor and nature, and equally necessary.

§3. _Waiting for Consumption_. But let us carry the argument a step
further. After the farmer has sold his crops, there are many stages
through which they must pass, at each of which more waiting is
required, before they reach the ultimate consumer. But then the
waiting is at an end.

This, however, is by no means the case with a great number of
commodities. Let us take the case of a speculative builder. While he
is building a house he, like the farmer, must wait (or find someone to
wait on his behalf), for his own reward, and for the repayment of his
expenditure on wages and materials. But, after the house is built, if
he lets it to a tenant for an annual rent, his waiting is far from
over. Not until many years have passed will the rent payments add up
to a sum which equals or exceeds his outlay. He may, of course, sell
the house, and thus bring his waiting to an end. But then the
purchaser must wait, no matter whether or not he is the occupier. For
no one would consider the use of a house for a day, a month, or a year
as an adequate return for the price it cost to buy. The occupier-owner
pays for the prospect of its use for a long and perhaps indefinite
number of years ahead, and he must wait to enjoy the benefits for
which he pays now in full. Waiting is as inherent in the consumption
of durable things as it is in all production.

Now most industries are consumers of durable things of a very
expensive kind. Here we come back to the factories and machinery which
ordinarily spring to our mind at the mention of the word capital. Not
merely does the construction of these things involve waiting; their
consumption involves waiting on a vastly larger scale. Just as with a
house, many years must elapse before their derived utility can even
approximate to their purchase price. It is mainly to supply the
waiting involved in the consumption of such durable goods, that a
typical joint-stock company issues shares for public subscription. The
waiting required to cover the period of time, which its own productive
process requires, is largely supplied by means of bank overdrafts or
other forms of short-period borrowing. More strictly, fixed capital
represents the waiting involved in the consumption of durable things;
circulating capital the waiting involved in current production.

This distinction loses its sharpness when we consider not the affairs
of a particular business, but the industrial system as a whole. Then
the period of time involved in the consumption of durable instruments
falls into place as part of the time required for the production of
the ultimate consumers' goods. We can even, perhaps, conceive of an
"average period of production" for industry and commerce as a whole;
and this conception is not without its uses. For it serves to bring
out the fact that the period of consumption, and the period of
production in the narrower sense, are only two aspects of the same
fundamental thing, the interval of time which elapses between work and
the utility, which is its ultimate purpose. It serves, moreover, to
make clear that anything which lengthens this interval of time
increases the demand for waiting, or in other words, the demand for
capital; and, conversely, that anything which shortens this interval
diminishes the demand for capital.

§4. _Capital not a Stock of Consumable Goods_. But the distinction
between the two forms of waiting, though not fundamental, is none the
less worth noting. It enables us to keep our theory in conformity
with fact, to look at the phenomenon of capital the right way up; and
it is easy, if we are not careful, to slip into the habit of looking
at it upside down. People sometimes speak as though the commodities
which constitute our capital, instead of being mainly, as our plain
sense tells us that they are, factories, machinery and other durable
instruments, were rather a _store_ or _stock_ of immediately
consumable goods. The argument takes the following form. It is
consumers' goods, things like food and clothes, which the farmer, the
builder and their workpeople consume while they are working. To enable
them to work, therefore, it is vital that such things should not in
the past have been consumed as soon as they were made; part of them
must have been saved, and carried forward for future use.
Furthermore, the longer the time that the work on which people are now
engaged takes to yield its product, the larger must be this store of
consumers' goods. For these products, when they are completed, will
serve (taking society as a whole) to replace the store which in the
meantime is being used up, so that the longer this replacement takes,
the larger must be the initial store. Conversely, the larger the
store of consumers' goods available, the more distant is the future
for which we can afford to work. It is thus the store or stock of
consumers' goods which represents our real capital; for it is the
magnitude of this store which determines how far we can devote our
energies to purposes which are remote in time.

Now this is pure mysticism. Regarded literally, it is in direct
conflict with the facts. The processes of industry are fairly regular
and continuous. At any moment, large quantities of consumers' goods of
almost every kind are on the point of completion; at the same moment
equally large quantities are consumed. The things which we buy were
finished, very likely, only recently; or, if in fact they have lain
idle for some time in stock, there is nothing essential or at all
helpful in that fact. It represents rather a defect--a maladjustment
which should be rectified. Even many kinds of agricultural produce do
not need to be carried forward from one year to another, for they are
produced in many parts of the world, where the seasons come at
different periods of the year. It is conceivable, therefore, that we
might consume all non-durable things the moment they were ready, and
the degree to which we approximate to this ideal is a mark of the
efficiency of our economic system. A large store of consumable goods
is thus _not_ a fundamental necessity of a prosperous society.

What _is_ necessary is plainly the power to produce these things in
large quantities as they are required. And this power is furnished by
the durable instruments of production, which we thus rightly regard as
the true representatives of modern capital. If it is argued that this
power to produce consumable goods may be regarded as being _in effect_
a store of consumable goods, it must be sternly replied that this is
the language of symbolism, not of science, and that symbolism is
highly dangerous in this connection. The false conception of capital
as essentially a store of consumers' goods has led and still leads to
many serious fallacies. It was this that gave rise to the notorious
doctrine of the Wages Fund; the notion that the sum which can at any
time be paid in wages is equal to the quantity of capital, _alias_
consumable goods, which happens to exist. To this day it blocks, with
an undergrowth of obscurantist controversies, the way to a
straightforward account of the problem of trade cycles.

§5. _The Essence of Waiting_. But it is with positive conclusions that
we must here concern ourselves. What is the essence of this waiting,
as we have called it? What are its results from the point of view of
the community? The individual, who saves and lends, waits in the
obvious sense that he postpones consumption. He foregoes his right to
purchase now a quantity of consumers' goods in consideration of the
prospect of purchasing a larger quantity of such things in the
future. From the standpoint of the whole community, there is a similar
postponement of consumption, though it need not commence so soon. The
store of consumable goods is what it is: the quantity of goods in
_process_ of manufacture, which will shortly be coming forward, is
also what it is. For some time, therefore, a sudden access of saving
cannot affect the quantity of goods available for consumption; and if,
in fact, they should be consumed less rapidly, that will represent an
unfortunate defect, not an essential condition of a smoothly working
system. The _necessary_ consequence comes later. The increased saving
will cause labor, materials, land, agents of production generally, to
be devoted to distant purposes. Men will be set to work producing
durable goods, largely durable instruments of production like ships or
railways or factories or plant. If the increased saving is
considerable, the labor, materials, etc., required for these purposes
will be withdrawn even under our present system, as under a smoothly
working system they clearly must be, from the production of other and
more immediately consumable things. Hence, some time later, the
supplies of consumable things will be diminished, while at a later
period still they will be more than correspondingly increased as the
result of the assistance of the new durable instruments. That is the
essence of saving from the social standpoint. An early future is
sacrificed to a more remote future. The aggregate consumable income of
the present is unaffected; the aggregate consumable income of the near
future is actually diminished; it is not until at least some years
later that the aggregate consumable income is increased.

§6. _Individual and Social Saving_. This conclusion is important: but
there is an obvious misinterpretation against which it will be well to
guard. It is customary for social moralists to preach thrift and
saving as a public duty, and to impart to their appeals a special note
of urgency in times like the present, when, as the result of the havoc
of the war, destitution is widespread over Europe. Now obviously these
advisers do not mean to recommend something which will impoverish the
world next year and the year after and the benefit of which will
accrue only in a distant future: it is the immediate urgency of the
world's needs which is rather the substance of their case. Nor would
it be right to conclude that these wise men are the victims of a
delusion, and advocate a course, the consequence of which they do not
understand. The explanation of the paradox is simple. The more the
community as a whole saves now, the less in the near future will be
the aggregate consumable income of the whole community: but not of the
_remainder_ of the community, exclusive of the savers. It is the saver
who must wait, whose consumption must be postponed to perhaps a
distant future; but _at no time_ does his saving result in a smaller
income of consumable goods for other people. The aggregate consumable
income of the near future will be diminished, but it may be better
distributed, and it may consist of things of a different _kind_. For
consumers' goods, we must remember, comprise champagne and motor cars
as well as food and clothes; and, if a rich man saves, it may be
purely articles of luxury, the production of which will shortly be
diminished. Moreover, if his saving has the effect of transferring
purchasing power to impoverished people, like those in Central Europe,
it will not be devoted to a distant future; it will very likely be
devoted to quite immediate ends. In other words, it may not result in
any "creation of capital"; it may not represent any saving on the part
of the community as a whole. A relatively rich man waits, and a
relatively poor man _anticipates_ his income to a corresponding
extent; and it is precisely this that is so urgently desirable in a
time of widespread poverty and chaos.

This is no matter of hair-splitting, and making plain things
obscure. While it is always better for the _rest_ of us that an
individual, who can afford to save, should save rather than spend
(though it might be better for us still if we could have his money to
spend ourselves) and while this is the more important the greater is
the poverty which generally prevails; yet, as a community we cannot
save so much, we _ought_ not to save so much, when we are impoverished
as when we are prosperous. It is vital to appreciate this truth,
because, as we shall see, by no means all the saving of the world is
done by individuals. There are many forms of "collective saving,"
which take place in actual fact; still more which we are often urged
to undertake. And it is of practical importance to realize that the
very considerations, which call most urgently for individual thrift,
forbid a great indulgence in such projects. A time of national poverty
is not a time when it is suitable for the State to embark on large
schemes of capital development: we require our resources for more
immediate ends. Faced with such problems, our practical sense may no
doubt suffice to keep us straight; but it is apt to do so at the
expense of a complete inversion of the real issues. If, for instance,
we call for Governmental retrenchment on what we deem extravagant
policies of housing and education, we usually speak as though they
represented the profligacy of a spendthrift as contrasted with the
saving that is indispensable. The truth is rather that these policies
represent a saving, an investment for future purposes, which may
conceivably be greater (this must not be taken as representing my
personal opinion) than the community can properly afford. This is
another instance of what I mean by looking at the problem of capital
the right way up.

§7. _The Necessity of Interest_. It is only now that we are in a
position to appreciate the true functions of a rate of interest, and
the nature of its claims to be regarded as a "real cost." Interest, it
is sometimes said, is necessary to provide for the future. It is far
more certain that interest is necessary to provide for the present. It
is a matter of legitimate doubt how far it is necessary to _pay_
interest to secure a supply of capital; there is no doubt at all that
it is necessary to _charge_ interest to limit the demand for it. As we
saw in Chapter I, a world socialist commonwealth would require to
retain a rate of interest, if only as a matter of bookkeeping, in
order to choose between the various capital undertakings that were
technically possible. And this is the primary function which the fate
of interest fulfils in our present-day society. It separates the sheep
from the goats. It serves as a screen, by means of which capital
projects are sifted, and through which only those are allowed to pass
which will benefit the future in a high degree. For this essential
purpose it is hard to imagine how a better instrument could be

§8. _The Supply of Capital_. Let us dwell for a moment on this image
of a screen, or sieve. One condition of a good sieve is that its
meshes should all be of the same size. This condition the rate of
interest almost perfectly fulfils. But it is also important that the
meshes should be of the _right_ size. Whether this is true of the
actual rate of interest is a far more doubtful matter. It is, indeed,
plain that it is not altogether devoid of merit in this respect. In
times of general world poverty, like those which follow upon a great
war, it is desirable, as has been argued, that more of our productive
resources should be devoted to immediately useful purposes, and a
smaller portion dedicated to a distant future. This readjustment the
rate of interest helps to bring about. For it rises to a higher
level, and there is accordingly a strong inducement to all
manufacturers and traders to economize their use of capital, and thus
to set free productive resources for more urgent needs. But, while the
meshes of the sieve, as it were, contract in times when it is
desirable that they should contract, we have no reason for supposing
that they will contract in just the degree that is desired, neither
more nor less; or, indeed, that at any time they approximate to the
right size. We in the twentieth century owe much of the material
wealth that we enjoy to the fact that over the last century men saved
as largely as they did. But our natural gratitude should not restrain
us from doubting whether they were really well advised to do so. If we
ask the question _how_ they managed to do so, our doubts are
deepened. For first place among the explanations must be assigned to
the inequality in the then distribution of wealth. It was because many
men in England were rich enough to save that our railways were built,
and the resources of new Continents were opened up. But England, a
century or even half a century ago, was not really a rich
community. And if the national income in those days had been
distributed more evenly among the people, can we doubt that they would
have spent a far larger proportion of it on immediate needs; can we
doubt that they would have been right to do so? We may rather doubt,
in view of the reactions of poverty on physical and mental efficiency,
on social harmony, even possibly on population, whether we to-day
would have been really injured as much as might appear. How, then, can
we suppose that the sum of the amounts which it suits individuals to
save will bear any close relation to the resources which the community
can properly devote to future ends? Are we to regard an unjust
distribution of wealth as a mysterious dispensation of Providence for
securing perfect harmony between the future and the present? The
point need not be labored further. There are no grounds for assuming
that we save, as a community, even roughly what we ought to save. If
we wish to believe we do, we must turn for support from economics to

It is important to be clear upon this issue in order to distinguish it
from another, with which it sometimes seems to be confused. This is
the question, briefly outlined in Chapter II, of the effect of changes
in the rate of interest on the supply of capital. As was there
indicated, there are good reasons for supposing that a fall in the
rate of interest would induce some people to save more, and
conversely. But the balance of probability is in favor of the
conclusion that the _net_ effect of changes in the rate of interest,
though perhaps slight, is usually of the more ordinary kind. The
decisive argument in this connection is the fact, upon which we have
just touched, that savings are supplied largely by people who are
relatively rich, and who become richer when the rate of interest
rises. For at this point it is necessary to be careful. It is easy to
slide from the above conclusion into an argument of the following
kind. A higher rate of interest leads to more saving; it is thus
necessary to _evoke_ more saving; it is thus required as an
_incentive_ to induce people to incur the _sacrifice_ of waiting; this
sacrifice represents the "real cost" for which interest is paid.

This terminology of incentive, inducement and sacrifice is of very
dubious validity. A rich man, who is made richer by a rise in the rate
of interest, will probably save more, but it will be rather because he
has become richer than because he is tempted by the higher rate: and
the less we talk about his sacrifice the better. Nor is it clear that
the attraction of a high rate of interest is an operative factor on
the mind of a man to whom saving means a real sacrifice of immediate
comfort or enjoyment. Certainly it is only one among many factors, and
seldom an important one. A really poor man will think not so much of
the annual income which will accrue from his savings, as of the
capital sum upon which he or his family can fall back if a rainy day
should come. And for this purpose he might save as much as he saves
now, even if there were no interest to be obtained thereby. He might
even be prepared to lend what he had saved, at least to banks (a
deposit with a bank is in effect a loan), for the mere advantage of
safe custody. The people who save rather for the sake of the capital
sum that can be realized than for that of the annual interest are very
numerous, and probably include many men in receipt of quite
considerable earned incomes. Moreover, those who consider mainly the
future annual income which their savings will yield them, are usually
more concerned with its absolute amount than with the ratio it bears
to the amount they must save in order to acquire it. For this reason,
as has been often recognized, they may save less when the rate of
interest rises, since a smaller quantity of savings will insure to
them the future annual income they desire to obtain. There is no need
to be dogmatic upon any of these points. The psychology of saving is
both complex and obscure. Our conclusion must be the negative one that
we have insufficient evidence to warrant the assertion that the
particular rate of interest which happens to prevail is a measure of
the sacrifice involved in saving, even in the case of what we might
regard as the "marginal saving." And, if we cannot assert this, we
must be careful not to assume it as the basis of other arguments, or
as part of a general analysis of price or exchange value.

It is of some interest to observe that the difficulties which our
world socialist commonwealth would encounter if it attempted to
dispense with the rate of interest, would not necessarily include that
of obtaining a supply of capital. It might, indeed, not find it easy
to determine the proportions in which it should allocate its
productive resources between immediate and distant ends. Our present
system cannot be said to have evolved satisfactory principles for the
solution of this question; and the socialist commonwealth would have
to work out its own solution. But when it directed that labor and
materials should be devoted to purposes of long-period utility, there
would be an automatic collective saving, of which no one would be
conscious as an individual sacrifice. Even at the present time, our
capital is not supplied entirely by the savings of individuals, but to
an extent, which though quite incalculable is yet certainly
considerable, by involuntary saving of an essentially similar type to
the above.

§9. _Involuntary Saving_. When a municipality embarks on a municipal
tramways scheme or any other industrial enterprise, and pays off by
means of a sinking-fund the capital which it borrows in the first
instance, the proceeding amounts, as the defenders of municipal
trading have rightly claimed, to a compulsory and unconscious saving
on the part of the citizens. Their consumption has been postponed
willy-nilly as the result of the increased rates or the high charges
which they have had to pay; and, when the subscribers to the original
loan have been paid off, the capital of the community is enhanced to
the extent of that loan. Central governments might similarly increase
the supply of capital by devoting annual revenue to capital purposes;
though their actual record, as it happens, is mainly of a different
kind. But what is chiefly a possibility in the case of Governments has
actually been carried out on an enormous scale by other institutions.
The development of the joint-stock company system has introduced a new
factor into the problem of the supply of capital, which is of immense
though but dimly perceived importance. The directors of a company are
technically no more than the servants of the shareholders. It is the
profit of the shareholders that it is the directors' duty to promote
with a single mind, and the whole capital of the concern, including
its reserves both open and concealed, is the shareholders' exclusive
property. But realities have a way of differing from forms, and just
as in political affairs it is common to regard the State as a very
different thing to the people who compose it, as a sublime entity with
a separate existence of its own, so directors are apt to distinguish
between the company and the shareholders. It is the company to which
they owe allegiance. To pay away in dividends to shareholders money
which they could employ in extending the business or strengthening the
position of the company appears to some directors a necessity hardly
less unpleasant than an increased wages bill, or an Excess Profits
Duty. Concessions must indeed be made to the shareholders' rapacity:
but when something has been done in this direction, dust can easily be
thrown in their not very observant eyes. Reserves, which within
limits are a necessity of sound finance, can be accumulated beyond
those limits, and, when the further limits of an extreme but just
arguable conservatism have been passed, there remain the innumerable
devices, known to every resourceful Board, of hidden reserves, the
secret of which is unmenaced by the meager information of a
balance-sheet. In all this the shareholder, as the directors
occasionally assure themselves, has no real grievance, for he will
gain in the long run, from the appreciation in the capital value of
his shares, all and perhaps more than all that he foregoes in the
meantime in the way of dividends.

In the long run the shareholder is not injured; but in the meantime he
is in effect compelled, without any consciousness of the proceeding,
to save and to reinvest in the company a portion of the dividends,
which he might otherwise have spent. The reserves which are
accumulated are not allowed to lie idle: they are employed either in
what are really capital extensions of the business, or in the purchase
of outside securities, and in either case they represent an increase
in the total supply of capital. The principal which these proceedings
represent is capable of indefinite extension.

But however possible it might be to secure a supply of capital without
the inducement of a rate of interest, that rate is indispensable for
dealing with the demand. It is no good saying, "Three per cent seems
a fair rate of interest; let us try and limit it to that." Given the
amount of savings which are supplied, the rate of interest must be
allowed to reach whatever figure is necessary to confine the demand to
that amount. Given the quantity of resources which you have available
for future needs, the meshes of the sieve must be made as narrow as is
necessary to confine the projects that pass through within those
limits. And so, indeed, it becomes necessary for any particular
business to pay for its capital interest at the market rate, not so
much to secure the saving of it as to secure its allocation from the
common pool.

§10. _Interest and Distribution_. It is unavoidable that this interest
should accrue to whoever it is that supplies the capital. If the
capital were supplied, as it might conceivably be, collectively by the
community, the interest would accrue to the community, and all would
be well. But as things are, the capital is supplied mainly by the
savings of individuals, and largely by individuals confined to a
relatively narrow class. The profits of Capital have thus a vital
influence on the very serious matter of the distribution of wealth
between social classes. Now, as experience shows, there is no element
in profits which is capable of such radical change in so short a space
of time, as is the rate of interest. Even before the war it had become
hard for people in Great Britain to realize that 3 per cent Consols
had stood at 114 as late as 1896. "How blest," wrote two cynical
satirists of society in the same period:

"How blest the prudent man, the maiden pure,
Whose income is both ample and secure,
Arising from Consolidated Three
Per cent Annuities, paid quarterly."[1]

It is impossible to read those lines now without a sense of irony,
different from that which they were intended to convey.

Not only is the rate of interest now double what it was a generation
ago; we have no good reason to suppose that the present high level
will quickly be reduced. The havoc of the war, of which the
widespread poverty of Europe and the huge debts of Governments are but
two different aspects, makes it almost inevitable that the rate should
rule high in the present decade. This cannot but exercise a profound
influence, of a most disquieting character on the general level of
profits, and to a lesser extent (for here we must allow for the
effects of high taxation) on the distribution of real wealth between
social classes. Here we are on the threshold of tremendous issues. We
almost feel the earth quake beneath our feet. We hear the muffled roar
of far-reaching social controversy:

"And 'mid this tumult Kubla heard from far
Ancestral voices prophesying war."

[Footnote 1: _Narcissus_, by Samuel Butler and Henry Festing Jones.]



§1. _A Retrospect on Laissez-faire_. When, a century and a half ago,
the foundations were being laid in the Western world of systematic
economic theory, the public attention was much occupied with a
subject, which indeed has not ceased to hold it: that of the failings
of Governments. The general interest in that topic was shared by the
pioneers of economic thought, of whom, in Great Britain, Adam Smith
was the most notable. It was indeed their practical concern with the
concrete economic issues of the day which very naturally gave the
impetus to their scientific quest. It was hardly less natural that
they should have expressed their opinions on these concrete issues
with considerable emphasis.

Now the keynote of their practical conclusions was that Governments
were doing immense mischief by meddling with a great many matters,
which they would have done better to leave alone. In this they were in
general agreement with one another; incidentally--let there be no
mistake about it--they were right. But, as invariably happens in
public controversy, their opinions became crystallized in a compact
formula, or cry, with unduly sweeping implications. This was the cry
of "_laissez-faire_." Let Governments preserve law and order; and
leave the economic sphere alone. The economists picked no quarrel with
this formula; it served well enough for workaday purposes to indicate
the lines of policy which they rightly thought essential in their day.

The history of this cry is the history of every cry which has won a
wide acceptance from mankind. It did good work for perhaps half a
century; but then many crimes were committed in its name. The
instrument which had been forged to clear away a noxious tariff jungle
and the monstrous laws of Settlement, was turned against Lord
Shaftesbury and the Factory Acts. Not only was inaction recommended
to Governments as the highest wisdom; other institutions, like trade
unions, were warned off the economic grass. An ideal of perfect
competition became an idol to which much human flesh and blood were

But, what is more to our present purpose, the idea took root of an
intimate association between the laws of economics and the policy of
_laissez-faire_. People who opposed some long-overdue measure of State
regulation believed themselves to be justified by the eternal verities
of economic law, and this claim even the advocates of the measure
seldom ventured to dispute. They took refuge rather in a conception of
economic law as a dangerous monster, whose claws must be clipped in
the interests of the higher good. This notion that all interference
with so-called "free competition," is a violation (though very likely
fully justified) of economic laws has sunk deep into our common
thought. So that to this day, whenever we see at work the hand of a
State department, a trust or a trade union, we are apt to say "Demand
and supply are here in abeyance," and possibly we add "A good thing
too." Since in the matter of wages, the hand of the trade union is
very generally evident, it is impossible to discuss the subject-matter
of this chapter, until we have rid our minds of this quite baseless
prepossession. To sweep away this cobweb, I urge the reader to recall
here the general tenor of the analysis of the preceding
chapters. Whether we were dealing with the price of an ordinary
commodity, with joint products, land or capital, we came across
relationships which seemed altogether more fundamental than our
present industrial system; nor, we may incidentally observe, were we
ever required to suppose that the present system was one of "perfect
competition." These relationships were almost invariably such that
even a world socialist commonwealth would find it necessary to
maintain them. It was not suggested, and most certainly it must not be
thought, that a world socialist commonwealth, or even a more modest
remodeling of the social order would not effect great changes,
possibly for good, and possibly for ill. The same economic laws might
be made to bear very different fruits, but they themselves would
remain unchanged. What is true in all these other fields--this should
be our predisposition--is not likely to be quite untrue in the field
of labor.

§2. _Ideas and Institutions_. Another point is worth noting here. We
are sometimes advised to distinguish sharply between "What should be"
and "What is"; often two very different things. The advice is
pertinent and useful, particularly in the sphere of sociology. But
our incorrigible habit of confusing the two things together is not
without justification, or at least excuse. For, in fact, they
gravitate towards one another with a force which is just as strong as
the capacity of man for understanding and controlling his
environment. When we have a system which is clearly bad, _and_ when we
see our way to make it better, we generally make the change however
tardily. Our sense of "What should be" thus reacts upon "What is."
Meanwhile, until we can make the system better, our appreciation of
"What is" affects our sense of "What should be." And the more so, as
we are sensible. For "What should be" is pre-eminently an affair of
relativity. A man may hold very strongly that equal pay to every
individual is desirable, as he puts it, as an ideal. But this will not
prevent him, in a world in which managers are paid far more than
manual workers, from maintaining hotly (at any rate, if he is
sensible) that to pay the manager of a particular concern a manual
worker's wage would be monstrously unfair. He would also argue that it
would be highly inexpedient. Equity and expediency are, in fact,
intricately intertwined in our sense of "What should be"; and our
sense of "What should be" in the particular is governed by our
knowledge of "What is" in the general.

These may seem unnecessary commonplaces. But they have a vital bearing
on the _modus operandi_ of economic laws. These laws do not work _in
vacuo_. They work through the medium of the acts of men. The acts of
men are greatly influenced by their institutions, and by their ideas
of right and wrong. Both institutions and ideas may serve to smooth
rather than obstruct the path of economic laws; because the laws may
represent either "what should be" in the general, or "what is" in the
general, and therefore "what should be" in the particular. This may
hold true even of a trade union or a sense of "fair wages." The
business of economic theory is not to justify a regime of
_laissez-faire_, still less to show the folly of bringing morals into
business. Its value is rather that it may help us, by improving our
understanding, to shape our institutions, and to adopt our moral
sentiments so as to promote the public welfare. With these general
notions in our minds, let us turn to see how stands the case with

§3. _The General Wage Level_. The term Labor may be used in a broad or
in a narrow sense. It may be confined to weekly wage-earners: it may
be extended to include all those who work, as the phrase goes, "with
either hand or brain." It is with all classes of Labor, in the
broadest sense of the term, that we must here concern ourselves. It
will be convenient, however, in the first instance to ignore the
differences between them, and to consider the forces which determine
what we may regard as the general wage-level.

The general laws of supply and demand hold good. The wages of labor
tend to a level at which the demand is equal to the supply. For, if
the demand exceeds the supply, if, in other words, labor is scarce,
wages tend to rise, sooner or later in any case, and the more promptly
in proportion as the workpeople are organized. Conversely, if the
supply exceeds the demand, if in other Words there is general
unemployment, wages tend to fall, and the strongest trade unions
cannot resist the tendency, though they may delay it. Moreover, the
higher the wages that must be paid, the smaller, other things being
equal, is the demand for labor. For, even if we leave foreign
competition out of account, and consider, as it were, labor throughout
the world as a whole, the demand for labor is by no means
inelastic. It is derived along with the demand for the other agents of
production in the manner described in Chapter V. As was there shown,
the greater the supply of the other agents of production, the greater
is likely to be the demand for labor; but these other agents can be
substituted for labor in a great variety of ways, and an increase in
wages (unless accompanied by increased efficiency) will make it
profitable for employers to effect such a substitution, where it was
not profitable before. Thus, higher wages for the same labor
efficiency must stimulate the tendency for capital to act as a
substitute for labor at the expense necessarily (since the aggregate
supply of capital will not be increased thereby) of its tendency to
serve as a complement; and this must mean a decrease in the volume of
employment. Hence the power of labor to secure a general advance of
wages by concerted or simultaneous trade union action, applied if you
will, not merely to every industry, but to every country, is
necessarily very limited. Beyond a certain point, such a policy must
result in general unemployment; and, if pushed sufficiently far, in
unemployment so extensive that it would continue even in periods of
active trade. Such a policy could neither be maintained in practice
nor would it be a wise policy from the workers' point of view.

In other words, given on the one hand the conditions of the demand for
labor (i.e. the supply of capital, natural resources, business
ability, risk-bearing and knowledge of technical processes, etc.,
which happens to exist), and given on the other hand the supply of
labor (i.e. both the numbers of workpeople and their efficiency), the
wage-level in the long run is fairly rigidly determined. The
introduction of the phrase "in the long run" in this connection is apt
to provoke comment which may be pertinent, but may be misconceived.
The worker, it is pointed out, is deeply concerned with "the short
run" in which he has to live. It is very true; and it is this that
supplies one of the many justifications of trade unionism. To secure
for the workers advances of wages, which economic conditions justify,
sooner than would otherwise have been obtained, is certainly no
trivial or contemptible function. But it is none the less an illusion
to suppose that the general wage-level can be appreciably and
permanently raised by trade union action, except in so far as it
increases the efficiency of the workers or incidentally stimulates the
efficiency of the employers.

§4. _The Supply of Labor in General_. The efficiency of labor may be
regarded as affecting either the demand for labor on the one hand or
the supply of it on the other, according as we look at the matter from
the worker's or the employer's standpoint. The employer is concerned
with the labor costs per unit of his output, the worker is concerned
with the wages he receives. An increase in the efficiency of labor
may, and usually will, mean both a decrease in labor costs to the
employer and an increase in the earnings of the worker. It is thus
wholly to the good. But the effects of an increase in the supply of
labor in the sense of a growth in the numbers of the population are
far more dubious. Unaccompanied by an increase in the _demand_ for
labor, it _must_ result in a diminished remuneration for the
individual worker. To some extent indeed the demand for labor would
almost certainly be increased. The supply of Capital may expand,
perhaps proportionately, perhaps more than proportionately to the
increase in population. But one factor of production, as we have seen,
is not capable of such expansion. This is the factor of Land, or
Natural Resources. It is the limitation of this factor which gives
rise to what we have most of us heard of as The Law of Diminishing
Returns. It is this that is the essence of the problem of Population,
portrayed in somber hues more than a hundred years ago by Malthus.

This problem will form the subject of the sixth volume of the present
series. In the meantime it may be suggested that we are easily
credulous if we suppose that the problem has been finally disposed of
by the peculiar progress of an abnormal century. But that experience
has at least destroyed the view that there _need be_, or even is in
fact in Western countries, a relation between real wages and the
numbers of the people so close and direct that an improved standard of
living must be temporary only, doomed to destroy itself by the
increased population it engenders. One may perhaps go further and say
that it is doubtful even in what direction changes in remuneration
will influence the aggregate supply of labor. When we pass to "what
should be," it is plain that there is nothing whatever to be said for
the sort of relation indicated above. The view once widely held that
the principle of population must inevitably keep the mass of people
close to the verge of the bare means of subsistence was no statement
of a desirable ideal. It was a nightmare; a nightmare none the less
though it may haunt us yet. It is far from fanciful to suggest that it
is because this relation is so obviously _not_ "what should be" that
it may be ceasing to hold true in fact. But it would be very fanciful
indeed to maintain that as yet "what should be" is represented by the
actual population. Thus, just as with capital, so with labor, there is
no reason to suppose that the aggregate supply is determined by any
fundamental economic law, or corresponds in practice to what is
socially desirable.

§5. _The Apportionment of Labor among Places_. Again, as with capital,
it is when we turn to the _apportionment_ of labor between different
employments that both economic law and social ideal make their
appearance. It will be well, however, to consider briefly in the
first instance the different question of its apportionment between
places. This was hardly necessary in the case of capital, because the
possibilities of foreign investment are very numerous and easy: the
mobility of capital is thus sufficiently strong (once again it is only
_marginal_ adjustment that is necessary) to establish over at least a
large part of the world something near to a uniform rate of
interest. But this is not the case with labor. People do indeed move
from place to place within a country, and from one country to another,
in response to economic opportunities. That even the latter movement
may be a considerable thing, the present population of the United
States is a striking testimony. But obviously the mobility is very
incomplete. Here, then, we have what we might _loosely_ call an
economic law that labor tends to "flow" (as it is sometimes unhappily
phrased) to those places where it can command the highest reward; we
have this tendency in evidence, but it is far too weak to enable us to
lay down what would deserve more strictly the title of an economic
law, that in the long run the reward of the same kind of labor is
roughly equal in all places. Perhaps we can say this for many
districts in a single country; but for few countries is this true as
between all their districts. As between countries, it is not remotely

Here, however, the imperfection of economic law is balanced by an
extreme uncertainty as to the ideal. Perfect mobility of labor may be
_economically_ desirable in a very narrow sense of the term; but it
opens out a vista of racial, national and cultural problems, into
which it will be better for us not to enter here. We must take for
granted the population of a country, like that of the world, as a
given fact.

When we do this, the question of its remuneration is on all fours with
the more general question discussed above. That the remuneration of
the labor of a country is mainly governed by the relations between
demand and supply is an inexorable fact. In view of the international
mobility of capital, the main distinctive factor in the demand for the
labor of a particular country is the supply of natural resources,
which it knows how to use. Where the natural resources are great
relatively to the population, there wages will rule high; where the
converse is true, wages will rule low. This result of economic
analysis is abundantly confirmed by experience. The relatively high
wages in the new world, the low standard of living in the densely
populated East; the economic history of Ireland are so many
object-lessons of its truth.

§6. _The Apportionment of Labor among Social Grades_. The question of
the apportionment of the labor of a country among different
employments falls under two heads. Some differences of occupation are
associated particularly in Great Britain with differences of what we
know as class. The movement of labor between different social grades
is clearly a very different thing from its movement between different
occupations in the same grade. The grades themselves are not easy to
define: not a little ingenuity has been expended on the attempt, and
perhaps the best brief classification that has been put forward is one
which divides labor into the following four grades:--

(1) Automatic manual labor.
(2) Responsible manual labor.
(3) Automatic brain workers.
(4) Responsible brain workers.

But the matter is one perhaps for the satirist of manners rather than
the economist. It suffices for our purpose that the distinctions,
however vague, are very real.

It is obvious the mobility of labor between the occupations of a
platelayer and a barrister is not very great. It may seem perhaps to
be even smaller than it is. For here it is important to bear in mind a
general consideration which is equally applicable to horizontal
movements within any social grade. There may be a considerable
movement of labor between different employments without any individual
worker having to change his occupation. The personnel of any industry
is constantly changing. At one end, men die, retire, or are pensioned
off; at the other end, young recruits are taken on. By a diversion of
the new recruits from one employment to another, a radical change can
be made in the occupational census in a comparatively short space of
time. It is in this manner that such movement as takes place is
largely effected at the present time. Within the ranks of the
professional classes, a man does not commonly leave the profession to
which he has been trained. But his _choice_ of profession is
determined by him or his parents not solely on pecuniary grounds but
usually with an anxious scanning of the general prospects, which
include pecuniary advantages together with many other things. The same
thing is true in no small measure of manual wage-earners. This general
consideration must be borne in mind throughout the remainder of this

But even the sons of platelayers do not commonly practise at the
bar. The obstacles in the way are various and subtle. Many of them are
ideas, inherited from a bygone epoch, about keeping other people "in
their proper stations," which the whole drift of circumstance, and the
spirit of the age are rapidly wearing down. In the new world such
obstacles are rare. But an obstacle of a more tangible and formidable
kind arises from the fact that the liberal professions and many
business careers require a long and expensive education and training,
which the platelayer is quite unable to afford to give his son.

Now this expense of training is highly relevant not only to "what is,"
but to "what should be." It includes, it should be observed, a
negative as well as a positive element; a long period of waiting
before income begins, as well as the actual outlay on educational and
other charges. When the burden both of the waiting and the positive
costs must be borne either by the individual or the family, there are
few people who would seriously dispute that this goes to justify, on
grounds of fairness as well as of expediency, a higher level of annual
remuneration later on; though many people would doubtless argue that
the amenities and dignities of the professions should be taken into
account on the other side. But the same consideration makes it a
matter of legitimate doubt whether it would be desirable, even as an
ideal, that the community should provide so completely the costs of
training and of maintenance in the waiting period, as to make it no
longer "fair" that the individual should be remunerated more highly
than workers in less expensive occupations. For this would mean that
more labor would be absorbed in the former employments than in
principle would be socially desirable, for reasons which the argument
of the next chapter will make plain. But the most desirable number of
doctors, barristers, teachers, etc., is not a thing which can be
settled on purely economic grounds, and it is unprofitable to carry
further this particular line of thought. Few people would advocate, as
an ultimate ideal, that the remuneration of the professional grades of
labor should exceed that of lower grades by _more_ than the extra
expense of training and waiting they involve. That the excess is
usually greater than this at the present time seems very probable:
though it is a matter on which it is very hard to generalize. But it
would certainly be far greater than it is if the principle of
_laissez-faire_ ruled supreme in these affairs. Fortunately it does
not, and has never done so. Even before the days of free elementary
education, the endowment of education was not unknown. The ancient
public schools and universities, which have come down to us from the
Middle Ages, are a standing witness to what in this field a far poorer
community thought fit to do. Their systems of scholarships and
exhibitions, no less than their courts and towers, deserve our
notice. For these were designed to form what we now call "a ladder" by
which talent could climb from the humblest origins to the callings
which then seemed the summit either of spiritual or of worldly

This reference to "talent" makes it well to consider here a factor
which necessarily complicates, though it does not substantially
affect, the whole argument of the present chapter. There are
differences of natural ability, which no education or training can
obliterate, which it should rather be their business to excite. These
differences are associated to a great extent with differences of
occupation; they _should be_ so associated far more closely than in
fact they are. They are also associated with differences of
remuneration even within the same occupation; "what should be" here is
a question which we may excuse ourselves from discussing. The
principle which, however vague, is sufficient for our present purpose
is that the same _natural ability_ should command the same reward in
all occupations, subject to differences which should not exceed the
differences of educational cost and initial waiting they involve. We
cannot assert, as an economic law, that this is generally true in
fact. If ever it becomes true, it will be due not to
"_laissez-faire_," or "free competition," but to social arrangements,
which express a sense of what is right.

§7. _The Apportionment of Labor among Occupations_. When we pass to
the apportionment of labor among different occupations in the same
social grade, the same principle as to "what should be" applies in a
simpler form. Equal natural ability should command an equal reward in
all occupations; assuming that differences in cost of training can be
ignored. The reward must, of course, be interpreted not in terms of
money only but of "real wages," with allowance for the varying
amenities of different tasks. Now it was here that the extreme
advocates of _laissez-faire_ made one of their cardinal mistakes. They
assumed that this ideal would be best secured by "perfect
competition." The employer would choose the worker who would come for
the lowest wage; the worker would choose the employer who would pay
him the highest wage; and so, by a process similar to the higgling of
a commodity market, the desirable uniform wage-level would become
established. But in fact the conditions of the labor market differ
greatly from those of a commodity market. People are ignorant, do not
look ahead, cannot afford to risk the loss of a job, however wretched,
which they happen to have got. For reasons such as these, a
considerable departure from _laissez-faire_ is necessary in order to
realize the theoretical results of _laissez-faire_. To prevent the
putting of boys in large numbers into "blind alley" occupations, you
must supplement the foresight of parents with Juvenile Employment
Exchanges and After-Care Committees. To secure a proper uniformity of
wages within the same occupation, you must have trade unions. To
secure a proper uniformity between different occupations, you must
have again trade unions, or, failing them, Trade Boards.

That the actions of trade unions are very largely of this type is a
fact insufficiently appreciated by the middle-class public. The
elaborate system of piece-rate lists which has been evolved in the
Lancashire cotton industry is primarily designed to secure the same
wage for workers of equal efficiency in all mills, irrespective of the
degree to which the machinery is antiquated or up to date. This result
is wholly to the good: not only does it secure "fairness" for the
worker, it stimulates the employer wonderfully to efficiency. The same
result could never be secured so effectively by the free play of
competition. But this tendency, which is easily the predominant
element in the trade union regulations of the cotton trade, is at
least an important element in the policy of "The Common Rule" of all
trade unions, though it may often be mixed up with the more
questionable tendency to eliminate differences of pay for differences
of natural ability, and the unquestionably bad tendency to discourage
output. As between different occupations, the insistence of a trade
union that wages must be leveled up towards the wages obtaining in
similar trades acts again as a far more powerful force than

But the actions of trade unions are by no means wholly of this
type. They often serve rather to secure still higher wages for workers
who, comparatively speaking, are already highly paid. It makes little
difference whether this effect is secured directly by wage demands, or
indirectly by restricting the right of the entry to the trade. In
either case the consequences are the same, and there should be no
ambiguity as to their nature. They are certainly bad for the
community, certainly bad for the _other_ workers of the grade, almost
certainly bad for the workers of the grade regarded as a whole. The
higher wages must raise the money costs of production, and result,
sooner or later, in fewer workpeople being employed in that
occupation; larger numbers must accordingly seek employment elsewhere;
and this cannot but depress the wage rates of less strongly organized
trades. Thus the effect is twofold: a larger proportion of workpeople
will be employed in badly paid occupations; and the wages there will
be lessened.

The power of a strong trade union to secure wage advances of this type
is considerable, but it must not be exaggerated. Trade unions employ
as a matter of course devices which, in the case of trusts, we regard
as the extremest weapons of monopoly. To say, "If you buy from anyone
except us, you must not buy at a lower price than ours," which
Messrs. J. & P. Coats are represented as having done, is analogous to
insisting that if non-unionists are employed, it shall be at the trade
union rate, as every trade union very properly insists. To say, "You
must buy _only_ from us," the method of the boycott, as it is called,
is analogous to the very common refusal to work with non-unionists at
all. But in one important respect the tactical position of a trade
union is weaker than that of an ordinary combination. It has usually
got a buyers' combination up against it, in the shape of an
association of employers. The latter will be governed in their
attitude towards the workpeople's demands, not only by immediate
expediency, but also by their own sense of "what should be"; and they
will usually resist demands for wages greatly in excess of those
obtaining in comparable trades. In this way, the tendency for workers
of the same efficiency to receive the same real wages in all
employments is far stronger than might at first sight appear.

If we had to rely for this result upon trade unions alone, it would be
highly problematical. For here a psychological curiosity emerges,
which, familiar and intelligible as it is, is none the less a
curiosity. So far from still higher wages for well-paid workpeople
being regarded in the world of manual labor as detrimental to the
interests of other workpeople, it has become almost a point of honor
to believe the contrary. A wage dispute in a particular trade is
conceived as an engagement in a far-flung battle between Capital and
Labor, in which success at any part of the line will facilitate the
victory of the whole army. This conception contains a measure of
truth, as regards immediate and purely temporary effects; though, even
here, it is made to seem unduly plausible by the recurrence of trade
cycles, which cause wages at any time to move in the same direction
all along the line. But, if the foregoing analysis has been
appreciated, the essential falsity of this notion should be evident.
It is an illusion, which should receive no endorsement, either tacit
or express, in any work on economics. The general wage level of a
country cannot be regarded (except temporarily, and within narrow
limits) as a function of the efficiency of labor organization; it
depends on the far deeper economic facts set out in §3 above.

Let us now try to summarize the conclusions of this section. There
_is_ a tendency towards a uniformity of real wages for workers of the
same grade and of the same efficiency. This tendency is not due to
competition alone. It is helped by many acts of a collective kind,
arising from a sense of "what should be"; it is obstructed by other
acts of a like kind, where the sense of "what should be" is based on
imperfect understanding. The more people act in accordance with "what
should be," and the better their understanding, the more will this
tendency approximate to an accurate economic law.

§8. _Women's Wages_. The wages of women represent a problem of great
public interest, upon which the principles laid down in this chapter
have a most important bearing, and which in its turn serves to
illustrate these principles further. It has been suggested that male
and female labor can be regarded as a strong case of Joint Supply, and
the suggestion is not merely facetious. The essential point, that the
proportions of available male and female labor are fairly constant
(not that they may not alter with time and circumstances, but that
they are essentially independent of the conditions of demand) holds
true not only of a country as a whole, but hardly less of a particular
district. If men and women are to be regarded as separate grades, they
are grades between which immobility is complete. Now men and women
differ in many ways which affect both the demand for and the supply of
their services. On the one hand, far fewer women wish to enter
business employments of any kind, as women have plenty of work that
must be done at home. On the other hand, though women can do many
kinds of work as well as or better than men, it so happens that for
much the greater number of services, which are in large demand in the
business world, men are the more efficient. Incidentally, it happens
that many occupations which women _might_ do as well as men are closed
to them by exclusive regulations. The resultant of these forces is
that men and women are for the most part employed in different
occupations, and the scale of payment in women's occupations is far
lower than that in men's. Of this last fact singularly small
complaint is made.

It is otherwise, however, when we come to occupations where men are
either wholly or partially employed, where women are at least
approximately as efficient as men, and where the barriers to their
entry are at least formally removed. There a ferocious controversy
rages over what is known as the principle of "equal pay for equal
work." It is easy to understand why the male trade unionists in, let
us say, the engineering trades, should support this claim. It is also,
indeed, _intelligible_ why the enthusiasts for Women's Rights should
urge it; but it is much more doubtful whether they are wise. Possibly
they are wise enough in their generation, since it might not serve
them on this matter to get across the men. But it is clearly not
prudential considerations of this kind by which they are mainly
actuated. They make the demand, with extreme intensity of feeling, as
a demand for fundamental justice. They are also very obviously
inspired with the belief (similar to the illusion which is a point of
honor with the male trade unionist) that high wages for women in
well-paid occupations will help to raise the wages of sweated women
workers in other trades.

Now, here again, any lack of candor would be inexcusable. The effect
of this policy on the wages in women's trades is certainly to reduce
them. The policy serves, as powerfully as any trade union custom, to
restrict the entry of women into the men's employments, and often
spells virtual exclusion. For the "equal efficiency" may be
approximate only, and there may be advantages in male labor from the
employer's standpoint which are none the less important, because they
are not easy to define. Moreover, from the employer's standpoint, the
efficacy of female labor will be largely a matter for _experiment_,
and "equal pay" will give him no inducement to experiment at all. The
diminished number of women in these occupations (as compared with what
might have been) increases the number who must fall back on the purely
women's trades; and it _must_ serve to reduce the wages there, where
organization is by no means strong. I am far from asserting that this
consideration is conclusive against the principle of "equal pay for
equal work" (though I think it conclusive against a rigid
interpretation of it); for other matters, such as the standpoint of
the male trade unionist must be taken into account. But the reactions
on the wages in women's trades permit of no ambiguity.

In occupations of another type, the issue takes a somewhat different
form. In the teaching profession, "equal pay" would not exclude the
women; it would be far more likely to exclude the men. For, though the
advocates of the principle would declare that their intention is that
the salaries of women should be leveled up to those of men, it is more
probable that the ultimate outcome would be a leveling down.
Educational authorities have the ratepayer and the taxpayer to
consider; and, apart from this, they have their own interpretation of
"what should be." To pay a woman less than a man for the same work may
seem glaringly unfair; but it is not very clear why a woman, who is an
elementary school teacher, should be paid much more than, say, a
hospital nurse, merely because in the former case a number of men
happen also to be employed. In fact, there is a clashing of equities
in this connection; and there is little doubt which of them the
educational authorities would prefer. A leveling down of the men's
salaries would make it all but impossible to attract men of the
desired type into the profession, and would thus lead to the virtual
extinction of the male elementary school teacher. This might seem in a
narrow sense to be economically desirable. Why should not men take
their services to the tasks for which they can command a higher
reward, and which women cannot do as well? But whether this would be
desirable in the true interests of education is a far more doubtful
matter. And this is the real problem of "equal pay for equal work" for
male and female school teachers. The reader will notice that I have
refrained from alluding to the controversy as to whether men should
receive more on the grounds that they have wives and families to
maintain. That, although a most absorbing issue, is not the real issue
in practice at the present time. The real issue is a clashing between
a sense of "what should be" on obvious general grounds and a sense of
"what should be" in the particular, derived from the very patent and
general "what is" that men receive as a rule far higher pay than



§1. _Comparative Costs_. Beneath the great diversity of the
considerations which are applicable to the different agents of
production, certain general conclusions emerge from the analysis of
the last four chapters. In no case did we find that the aggregate
supply of the agent was determined by clear and certain economic laws,
possessing any fundamental significance. The supply of natural
resources is a fixed thing, quite independent of the efforts or the
desires of man. However the supply of capital and the supply of labor
may react under present conditions towards economic stimuli, these
reactions possess no quality of inevitability and bear no clear
relation to "what should be." The supply of risk-bearing responds
perhaps more decidedly to the prospects of increased reward; but it is
so intimately associated with special knowledge and the qualities of
business enterprise, as to leave some uncertainty attaching even to
this conclusion. When, on the other hand, we turn to the
apportionment of these factors among different uses, we find relations
which are both clear and fundamental. Laws emerge which state at once
not only "what is" or at least "what tends to be," but also "what
should be"; and it is the fact that they taste "what should be" that
gives them their fundamental character.

These conclusions enable us to give a general answer to the question
which was raised at the end of Chapter V: What are the ultimate real
costs to which the money cost of production correspond? The attempt
has often been made to relate money costs to such things as the effort
of working and the sacrifice of waiting. The existence of such costs
is beyond dispute. Much saving does mean a sacrifice of immediate
enjoyment to the man who saves. Most labor is irksome and disagreeable
in itself, and involves strain and wear and tear; while all labor
means a deprivation of the utility of leisure. Workpeople, moreover,
do not grow on gooseberry bushes, but must be fed and clothed from the
cradle; and their rearing and maintenance represents a real cost which
someone must incur.

But the existence (or the importance) of such costs is one thing,
their relation to money costs is another. In Chapter VIII we saw how
difficult it was to establish any clear relation between the rate of
interest and the sacrifice of saving. The costs of labor present
similar difficulties. The relative irksomeness of two occupations may
affect the relative wages which will rule in the two cases; so,
certainly, will the differences in the cost of education and training
which they require. But these are matters which concern the
_apportionment_ of labor between different employments. There is no
good reason to suppose that the general wage-level would be reduced,
merely because work as a whole became less irksome, or involved a
smaller physical or mental strain. The supply of people is not
determined by the same kind of influences as is the supply of a
commodity. Parents do not produce children for the sake of the wages
which the children will receive when they go out to work; or, if this
happens, we rightly regard it as a horrible anomaly. In so far as
parents are affected by economic conditions it is by their own
economic conditions; the question is rather one of how many children
they can afford to have, than of a balancing of the cost to them
against the incomes which their children may subsequently acquire. But
other considerations enter in; and, in fact, it is doubtful how the
aggregate supply of labor will react to changes in prosperity.
Finally, the supply of land involves neither effort nor sacrifice;
and, among our money costs, we have to account for the item
of the rent of land. To dispose of this difficulty by arguing that
rent does not enter into marginal costs (in any sense which is not
equally true of wages and profits) is to lose contact with
reality. Thus the attempt to explain money costs in terms of the costs
of producing the ultimate agents of production leads us into a
quagmire of unreality and dubious hypothesis. For a systematic theory,
which will rest on firm foundations, we must interpret money costs in
very different terms.

The real costs which the price of a commodity measures are not
absolute, but comparative. Marginal money costs reduce themselves in
the last analysis to the payments which must be made to secure the use
of the requisite agents of productions. These payments _tend_ to equal
the payments which the same agents could have commanded in alternative
employments. The payments which they could have commanded in
alternative employments, tend in their turn to equal the derived
marginal utilities of their services in those employments. It is thus
the loss of _Utility_ which arises from the fact that these agents of
production are not available for alternative employments that is
measured by the money costs of a commodity at the margin of

This conception of ultimate costs encounters an instinctive
repugnance, arising from a mistaken sense of logical symmetry, which
it will be well to examine. Cost, it is objected, so interpreted
loses its character as an independent entity. It is merely something
derived from utility. Now in the earlier chapters of this volume, we
found reason to be impressed with the general symmetry which pervades
the relations of demand and supply. Moreover, when we considered the
case of ordinary commodities we found that at the back of demand and
giving rise to it was utility; at the back of supply, and limiting it,
was cost. The general symmetry between demand and supply thus seemed
almost to imply a fundamental symmetry between utility and cost. If,
then, cost in the last analysis is derived from utility, does not this
make nonsense of the symmetry between demand and supply, or, if we
cling to this last symmetry as a demonstrable truth, must we not
refuse to admit that cost can be derived from utility?

This is one of those false dilemmas which supply the wiseacres of the
world with a plausible case for distrusting the logical faculty. If we
have good reason for believing that both of two apparently
inconsistent things are true, the explanation is seldom that one of
them is really false; it is more usually that they are not really
inconsistent. So it is here. The symmetry between demand and supply is
very great, and we should always look to see if it holds good, but it
is by no means perfect, and it is in the last analysis that it most
notably fails. It is most important to distinguish clearly between the
utility and the cost of a commodity as two separate and independent
things. In Chapter V, it will be remembered, we did not permit
ourselves to derive the costs of producing cotton lint from the
utility of cotton-seed. The refusal to do so was essential to clear
thought; it led to some very useful practical corollaries. But to
derive the cost of a commodity from the utility of something which is
produced _with_ it, as part of the same productive process; and to
derive the cost from the utilities which the agents, which help to
produce it, possess for other purposes, are two entirely different
things. In works on International Trade, the reader will discover that
the comparative nature of real costs is so unmistakable that a
Doctrine of Comparative Costs is expounded with much formality at the
outset. This doctrine is apt to prove somewhat puzzling, when we have
to deal with it as an apparent exception to the general tenor of
economic theory. Its difficulties disappear when we realize clearly
that the real cost of _anything_ is the curtailment of the supply of
other useful things, which the production of that particular thing

§2. _The Allocation of Resources_. However strange the above
conception may seem, there should be no doubt that this cost is very
"real." Here the irregularities and maladjustments of the economic
world, the recurrence of trade depressions and the like, do much to
obscure a clear vision of the essential realities. At a time when
there is much unemployment, and much machinery standing idle, it is so
clear to common sense that we _could_ produce more of some particular
thing without diminishing the supply of other things, that any
apparent statement to the contrary may perhaps seem the height of
academic pedantry. But let me ask the reader to consider with an open
mind a familiar parallel. During the recent war there was inevitably
much waste and muddle in the utilization of the military resources of
the Allies. Some regiments would be kept inactive for long periods,
not for purposes of rest or training, but owing to some defect of
organization. In the manufacture of munitions, an insufficient
appreciation of the principles of joint demand led to the piling up of
excessive stores of certain materials, which were useless until
commensurate supplies of the complementary factors could be
obtained. It is unnecessary to multiply examples. The waste of both
man-power and material was immense. But the allocation of these
resources between, for instance, the various theaters of war was none
the less a very real problem, which gave rise to much engrossing
controversy. It was an axiom that the more resources you employed in
Mesopotamia or in Palestine, the less resources remained available for
France. No one thought of maintaining that, as long as there was any
waste of these resources, so long as there remained any men to be
"combed out" of unessential industries, you could pour troops and
munitions into Salonika without stopping to consider the needs of
other theaters of war. Such a notion would have been clearly imbecile,
for the sufficient reason that the sending of armies to Salonika would
do nothing in itself to secure (however much it might incidentally
stimulate) the more efficient use of the resources which remained.

Now this is precisely analogous to the problem of the allocation of
our resources for the purpose of peace. Notwithstanding all the
wastes and maladjustments of the economic system, the use of resources
to produce one commodity _does_ in general curtail the production of
others. The mere launching of a new business enterprise does no more
than the sending of an army to Salonika, to eliminate waste in the
remainder of the economic organism. Unemployment, broadly speaking, is
a function not of the magnitude of the normal demand for labor (which
affects rather the wage-level), but of fluctuations in the demand for
labor; fluctuations from one day to another as at the docks, from one
season to another as in the building trades, above all from one period
of years to another as in the cycles of general trade boom and
depression. Nothing will diminish unemployment which does not serve to
diminish these fluctuations. A new business will not, as a rule, have
any such effect. If it is launched during a trade depression (a most
unusual proceeding), it may temporarily absorb unemployed labor and
idle materials. But when the next boom comes, it will be using, though
presumably to greater advantage, labor and materials which, but for
it, would have been employed for other purposes. Meanwhile the causes
making for unemployment will be unaffected. Miscalculations will
still be made, the building trades will still become slack in the
winter, the casual methods of engaging dock laborers will still
continue, trade cycles will still recur, while beneath them, and
concealed by them, some industries will expand and others will decay.
Thus, like the armies at Salonika, the new business would in effect
divert resources from elsewhere.

This truth needs to be firmly grasped in mind. It is this that makes
it in general unsound policy to subsidize industries, either directly
or indirectly, by means of a protective tariff. It is this, indeed,
that supplies the answer to half the economic fallacies that are
always current.

The allocation of resources so as to yield the maximum effect was
rightly recognized as one of the most vital and difficult of our
war-time problems. To cope with it, the Allied peoples devised one
instrument after another, and finally evolved the Supreme Allied
Council. The analogous problem in the economic world of peace time is
no less important and far more difficult; but there is nothing to
correspond to the Supreme Allied Council. There we rely upon a
co-operation which, as was stressed in Chapter I, is unco-ordinated.
That co-operation has been evolved by the mutual competition
of innumerable business concerns, controlled by men largely
animated by the motive of pecuniary profit. But it has not
been evolved wholly by such means: and how far that competition or
that motive of profit is essential to its efficiency are questions
with which this volume has not been in any way concerned. The economic
laws, the relations between utility, and price and cost, with which it
has been occupied, are an entirely different matter; and these _are_
essential to the efficiency of any system of society. For if the
marginal utility of a commodity is equal to its marginal cost, and if
this marginal cost is composed of payments to the various agents of
production at least as great as they could have obtained if they had
been used otherwise, this amounts to saying that the agents of
production are so utilized as to yield the maximum utility; and this
is the same thing as saying that they are so utilized as to produce
the maximum wealth.

§3. _Utility and Wealth_. Upon this last point it is important to be
quite clear. An increase in wealth seems a solid, tangible reality;
something, which, however much we may scorn it in our more precious
moods, we recognize, for a rather poor community, to be an important
object of endeavor. But an increase in utility seems a vague,
impalpable notion, hardly deserving the same practical concern. None
the less the two things are identical. We greatly deceive ourselves if
we suppose wealth to be an objective reality. It is true that, when
we get behind the money in which it is measured, we come upon
commodities, like food and clothes and houses and factories, which
seem comfortably solid and objective things; but we also come upon
many services, like those of gardeners and doctors and hospital
nurses, which we are bound to reckon as part of our wealth, although
they are not embodied in any tangible commodities. Moreover, although
material commodities are objective realities in themselves, and in
many of their properties, they are _not_ objective realities in their
property as wealth. A pair of boots is an objective fact; so is the
number of pairs in existence at any time, so is their size, their
weight, the quantity of leather or of paper which they happen to
contain. But the wealth which those boots represent is not an
objective fact. It depends upon the opinion which men and women
entertain as to their utility; and these opinions take us into the
subjective regions of human psychology. Let us suppose, for instance,
that we calculated, on the basis of present prices, that the boots in
existence at the present time represented 1/1000 part of our total
wealth. Suppose, then, that a miracle were to happen; that the skies
opened and rained boots upon us, of every size and shape and pattern,
until we had 1000 times as many boots as we had before. Could we say
that our total real wealth had been doubled? Clearly we could not. To
obtain boots for nothing, and to wear a new pair every week, would
make us somewhat better off, but not twice as well off as we were
previously. In other words, the real wealth of a thousand times as
many boots as we have now, is not a thousand times as great as the
wealth of the present number of boots. We are, indeed, practically
restating the Law of Diminishing Utility; and this perhaps is enough
to show that wealth is fundamentally the same thing as utility.

Another point, however, is worth noting. Our real wealth would be
somewhat increased in the case supposed; but if we were to turn to the
money measure of wealth, the opposite result would be far more likely,
For the price of boots would most likely fall to nothing, and the
total value of boots, in the commercial sense, would accordingly be
nothing also. This shows that money values may be a most imperfect
measure of aggregate wealth; for what money values represent is the
product of the quantity of the commodity and its _marginal_ utility,
while aggregate wealth is _total_ utility, which is a very different
thing. This, it may be observed, makes all attempts to compare the
wealth of different countries or different times, and no less to
construct Index Numbers of Prices, imperfect of necessity, and
arbitrary in their foundations.

§4. _Criteria of Policy_. The point has now been reached at which we
must take into account the very important fact which was mentioned at
the close of Chapter III. The maximum utility which the laws of
supply and demand tend to bring about is a maximum _total_ utility
indeed, but one still measured in terms of money. An unequal
distribution of wealth destroys any necessary correspondence between
that and the maximum _real_ utility. This consideration, however, does
not affect the general validity of the conclusion that the laws of
supply and demand represent what is socially desirable now or under
any system. For what is at fault here is the distribution of wealth;
and it is that which should be changed, in so far as it is possible to
do so. Now it is important to realize that whenever it is possible to
supply a commodity to poor people below cost price, it is possible to
alter the distribution of wealth, for that in effect is what is
done. Purchasing power, which may be taken from richer people by
taxation, or which may be obtained from "collective" profits on other
trading, is in effect transferred to the poor people in question,
though the transference is coupled with the condition that the
purchasing power must be expended in a particular way. It is _in
general_ desirable that the transference should be made without this
condition being attached. To this general statement, exceptions indeed
exist so numerous and important as possibly to justify a great
extension of social expenditure of this type. Education should
certainly be provided free of charge, there are strong arguments for
subsidizing housing; the provision of milk to expectant mothers, the
feeding of school children, such instances can be multiplied into a
very extensive list. But it is important to observe that in each case
the justification of the policy rests in the presumption that the
service supplied is one which it is particularly important that the
beneficiaries should have, _as compared with_ the other things upon
which they might have preferred to expend the equivalent purchasing
power, had it been transferred to them without conditions. Where there
is no such presumption, as surely there is none in the case of the
great bulk of commodities, the relation between price and marginal
cost should be rigidly maintained; it is the distribution of
purchasing power which we should rather seek to alter. How far is it
possible to alter that?

I suppose that it is inevitable that many readers will have concluded
that the preceding chapters must be taken to mean that the
distribution of wealth is not susceptible of any appreciable change. I
would remind those readers of an important distinction upon which
impatient people have sometimes based a complaint against
economists. The economist, it is said, analyses with great pomp and
ceremony the laws governing the distribution of wealth among the
agents of production, but says practically nothing about the
distribution between individuals and classes, which is the only thing
of any real interest to practical people. Now the economist
concentrates on the agents of production for the very good reason that
it is only with respect to them that any clear and certain laws as to
distribution can be laid down. Into the distribution between
individuals and classes there enter other and variable factors,
governed by no fundamental economic law; and _here_, the conclusion
should at once suggest itself, is the field for action designed to
alter the distribution of wealth. What is possible or desirable in
this field, it is again not the purpose of this volume to discuss. It
is an obvious, even if not a very helpful conclusion that an increase
in the habit of saving among weekly wage-earners might, without
appreciably affecting the distribution between Capital and Labor,
greatly modify the resulting distribution between social classes. But
questions as to how far it might be possible or justifiable to achieve
a similar result by the use of the weapon of taxation, by changes in
inheritance laws, or by the public ownership of industry take us into
a far more uncertain and controversial sphere. The difficulties and
objections which present themselves are familiar and formidable; but
they are of quite a different order from the economic laws which we
have been examining. The laws themselves do not entitle us to make any
dogmatic pronouncement upon these large issues of social policy.

But this is not to deprive these laws of practical importance. They
represent essential criteria of sound policy in the sphere of social
reorganization no less than in ordinary business. In our days a
curious obsession has led many people to disparage these criteria, as
though they were the sordid prejudices of a stupid tradesman. Because
it has been found a matter of obvious practical convenience to
maintain the roads out of taxation or of rates, and to dispense with
charges for their use, it is suggested that the same principle should
be applied to the railways. Or, more commonly, because it has been
found convenient to make the same charge for the carrying of letters
between Land's End and John o' Groats as between Hampstead and
Highgate, it is suggested that _this_ principle should be applied to
railway rates and fares. It may be well, therefore, to point out that
the justification of uniform postal charges rests upon the facts: (1)
that the costs of collection, sorting, etc., are so large a part of
the costs of carrying a letter, that the real cost between John o'
Groats and Land's End does not differ from that between Hampstead and
Highgate by as much as might at first sight appear, (2) that the
charges in any case are very small; so that (3) the avoidance of the
small degree of taxes and bounties which the present system implies is
not worth the book-keeping expenses which differential charges would
involve. It should be obvious that these considerations apply to the
railways with a greatly diminished force. They might possibly justify
what is known as the "zone" system of charges, i.e. uniform rates
within certain narrow areas. But the notion of uniform rates
throughout Great Britain conjures up a vision of trains taking coal
from South Wales to Scotland, and others taking coal from Scotland to
South Wales, in accordance with the slightest preferences of the
consumers, and without regard to the extra real cost involved, on a
scale to which the "wastes of competition" afford no parallel. It
would in fact achieve the essential folly of "sending coals to
Newcastle." These considerations, however, are not what interest the
advocates of the postal principle. They seem to recommend the
obliteration or the confusion of the relations between price and cost
as a superior ideal. It is important to be clear what exactly this
ideal involves.

It involves, in the first place, as the whole argument of this volume
has gone to show, a less economical employment of our productive
resources; they would be diverted to ends of less utility, and so
produce less real wealth. But this is not the worst. There is plenty
of waste and maladjustment in our economic system at the present
time. The desirable relation of price to marginal cost is but
imperfectly attained. The further departures from this relation, which
would follow from any likely applications of the postal principle,
might not matter in themselves so very much. What is far more serious
is that the criteria of efficiency would become blunted, and the clear
aims of management would be confused in fog. It is essential that
every manager should be on the alert to eliminate waste and to improve
efficiency, that he should be always trying to secure the best
results; but how can he do this if he has no simple means of
_measuring_ what results are good and what are bad? The measure which
he has at present is that of price, cost and the resultant profit, and
it would be fatal to take that away, unless an equally simple and more
accurate measure could be substituted for it.

This is not a question, it should be observed, of motive or
incentive. Very likely we much exaggerate the importance of the profit
motive. It may be true that men would work, perhaps that they already
work in fact, as zealously for a fixed salary, as for personal
gain. But aim and motive are two somewhat different things, and the
_aim_ of profit, is, and will remain, essential to the efficient
conduct of business. In a game the players are not animated by the
motive of scoring runs or points, but they aim at them; and the zest
disappears very speedily from the game, if that aim ceases to be of
interest. Moreover, while a scoring system is always a somewhat
arbitrary thing, measuring imperfectly the true merits of the play, if
it measures them with the roughest accuracy, we prefer the issue of
our games to be decided so, rather than by the decisions of an
impartial judge, who can take into account the finest points of
skill. So it is in the world of business. The scoring-board of profits
may be an imperfect one; let us, by all means, where we can, alter the
rules of the game so as to make it better. But let us not imagine that
it displays a finer insight or a superior intellect to speak as though
the scoring-board could be dispensed with, and the test of profit and
loss treated as irrelevant. Quantitative measurement is essential to
efficiency. Let us be careful to remember all that this implies.


Allocation of resources

Bastiat, Frederic
Beef and hides
Borrowing and lending, system of
Business efficiency
Business man as a purchaser
Business risk

  as representing a period of waiting;
  distribution and rate of interest;
  effect on labor of an increased supply;
  not a stock of consumable goods;
  reaction of price charges on;
  reflections upon;
  supply as affected by charges in interest rate
Capital goods
Capital market
Coal industry, cost of production and price;
  miners' wages
Coats, J. & P.
Collective saving
  labor as a commodity
Composite demand
Composite supply
Consumable goods
Consumers' goods and producers' goods
Consumption, margin of;
  waiting for
Control and risk-taking
Cost, general relation of price, utility and cost;
  price relation to;
  rent as factor in real costs;
  utility and
Cotton and cotton-seed;
  contrast to wool and mutton
Cotton industry
Criteria of policy
Currency inflation

Demand, ambiguity of expression "increase in demand,";
  elastic and inelastic;
  _see also_ Composite demand; Joint demand; Supply and demand
Derived demand
Derived utility
Diagrams, use of
Diminishing utility;
  money and
Distribution of wealth;
  interest rate and
Division of labor

Economic laws;
  fundamental character
Economic theory;
  fact and
Economic world, orderly nature
Elastic demand
Employers' associations
"Equal pay for equal work,"

Fact and theory

Government, enterprises;

Hides and beef
Housewife as purchaser

Ideas and institutions
Increase in demand, ambiguity
Index numbers
Inelastic demand
Institutions and ideas
Insurance companies;
  necessity of
Interest rate;
  changes and their effect on supply of capital;
  distribution and;
  price of land and

Joint demand;
  importance of the unimportant;
  marginal utility under;
  summary of considerations
Joint products;
  cost of production
Joint-stock company
Joint supply, marginal cost under;
  summary of considerations

Keynes, J. M.

  apportionment among occupations;
  apportionment among places;
  apportionment among social grades;
  as a commodity;
  cost, difficulty of estimating;
  effect of increased supply of capital;
  four grades;
  product of;
  reaction of price changes on;
  supply in general
  retrospect on
Land, characteristics;
  differential aspect;
  margin of transference;
  price and rent, relation;
  question of real costs;
  scarcity aspect;
  _see also_ Rent
Large scale business
Laws, fundamental

Malthus, T.R.
Margin, danger of ignoring
Margin of consumption
Margin of production
Margin of transference
Marginal cost, aspects;
  under joint supply
Marginal land
Marginal purchaser
Marginal utility;
  price relation to;
  under joint demand
Marshall, Alfred
Marx, Karl
Mill, J. S.
Monetary changes, disturbances of
Money, diminishing utility
Monte Carlo
Mutton. _See_ Wool and Mutton

Natural ability
Normal conditions

  apportionment of labor among
Order, economic

Pasture versus tillage
Pigou, A. C.
Policy, criteria
Postal charges
Price, consequences of higher;
  general relation with utility and cost;
  law of tendency;
  marginal utility and;
  reaction of changes in demand and supply;
  relation of demand and supply to;
  utility and
Producers' goods
Production, power of;
  real costs;
  waiting for
  general analysis;
  in risky industries
Protective tariff
Psychology and economics
Purchasers, business man;
Purchasing power

Railway rates
Rate of interest. _See_ Interest rate
  complex character;
  marginal land;
  rate of interest and
Residuary profits
Resources, allocation
Risk, reward for;
  under large-scale organization

School teachers
Serving cotton
Smith, Adam
Social grades, labor movement among
Steel smelters
Subsidies, industrial
Supply, reactions of price changes on;
  _see also_ Composite supply; Joint supply
Supply and demand, changes in, and their reaction on price;
  forces behind;
  general laws;
  relation of price to;
  wages and
Supreme Allied Council

Theory, economic
Tillage versus pasture
Trade cycles
Trade depression
Trade unions;
  wage level and

Ultimate real costs
Unearned increment
  trade union policy and
  cost and;
  general relation of price, utility and cost;
  law of diminishing utility;
  law of diminishing utility as applied to money;
  price relation to;
  wealth and

Wages, general wage level;
  trade unions and;
Wages Fund
Waiting, essence of;
  for consumption;
  for production
Waste, economic
Wealth, distribution;
  utility and
"What should be" and "What is,"
Women's wages
Wool and mutton;
  contrast to cotton and cotton-seed
Workers' control

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