Part 2 (1/2)

”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 ent.i.tled to a.s.sume 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 a.s.sumption 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 pa.s.s 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, ”a.s.suming that there is no change in the general volume of purchasing power.”

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

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

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

CHAPTER III

UTILITY AND THE MARGIN OF CONSUMPTION

--1. _The Forces behind Supply and Demand_. The laws enunciated in the preceding chapter const.i.tute the framework and skeleton of all economic a.n.a.lysis; 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 quant.i.tative 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 ma.s.s 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 a.s.suming 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 Diminis.h.i.+ng 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 a.s.serted 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 quant.i.ties 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. .h.i.therto, 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 ill.u.s.tration 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 diminis.h.i.+ng rate. This law is usually called The Law of Diminis.h.i.+ng Utility.

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

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

--4. _The Marginal Purchaser_. A possible objection to the preceding argument deserves to be considered. Some readers may find the picture I have drawn of the hesitating housewife entirely unconvincing. They may declare that her mind does not work at all in the manner I have indicated. She will have formed certain habits in regard to her weekly purchases of sugar, which are connected very vaguely, if at all, with any conscious processes of thought. She will buy so many pounds of sugar weekly without troubling her head over the specific utility of the last pound she buys. When the price falls she may, indeed, buy more; but it will not be because she separates out and considers by itself the extra utility of an additional pound. She may buy more, because she has formed the habit of spending so much money on sugar; and now that the price has fallen, the same amount of money will enable her to buy more pounds. Or, perhaps, she may be moved by instinctive and irresistible attraction to buy more of a thing when it is cheaper, similar to that which inspires so many people to face with ardor the horrors of a bargain sale. In any case the fine calculations I have imagined convey a fantastic picture of her state of mind. And how much more fantastic, the critic may continue, of the state of mind in which things of a different kind are bought by less careful people. When, for instance, one of us happy-go-lucky males (more liberally supplied, perhaps, than the housewife with the necessary cash), decides to buy a motor bicycle, or to replenish his stock of collars or ties, does the above a.n.a.lysis 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 grat.i.tude, 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 const.i.tute 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 const.i.tutes 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.