Principles of Economics
BOOK V, CHAPTER XII
EQUILIBRIUM OF NORMAL DEMAND AND SUPPLY, CONTINUED, WITH REFERENCE TO THE LAW OF INCREASING RETURN.
§ 1. We may now continue the study begun in chapters III. and V.; and examine some difficulties connected with the relations of demand and supply as regards commodities the production of which tends to increasing return.
We have noted that this tendency seldom shows itself immediately on an increase of demand. To take an example, the first effect of a sudden fashion for watch-shaped aneroids would be a temporary rise of price, in spite of the fact that they contain no material of which there is but a scanty stock. For highly paid labour, that had no special training for the work, would have to be drawn in from other trades; a good deal of effort would be wasted, and for a time the real and the money cost of production would be increased.
But yet, if the fashion lasted a considerable time, then even independently of any new invention, the cost of making aneroids would fall gradually. For specialized skill in abundance would be trained, and properly graduated to the various work to be done. With a large use of the method of interchangeable parts, specialized machinery would do better and more cheaply much of the work that is now done by hand; and thus a continued increase in the annual output of watch-shaped aneroids would lower their price very much.
Here there is to be noted an important difference between demand and supply. A fall in the price, at which a commodity is offered, acts on demand always in one direction. The amount of the commodity demanded may increase much or little according as the demand is elastic or inelastic: and a long or short time may be required for developing the new and extended uses of the commodity, which are rendered possible by the fall in price*108. But—at all events if exceptional cases in which a thing is driven out of fashion by a fall in its price be neglected—the influence of price on demand is similar in character for all commodities: and, further, those demands which show high elasticity in the long run, show a high elasticity almost at once; so that, subject to a few exceptions, we may speak of the demand for a commodity as being of high or low elasticity without specifying how far we are looking ahead.
But there are no such simple rules with regard to supply. An increase in the price offered by purchasers does indeed always increase supply: and thus it is true that, if we have regard to short periods only, and especially to the transactions of a dealer's market, there is an "elasticity of supply" which corresponds closely to elasticity of demand. That is to say, a given rise in price will cause a great or a small increase in the offers which sellers accept, according as they have large or small reserves in the background, and as they have formed low or high estimates of the level of prices at the next market: and this rule applies nearly in the same way to things which in the long run have a tendency to diminishing return as to those which have a tendency to increasing return. In fact if the large plant needed in a branch of manufacture is fully occupied, and cannot be rapidly increased, an increase in the price offered for its products may have no perceptible effect in increasing the output for some considerable time: while a similar increase in the demand for a hand-made commodity might call forth quickly a great increase in supply, though in the long run its supply conformed to that of constant return or even of diminishing return.
In the more fundamental questions which relate to long periods, the matter is even more complex. For the ultimate output corresponding to an unconditional demand at even current prices would be theoretically infinite; and therefore the elasticity of supply of a commodity which conforms to the law of Increasing Return, or even to that of Constant Return, is theoretically infinite for long periods*109.
§ 2. The next point to be observed is that this tendency to a fall in the price of a commodity as a result of a gradual development of the industry by which it is made, is quite a different thing from the tendency to the rapid introduction of new economies by an individual firm that is increasing its business.
We have seen how every step in the advance of an able and enterprising manufacturer makes the succeeding step easier and more rapid; so that his progress upwards is likely to continue so long as he has fairly good fortune, and retains his full energy and elasticity and his liking for hard work. But these cannot last for ever: and as soon as they decay, his business is likely to be destroyed through the action of some of those very causes which enabled it to rise; unless indeed he can pass it over into hands as strong as his used to be. Thus the rise and fall of individual firms may be frequent, while a great industry is going through one long oscillation, or even moving steadily forwards; as the leaves of a tree (to repeat an earlier illustration) grow to maturity, reach equilibrium, and decay many times, while the tree is steadily growing upwards year by year*110.
The causes which govern the facilities for production at the command of a single firm, thus conform to quite different laws from those which control the whole output of an industry. And the contrast is perhaps heightened, when we take the difficulties of marketing into account. For instance, manufactures, which are adapted to special tastes, are likely to be on a small scale; and they are generally of such a character that the machinery and modes of organization already developed in other trades, could be easily adapted to them; so that a great increase in their scale of production would be sure to introduce vast economies at once. But these are the very industries in which each firm is likely to be confirmed more or less to its own particular market; and, if it is so confined, any hasty increase in its production is likely to lower the demand price in that market out of all proportion to the increased economies that it will gain; even though its production is but small relatively to the broad market for which in a more general sense it may be said to produce.
In fact, when trade is slack, a producer will often try to sell some of his surplus goods outside of his own particular market at prices that do little more than cover their prime costs: while within that market he still tries to sell at prices that nearly cover supplementary costs; and a great part of these are the returns expected on capital invested in building up the external organization of his business*111.
Again supplementary costs are, as a rule, larger relatively to prime costs for things that obey the law of increasing return than for other things*112; because their production needs the investment of a large capital in material appliances and in building up trade connections. This increases the intensity of those fears of spoiling his own peculiar market, or incurring odium from other producers for spoiling the common market; which we have already learnt to regard as controlling the short-period supply price of goods, when the appliances of production are not fully employed.
We cannot then regard the conditions of supply by an individual producer as typical of those which govern the general supply in a market. We must take account of the fact that very few firms have a long-continued life of active progress, and of the fact that the relations between the individual producer and his special market differ in important respects from those between the whole body of producers and the general market*113.
§ 3. Thus the history of the individual firm cannot be made into the history of an industry any more than the history of an individual man can be made into the history of mankind. And yet the history of mankind is the outcome of the history of individuals; and the aggregate production for a general market is the outcome of the motives which induce individual producers to expand or contract their production. It is just here that our device of a representative firm comes to our aid. We imagine to ourselves at any time a firm that has its fair share of those internal and external economies, which appertain to the aggregate scale of production in the industry to which it belongs. We recognize that the size of such a firm, while partly dependent on changes in technique and in the costs of transport, is governed, other things being equal, by the general expansion of the industry. We regard the manager of it as reckoning up whether it would be worth his while to add a certain new line to his undertakings; whether he should introduce a certain new machine and so on. We regard him as treating the output which would result from that change more or less as a unit, and weighing in his mind the cost against the gain*114.
This then is the marginal cost on which we fix our eyes. We do not expect it to fall immediately in consequence of a sudden increase of demand. On the contrary we expect the short-period supply price to increase with increasing output. But we also expect a gradual increase in demand to increase gradually the size and the efficiency of this representative firm; and to increase the economies both internal and external which are at its disposal.
That is to say, when making lists of supply prices (supply schedules) for long periods in these industries, we set down a diminished supply price against an increased amount of the flow of the goods; meaning thereby that a flow of that increased amount will in the course of time be supplied profitably at that lower price, to meet a fairly steady corresponding demand. We exclude from view any economies that may result from substantive new inventions; but we include those which may be expected to arise naturally out of adaptations of existing ideas; and we look towards a position of balance or equilibrium between the forces of progress and decay, which would be attained if the conditions under view were supposed to act uniformly for a long time. But such notions must be taken broadly. The attempt to make them precise over-reaches our strength. If we include in our account nearly all the conditions of real life, the problem is too heavy to be handled; if we select a few, then long-drawn-out and subtle reasonings with regard to them become scientific toys rather than engines for practical work.
The theory of stable equilibrium of normal demand and supply helps indeed to give definiteness to our ideas; and in its elementary stages it does not diverge from the actual facts of life, so far as to prevent its giving a fairly trustworthy picture of the chief methods of action of the strongest and most persistent group of economic forces. But when pushed to its more remote and intricate logical consequences, it slips away from the conditions of real life. In fact we are here verging on the high theme of economic progress; and here therefore it is especially needful to remember that economic problems are imperfectly presented when they are treated as problems of statical equilibrium, and not of organic growth. For though the statical treatment alone can give us definiteness and precision of thought, and is therefore a necessary introduction to a more philosophic treatment of society as an organism; it is yet only an introduction.
The Statical theory of equilibrium is only an introduction to economic studies; and it is barely even an introduction to the study of the progress and development of industries which show a tendency to increasing return. Its limitations are so constantly overlooked, especially by those who approach it from an abstract point of view, that there is a danger in throwing it into definite form at all. But, with this caution, the risk may be taken; and a short study of the subject is given in Appendix H.
Notes for this chapter
See above III. IV. 5.
Strictly speaking, the amount produced and the price at which it can be sold, are functions one of another, account being taken of the length of time allowed for the evolution of appropriate plant and organization for production on a large scale. But in real life, the cost of production per unit is deduced from the amount expected to be produced, and not vice versâ. Economists commonly follow this practice; and they follow also the practice of business life in inverting this order with regard to demand. That is, they consider the increase of sales that will follow from a given reduction of price, more frequently than the diminution of price which will be required to effect a given increase of sales.
See IV. IX-XIII.; and especially XI. 5.
This may be expressed by saying that when we are considering an individual producer, we must couple his supply curve—not with the general demand curve for his commodity in a wide market, but—with the particular demand curve of his own special market. And this particular demand curve will generally be very steep; perhaps as steep as his own supply curve is likely to be, even when an increased output will give him an important increase of internal economies.
Of course this rule is not universal. It may be noted, for instance, that the net loss of an omnibus, that is short of passengers throughout its trip, and loses a fourpenny fare, is nearer fourpence than threepence, though the omnibus trade conforms perhaps to the law of constant return. Again, if it were not for the fear of spoiling his market, the Regent Street shoemaker, whose goods are made by hand, but whose expenses of marketing are very heavy, would be tempted to go further below his normal price in order to avoid losing a special order, than a shoe manufacturer who uses much expensive machinery and avails himself generally of the economies of production on a large scale. There are other difficulties connected with the supplementary costs of joint products, e.g. the practice of selling some goods at near prime cost, for the purpose of advertisement (see above V. VII. 2). But these need not be specially considered here.
Abstract reasonings as to the effects of the economies in production, which an individual firm gets from an increase of its output are apt to be misleading, not only in detail, but even in their general effect. This is nearly the same as saying that in such case the conditions governing supply should be represented in their totality. They are often vitiated by difficulties which lie rather below the surface, and are especially troublesome in attempts to express the equilibrium conditions of trade by mathematical formulæ. Some, among whom Cournot himself is to be counted, have before them what is in effect the supply schedule of an individual firm; representing that an increase in its output gives it command over so great internal economies as much to diminish its expenses of production; and they follow their mathematics boldly, but apparently without noticing that their premises lead inevitably to the conclusion that, whatever firm first gets a good start will obtain a monopoly of the whole business of its trade in its district. While others avoiding this horn of the dilemma, maintain that there is no equilibrium at all for commodities which obey the law of increasing return; and some again have called in question the validity of any supply schedule which represents prices diminishing as the amount produced increases. See Mathematical Note XIV where reference is made to this discussion.
The remedy for such difficulties as these is to be sought in treating each important concrete case very much as an independent problem, under the guidance of staple general reasonings. Attempts so to enlarge the direct applications of general propositions as to enable them to supply adequate solutions of all difficulties, would make them so cumbrous as to be of little service for their main work. The "principles" of economics must aim at affording guidance to an entry on problems of life, without making claim to be a substitute for independent study and thought.
See above V. V. 6.
End of Notes
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