Part 3 (1/2)

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 them.

[Footnote 1: a.s.suming 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, --10]

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 pa.s.s 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 c.u.mbrous 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.

CHAPTER V

JOINT DEMAND AND SUPPLY

--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 b.a.l.l.s, 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 pa.s.s 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 circ.u.mstances, 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 subst.i.tute, for the merino, the crossbred sheep which yields a larger quant.i.ty of mutton and a smaller quant.i.ty of wool of poorer quality. Now if we calculate the cost of maintaining the number of merino sheep which will yield a given quant.i.ty of wool, and calculate the cost of maintaining the larger number of crossbred sheep which will be required to yield the _same_ quant.i.ty 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 const.i.tuting 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 subst.i.tution of crossbred for merino sheep. The process of subst.i.tution 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 quant.i.ty 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 plainer:--

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 wool.

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 a.s.signable 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 subst.i.tute 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 subst.i.tution, 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 subst.i.tution 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 subst.i.tution” 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 subst.i.tution 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 quant.i.ties 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 subst.i.tution 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 quant.i.ties of one factor are employed, together with equal quant.i.ties of the others. The extra product which will be yielded in the case in which the larger quant.i.ty of the varying factor is employed can then be regarded as the marginal product (or marginal utility) of the extra quant.i.ty 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.