Principles of Economics

§ 2. The simplest account of the causes which determine the distribution of the national income is that given by the French economists who just preceded Adam Smith; and it is based upon the peculiar circumstances of France in the latter half of last century. The taxes, and other exactions levied from the French peasant, were then limited only by his ability to pay; and few of the labouring classes were far from starvation. So the Economists or Physiocrats, as they were called, assumed for the sake of simplicity, that there was a natural law of population according to which the wages of labour were kept at starvation limit
*1. They did not suppose that this was true of the whole working population, but the exceptions were so few, that they thought that the general impression given by their assumption was true: somewhat in the same way as it is well to begin an account of the shape of the earth, by saying that it is an oblate spheroid, although a few mountains do project as much as a thousandth part of its radius beyond the general level.

Again, they knew that the rate of interest in Europe had fallen during the five preceding centuries, in consequence of the fact that “economy had in general prevailed over luxury.” But they were impressed very much by the sensitiveness of capital, and the quickness with which it evaded the oppressions of the tax-gatherer by retiring from his grasp; and they therefore concluded that there was no great violence in the supposition that if its profits were reduced below what they then were, capital would speedily be consumed or migrate. Accordingly they assumed, again for the sake of simplicity, that there was something like a natural, or necessary rate of profit, corresponding in some measure to the natural rate of wages; that if the current rate exceeded this necessary level, capital would grow rapidly, till it forced down the rate of profit to that level; and that, if the current rate went below that level, capital would shrink quickly, and the rate would be forced upwards again. They thought that, wages and profits being thus fixed by natural laws, the natural value of everything was governed simply as the sum of wages and profits required to remunerate the producers
*2.

Adam Smith worked out this conclusion more fully than the Physiocrats did; though it was left for Ricardo to make clear that the labour and capital needed for production must be estimated at the margin of cultivation, so as to avoid the element of rent. But Adam Smith saw also that labour and capital were not at the verge of starvation in England, as they were in France. In England the wages of a great part of the working classes were sufficient to allow much more than the mere necessaries of existence; and capital had too rich and safe a field of employment there to be likely to go out of existence, or to emigrate. So when he is carefully weighing his words, his use of the terms “the natural rate of wages,” and “the natural rate of profit,” has not that sharp definition and fixedness which it had in the mouths of the Physiocrats; and he goes a good way towards explaining how they are determined by the ever-fluctuating conditions of demand and supply. He even insists that the liberal reward of labour “increases the industry of the common people”; that “a plentiful subsistence increases the bodily strength of the labourer; and the comfortable hope of bettering his condition, and of ending his days perhaps in ease and plenty, animates him to exert that strength to the utmost. Where wages are high, accordingly, we shall always find the workman more active, diligent and expeditious, than where they are low; in England, for example, than in Scotland; in the neighbourhood of great towns than in remote country places
*3.” And yet he sometimes falls back into the old way of speaking, and thus makes careless readers suppose that he believes the mean level of the wages of labour to be fixed by an iron law at the bare necessaries of life.

Malthus again, in his admirable survey of the course of wages in England from the thirteenth to the eighteenth centuries, shows how their mean level oscillated from century to century, falling sometimes down to about half a peck of corn a day, and rising sometimes up to a peck and a half or even, in the fifteenth century, to about two pecks. But although he observes that “an inferior mode of living may be a cause as well as a consequence of poverty,” he traces this effect almost exclusively to the consequent increase of numbers; he does not anticipate the stress which economists of our own generation lay on the influence which habits of living exercise on the efficiency, and therefore on the earning power of the labourer
*4.

Ricardo’s language is even more unguarded than that of Adam Smith and Malthus. It is true, indeed, that he says distinctly
*5:—”It is not to be understood that the natural price of labour estimated in food and necessaries is absolutely fixed and constant … It essentially depends on the habits and customs of the people.” But, having said this once, he does not take the trouble to repeat it constantly; and most of his readers forget that he says it. In the course of his argument he frequently adopts a mode of speaking similar to that of Turgot and the Physiocrats
*6; and seems to imply that the tendency of population to increase rapidly as soon as wages rise above the bare necessaries of life, causes wages to be fixed by “a natural law” to the level of these bare necessaries. This law has been called, especially in Germany, Ricardo’s “iron” or “brazen” law: many German socialists believe that this law is in operation now even in the western world; and that it will continue to be so, as long as the plan on which production is organized remains “capitalistic” or “individualistic”; and they claim Ricardo as an authority on their side
*7.

In fact, however, Ricardo was not only aware that the necessary or natural limit of wages was fixed by no iron law, but is determined by the local conditions and habits of each place and time: he was further keenly sensitive to the importance of a higher “standard of living,” and called on the friends of humanity to exert themselves to encourage the growth of a resolve among the working classes not to allow their wages to fall anywhere near the bare necessaries of life
*8.

The persistency with which many writers continue to attribute to him a belief in the “iron law” can be accounted for only by his delight “in imagining strong cases,” and his habit of not repeating a hint, which he had once given, that he was omitting for the sake of simplicity the conditions and limitations that were needed to make his results applicable to real life
*9.

Mill did not make any great advance in the theory of wages beyond his predecessors, in spite of the care with which he set himself to emphasize the distinctly human element in economics. He, however, followed Malthus in dwelling on those lessons of history which show that, if a fall of wages caused the labouring classes to lower their standard of comfort “the injury done to them will be permanent, and their deteriorated condition will become a new minimum tending to perpetuate itself as the more ample minimum did before
*10.

But it was only in the last generation that a careful study was begun to be made of the effects that high wages have in increasing the efficiency not only of those who receive them, but also of their children and grandchildren. In this matter the lead has been taken by Walker and other American economists; and the application of the comparative method of study to the industrial problems of different countries of the old and new worlds is forcing constantly more and more attention to the fact that highly paid labour is generally efficient and therefore not dear labour; a fact which, though it is more full of hope for the future of the human race than any other that is known to us, will be found to exercise a very complicating influence on the theory of distribution.

It has now become certain that the problem of distribution is much more difficult than it was thought to be by earlier economists, and that no solution of it which claims to be simple can be true. Most of the old attempts to give an easy answer to it, were really answers to imaginary questions that might have arisen in other worlds than ours, in which the conditions of life were very simple. The work done in answering these questions was not wasted. For a very difficult problem can best be solved by being broken up into pieces: and each of these simple questions contained a part of the great and difficult problem which we have to solve. Let us profit by this experience and work our way by successive steps in the remainder of this chapter towards understanding the general causes which govern the demand for labour and capital in real life
*11.

§ 3. Let us begin by studying the influence of demand on the earnings of labour, drawn from an imaginary world in which everyone owns the capital that aids him in his labour; so that the problem of the relations of capital and labour do not arise in it. That is, let us suppose but little capital to be used; while everyone owns whatever capital he does use, and the gifts of nature are so abundant that they are free and unappropriated. Let us suppose, further, that everyone is not only of equal capacity, but of equal willingness to work, and does in fact work equally hard: also that all work is unskilled,—or rather unspecialized in this sense, that if any two people were to change occupations, each would do as much and as good work as the other had done. Lastly, let us suppose that everyone produces things ready for sale without the aid of others, and that he himself disposes of them to their ultimate consumers: so that the demand for everything is direct.

In this case the problem of value is very simple. Things exchange for one another in proportion to the labour spent in producing them. If the supply of any one thing runs short, it may for a little time sell for more than its normal price: it may exchange for things the production of which had required more labour than it had: but, if so, people will at once leave other work to produce it, and in a very short time its value will fall to the normal level. There may be slight temporary disturbances, but as a rule anyone’s earnings will be equal to those of anyone else. In other words, each will have an equal share in the net sum total of things and services produced; or, as we may say, the
national income or
dividend; which will constitute the demand for labour
*12.

If now a new invention doubles the efficiency of work in any trade, so that a man can make twice as many things of a certain kind in a year without requiring additional appliances, then those things will fall to half their old exchange value. The effective demand for everyone’s labour will be a little increased, and the share which each can draw from the common earnings-stream will be a little larger than before. He may if he chooses take twice as many things of this particular kind, together with his old allowance of other things: or he may take somewhat more than before of everything. If there be an increase in the efficiency of production in many trades the common earnings-stream or dividend will be considerably larger; the commodities produced by those trades will constitute a considerably larger demand for those produced by others, and increase the purchasing power of everyone’s earnings.

§ 4. Nor will the position be greatly changed if we suppose that some specialized skill is required in each trade, provided other things remain as before: that is, provided the workers are still supposed to be all of equal capacity and industry; and all trades to be equally agreeable and equally easy to be learnt. The normal rate of earnings will still be the same in all trades; for if a day’s labour in one trade produces things that sell for more than a day’s labour in others, and this inequality shows any signs of lasting, people will bring up their children by preference to the favoured trade. It is true that there may be some slight irregularities. The drifting from one trade to another must occupy time; and some trades may for a while get more than their normal share of the earnings-stream, while others get less, or even lack work. But in spite of these disturbances, the current value of everything will fluctuate about its normal value; which will in this case, as in the preceding, depend simply on the amount of labour spent on the thing: for the normal value of all kinds of labour will still be equal. The productive power of the community will have been increased by the division of labour; the common national dividend or earnings-stream will be larger; and as all will, putting aside passing disturbances, share alike in it, each will be able to buy with the fruits of his own labour things more serviceable to him than he could have produced for himself.

In this stage, as in those considered before, it is still true that the value of each thing corresponds closely to the amount of labour spent upon it; and that the earnings of everyone are governed simply by the bounty of nature and by the progress of the arts of production.

§ 5. Next, let us still neglect the influence which the liberality of the expenditure on rearing and training workers exerts on their efficiency, leaving that matter to be discussed with other aspects of the supply side of distribution in the next chapter: and let us look at the influence that changes in the numbers of the population exert on the incomes which nature will yield. We suppose then that the growth of population proceeds at a rate, which is either fixed; or, at all events, not affected by the rate of wages: it may be influenced by changes in custom, in moral opinion and in medical knowledge. And we still suppose all labour to be of the same grade, and the national dividend to be divided out equally to each family, save for some slight passing inequalities. In this case every improvement in the arts of production or transport, every new discovery, every new victory over nature will increase equally the comforts and luxuries at the command of each family.

But this case differs from the last; because in this case, the increase of population, if maintained long enough, must ultimately outgrow the improvements in the arts of production, and cause the law of diminishing return to assert itself in agriculture. That is to say, those who work on the land will get less wheat and other produce in return for their labour and capital. An hour’s labour will represent a less quantity of wheat than before throughout the agricultural trades, and therefore throughout all other trades; since all labour is supposed to be of the same grade, and earnings are therefore as a rule equal in all trades.

Further we must note that the surplus or rental value of land will tend to rise. For the value of any kind of produce must equal that of the labour, aided on our supposition by a uniform quantity of capital throughout, which is required to produce it, whether on good land or bad, under barely remunerative, or marginal conditions. More labour and capital than before will be needed to raise a quarter of wheat, etc., on the margin; and therefore the wheat, etc., which is returned by nature to the labour applied under advantageous circumstances, will have a higher value relatively to that labour and capital than before: or, in other words, it will yield a larger surplus value over that of the labour and capital used in raising it.

§ 6. Let us now drop the supposition that labour is so mobile as to ensure equal remuneration for equal efforts, throughout the whole of society, and let us approach much nearer to the actual condition of life by supposing that labour is not all of one industrial grade, but of several. Let us suppose that parents always bring up their children to an occupation in their own grade; that they have a free choice within that grade, but not outside it. Lastly, let us suppose that the increase of numbers in each grade is governed by other than economic causes: as before it may be fixed, or it may be influenced by changes in custom, in moral opinion, etc. In this case also the aggregate national dividend will be governed by the abundance of nature’s return to man’s work in the existing state of the arts of production; but the distribution of that dividend between the different grades will be unequal. It will be governed by the demand of the people themselves. The share of those in any industrial compartment will be the higher, the more extensive and urgent the needs which they are able to satisfy on the part of those who are themselves drawing large shares of the national income.

Suppose, for instance, artists to form a grade or caste or industrial compartment by themselves; then, their number being fixed, or at least controlled by causes independent of their earnings, their earnings will be governed by the resources and the eagerness of those classes of the population who care for such gratifications as artists can furnish.

§ 7. We may now leave the imaginary world, in which everyone owns the capital that aids him in his work; and return to our own, where the relations of labour and capital play a great part in the problem of distribution. But let us still confine our attention to the distribution of the national dividend among the various agents of production, in accordance with the quantity of each agent, and the services which it renders; and leave the reflex influence which the remuneration of each agent exerts on the supply of that agent, to be considered in the next chapter.

We have seen how the alert business man is ever seeking for the most profitable application of his resources, and endeavouring to make use of each several agent of production up to that margin, or limit, at which he would gain by transferring a small part of his expenditure to some other agent; and how he is thus, so far as his influence goes, the medium through which the principle of substitution so adjusts the employment of each agent that, in its marginal application, its cost is proportionate to the additional net product resulting from its use. We have to apply this general reasoning to the case of the hire of labour
*13.

A question constantly in the mind of the careful business man is whether he has the right number of men for his work. In some cases that is settled for him by his plant: there must be one and only one engine driver on each express locomotive. But some express trains have only one guard; and when the traffic is heavy they may lose a few minutes which could be saved by a second guard: therefore an alert manager is constantly weighing the net product in saving of time and of annoyance to passengers, that will accrue from the aid of a second guard on an important train, and considering whether it will be worth its cost. This question is similar in kind to, but simpler in form than, the question whether “it would pay” to put an additional train on the time-table, which would call for more expenditure on plant as well as on labour.

Again one sometimes hears it said that a certain farmer starves his land for labour. Perhaps he has enough horses and plant; but “if he took on another man, he would get his money back, and a good deal more”: that is, the net product of an additional man would more than cover his wages. Let us suppose that a farmer is raising such a question as to the number of his shepherds. For simplicity, we may suppose that an additional man would not require any further expenditure on plant or stock: that he would save the farmer himself just as much trouble in some ways as he gives in others; so that nothing has to be allowed for earnings of management (even when these are interpreted broadly so as to include insurance against risk, etc.): and lastly that the farmer reckons that he would do just so much in preventing the wastage of lambs, and in other ways as will increase by twenty his annual output of sheep in good condition. That is to say, he reckons that the net product of an additional man will be twenty sheep. If he can be got for much less than the equivalent of their price, the alert farmer will certainly hire him; but, if only for about that price, the farmer will be on the margin of doubt; and the man may then be called a
marginal shepherd, because his employment is marginal.

It is best to assume throughout that the man is of normal efficiency. He would indeed be the marginal shepherd even if he were of exceptional efficiency, provided only that his net produce were equal to his wages: the farmer might have reckoned that a shepherd of normal efficiency would have added only sixteen sheep to output; and therefore have been willing to hire this man at a quarter more than the ordinary wages. But to assume him to be thus exceptional would be most inexpedient. He should be representative: that is, of normal efficiency
*14.

If he is representative, and his employer is representative, the twenty sheep will represent the net product and therefore the earning power of a shepherd. But if the employer is a bad manager, if for instance he lets his men run short of necessaries for the sheep, the man may save only fifteen sheep instead of twenty. Net product tends to represent normal wages only if the worker and his conditions of employment are both normal.

The additional product to be got by this shepherd’s labour is largely influenced by the number of shepherds whom the farmer already employs. And this again is governed by general conditions of demand and supply, and especially by the number of those from whom the ranks of shepherds could have been recruited during the current generation; by the demand for mutton and wool and by the area from which supplies of them can be obtained; by the effectiveness of the shepherds on all other farms; and so on. And the amount of the marginal product is further largely influenced by the competition of other uses for land: the space available for sheep-farming is curtailed by the demand for land for growing timber or oats, preserving deer, etc.
*15

This illustration has been chosen from a simple industry; but, though the form may be different, the substance of the problem is the same in every industry. Subject to conditions which are indicated in the footnote, but are not important for our main purpose, the wages of every class of labour tend to be equal to the net product due to the additional labour of the marginal labourer of that class
*16.

This doctrine has sometimes been put forward as a theory of wages. But there is no valid ground for any such pretension. The doctrine that the earnings of a worker tend to be equal to the net product of his work, has by itself no real meaning; since in order to estimate net product, we have to take for granted all the expenses of production of the commodity on which he works, other than his own wages.

But though this objection is valid against a claim that it contains a theory of wages; it is not valid against a claim that the doctrine throws into clear light the action of one of the causes that govern wages.

§ 8. In later chapters we shall need to take other illustrations for special purposes of the principle illustrated in the last section from the case of manual labour; and in particular to show how the value of some parts of the work of business management can be measured, when it is found that the effective output of a business is increased as much by some additional superintendence, as it would be by the hire of an additional ordinary worker. Again, the earnings of a machine can sometimes be estimated by the addition to the output of a factory which it might effect in certain cases without involving any incidental extra expense.

Generalizing from the work of a particular machine to that of machinery of a given aggregate value, we may suppose that in a certain factory an extra £100 worth of machinery can be applied so as not to involve any other extra expense, and so as to add annually £4 worth to the net output of the factory, after allowing for its own wear-and-tear. If the investors of capital push it into every occupation in which it seems likely to gain a high reward; and if, after this has been done and equilibrium has been found, it still pays and only just pays to employ this machinery, we can infer from this fact that the yearly rate of interest is 4 per cent. But illustrations of this kind merely indicate part of the action of the great causes which govern value. They cannot be made into a theory of interest, any more than into a theory of wages, without reasoning in a circle.

It may however be well to carry a little further our illustration of the nature of the demand for capital for any use; and to observe the way in which the aggregate demand for it is made up of the demands for many different uses.

To fix the ideas, let us take some particular trade, say that of hat-making, and inquire what determines the amount of capital which it absorbs. Suppose that the rate of interest is 4 per cent. per annum on perfectly good security; and that the hat-making trade absorbs a capital of one million pounds. This implies that the hat-making trade can turn the whole million pounds’ worth of capital to so good account that they would pay 4 per cent. per annum
net for the use of it rather than go without any of it
*17.

Some things are necessary to them; they must have not only some food, clothing, and house room, but also some circulating capital, such as raw material, and some fixed capital, such as tools and perhaps a little machinery. And though competition prevents anything more than the ordinary trade profit being got by the use of this necessary capital; yet the loss of it would be so injurious that those in the trade would have been willing to pay 50 per cent. on it, if they could not have got the use of it on easier terms. There may be other machinery which the trade would have refused to dispense with if the rate of interest had been 20 per cent. per annum, but not if it had been higher. If the rate had been 10 per cent., still more would have been used; if it had been 6 per cent., still more; if 5 per cent., still more; and finally the rate being 4 per cent. they use more still. When they have this amount, the marginal utility of the machinery,
i.e. the utility of that machinery which it is only just worth their while to employ, is measured by 4 per cent.

A rise in the rate of interest would diminish their use of machinery; for they would avoid the use of all that did not give a net annual surplus of more than 4 per cent. on its value. And a fall in the rate of interest would lead them to demand the aid of more capital, and to introduce machinery which gave a net annual surplus of something less than 4 per cent. on its value. Again, the lower the rate of interest, the more substantial will be the style of building used for the hat-making factories and the homes of the hat-makers; and a fall in the rate of interest will lead to the employment of more capital in the hat-making trade in the form of larger stocks of raw material, and of the finished commodity in the hands of retail dealers
*18.

The methods in which capital will be applied may vary much even within the same trade. Each undertaker having regard to his own means, will push the investment of capital in his business in each several direction until what appears in his judgment to be the margin of profitableness is reached; and that margin is, as we have said, a boundary line cutting one after another every possible line of investment, and moving irregularly outwards in all directions whenever there is a fall in the rate of interest at which extra capital can be obtained. Thus the demand for the loan of capital is the aggregate of the demands of all individuals in all trades; and it obeys a law similar to that which holds for the sale of commodities: just as there is a certain amount of a commodity which can find purchasers at any given price. When the price rises the amount that can be sold diminishes, and so it is with regard to the use of capital.

And as with borrowings for productive purposes, so with those of spendthrifts or governments who mortgage their future resources in order to obtain the means of immediate expenditure. It is true that their actions are often but little governed by cool calculation, and that they frequently decide how much they want to borrow with but little reference to the price they will have to pay for the loan; but still the rate of interest exercises a perceptible influence on borrowings even of this kind.

§ 9. To sum up the whole in a comprehensive, if difficult, statement:—Every agent of production, land, machinery, skilled labour, unskilled labour, etc., tends to be applied in production as far as it profitably can be. If employers, and other business men, think that they can get a better result by using a little more of any one agent they will do so. They estimate the net product (that is the net increase of the money value of their total output after allowing for incidental expenses) that will be got by a little more outlay in this direction, or a little more outlay in that; and if they can gain by shifting a little of their outlay from one direction to another, they will do so
*19.

Thus then the uses of each agent of production are governed by the general conditions of demand in relation to supply: that is, on the one hand, by the urgency of all the uses to which the agent can be put, taken together with the means at the command of those who need it; and, on the other hand, by the available stocks of it. And equality is maintained between its values for each use by the constant tendency to shift it from uses, in which its services are of less value to others in which they are of greater value, in accordance with the principle of substitution.

If less use is made of unskilled labour or any agent, the reason will be that at some point at which people were on the margin of doubt whether it was worth while to use that agent, they have decided that it is not worth their while. That is what is meant by saying that we must watch the
marginal uses, and the
marginal efficiency of each agent. We must do so, simply because it is only at the margin that any of those shiftings can occur by which changed relations of supply and demand manifest themselves.

If we neglected differences between the grades of labour, and regarded all labour as of one kind, or at least as all expressed in terms of a certain kind of labour of standard efficiency, we might look for the margin of indifference between the direct application of labour and that of material capital; and we might say shortly, to quote von Thünen’s words, that “the efficiency of capital must be the measure of its earnings, since if the labour of capital were cheaper than that of men, the undertaker would dismiss some of his workmen, and in the opposite case he would increase their number
*20.”

But, of course, the increased competition of capital in general for employment is of a different character from the competition of machinery for employment in any single trade. The latter may push a particular kind of labour out of employment altogether; the former cannot displace labour in general, for it must cause an increased employment of the makers of those things which are used as capital. And in fact, the substitution of capital for labour is really the substitution of labour, combined with much waiting, in the place of other forms of labour combined with little waiting
*21.

§ 10. When we speak of the national dividend, or distributable net income of the whole nation, as divided into the shares of land, labour and capital, we must be clear as to what things we are including, and what things we are excluding. It will seldom make very much difference to our argument whether we use all the terms broadly, or all the terms narrowly. But it is essential that our usage should be consistent throughout any one argument; and that, whatever is included on one side of the account of the demand for, and supply of, land, labour, and capital, should be included also on the other.

The labour and capital of the country, acting on its natural resources, produce annually a certain
net aggregate of commodities, material and immaterial, including services of all kinds. The limiting word “net” is needed to provide for the using up of raw and half-finished commodities, and for the wearing out and depreciation of plant which is involved in production: all such waste must of course be deducted from the gross produce before the true or net income can be found. And net income due on account of foreign investments must be added in. (See above II. IV. 6.) This is the true net annual income, or revenue, of the country; or, the national dividend: we may, of course, estimate it for a year or for any other period. The terms National Income and National Dividend are convertible; only the latter is the more significant when we are looking at the national income in the character of the sum of the new sources of enjoyments that are available for distribution. But it is best here to follow the common practice, and not count as part of the national income or dividend anything that is not commonly counted as part of the income of the individual. Thus, unless anything is said to the contrary, the services which a person renders to himself, and those which he renders gratuitously to members of his family or friends; the benefits which he derives from using his own personal goods, or public property such as toll-free bridges, are not reckoned as parts of the national dividend, but are left to be accounted for separately.

Some part of production goes to increase the stock of raw material, machinery, etc., and does not merely replace material that has been used up, or machinery that has been worn out: and this part of the national income or dividend does not pass direct into personal consumption. But it does pass into consumption in the broad sense of the term which is commonly used by, say, a manufacturer of printing machines, when some of his stock is sold to printers. And in this broad sense it is true that all production is for consumption; that the national dividend is convertible with the aggregate of net production, and also with the aggregate of consumption. Under ordinary conditions of industry, production and consumption move together: there is no consumption except that for which the way has been prepared by appropriate production: and all production is followed by the consumption for which it was designed. There may indeed be some miscalculation in particular branches of production; and a collapse of commercial credit may fill nearly all warehouses for a time with unsold goods. But such conditions are exceptional and are not within our present view. (See below V. XIII. 10; and Appendix J, 3.)