Principles of Economics
BOOK V, CHAPTER III
EQUILIBRIUM OF NORMAL DEMAND AND SUPPLY.
§ 1. We have next to inquire what causes govern supply prices, that is prices which dealers are willing to accept for different amounts. In the last chapter we looked at the affairs of only a single day; and supposed the stocks offered for sale to be already in existence. But of course these stocks are dependent on the amount of wheat sown in the preceding year; and that, in its turn, was largely influenced by the farmers' guesses as to the price which they would get for it in this year. This is the point at which we have to work in the present chapter.
Even in the corn-exchange of a country town on a market-day the equilibrium price is affected by calculations of the future relations of production and consumption; while in the leading corn-markets of America and Europe dealings for future delivery already predominate and are rapidly weaving into one web all the leading threads of trade in corn throughout the whole world. Some of these dealings in "futures" are but incidents in speculative manœuvres; but in the main they are governed by calculations of the world's consumption on the one hand, and of the existing stocks and coming harvests in the Northern and Southern hemispheres on the other. Dealers take account of the areas sown with each kind of grain, of the forwardness and weight of the crops, of the supply of things which can be used as substitutes for grain, and of the things for which grain can be used as a substitute. Thus, when buying or selling barley, they take account of the supplies of such things as sugar, which can be used as substitutes for it in brewing, and again of all the various feeding stuffs, a scarcity of which might raise the value of barley for consumption on the farm. If it is thought that the growers of any kind of grain in any part of the world have been losing money, and are likely to sow a less area for a future harvest; it is argued that prices are likely to rise as soon as that harvest comes into sight, and its shortness is manifest to all. Anticipations of that rise exercise an influence on present sales for future delivery, and that in its turn influences cash prices; so that these prices are indirectly affected by estimates of the expenses of producing further supplies.
But in this and the following chapters we are specially concerned with movements of price ranging over still longer periods than those for which the most far-sighted dealers in futures generally make their reckoning: we have to consider the volume of production adjusting itself to the conditions of the market, and the normal price being thus determined at the position of stable equilibrium of normal demand and normal supply.
§ 2. In this discussion we shall have to make frequent use of the terms cost and expenses of production; and some provisional account of them must be given before proceeding further.
We may revert to the analogy between the supply price and the demand price of a commodity. Assuming for the moment that the efficiency of production depends solely upon the exertions of the workers, we saw that "the price required to call forth the exertion necessary for producing any given amount of a commodity may be called the supply price for that amount, with reference of course to a given unit of time*10." But now we have to take account of the fact that the production of a commodity generally requires many different kinds of labour and the use of capital in many forms. The exertions of all the different kinds of labour that are directly or indirectly involved in making it; together with the abstinences or rather the waitings required for saving the capital used in making it: all these efforts and sacrifices together will be called the real cost of production of the commodity. The sums of money that have to be paid for these efforts and sacrifices will be called either its money cost of production, or, for shortness, its expenses of production; they are the prices which have to be paid in order to call forth an adequate supply of the efforts and waitings that are required for making it; or, in other words, they are its supply price*11.
The analysis of the expenses of production of a commodity might be carried backward to any length; but it is seldom worth while to go back very far. It is for instance often sufficient to take the supply prices of the different kinds of raw materials used in any manufacture as ultimate facts, without analysing these supply prices into the several elements of which they are composed; otherwise indeed the analysis would never end. We may then arrange the things that are required for making a commodity into whatever groups are convenient, and call them its factors of production. Its expenses of production when any given amount of it is produced are thus the supply prices of the corresponding quantities of its factors of production. And the sum of these is the supply price of that amount of the commodity.
§ 3. The typical modern market is often regarded as that in which manufacturers sell goods to wholesale dealers at prices into which but few trading expenses enter. But taking a broader view, we may consider that the supply price of a commodity is the price at which it will be delivered for sale to that group of persons whose demand for it we are considering; or, in other words, in the market which we have in view. On the character of that market will depend how many trading expenses have to be reckoned to make up the supply price*12. For instance, the supply price of wood in the neighbourhood of Canadian forests often consists almost exclusively of the price of the labour of lumber men: but the supply price of the same wood in the wholesale London market consists in a large measure of freights; while its supply price to a small retail buyer in an English country town is more than half made up of the charges of the railways and middlemen who have brought what he wants to his doors, and keep a stock of it ready for him. Again, the supply price of a certain kind of labour may for some purposes be divided up into the expenses of rearing, of general education and of special trade education. The possible combinations are numberless; and though each may have incidents of its own which will require separate treatment in the complete solution of any problem connected with it, yet all such incidents may be ignored, so far as the general reasonings of this Book are concerned.
In calculating the expenses of production of a commodity we must take account of the fact that changes in the amounts produced are likely, even when there is no new invention, to be accompanied by changes in the relative quantities of its several factors of production. For instance, when the scale of production increases, horse or steam power is likely to be substituted for manual labour; materials are likely to be brought from a greater distance and in greater quantities, thus increasing those expenses of production which correspond to the work of carriers, middlemen and traders of all kinds.
As far as the knowledge and business enterprise of the producers reach, they in each case choose those factors of production which are best for their purpose; the sum of the supply prices of those factors which are used is, as a rule, less than the sum of the supply prices of any other set of factors which could be substituted for them; and whenever it appears to the producers that this is not the case, they will, as a rule, set to work to substitute the less expensive method. And further on we shall see how in a somewhat similar way society substitutes one undertaker for another who is less efficient in proportion to his charges. We may call this, for convenience of reference, The principle of substitution.
The applications of this principle extend over almost every field of economic inquiry*13.
§ 4. The position then is this: we are investigating the equilibrium of normal demand and normal supply in their most general form; we are neglecting those features which are special to particular parts of economic science, and are confining our attention to those broad relations which are common to nearly the whole of it. Thus we assume that the forces of demand and supply have free play; that there is no close combination among dealers on either side, but each acts for himself, and there is much free competition; that is, buyers generally compete freely with buyers, and sellers compete freely with sellers. But though everyone acts for himself, his knowledge of what others are doing is supposed to be generally sufficient to prevent him from taking a lower or paying a higher price than others are doing. This is assumed provisionally to be true both of finished goods and of their factors of production, of the hire of labour and of the borrowing of capital. We have already inquired to some extent, and we shall have to inquire further, how far these assumptions are in accordance with the actual facts of life. But meanwhile this is the supposition on which we proceed; we assume that there is only one price in the market at one and the same time; it being understood that separate allowance is made, when necessary, for differences in the expense of delivering goods to dealers in different parts of the market; including allowance for the special expenses of retailing, if it is a retail market.
In such a market there is a demand price for each amount of the commodity, that is, a price at which each particular amount of the commodity can find purchasers in a day or week or year. The circumstances which govern this price for any given amount of the commodity vary in character from one problem to another; but in every case the more of a thing is offered for sale in a market the lower is the price at which it will find purchasers; or in other words, the demand price for each bushel or yard diminishes with every increase in the amount offered.
The unit of time may be chosen according to the circumstances of each particular problem: it may be a day, a month, a year, or even a generation: but in every case it must be short relatively to the period of the market under discussion. It is to be assumed that the general circumstances of the market remain unchanged throughout this period; that there is, for instance, no change in fashion or taste, no new substitute which might affect the demand, no new invention to disturb the supply.
The conditions of normal supply are less definite; and a full study of them must be reserved for later chapters. They will be found to vary in detail with the length of the period of time to which the investigation refers; chiefly because both the material capital of machinery and other business plant, and the immaterial capital of business skill and ability and organization, are of slow growth and slow decay.
Let us call to mind the "representative firm," whose economies of production, internal and external, are dependent on the aggregate volume of production of the commodity that it makes*14; and, postponing all further study of the nature of this dependence, let us assume that the normal supply price of any amount of that commodity may be taken to be its normal expenses of production (including gross earnings of management*15) by that firm. That is, let us assume that this is the price the expectation of which will just suffice to maintain the existing aggregate amount of production; some firms meanwhile rising and increasing their output, and others falling and diminishing theirs; but the aggregate production remaining unchanged. A price higher than this would increase the growth of the rising firms, and slacken, though it might not arrest, the decay of the falling firms; with the net result of an increase in the aggregate production. On the other hand, a price lower than this would hasten the decay of the falling firms, and slacken the growth of the rising firms; and on the whole diminish production: and a rise or fall of price would affect in like manner though perhaps not in an equal degree those great joint-stock companies which often stagnate, but seldom die.
§ 5. To give definiteness to our ideas let us take an illustration from the woollen trade. Let us suppose that a person well acquainted with the woollen trade sets himself to inquire what would be the normal supply price of a certain number of millions of yards annually of a particular kind of cloth. He would have to reckon (i) the price of the wool, coal, and other materials which would be used up in making it, (ii) wear-and-tear and depreciation of the buildings, machinery and other fixed capital, (iii) interest and insurance on all the capital, (iv) the wages of those who work in the factories, and (v) the gross earnings of management (including insurance against loss), of those who undertake the risks, who engineer and superintend the working. He would of course estimate the supply prices of all these different factors of production of the cloth with reference to the amounts of each of them that would be wanted, and on the supposition that the conditions of supply would be normal; and he would add them all together to find the supply price of the cloth.
Let us suppose a list of supply prices (or a supply schedule) made on a similar plan to that of our list of demand prices*16: the supply price of each amount of the commodity in a year, or any other unit of time, being written against that amount*17. As the flow, or (annual) amount of the commodity increases, the supply price may either increase or diminish; or it may even alternately increase and diminish*18. For if nature is offering a sturdy resistance to man's efforts to wring from her a larger supply of raw material, while at that particular stage there is no great room for introducing important new economies into the manufacture, the supply price will rise; but if the volume of production were greater, it would perhaps be profitable to substitute largely machine work for hand work and steam power for muscular force; and the increase in the volume of production would have diminished the expenses of production of the commodity of our representative firm. But those cases in which the supply price falls as the amount increases involve special difficulties of their own; and they are postponed to chapter XII. of this Book.
§ 6. When therefore the amount produced (in a unit of time) is such that the demand price is greater than the supply price, then sellers receive more than is sufficient to make it worth their while to bring goods to market to that amount; and there is at work an active force tending to increase the amount brought forward for sale. On the other hand, when the amount produced is such that the demand price is less than the supply price, sellers receive less than is sufficient to make it worth their while to bring goods to market on that scale; so that those who were just on the margin of doubt as to whether to go on producing are decided not to do so, and there is an active force at work tending to diminish the amount brought forward for sale. When the demand price is equal to the supply price, the amount produced has no tendency either to be increased or to be diminished; it is in equilibrium.
When demand and supply are in equilibrium, the amount of the commodity which is being produced in a unit of time may be called the equilibrium-amount, and the price at which it is being sold may be called the equilibrium-price.
Such an equilibrium is stable; that is, the price, if displaced a little from it, will tend to return, as a pendulum oscillates about its lowest point; and it will be found to be a characteristic of stable equilibria that in them the demand price is greater than the supply price for amounts just less than the equilibrium amount, and vice versâ. For when the demand price is greater than the supply price, the amount produced tends to increase. Therefore, if the demand price is greater than the supply price for amounts just less than an equilibrium amount; then, if the scale of production is temporarily diminished somewhat below that equilibrium amount, it will tend to return; thus the equilibrium is stable for displacements in that direction. If the demand price is greater than the supply price for amounts just less than the equilibrium amount, it is sure to be less than the supply price for amounts just greater: and therefore, if the scale of production is somewhat increased beyond the equilibrium position, it will tend to return; and the equilibrium will be stable for displacements in that direction also.
When demand and supply are in stable equilibrium, if any accident should move the scale of production from its equilibrium position, there will be instantly brought into play forces tending to push it back to that position; just as, if a stone hanging by a string is displaced from its equilibrium position, the force of gravity will at once tend to bring it back to its equilibrium position. The movements of the scale of production about its position of equilibrium will be of a somewhat similar kind*19.
But in real life such oscillations are seldom as rhythmical as those of a stone hanging freely from a string; the comparison would be more exact if the string were supposed to hang in the troubled waters of a mill-race, whose stream was at one time allowed to flow freely, and at another partially cut off. Nor are these complexities sufficient to illustrate all the disturbances with which the economist and the merchant alike are forced to concern themselves. If the person holding the string swings his hand with movements partly rhythmical and partly arbitrary, the illustration will not outrun the difficulties of some very real and practical problems of value. For indeed the demand and supply schedules do not in practice remain unchanged for a long time together, but are constantly being changed; and every change in them alters the equilibrium amount and the equilibrium price, and thus gives new positions to the centres about which the amount and the price tend to oscillate.
These considerations point to the great importance of the element of time in relation to demand and supply, to the study of which we now proceed. We shall gradually discover a great many different limitations of the doctrine that the price at which a thing can be produced represents its real cost of production, that is, the efforts and sacrifices which have been directly and indirectly devoted to its production. For, in an age of rapid change such as this, the equilibrium of normal demand and supply does not thus correspond to any distinct relation of a certain aggregate of pleasures got from the consumption of the commodity and an aggregate of efforts and sacrifices involved in producing it: the correspondence would not be exact, even if normal earnings and interest were exact measures of the efforts and sacrifices for which they are the money payments. This is the real drift of that much quoted, and much-misunderstood doctrine of Adam Smith and other economists that the normal, or "natural," value of a commodity is that which economic forces tend to bring about in the long run. It is the average value which economic forces would bring about if the general conditions of life were stationary for a run of time long enough to enable them all to work out their full effect*20.
But we cannot foresee the future perfectly. The unexpected may happen; and the existing tendencies may be modified before they have had time to accomplish what appears now to be their full and complete work. The fact that the general conditions of life are not stationary is the source of many of the difficulties that are met with in applying economic doctrines to practical problems.
Of course Normal does not mean Competitive. Market prices and Normal prices are alike brought about by a multitude of influences, of which some rest on a moral basis and some on a physical; of which some are competitive and some are not. It is to the persistence of the influences considered, and the time allowed for them to work out their effects that we refer when contrasting Market and Normal price, and again when contrasting the narrower and the broader use of the term Normal price*21.
§ 7. The remainder of the present volume will be chiefly occupied with interpreting and limiting this doctrine that the value of a thing tends in the long run to correspond to its cost of production. In particular the notion of equilibrium, which has been treated rather slightly in this chapter, will be studied more carefully in chapters V. and XII. of this Book: and some account of the controversy whether "cost of production" or "utility" governs value will be given in Appendix I. But it may be well to say a word or two here on this last point.
We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.
In the same way, when a thing already made has to be sold, the price which people will be willing to pay for it will be governed by their desire to have it, together with the amount they can afford to spend on it. Their desire to have it depends partly on the chance that, if they do not buy it, they will be able to get another thing like it at as low a price: this depends on the causes that govern the supply of it, and this again upon cost of production. But it may so happen that the stock to be sold is practically fixed. This, for instance, is the case with a fish market, in which the value of fish for the day is governed almost exclusively by the stock on the slabs in relation to the demand: and if a person chooses to take the stock for granted, and say that the price is governed by demand, his brevity may perhaps be excused so long as he does not claim strict accuracy. So again it may be pardonable, but it is not strictly accurate to say that the varying prices which the same rare book fetches, when sold and resold at Christie's auction room, are governed exclusively by demand.
Taking a case at the opposite extreme, we find some commodities which conform pretty closely to the law of constant return; that is to say, their average cost of production will be very nearly the same whether they are produced in small quantities or in large. In such a case the normal level about which the market price fluctuates will be this definite and fixed (money) cost of production. If the demand happens to be great, the market price will rise for a time above the level; but as a result production will increase and the market price will fall: and conversely, if the demand falls for a time below its ordinary level.
In such a case, if a person chooses to neglect market fluctuations, and to take it for granted that there will anyhow be enough demand for the commodity to insure that some of it, more or less, will find purchasers at a price equal to this cost of production, then he may be excused for ignoring the influence of demand, and speaking of (normal) price as governed by cost of production—provided only he does not claim scientific accuracy for the wording of his doctrine, and explains the influence of demand in its right place.
Thus we may conclude that, as a general rule, the shorter the period which we are considering, the greater must be the share of our attention which is given to the influence of demand on value; and the longer the period, the more important will be the influence of cost of production on value. For the influence of changes in cost of production takes as a rule a longer time to work itself out than does the influence of changes in demand. The actual value at any time, the market value as it is often called, is often more influenced by passing events and by causes whose action is fitful and short lived, than by those which work persistently. But in long periods these fitful and irregular causes in large measure efface one another's influence; so that in the long run persistent causes dominate value completely. Even the most persistent causes are however liable to change. For the whole structure of production is modified, and the relative costs of production of different things are permanently altered, from one generation to another.
When considering costs from the point of view of the capitalist employer, we of course measure them in money; because his direct concern with the efforts needed for the work of his employees lies in the money payments he must make. His concern with the real costs of their effort and of the training required for it is only indirect, though a monetary assessment of his own labour is necessary for some problems, as will be seen later on. But when considering costs from the social point of view, when inquiring whether the cost of attaining a given result is increasing or diminishing with changing economic conditions, then we are concerned with the real costs of efforts of various qualities, and with the real cost of waiting. If the purchasing power of money, in terms of effort has remained about constant, and if the rate of remuneration for waiting has remained about constant, then the money measure of costs corresponds to the real costs: but such a correspondence is never to be assumed lightly. These considerations will generally suffice for the interpretation of the term Cost in what follows, even where no distinct indication is given in the context.
Notes for this chapter
IV. I. 2.
Mill and some other economists have followed the practice of ordinary life in using the term Cost of production in two senses, sometimes to signify the difficulty of producing a thing, and sometimes to express the outlay of money that has to be incurred in order to induce people to overcome this difficulty and produce it. But by passing from one use of the term to the other without giving explicit warning, they have led to many misunderstandings and much barren controversy. The attack on Mill's doctrine of Cost of Production in relation to Value, which is made in Cairnes' Leading Principles, was published just after Mill's death; and unfortunately his interpretation of Mill's words was generally accepted as authoritative, because he was regarded as a follower of Mill. But in an article by the present writer on "Mill's Theory of Value" (Fortnightly Review, April 1876) it is argued that Cairnes had mistaken Mill's meaning, and had really seen not more but less of the truth than Mill had done.
The expenses of production of any amount of a raw commodity may best be estimated with reference to the "margin of production" at which no rent is paid. But this method of speaking has great difficulties with regard to commodities that obey the law of increasing return. It seemed best to note this point in passing: it will be fully discussed later on, chiefly in ch. XII.
We have already (II. III.) noticed that the economic use of the term "production" includes the production of new utilities by moving a thing from a place in which it is less wanted to a place in which it is more wanted, or by helping consumers to satisfy their needs.
See III. V. and IV. VII. 8.
See IV. XIII. 2.
See last paragraph of IV. XII.
See III. III. 4.
Measuring, as in the case of the demand curve, amounts of the commodity along Ox and prices parallel to Oy, we get for each point M along Ox a line MP drawn at right angles to it measuring the supply price for the amount OM, the extremity of which, P, may be called a supply point; this price MP being made up of the supply prices of the several factors of production for the amount OM. The locus of P may be called the supply curve.
Suppose, for instance, that we classify the expenses of production of our representative firm, when an amount OM of cloth is being produced under the heads of (i) Mp1, the supply price of the wool and other circulating capital which would be consumed in making it, (ii) p1p2 the corresponding wear-and-tear and depreciation on buildings, machinery and other fixed capital; (iii) p2p3 the interest and insurance on all the capital, (iv) p3p4 the wages of those who work in the factory, and (v) p4P the gross earnings of management, etc. of those who undertake the risks and direct the work. Thus as M moves from O towards the right p1, p2, p3, p4 will each trace out a curve, and the ultimate supply curve traced out by P will be thus shown as obtained by superimposing the supply curves for the several factors of production of the cloth.
It must be remembered that these supply prices are the prices not of units of the several factors but of those amounts of the several factors which are required for producing a yard of the cloth. Thus, for instance, p3p4 is the supply price not of any fixed amount of labour but of that amount of labour which is employed in making a yard where there is an aggregate production of OM yards. (See above, § 3.) We need not trouble ourselves to consider just here whether the ground-rent of the factory must be put into a class by itself: this belongs to a group of questions which will be discussed later. We are taking no notice of rates and taxes, for which he would of course have to make his account.
That is, a point moving along the supply curve towards the right may either rise or fall, or even it may alternately rise and fall; in other words, the supply curve may be inclined positively or negatively, or even at some parts of its course it may be inclined positively and at others negatively. (See footnote on p. 99.)
Compare V. I. 1. To represent the equilibrium of demand and supply geometrically we may draw the demand and supply curves together as in Fig. 19. If then OR represents the rate at which production is being actually carried on, and Rd the demand price is greater than Rs the supply price, the production is exceptionally profitable, and will be increased. R, the amount-index, as we may call it, will move to the right. On the other hand, if Rd is less than Rs, R will move to the left. If Rd is equal to Rs, that is, if R is vertically under a point of intersection of the curves, demand and supply are in equilibrium.
This may be taken as the typical diagram for stable equilibrium for a commodity that obeys the law of diminishing return. But if we had made SS' a horizontal straight line, we should have represented the case of "constant return," in which the supply price is the same for all amounts of the commodity. And if we had made SS' inclined negatively, but less steeply than DD' (the necessity for this condition will appear more fully later on), we should have got a case of stable equilibrium for a commodity which obeys the law of increasing return. In either case the above reasoning remains unchanged without the alteration of a word or a letter; but the last case introduces difficulties which we have arranged to postpone.
See below V. V. 2 and Appendix H. 4.
See above pp. 34-36.
End of Notes
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