Principles of Economics

An increase of normal demand for a commodity involves an increase in the price at which each several amount can find purchasers; or, which is the same thing, an increase of the quantity which can find purchasers at any price. This increase of demand may be caused by the commodity’s coming more into fashion, by the opening out of a new use for it or of new markets for it, by the permanent falling off in the supply of some commodity for which it can be used as a substitute, by a permanent increase in the wealth and general purchasing power of the community, and so on. Changes in the opposite direction will cause a falling off in demand and a sinking of the demand prices. Similarly an increase of normal supply means an increase of the amounts that can be supplied at each several price, and a diminution of the price at which each separate amount can be supplied
*115. This change may be caused by the opening up of a new source of supply, whether by improved means of transport or in any other way, by an advance in the arts of production, such as the invention of a new process or of new machinery, or again, by the granting of a bounty on production. Conversely, a diminution of normal supply (or a raising of the supply schedule) may be caused by the closing up of a new source of supply or by the imposition of a tax.

§ 2. We have, then, to regard the effects of an increase of normal demand from three points of view, according as the commodity in question obeys the law of constant or of diminishing or of increasing return: that is, its supply price is practically constant for all amounts, or increases or diminishes with an increase in the amount produced.

In the first case an increase of demand simply increases the amount produced without altering its price; for the normal price of a commodity which obeys the law of constant return is determined absolutely by its expenses of production: demand has no influence in the matter beyond this, that the thing will not be produced at all unless there is some demand for it at this fixed price.

If the commodity obeys the law of diminishing return an increase of demand for it raises its price and causes more of it to be produced; but not so much more as if it obeyed the law of constant return.

On the other hand, if the commodity obeys the law of increasing return, an increase of demand causes much more of it to be produced,—more than if the commodity obeyed the law of constant return,—and at the same time lowers its price. If, for instance, a thousand things of a certain kind have been produced and sold weekly at a price of 10
s., while the supply price for two thousand weekly would be only 9
s., a small rate of increase in normal demand may gradually cause this to become the normal price; since we are considering periods long enough for the full normal action of the causes that determine supply to work itself out. The converse holds in each case should normal demand fall off instead of increasing
*116.

The argument of this section has been thought by some writers to lend support to the claim that a Protective duty on manufactured imports in general increases the home market for those imports; and, by calling into play the Law of Increasing Return,
ultimately lowers their price to the home consumer. Such a result may indeed ultimately be reached by a wisely chosen system of “Protection to nascent industries” in a new country; where manufactures, like young children, have a power of rapid growth. But even there the policy is apt to be wrenched from its proper uses, to the enrichment of particular interests: for those industries which can send the greatest number of votes to the poll, are those which are already on so large a scale, that a further increase would bring very few new economies. And of course the industries in a country so long familiar with machinery as England is, have generally passed the stage at which they can derive much real help from such Protection: while Protection to any one industry nearly always tends to narrow the markets, especially the foreign markets, for other industries. These few remarks show that the question is complex: they do not pretend to reach further than that.

§ 3. We have seen that an increase in normal demand, while leading in every case to an increased production, will in some cases raise and in others lower prices. But now we are to see that increased facilities for supply (causing the supply schedule to be lowered) will always lower the normal price at the same time that it leads to an increase in the amount produced. For so long as the normal demand remains unchanged an increased supply can be sold only at a diminished price; but the fall of price consequent on a given increase of supply will be much greater in some cases than in others. It will be small if the commodity obeys the law of diminishing return; because then the difficulties attendant on an increased production will tend to counteract the new facilities of supply. On the other hand, if the commodity obeys the law of increasing return, the increased production will bring with it increased facilities, which will co-operate with those arising from the change in the general conditions of supply; and the two together will enable a great increase in production and consequent fall in price to be attained before the fall of the supply price is overtaken by the fall of the demand price. If it happens that the demand is very elastic, then a small increase in the facilities of normal supply, such as a new invention, a new application of machinery, the opening up of new and cheaper sources of supply, the taking off a tax or granting a bounty, may cause an enormous increase of production and fall of price
*117.

If we take account of the circumstances of composite and joint supply and demand discussed in chapter VI., we have suggested to us an almost endless variety of problems which can be worked out by the methods adopted in these two chapters.

§ 4. We may now consider the effects which a change in the conditions of supply may exert on consumers’ surplus or rent. For brevity of language a tax may be taken as representative of those changes which may cause a general increase, and a bounty as representative of those which may cause a general diminution in the normal supply price for each several amount of the commodity.

Firstly, if the commodity is one, the production of which obeys the law of constant return, so that the supply price is the same for all amounts of the commodity, consumers’ surplus will be diminished by more than the increased payments to the producer; and therefore, in the special case of a tax, by more than the gross receipts of the State. For on that part of the consumption of the commodity, which is maintained, the consumer loses what the State receives: and on that part of the consumption which is destroyed by the rise in price, the consumers’ surplus is destroyed; and of course there is no payment for it to the producer or to the State
*118. Conversely, the gain of consumers’ surplus caused by a bounty on a commodity that obeys the law of constant return, is less than the bounty itself. For on that part of the consumption which existed before the bounty, consumers’ surplus is increased by just the amount of the bounty; while on the new consumption that is caused by the bounty, the gain of the consumers’ surplus is less than the bounty
*119.

If however the commodity obeys the law of diminishing return; a tax by raising its price, and diminishing its consumption, will lower its expenses of production other than the tax: and the result will be to raise the supply price by something less than the full amount of the tax. In this case the gross receipts from the tax
may be greater than the resulting loss of consumers’ surplus, and they
will be greater if the law of diminishing return acts so sharply that a small diminution of consumption causes a great falling-off in the expenses of production other than the tax
*120.

On the other hand, a bounty on a commodity which obeys the law of diminishing return will lead to increased production, and will extend the margin of cultivation to places and conditions in which the expenses of production, exclusive of the bounty, are greater than before. Thus it will lower the price to the consumer and increase consumers’ surplus less than if it were given for the production of a commodity which obeyed the law of constant return. In that case the increase of consumers’ surplus was seen to be less than the direct cost of the bounty to the State; and therefore in this case it is much less
*121.

By similar reasoning it may be shown that a tax on a commodity which obeys the law of increasing return is more injurious to the consumer than if levied on one which obeys the law of constant return. For it lessens the demand and therefore the output. It thus probably increases the expenses of manufacture somewhat: sends up the price by more than the amount of the tax; and finally diminishes consumers’ surplus by much more than the total payments which it brings in to the exchequer
*122. On the other hand, a bounty on such a commodity causes so great a fall in its price to the consumer, that the consequent increase of consumers’ surplus may exceed the total payments made by the State to the producers; and certainly will do so in case the law of increasing return acts at all sharply
*123.

These results are suggestive of some principles of taxation which require careful attention in any study of financial policy; when it will be necessary to take account of the expenses of collecting a tax and of administering a bounty, and of the many indirect effects, some economic and some moral, which a tax or a bounty is likely to produce. But these partial results are well adapted for our immediate purpose of examining a little more closely than we have done hitherto the general doctrine that a position of (stable) equilibrium of demand and supply is a position also of
maximum satisfaction: and there is one abstract and trenchant form of that doctrine which has had much vogue, especially since the time of Bastiat’s
Economic Harmonics, and which falls within the narrow range of the present discussion.

§ 5. There is indeed one interpretation of the doctrine according to which every position of equilibrium of demand and supply may fairly be regarded as a position of maximum satisfaction
*124. For it is true that so long as the demand price is in excess of the supply price, exchanges can be effected at prices which give a surplus of satisfaction to buyer or to seller or to both. The marginal utility of what he receives is greater than that of what he gives up, to at least one of the two parties; while the other, if he does not gain by the exchange, yet does not lose by it. So far then every step in the exchange increases the aggregate satisfaction of the two parties. But when equilibrium has been reached, demand price being now equal to supply price, there is no room for any such surplus: the marginal utility of what each receives no longer exceeds that of what he gives up in exchange: and when the production increases beyond the equilibrium amount, the demand price being now less than the supply price, no terms can be arranged which will be acceptable to the buyer, and will not involve a loss to the seller.

It is true then that a position of equilibrium of demand and supply is a position of maximum satisfaction in this limited sense, that the aggregate satisfaction of the two parties concerned increases until that position is reached; and that any production beyond the equilibrium amount could not be permanently maintained so long as buyers and sellers acted freely as individuals, each in his own interest.

But occasionally it is stated, and very often it is implied, that a position of equilibrium of demand and supply is one of maximum aggregate satisfaction in the full sense of the term: that is, that an increase of production beyond the equilibrium level would directly (
i.e. independently of the difficulties of arranging for it, and of any indirect evils it might cause) diminish the aggregate satisfaction of both parties. The doctrine so interpreted is not universally true.

In the first place it assumes that all differences in wealth between the different parties concerned may be neglected, and that the satisfaction which is rated at a shilling by any one of them, may be taken as equal to one that is rated at a shilling by any other. Now it is obvious that, if the producers were as a class very much poorer than the consumers, the aggregate satisfaction might be increased by a stinting of supply when it would cause a great rise in demand price (
i.e. when the demand is inelastic); and that if the consumers were as a class much poorer than the producers, the aggregate satisfaction might be increased by extending the production beyond the equilibrium amount and selling the commodity at a loss
*125.

This point however may well be left for future consideration. It is in fact only a special case of the broad proposition that the aggregate satisfaction can
primâ facie be increased by the distribution, whether voluntarily or compulsorily, of some of the property of the rich among the poor; and it is reasonable that the bearings of this proposition should be set aside during the first stages of an inquiry into existing economic conditions. This assumption therefore may be properly made, provided only it is not allowed to slip out of sight.

But in the second place the doctrine of maximum satisfaction assumes that every fall in the price which producers receive for the commodity, involves a corresponding loss to them; and this is not true of a fall in price which results from improvements in industrial organization. When a commodity obeys the law of increasing return, an increase in its production beyond equilibrium point may cause the supply price to fall much; and though the demand price for the increased amount may be reduced even more, so that the production would result in some loss to the producers, yet this loss may be very much less than that money value of the gain to purchasers which is represented by the increase of consumers’ surplus.

In the case then of commodities with regard to which the law of increasing return acts at all sharply, or in other words, for which the normal supply price diminishes rapidly as the amount produced increases, the direct expense of a bounty sufficient to call forth a greatly increased supply at a much lower price, would be much less than the consequent increase of consumers’ surplus. And if a general agreement could be obtained among consumers, terms might be arranged which would make such action amply remunerative to the producers, at the same time that they left a large balance of advantage to the consumers
*126.

§ 6. One simple plan would be the levying of a tax by the community on their own incomes, or on the production of goods which obey the law of diminishing return, and devoting the tax to a bounty on the production of those goods with regard to which the law of increasing return acts sharply. But before deciding on such a course they would have to take account of considerations, which are not within the scope of the general theory now before us, but are yet of great practical importance. They would have to reckon up the direct and indirect costs of collecting a tax and administering a bounty; the difficulty of securing that the burdens of the tax and the benefits of the bounty were equitably distributed; the openings for fraud and corruption; and the danger that in the trade which had got a bounty and in other trades which hoped to get one, people would divert their energies from managing their own businesses to managing those persons who control the bounties.

Besides these semi-ethical questions there will arise others of a strictly economic nature, relating to the effects which any particular tax or bounty may exert on the interests of landlords, urban or agricultural, who own land adapted for the production of the commodity in question. These are questions which must not be overlooked; but they differ so much in their detail that they cannot fitly be discussed here
*127.

§ 7. Enough has been said to indicate the character of the second great limitation which has to be introduced into the doctrine that the maximum satisfaction is
generally to be attained by encouraging each individual to spend his own resources in that way which suits him best. It is clear that if he spends his income in such a way as to increase the demand for the services of the poor and to increase their incomes, he adds something more to the total happiness than if he adds an equal amount to the incomes of the rich, because the happiness which an additional shilling brings to a poor man is much greater than that which it brings to a rich one; and that he does good by buying things the production of which raises, in preference to things the production of which lowers the character of those who make them
*128. But further, even if we assume that a shilling’s worth of happiness is of equal importance to whomsoever it comes, and that every shilling’s worth of consumers’ surplus is of equal importance from whatever commodity it is derived, we have to admit that the manner in which a person spends his income is a matter of direct economic concern to the community. For in so far as he spends it on things which obey the law of diminishing return, he makes those things more difficult to be obtained by his neighbours, and thus lowers the real purchasing power of their incomes; while in so far as he spends it on things which obey the law of increasing return, he makes those things more easy of attainment to others, and thus increases the real purchasing power of their incomes.

Again, it is commonly argued that an equal
ad valorem tax levied on all economic commodities (material and immaterial), or which is the same thing a tax on expenditure, is
primâ facie the best tax; because it does not divert the expenditure of individuals out of its natural channels: we have now seen that this argument is invalid. But ignoring for the time the fact that the direct economic effect of a tax or a bounty never constitutes the whole, and very often not even the chief part of the considerations which have to be weighed before deciding to adopt it, we have found:—firstly, that a tax on expenditure generally causes a greater destruction of consumers’ surplus than one levied exclusively on commodities as to which there is but little room for the economies of production on a large scale, and which obey the law of diminishing return; and secondly, that it might even be for the advantage of the community that the government should levy taxes on commodities which obey the law of diminishing return, and devote part of the proceeds to bounties on commodities which obey the law of increasing return.

These conclusions, it will be observed, do not by themselves afford a valid ground for government interference. But they show that much remains to be done, by a careful collection of the statistics of demand and supply, and a scientific interpretation of their results, in order to discover what are the limits of the work that society can with advantage do towards turning the economic actions of individuals into those channels in which they will add the most to the sum total of happiness
*129.

116.

Diagrams are of especial aid in enabling us to comprehend clearly the problems of this chapter.

The three figures 24, 25, 26 represent the three cases of constant, diminishing and increasing return respectively. The return in the last case is a diminishing one in the earlier stages of the increase of production, but an increasing one in those subsequent to the attainment of the original position of equilibrium,
i.e. for amounts of the commodity greater than
OH. In each case
SS’ is the supply curve,
DD’ the old position of the demand curve, and
dd’ its position after there has been increase of normal demand. In each case
A and
a are the old and new positions of equilibrium respectively,
AH and
ah are the old and new normal or equilibrium prices, and
OH and
Oh the old and new equilibrium amounts.
Oh is in every case greater than
OH, but in fig. 25 it is only a little greater, while in fig. 26 it is much greater. (This analysis may be carried further on the plan adopted later on in discussing the similar but more important problem of the effects of changes in the conditions of normal supply.) In fig. 24
ah is equal to
AH, in fig. 25 it is greater, in fig. 26 it is less.

The effect of a falling-off of normal demand can be traced with the same diagrams,
dd’ being now regarded as the old and
DD’ as the new position of this demand curve;
ah being the old equilibrium price, and
AH the new one.

117.

All this can be most clearly seen by the aid of diagrams, and indeed there are some parts of the problem which cannot be satisfactorily treated without their aid. The three figures 27, 28, 29 represent the three cases of constant and diminishing and increasing returns, respectively.

In each case
DD‘ is the demand curve,
SS‘ the old position, and
ss‘ the new position of the supply curve.
A is the old, and
a the new position of stable equilibrium.
Oh is greater than
OH, and
ah is less than
AH in every case: but the changes are small in fig. 28 and great in fig. 29. Of course the demand curve must lie below the old supply curve to the right of
A, otherwise
A would be a point not of stable, but of unstable equilibrium. But subject to this condition the more elastic the demand is, that is, the more nearly horizontal the demand curve is at
A the further off will
a be from
A, and the greater therefore will be the increase of production and the fall of price.

The whole result is rather complex. But it may be stated thus. Firstly, given the elasticity of demand at
A, the increase in the quantity produced and the fall in price will both be the greater, the greater be the return got from additional capital and labour applied to the production. That is, they will be the greater, the more nearly horizontal the supply curve is at
A in fig. 28, and the more steeply inclined it is in fig. 29 (subject to the condition mentioned above, that it does not lie below the demand curve to the right of
A, and thus turn
A into a position of unstable equilibrium). Secondly, given the position of the supply curve at
A, the greater the elasticity of demand the greater will be the increase of production in every case; but the smaller will be the fall of price in fig. 28, and the greater the fall of price in fig. 29. Fig. 27 may be regarded as a limiting case of either fig. 28 or 29.

All this reasoning assumes that the commodity either obeys the law of diminishing return or obeys the law of increasing return throughout. If it obeys first one, and then the other, so that the supply curve is at one part inclined positively and at another negatively, no general rule can be laid down as to the effect on price of increased facilities of supply, though in every case this must lead to an increased volume of production. A great variety of curious results may be got by giving the supply curve different shapes, and in particular such as cut the demand curve more than once.

This method of inquiry is not applicable to a tax on wheat in so far as it is consumed by a labouring class which spends a great part of its income on bread; and it is not applicable to a general tax on all commodities: for in neither of these cases can it be assumed that the marginal value of money to the individual remains approximately the same after the tax has been levied as it was before.

118.

This is most clearly seen by aid of a diagram.
SS‘, the old constant return supply curve, cuts
DD‘ the demand curve in
A: DSA is the consumers’ surplus. Afterwards a tax
Ss being imposed the new equilibrium is found at
a, and consumers’ surplus is
Dsa. The gross tax is only the rectangle
sSKa, that is, a tax at the rate of
Ss on an amount
sa of the commodity. And this falls short of the loss of consumers’ surplus by the area
aKA. The net loss
aKA is small or great, other things being equal, as
aA is or is not inclined steeply. Thus it is smallest for those commodities the demand for which is most inelastic, that is, for necessaries. If therefore a given aggregate taxation has to be levied ruthlessly from any class it will cause less loss of consumers’ surplus if levied on necessaries than if levied on comforts; though of course the consumption of luxuries and in a less degree of comforts indicates ability to bear taxation.

120.

Let the old supply curve be
SS‘ fig. 31, and let the imposition of a tax raise it to
ss‘; let
A and
a be the old and new positions of equilibrium, and let straight lines be drawn through them parallel to
Ox and
Oy, as in the figure. Then the tax being levied, as shown by the figure, at the rate of
aE on each unit; and
Oh, that is,
CK units, being produced in the new position of equilibrium, the gross receipts of the tax will be
cFEa, and the loss of consumers’ surplus will be
cCAa; that is, the gross receipts from the tax will be greater or less than the loss of consumers’ surplus as
CFEK is greater or less than
aKA; and in the figure as it stands it is much greater. If
SS‘ had been so drawn as to indicate only very slight action of the law of diminishing return, that is, if it had been nearly horizontal in the neighbourhood of
A, then
EK would have been very small; and
CFEK would have become less than
aKA.

122.

Thus taking
SS‘ in fig. 32 to be the old position of the supply curve, and
ss‘ its position after the tax,
A to be the old and
a the new positions of equilibrium, we have, as in the case of
fig. 31, the total tax represented by
cFEa, and the loss of consumers’ surplus by
cCAa; the former being always less than the latter.

The statement in the text is put broadly and in simple outline. If it were applied to practical problems account would need to be taken of several considerations which have been ignored. An industry which yields an increasing return, is nearly sure to be growing, and therefore to be acquiring new economies of production on a large scale. If the tax is a small one, it may merely retard this growth and not cause a positive shrinking. Even if the tax is heavy and the industry shrinks, many of the economies gained will be in part at least preserved; as is explained above in Appendix H. In consequence
ss‘ ought properly not to have the same shape as
SS‘, and the distance
aE ought to be less than
AT.

127.

The incidence of a tax on agricultural produce will be discussed later on by the aid of diagrams similar to those used to represent the fertility of land (see IV. III.). Landlords’ rent absorbs a share of the aggregate selling price of almost all commodities: but it is most prominent in the case of those which obey the law of diminishing return; and an assumption of no extreme violence will enable fig. 33 (a reproduction of 31) to represent roughly the leading features of the problem.

It will be argued in Appendix H, 1, that we are not properly at liberty to assume that the expenses of raising the produce from the richer lands and under the more favourable circumstances are independent of the extent to which the production is carried; since an increased production is likely to lead to an improved organization, if not of farming industries themselves, yet of those subsidiary to them, and especially of the carrying trade. We may however permit ourselves to make this assumption provisionally, so as to get a clear view of the broad outlines of the problem; though we must not forget that in any applications of the general reasonings based on it account must be taken of the facts which we here ignore. On this assumption then
SS‘ being the supply curve before the imposition of a tax, landlords’ rent is represented by
CSA. After the tax has been imposed and the supply curve raised to
ss‘ the landlords’ rent becomes the amount by which
cOha, the total price got for
Oh produce sold at the rate
ha, exceeds the total tax
cFEa, together with
OhES the total expenses of production, exclusive of rent, for
Oh produce: that is, it becomes
FSE. (In the figure the curve
ss‘ has the same shape as
SS‘, thereby implying that the tax is
specific; that is, is a uniform charge on each unit of the commodity whatever be its value. The argument so far does not depend on this assumption, but if it is made we can by a shorter route get the new landlords’ rent at
csa, which then is equal to
FSE.) Thus the loss of landlords’ rent is
CFEA; and this added to
cCAa the loss of consumers’ surplus, makes up
cFEAa, which exceeds the gross tax by
aAE.

On the other hand, the direct payments under a bounty would exceed the increase of consumers’ surplus, and of landlords’ surplus calculated on the above assumptions. For taking
ss‘ to be the original position of the supply curve, and
SS‘ to be its position after the bounty, the new landlords’ surplus on these assumptions is
CSA, or which is the same thing
RsT; and this exceeds the old landlords’ rent
csa by
RcaT. The increase of consumers’ surplus is
cCAa; and therefore the total bounty, which is
RCAT, exceeds the gain of consumers’ surplus and landlords’ rent together by
TaA.

For reasons stated in Appendix II, 3, the assumption on which this reasoning proceeds is inapplicable to cases in which the supply curve is inclined negatively.