:t'l:ii!i!!|i,,,,|i,,,,, ,,, -IlliiPili P I "i' I, '' .M T I. ' , 'I I 1. ' 1 ! !ll!l!l!li ■ IHillllll'lll! Bu. iiiiiiiiiiiiiiiiiil iiiif" UNEARNED INCi W I! P liiiilllllitl III lllllllllf iiiiiii i!HJli!iriHd.il(i:'l!l i! i ill pi!;: iiii II 2fem Ifork Hntt (Jfolbgc of Agriculture At Qlnrncll Univetrattg 3tt{aca. N. 1. lOtbratg HB 601.B7°™""""'*"'»)"-lbrary ^"MiimSJUSf" earned s Cornell University Library The original of tiiis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/cletails/cu31924000499826 THE THEORY OF EARNED AND UNEARNED INCOMES THE THEORY OF EARNED AND UNEARNED INCOMES A STUDY OF THE ECONOMIC LAWS OF DISTRIBUTION WITH SOME OF THEIR APPLICATIONS TO SOCIAL POLICY BY HARRY GUNNISON BROWN PROFESSOR OF ECONOMICS IN THE UNIVERSITY OF MISSOURI Author of "Principles of Commerce'' ffldlumfaia, iffliaaouri MISSOURI BOOK COMPANY 191S Copyright, 1918 By Missouri Book Company Published September, 1918. Press of E. W- Stephens Publishing Co., Columbia, Missouri. PREFACE The study here ofifered is intended to appeal to several classes of readers. My hope is that it will be read by, among others, socialists of the Marxian school, single taxers, and economists. For those orthodox or Marxian socialists who are willing to reexamine the theoretical foundations of their doc- trines, interest will attach to the classification of incomes and to the attempt to distinguish between incomes which are earned and incomes which are unearned. The Marxian view that all income from property is "surplus value" and represents exploita- tion, is not accepted, but it is made clear that some income from property — as, indeed, from labor also — is unearned. To single taxers the discussion, in Chapter VI, of land rent and its taxation will per- haps be of chief interest, but the rest of the book leads up to and supplements the chapter on land rent in a way to make the whole study significant for this class of readers. I venture to hope, also, that professional economists, as such, will find enough of critical and constructive material in the text and footnotes, to make the study of interest to them. Finally, the book is intended to make an appeal to serious readers of no particular school or of any school of thought and of any business or profession, who are concerned with the evils in our present economic system and who look forward to worth-while changes during or after the war. World-wide democracy will be but half achieved if it be achieved in the political realm only, with no accompanying economic changes. V VI Preface I am under obligation to the Quarterly Journal of Economics for permission to republish, sub- stantially without change, the major part of an article on "The Marginal Productivity versus the Impatience Theory of Interest," first published in August, 1913. To the American Economic Review I am indebted for permission to use, also in Chap- ter IV, most of an article on "The Discount versus the Cost-of-Production Theory of Capital Valua- tion," originally published in June, 1914. To the Journal of Political Economy I am indebted for permission to republish, in Chapter VI, along with later additions, an article on "The Ethics of Land- Value Taxation," which appeared in May, 1917. The Macmillan Company have kindly consented to the use in Chapter I of this book, of about eight pages taken from the first two Chapters of my Principles of Commerce, published by them. Pro- fessor H. J. Davenport of Cornell University has given the manuscript a conscientious and critical overhauling and although I have not been able to accept all of his suggestions, the book has been im- proved because of his criticisms. To my wife I owe thanks for a careful and critical reading of the entire manuscript and for reading the proof. Harry Gunnison Brown Columbia, Mo. May, 1918. SUGGESTIONS TO READERS To the general reader whose time or patience may not permit his following the more difficult parts of the argument set forth in the succeeding pages but who nevertheless seeks an understanding of the principal practical conclusions reached, it is suggested that Chapters I, II and IV (but not the Introduction) be entirely omitted, along with the critical footnote discussions in the other chapters. But Chapter IV cannot fairly be omitted by the reader who, familiar with the controversial liter- ature on the theory of the interest rate, has tenta- tively adopted a conclusion in disagreement with that presented herein. Nor, indeed, should the critically-minded reader fail to glance at the foot- notes, since these are inserted in many cases for the express purpose of meeting anticipated criticisms. Vll SUMMARY OF CHAPTER TOPICS INTRODUCTION— THE POINT O? VIEW. CHAPTER I. THE DETERMINATION OF VALUE. CHAPTER II. ULTIMATE DETERMINANTS OF VALUE. CHAPTER III. THE CAUSES OF INTEREST. CHAPTER IV. THE RATE OF INTEREST. CHAPTER V. WAGES AND POPULATION. CHAPTER VI. THE RENT OF LAND AND ITS TAXATION. VIII CONTENTS BY SECTIONS INTBODUCTION. THE POINT OF VIEW 3-4 CHAPTER I. THE DETERMINATION OF VALUE 5-45 § t Value, or the Analogue of Value, to the Isolated Man. § 2 Conditions Determining the Extent of an Isolated Man's Pro- duction- § 3 Utility, Relative Production of Different Goods, and Value, in a Modern Community. § 4 Demand and Supply in Relation to Price. § 5 Exnlanations and Qualifications. § 6 Speculation in Relation to Price. § 7 The Determination of the General Level of Prices. § 8 The Relation of Commercial Banking to the General Level of Prices. I 9 Summary. CHAPTER II. ULTIMATE DETERMINANTS OF VALUE 46-75 § I Supply of One Good Means Demand for Other Goods. § z Influences Back of Demand. § 3 Influences Back of Supply. § 4 Labor Costs in Production. § 5 Land and Capital Costs in Production. § 6 The Value of Land. § 7 Joint Demand and Joint Supply. § 8 Summary. CHAPTER III. THE CAUSES OF INTEREST 76-in § I The Factors of Production. § 2 The Accumulation of Capital. IX X Contents by Sections § 3 The Productivity of Capital. § 4 Capital Accumulation versus Marginal Capital Productiveness. § 5 Saving or Abstinence in Relation to Interest. § 6 Summary. CHAPTER IV. THE RATE OF INTEREST 112-170 § I The Choices of a Crusoe- § 2 The Demand for Present Goods. § 3 The Supply of Present Goods Offered for Future Goods. § 4 Demand for and Supply of Present Goods Further Considered. § 5 A Concrete Illustration. § 6 Interest in a Money Economy. § 7 Changing Bank Reserves in Relation to Interest. § 8 Rising and Falling Prices in Relation to Interest. § 9 Some Further Complications in the Actual Industrial World. § 10 Interest Earned and Unearned. § II Summary. CHAPTER v^. WAGES AND POPULATION 171-198 § I The Proximate Determination of Wages. § ii Influence of Physical and Influence of Value Productivity en Wages. § 3 Comparative Wages in Different Labor Groups. § 4 A Side Light on the Interest Problem. § 5 General Wages and Population. § 6 Immigration and Wages. § 7 Summary. CHAPTER VI. THE RENT OF LAND AND ITS TAXATION 199-254 § I Land Rent as a Marginal Product of Land. § 2 Land Rent versus Capital Interest. § 3 Land Rent as an Unearned Income. § 4 Improvements by Special Assessments and the Right of Land- owners to a Rental Return. § 5 Other Services of City Landovfners. § 6 The Increment of Land Values in Relation to the Settlement of the American West. Contents by Sections xi § 7 Ownership of Land by omall-Family Groups versus Increas- ing Population in Other Groups. § 8 The Bearing of the Contention that there may be Other Un- earned Increments not Especially Associated with Land. § 9 The Taxation of Future Increments of Value. § lo Land-Value Taxation in Relation to the Theory of Vested Rights. § II A Few Additional Considerations. § 12 Summary. THE THEORY OF EARNED AND UNEARNED INCOMES Briefly, then, the universal basis of co-operation is the proportion- ing of benefits received to services rendered. Herbert Si-encer He who by any exertion of mind or body adds to the aggregate of enjoyable vvealth, increases the sum of human knowledge or gives to human life higher elevation or greater fullness — he is in the large meaning of the words,, a "producer," a "workingman," a "la- borer," and is honestly earning honest wages. But he who without doing aught to make mankind richer, wiser, better, happier, lives on the toil of others — he, no matter by what name of honor he may be called, or how lustily the priests of Mammon may swing their censers before him, is in the last analysis but a beggarman or a thief. Henry George (2) THE THEORY OF EARNED AND UNEARNED INCOMES INTRODUCTION THE POINT OF VIEW The science of economics may be pursued, as may any science, purely for its own sake. Its pursuit may be an intellectual amusement of the cultured, and the contemplation of its conclusions may be enjoyed by its votaries as one would enjoy a great epic. But the study of economics may also furnish guidance in matters of social policy and may thus serve two ends of which the second is probably by far the more important. In attempting, through the succeeding pages, to outline a theory of earned and unearned incomes, we shall not be able to lose sight of this second end. We shall, indeed, be continually inquiring how economic forces work, e. g., what influences fix value and price, what are the conditions which cause interest to be paid, how interest rates are determined, what conditions fix wages, what influences make land rent rise or fall. But back of our search for these scientific laws there will lie a purpose and a point of view. The purpose will be to find out those things in the theory of income distribution the knowledge of which may help us to the fairest possible economic organization of society. The point of view will be some notion as to what tests determine whether an income is earned or not and some sort of ideal (3) 4 Earned and Unearned Incomes regarding the desirability of permitting individuals to enjoy incomes which are not earned. With certain qualifications which will become clear as our investigation proceeds, we shall regard in- comes as earned when equivalent service is given by their recipients to those from whom the incomes are ultimately drawn; and we shall regard incomes as unearned when their recipients enjoy them without making a corresponding return. Whether such a distinction has any significance for any individual reader, will depend much on his ethical viewpoint, his general social philosophy. To one who regards absolute equality of incomes as the economic ideal, however great the differences in efficiency, an investigation into the question whether various incomes are earned or not, will seem irrelevant. Likewise, to one who regards the existence of privileged classes drawing large incomes, as a desirable condition of economic and social life, there will be little significance in a conclusion that many of these large incomes are wholly or partly unearned. But there are persons who believe, more or less on utilitarian grounds, that economic society is not well organized unless incomes have some reasonable relation to service rendered by the recipients to those from whom the incomes are in the last analysis, received, and that no class of citizens (unless by way of charitable relief) should be privileged to receive incomes not based on such service. To persons who hold this view, an analysis of incomes which leads eventually to their classification as earned and un- earned may seem in very truth to constitute the first step of an inquiry into the nature and possi- bility of economic democracy. CHAPTER I THE DETERMINATION OF VALUE § 1 Value, or the Analogue of Value, to the Isolated Man By value, in the sense of value in exchange, we ordinarily mean the number of units of some other good or goods, taken as a standard or measure of value^, that any given article or immaterial benefit will bring in trade. Thus, the value of a man's horse may be 150 bushels of wheat or 30 tons of coal or 75 days of common labor or two dozen operatic per- formances. The thought is that the horse would sell for — would bring in exchange — such an amount of other goods. Since money is the medium by which exchanges are commonly effected and, therefore, a generally recognized measure of value, we ordinarily express exchange relations in terms of money. We would be much more likely to state the value of the horse as $160 than to state it as (for example) 30 tons of coal. Everyone sells goods for money or buys goods with money or both. Everyone is toler- ably familiar with the value of the money unit in terms of various other goods. Everyone knows, that is, about how much of various other goods a dollar will buy. Consequently the statement that a horse is worth $160 includes the other statements and can be readily translated into them. Valuation of 1 Jevons, The Theory of Political Economy, fourth edition, London (Macmillan), 1911, pp- 78-83. (5) 6 Earned and Unearned Incomes goods in terms of money is really valuation of them in terms of goods-in-general. Exchange value is a social phenomenon. It in- volves the exchanging of one kind of goods for another kind (or kinds) of goods and a comparison of the utility or desirability of the one kind with that of the other. Such a comparison will presuma- bly be made, in fact, by both parties to an exchange. But though exchange value is thus a phenomenon involving human relations as well as involving goods and so is a social phenomenon, nevertheless nearly all of the factors that enter into its deter- mination exist in a state of isolation such as that of a Robinson Crusoe. And so we may, perhaps, with advantage, begin our study of value by a consideration of the comparisons that might enter the mind of a Crusoe who, alone on his island, is engaged in eking out a precarious living. To Crusoe, as to a man in the most advanced modern community, must be presented frequently the necessity of making a choice among different commodities, all of which together he can not secure in anything like the number or quantity desired, and all of which, possibly, he cannot use, since some may be substitutes for others. He must, therefore, compare the utility of one kind of goods with the utility of something else. It may be that he has occasion to decide whether a month's labor which he can spare from other purposes shall be used to build an additional room to his hut or dugout, or whether it shall be used to make him a canoe; whether today's efforts shall be devoted to killing and dressing a goat or whether the day shall be spent in catching fish. There is, The Determination op Value. 7 of course, for Crusoe, no value in the sense of power in exchange, since there is no one with whom exchanges can be made. But there is value, if we may use the term in an analogous case, in the sense of comparison of one thing with some other thing or things, i. e. there is comparative utility. If Crusoe would rather spend a month's labor which he has available, in building an ad- ditional room than in constructing a canoe, it is probably because the utility of the room is greater to him than the utility of the canoe, or, at any rate, that he believes it to be greater. If he could make the canoe in two weeks and a new goat-skin suit in another two weeks but would rather devote all four weeks to building the additional room, then the room has greater utility to him than the canoe and suit together; or, if the canoe and suit are reckoned equal, the room has more than twice the utility of either. Were Crusoe in a small community with several other inhabitants, he would perhaps be willing to make two canoes for two of his fellow islanders, in return for their building the additional room for him. Then we could say that the value of the room was two canoes or that a canoe was worth the half completed room. Crusoe, alone on his island, can make no trade; but he can appraise the room in terms of canoes and clothes to the extent of deciding whether he will produce the one or the other two. Similar comparisons would be made in the case of goods satisfying somewhat the same need. For a quart of berries, Crusoe might be willing to work two hours and for a boiled lobster two hours. Then the lobster would 8 Earned and Unearned Incomes. be worth, to Crusoe, two quarts of berries. Each article can be compared with each other, directly or through the common means of purchasing them all from nature, viz. labor.^ We have now to take into consideration another fact, so far not mentioned. This is that successive units of any article or service have a progressively lower degree of utility. Crusoe's one suit of goat skin, if he can afford no more, will have great utility to him, will be, in fact, indispensable. A second suit will be, perhaps, important but not as much so. A third will be comparatively unim- portant. Similarly, a one-room shelter will be indispensable; a second room may be almost indispensable; a third will be a great convenience, a fourth somewhat convenient, and so on. It is certain that Crusoe will get himself enough food to support life, if he possibly can. It is pretty certain that he will build and keep in some repair one room. It is pretty certain that he will keep himself sup- plied with one suit of clothes. How much beyond these essentials he will go will depend upon his intensity of desire for comforts and luxuries and also upon his strength, energy and willingness to work. Having seen that the utility of any good dimin- ishes for Crusoe according as he has a large amount of that good, let us reexamine our conclusion re- garding the utility to him of a room as compared with that of a canoe. The comparative utilities of these two items of wealth will depend on how much room Crusoe already has as well as upon his 2 Or labor and waiting. See Chapters III and IV. The Determination of Value. 9 need for room in general or for a canoe. If he has no room at all, a one-room hut will probably seem much more important to him than a canoe, and, rather than go without it, he might be willing to do much more work than he would do for a small boat. But the utility of a second room would be less and that of a third still less. Suppose Crusoe would as soon have a canoe as to have the third room. Then he would be willing to devote as much labor to getting the one as to securing the other. If the time necessary to build an additional room is four weeks and that necessary to make a canoe is two weeks, he would choose the canoe after he had a sufficient number of rooms so that an additional room would have less than twice the (marginal) utility of a canoe. If, that is, the labor of building a room remains always twice that of making a canoe, regardless of the number of rooms added, then this labor cost determines the number of rooms which Crusoe will build in preference to a canoe and, therefore, the marginal utility of a room (the utility of the last, final or marginal room). The value of a room in terms of canoes will depend upon the utility of an ad- ditional room, but this utility will depend upon the number of rooms Crusoe already has and this, again, will depend upon the labor required to build a room. But suppose that the nearby available material for house building is scarce, that additional rooms necessitate longer trips for materials, and, perhaps, greater search to find materials that are satis- factory, — in other words, that the labor of con- structing additional rooms becomes progressively 10 Earned and Unearned Incomes. greater as more rooms are built. Then the labor of construction no more determines the utility and value of a room than its utility and value deter- mine the amount of labor which Crusoe will undergo to build it. For if the utility of additional rooms to Crusoe is little, he will construct but one or two rooms and the labor of construction will be slight; whereas, if the utility of additional rooms is great, he will build them, in preference to a canoe, until the labor of construction (per added room) is considerable. Nevertheless it will still be true that when the utility of an additional room becomes less in relation to the labor of con- struction than is the utility of a canoe in relation to the labor of its construction, Crusoe will cease adding rooms and will turn to the building of a canoe. And the value of a room will still be measured by its utility in relation to the utility of a canoe, or by the labor of its construction in relation to the labor of constructing a canoe. Either method of measurement is correct since either is equivalent^ to the other. § 2 Conditions Determining The Extent of An Isolated Man's Production Having considered the principles determining the relative amounts of different goods that an isolated man will produce, and the values or the comparative utilities of these goods,* we may now profitably give brief attention to the considera- ^ At the margin. * See, however, the further considerations in Chapter IV, § i. The Determination of Value. 11 tions determining the total amount of such a man's production. Of course Crusoe will produce neces- sary food. It is scarcely less certain that he will make himself some clothing and get at least a crude kind of shelter. His different wants will receive satisfaction in the order of and to the extent commensurate with their importance and the ease with which they can be satisfied. The wants remaining unsatisfied will be of progressive- ly less importance in relation to the effort or other sacrifice necessary to satisfy them. On the other hand, additional hours of labor per day soon come to involve discomfort and sacrifice to an increasing degree. If Crusoe works thirteen hours, he will almost certainly find the thirteenth hour of labor harder than the tenth, eleventh or twelfth. He will choose to work eight, ten, twelve or thirteen hours as the case may be, according to the relation between the utility to him of the goods which the last hour's work produces and the disutility (discomfort or labor sacrifice) of the last hour's work. If the importance to him of the goods which his tenth hour produces is more than enough to compensate him for the work done, then he will work ten hours. Or, perhaps, at nine hours and three-quarters the last minute's work just balances in sacrifice the gains to be secured. Then it will be a matter of indifference to him whether he works nine hours and forty-four minutes or nine hours and forty-five minutes, but he will not work nine hours and forty-six minutes.^ 5 See Jevons, The Theory of Political Economy, fourth edition, p. 173- 12 Earned and Unearned Incomes. § 3 Utility, Relative Production of Different Goods, and Value, in a Modern Community We have seen how an isolated man compares the utility of different objects and what considera- tions determine the amounts of them that he will produce. Let us now consider how values are determined in a community of persons, where there is division of labor and where, therefore, exchange of goods is a characteristic feature of economic life. In general, and with a qualification which will be made shortly,^ an isolated group of producers, or an entire community isolated from other communities, or society as a whole, produces to a larger degree those things of which its mem- bers desire large amounts, provided the sacrifice or cost of production is no greater, and produces to a less extent goods not so much desired. Suppose, for instance, that we are considering a community whose members desire large amounts of bread and, therefore, wheat, but only a small quantity of apples. Then large amounts of wheat will be produced and not many apples. But since the producers of wheat and of apples do not consume most of their own production, their relative tastes and preferences as between these two kinds of goods can not, to any large extent, act upon them directly. It is the tastes and preferences of buyers which affect price by influencing demand. Thus the large general demand for wheat means that there are many persons willing to pay a good * See second and third paragraphs after this. The Determination of Value. 13 price for it rather than not to have it or rather than to have less of it, that the amounts these persons are wilhng to purchase can only be produced by the labor of many wheat raisers, and that the prices which the consuming purchasers are willing to pay are such as will make many persons willing to engage in (and devote their land to) wheat production. On the other hand, to say that apples are not greatly desired is to say that, unless the price is very low, there are few persons who want any or that those who want them want but small amounts, or both. It follows that large amounts can not be sold at a remuner- ative price and that the price consumers will pay is only high enough to keep a comparatively few producers (and few acres) in apple production, and is not high enough to tempt larger numbers into it. Of course if the apple growers do not receive almost as much for their work as the wheat raisers they may not consent, even in small numbers, to continue their occupation very long. But it is entirely possible that there will be a few who will like the work well enough to remain in it even if their return is very slightly less than it might be in the other line of production. There will be some, also, who, while earning, perhaps, less than most wheat raisers, remain apple growers because they are not well adapted for wheat raising and would make even smaller returns in it. Similarly some land will be devoted to apple growing, even with a low price of apples and with consequent small returns to the owner of the land so used, because the land will produce even smaller returns if used for the production of 14 Earned and Unearned Incomes. wheat. Furthermore, if there has been produced in the community in question a certain more or less necessary quantity of wheat, additional amounts of wheat will have so little utility that apples or other goods will be preferred. The conditions of demand and value will, therefore, encourage a larger production of wheat than of apples but not a production entirely devoted to wheat. Thus, in a considerable community, demand and the conditions of production determine the relative amounts of different goods which are produced. Variety of consumption results both from the fact that increasing amounts of any good reduce its marginal utility so that additional amounts are less desired than other things, and also from the fact that additional amounts of any kind of goods may cost more by requiring producers and land which, except for the offering of a high price, would be devoted to another line of production.' And as with an isolated individual, a community labors, through the activities of its members, to produce goods up to the point where the sacrifice of production is just balanced by the satisfaction or utility or the anticipated satisfaction of consump- tion. But in an organized community of the modern industrial type, carrying on economic activities with a considerable degree of specialization or ' The United States government has recognized this principle, during the present war, by guaranteeing to farmers a minimum price of wheat. An alternative might be government direction of occupations and investment by way of compulsion. A man might be compelled to work in some line of activity for a less return than he could get if allowed to work in some other line. The Determination of Value 15 division of labor, the utility of any goods consumed, to the consumer, is not necessarily or even probably just equal to the disutility of producing them, to the producer. For in such a community each person engaged in productive activity produces goods or services which others enjoy.* The labor sacrifice of the producers of hats may or may not — probably will not — be the exact equivalent of the enjoyment or anticipated enjoyment of the wearers of the hats. Thus, the hats in question may be of the variety affected by the well-to-do for formal evening wear, and may be, therefore, far removed from the list of necessities. The utility of or the satisfaction yielded by these hats may be compar- atively slight, but they are purchased because, to their purchasers, the utility of money is also comparatively slight. Yet the disutility of the last hour's work in making them, to the producers of the hats, may be considerable, far more than would be compensated by the enjoyment of such a luxury. These producers may be, for the most part, comparatively poor, so that the payment for the last hour of their labor represents necessities rather than luxuries. The necessities so purchased by them, although worth no more in the market than the hats which they have produced, have to these hat makers a utility corresponding to the labor sacrifice which they have to undergo in earning the necessities. Their necessities have, that is, a utility to them equal to the disutility of producing the hats. But the hats have not, to them, any such utility. s a. J- B. Clark, Distribution of Wealth, New York (Macrail- lan), 1899, p- 390. 16 Earned and Unearned Incomes On the other hand, the wearers of the hats may be engaged in producing (or capital which their earlier efforts and saving have enabled them to accumulate may be instrumental in producing) the very articles of necessity which the hat producers consume. The utility of these articles, or services, to those who consume them may there- fore be much greater than the disutility (of labor or waiting" or both) required for their production by the classes engaged in producing them.^° In modern industrial society, then, there is a rough correspondence between the utility of the goods which a man buys with the proceeds of his last hour of work, and the disutility of the work. But we cannot, in such a society with its division of labor, its strata of wealthy and poorer classes, and its differences of individual energy and taste, assert any very marked correspondence between the utility of goods to a consumer and the disutility of labor or labor and waiting undergone by a producer. § 4 Demand and Supply in Relation to Price The division of labor characteristic of modern society means that different persons produce different things for a market, that we specialize in ^ See Chapter III, §5, for a brief discussion of whether waiting involves a disutility in the sense of pain-cost. 10 ^e are here assuming that all the classes under discussion and enjoying incomes, contribute something to production. Neverthe- less, there are classes, as we shall later see, which reap where they have not sown. The Determination of Value. 17 production and then trade to get what as in- dividuals or family groups we want. The problem of value in such a society is the problem of explaining what factors determine the ratios of exchange between different kinds of goods. The explanation of the problem begins with a study of demand and supply. The price of any article is determined, by the competitive forces of business, at that point which equalizes demand and supply. As has been frequently pointed out, demand must be distinguished from mere desire and supply must be distinguished from stock. There may be many persons who desire automobiles, but whose desires are of no significance economically because not backed by any financial ability to purchase. Demand implies ability to buy as well as desire to buy. Furthermore, since the amount which would be purchased by buyers depends partly on price, demand should be stated in relation to some price. We should therefore say, in defining de- mand: the demand for any kind of goods, e. g. cotton cloth, at any given price (per yard) is the amount (number of yards) of those goods which purchasers would take at that price. It is a generally recognized fact that demand is greater, other things equal, when price is lower, and that demand is less when price is higher." Assuming other things equal, we can suppose a complete schedule of demands, corresponding to all possible prices. All but one of these demands are 11 The case of goods purchased for display is probably not an ex- ception since, first, a reduction of price simply means that the same display requires a larger purchase and, second, a reduction of price may make possible some display by a lower economic group. 18 Earned and Unearned Incomes. hypothetical, since they correspond to prices that do not exist. They are, in each case, what the demand would be if the price of the goods were thus and so. The demand corresponding to the actual price, represents an actual demand. But the other demands, especially those corresponding to prices near the actual price, are important, because they stand for forces of competition which help to determine actual price. If the price should go lower, demand would increase and might exceed supply, thus bringing price back again to the point of equilibrium. We must, therefore, recognize a series of potential demands corre- sponding to a series of hypothetical prices; yet we must, also, recognize that the actual demand for any article is the one which goes with the actual price or prices of that article during the period in question. Supply, also, needs to be carefully defined. The total stock, say of cotton, in existence at any time, is not the supply in the sense here used. Supply, like demand, should be spoken of in connection with price. The supply of any kind of goods, at any given price, is the amount which sellers would dispose of at that price. At a higher price, more persons would be encouraged to produce the goods for sale, and those already producing them would be inclined to produce more. At a lower price there would be less encouragement to the production of the goods. Even if we are dealing only with temporary or short-run supply, e. g. the supply of corn in April, so that a rise of prices could not for several months increase the amount produced, it might still be true that a higher price would The Determination of Value. 19 tend towards a greater supply and vice versa. For at a price much below normal, many who otherwise might sell their corn, would be inclined to hold it in the hope of a higher future price. As in the case of demand, we may have a supply schedule with a supply corresponding to each assumed price; and each such supply is hypothet- ical except the supply which corresponds to the actual price. But the hypothetical supplies are not to be ignored since consideration of them enables us better to understand the nature of the competitive conditions by which price is fixed. Both demand and supply operate only during a period of time. This period of time may be longer or shorter according as the problem which in- terests us is long-run or short-run price. If we are considering the determination of so-called market price, our concern is with demand and supply during a brief period, e. g. a week, a day, or an hour. If we are considering the determina- tion of seasonal price, say of corn or cotton, our concern is with demand and supply between one harvest and the next. If we are considering, for a certain manufactured good, the determination of the price corresponding in some degree to the seasonal price of an agricultural product, our concern is with demand and supply of this good during a period so short that additional plants for the manufacture of the good could not be con- structed and so short that existing factories and machinery would not wear out.^^ During such a 12 Cf. Taussig, Pinciples of Economics, second edition, New York (Macmillan), 1915, Vol. I, pp. 149, 150. 20 Earned and Unearned Incomes. period the good in question might be continuously produced, but the amount produced could not much exceed, though it might fall short of, the normal capacity of the plants. Finally, if we are considering long-run or normal price, our concern is with demand and supply over a longer period involving a number of seasons or, in the case of a manufactured good produced with large plant, involving a sufficient number of years so that the cost of construction of plants becomes an im- portant influence on the supply of the articles produced by such plants. It has been said above that the higher the price of a good, the larger (other things equal) will be the amount supplied, and the less will be the amount demanded. A high price, therefore, seems to be associated with a large supply and a low price with a large demand. This may appear to be contrary to the commonly accepted notion that high price means shortage of supply, or unusually large demand, or both. Yet in truth there is no inconsistency in the statement of these apparently opposite relationships. The phenomena in question involve an interaction of cause and effect. The prospect of being able to receive a high price for goods certainly stimulates the production of those goods. Yet a large production tends to force down the' price. So, also, in the case of demand, it is certainly true that low prices of goods encourage purchases, and it is likewise true that large pur- chases tend to make prices high. Our present task is to examine the exact way in which the forces on the demand and on the supply side of the market operate to determine price. The The Determination op Value. 21 price of any kind of goods tends always to be fixed at that point where demand and supply are equal. To demonstrate this tendency, let us assume prices at which demand and supply are not equal and show that such prices involve unstable equilib- rium and hence can not continue. We may sup- pose that, in a given market, a price of 8 cents a pound for cotton would equalize demand and supply and that, at such a price, both the demand and the supply would be 10,000,000 pounds. At 7 cents, the demand would be greater, say for 11,000,000 pounds, while the supply would be less, perhaps 9,000,000 pounds. Why, nevertheless, might not 7 cents be the resulting price? The answer is to be found, not in a mere statement that demand then would exceed supply, but in an analysis of the conditions and forces of the market, for which the terms demand and supply are merely our mode of expression. Since, at a price of 7 cents, there are prospective buyers whose total purchases would aggregate 11,000,000 pounds, while, at that price, only 9,000,000 pounds would be forthcoming, not all of the prospective buyers willing to purchase at 7 cents, could get the de- sired amounts of cotton. Many of them would bid more than 7 cents rather than not get the cotton wanted and this bidding would force the price up. Any price lower than 8 cents would leave a pre- ponderance of force on the demand side of the market, and would involve a further competitive bidding up of price. But we could not expect to have a bidding up of the price beyond 8 cents. For at 8 cents the supply is equal to the demand. In other words, all those who are willing to pay 8 cents a 22 Earned and Unearned Incomes. pound can get all the cotton which, at that price, they are willing to buy. No one of them has occasion to offer a higher price to insure his getting the desired amount of cotton. If any one of them, for any reason, chooses to offer and pay a higher price, other purchasers need not do so. For, by hypothesis, the supply at 8 cents a pound is enough to satisfy the demand. Hence, even after the purchases of any who for any reason pay more are completed, there will still be enough purchasable at 8 cents to satisfy the remainder of the demand. We see, then, that the conditions and forces of a market will not permit the continuance of a price below that which equalizes demand and supply, but that there is no reason why intending purchasers should pay more than this equalizing price. Let us now suppose a price above that which equalizes demand and supply, in order to see clearly that such a price, also, could not continue. At a price of (say) 9 cents a pound, the demand for cotton might aggregate not over 8,000,000 pounds ; while the supply would be more than at a price of 8 cents and might aggregate 11,000,000 pounds. Obviously, the 11,000,000 pounds which sellers might be willing to supply at a price of 9 cents a pound, could not be entirely disposed of at a price of 9 cents. Unless the price falls, some who are willing to sell for less than 9 cents rather than not sell, will be left with cotton on their hands. These will bid against each other in order to dispose of their cotton, and this bidding will lower the price to 8 cents. But it will not lower the price more than that, for all those who are The Determination of Value. 23 willing to sell at 8 cents a pound can find pur- chasers. Should any sellers choose, for some un- accountable reason, to dispose of their cotton at a lower price, nevertheless others would not have to do likewise; for the cotton supplied by these others at 8 cents a pound would be necessary to satisfy the demand and would, therefore, at this price, be purchased. We conclude that price is fixed, by market conditions, at a point such as to equalize demand and supply, since for price to be fixed at any other point involves a condition of unstable equilibrium. § 5 Explanations and Qualifications It is frequently stated that, assuming perfect competition, there can be but one price for a given kind of goods, in any market and at any one time. Thus, some men would not be selling cotton in a market at 7 cents a pound at the same time that others were selling for 8 cents. For, if the dealers asking 7 cents could completely satisfy the demand, those asking 8 cents would make no sales; while if those selling at 7 cents could not completely satisfy the demand, they would soon realize that a higher price could be asked. By a similar line of reasoning we may conclude that, if some purchasers were paying 8 cents and others only 7 cents, those having cotton to sell would sell it by preference to the former. If the pur- chasers at 8 cents could take the entire supply, those willing to pay but 7 cents would get no cotton, while, if the purchasers at 8 cents could not 24 Earned and Unearned Incomes. take the entire supply, they would soon realize that they could get what cotton they wanted without offering so high a price. When it is said, then, that perfect competition makes impossible more than one price for any kind of goods in a given market at any given time, perfect competition must be understood to mean complete knowledge on the part of all the buyers and sellers, of conditions throughout the market, a readiness on the part of each buyer to buy where he can buy most cheaply, and a corresponding en- deavor on the part of each seller to sell to whoever will pay the most. So far as knowledge is in- complete, or so far as buyers and sellers are actuated by motives not purely economic (e. g. by the motive of friendship), there is the possibility of two or more prices existing side by side in the same market. On the exchanges, where goods are bought and sold in such large quantities as to make the effort for complete information clearly worth while, there is seldom any great difference in price among different transactions in any one kind of goods, taking place at the same time. In retail trade, where the purchases of any individual from day to day are so small that it sometimes seems scarcely worth the trouble to investigate slight differences in price or to go much farther than the nearest store, differences in price are more likely to arise or to persist. Besides the possibility — and, in some cases, probability — of differences in the price of a kind of goods at any given time, there is also to be con- sidered the likelihood — almost the certainty — that price will fluctuate from month to month, from The Determination of Value. 25 week to week, from day to day, even from moment to moment. But some length of time is required for the carrying out of any transactions whatever. Demand and supply, therefore, almost necessarily have reference to a period of time rather than to an instant.^^ It follows that, except as we imagine a period of time infinitesimally brief, we cannot say with complete accuracy that demand and sup- ply are equalized by any one price. Demand for and supply of wheat, during a year, are equalized by a series of changing prices from day to day during the year, or by an average price. Either the seasonal price, or the long run or normal price is, then, an average of prices, an average of a se- ries of prices differing somewhat from each other. Even the market price has reference rather to a very short period than to a point of time. It is often said, in explanation of a rise in the price of some commodity, that the demand for it has increased or that the supply has decreased; and in explanation of a fall in price it is commonly stated that the demand has decreased or the supply increased. Obviously, an increased demand, say for cotton, which raises its price, is different from an increased demand which merely results from a fall of price. When we say that an increase of de- mand has raised the price of cotton, we mean that the potential demand at each possible price is ^3 Though we might define them as the amounts which, at any given instant, persons stand ready to buy and sell during some period. This would not help us any and would, indeed, be subject to the objection that what buyers and sellers, at any given moment, think they will do if prices remain unchanged, may not be at all what, even if prices so remained, they actually would do. 26 Earned and Unearned Incomes. greater than previously at the same price. In other words, the whole demand schedule has shift- ed.'* Population may have increased or new uses may have been discovered for cotton or tastes and styles may have changed, so that cotton goods are more desired than formerly. Unless, therefore, price is higher, demand will exceed supply, buyers will bid against each other, and price will have to rise. Likewise, if it is said that the price of cotton rises because of a decreased supply, this must be held to mean, not that there is a decreased supply consequent on a lower price, but that there is, at each assumed price, a less potential supply than formerly would have been forthcoming at that price. This fact might be the result of soil ex- haustion or of a possibility of using land more profitably for some other crop or (as for a single season) of destruction of part of the crop by the boll weevil. In any of these cases demand, at the former price, would exceed supply, and, therefore, a higher price must result. Consider now the conditions which make for a fall in price. The increase of supply which may cause such a fall is not the increase which results from a larger demand and a higher price, but is an increase of supply due to other conditions than a rise of price. It may be due to improved meth- ods of cultivation or (as for a single season) to exceptionally favorable weather conditions. Un- less the price falls, there will then be an excess of 1* See Fisher, Elementary Principles of Economics, New York (Macmillan), 1912, pp- 268-273. The Determination of Value. 27 supply over demand. Sellers of the cotton there- fore bid against each other in price reduction, caus- ing the price to be fixed at a point such that the demand will be equal to the now larger supply. But price may be lowered, also, through a de- creased demand. This decreased demand must be supposed to be a demand smaller at each price and not a smaller demand consequent merely on a higher price. It may result from change of taste or style or from inability of part of the buyers, owing to changed conditions diminishing their prosperity, to make their desires effective in demand. In any such case only a lower price can equalize demand and supply. The case of monopoly price is not altogether ex- ceptional. Monopoly price, also, is fixed where demand and supply are equal. But the monopolist controls the supply of his product and can there- fore ordinarily fix his price so as to secure a larger net profit than would be possible if competition had to be met. But if, in any industry, monopoly seems inevitable or socially preferable, government may regulate the price or prices in question. Such regulation, if effective, will remove the motive to limitation of supply. The regulated monopoly will rather prefer to extend its business, as the only way of making a considerable profit. To regulate any price to a lower point than gives a normal competitive return to the factors engaged in the production of the good will cause these factors to be shifted, in part, to other lines of production.^^ 1^ of course this does not mean that when the government, under its war power, limits a grocer's charge for sugar, the grocer will change his business. Even if the limitation were known to be for 28 Earned and Unearned Incomes. If such a law is not evaded, it can only be because its penalties or other causes bring about an ap- preciable curtailment of demand for the good the price of which is regulated. But to regulate monopoly price down to a level of competitive profits, will tend rather to increase supply than to decrease it. § 6 Speculation in Relation to Price It has been above pointed out" that the price of any kind of goods may fluctuate from week to week or from month to month. This fluctuation is, how- ever, limited in extent by the activities of specula- tors, at least when speculation is intelligently carrried on. We might be inclined to expect that the price of (say) wheat would be very low im- mediately after harvest, because of the large quan- tity suddenly thrown on the market, that this lowness of price would discourage its production, and that its scarcity, realized particularly when a long period, he might yet remain in the business because expecting a substantial profit from his sales of other groceries. Nor is there any intention to deny that, by means of regulation, priorities, appeals and otherwise, government may decrease the consumption of and the demand for many goods by civilians in war time, thus in efltect compelling them to lend it their funds for its purposes, for lack of the customary alternative. But if government expends these funds there is not likely to be a reduction in average prices. (See §7 of this Chapter). Permanently to regulate everyone's consumption of goods of every kind (assuming such regulation to be possible) would amount to doing away with the competitive money system, for few would bother to acquire funds which they might not expend. i®In the immediately preceding section (§5) of this Chapter. The Determination of Value. 29 each season's stock was nearly gone, would cause its price then to be very high. But speculators see chances to make profit from such differences of price. They, therefore, buy up the wheat in the fall, when its price is low, and hold it for sale at a time when a greater relative need makes its price higher. The large purchases in the fall tend to keep the price of wheat from going as low as it otherwise might, and the holding of a con- siderable stock into the spring for sale then, tends to prevent so great a rise as might otherwise occur. Speculative holding, in other words, increases the demand when price is low and increases the supply when price is high. The difference between the low and high prices will therefore, perhaps, on the average, about pay for the skill, trouble and capital furnished by the speculator. It is doubtless true that, in the absence of a speculating class, many farmers would themselves be inclined to hold their wheat till the season of highest price, but many others find this inconvenient and risky. The existence of a class of speculative buyers enables the farmers to sell at once for somewhere near the later and (on the average) higher price, and to avoid risk of loss. It is likely, therefore, to en- courage wheat production and thus to tend towards a reasonably low average price to the public. Purchase in the fall and holding by millers might, of course, serve in considerable degree the same purpose. But this would compel millers to be speculators and to invest large capital in the storage of wheat, and it is not certain that they would perform these services as cheaply as special- ists. 30 Earned and Unearned Incomes. Consider now another type of speculation. The speculator who "sells short" really promises to sell at a fixed future date and at an agreed price, goods which he does not possess at the time of making the promise. The buyer, of course, undertakes, on his part, to purchase the goods in question on the agreed date and at the agreed price. He is said to buy a "future." The buyer may be a manufacturer or a dealer to whom it is important that he shall know in advance just what certain supplies will cost when he is ready for them. He wishes to avoid any risk of fluctuation in the prices of these supplies. The speculator assumes this risk for him. Thus, a speculator may agree, in April, to sell wheat in June at $1.90 a bushel. The specu- lator should be an expert in predicting, so that to him the risk from possible fluctuations is less than it would be to others." But even to the specialist there is some element of risk. The market price when June arrives may be $1.95. In that case the speculator is obliged to buy for $1.95 a bushel the wheat which he has agreed to sell for $1.90,^^ and loses $0.05 on each bushel. If the price turns out to be $1.87, however, he gains $0.03 on each bushel delivered. The fact that there are experts 1' As Fisher has well pointed out, risk is fundamentally a matter of ignorance. Events occur only when their causes occur; and if we could know all the relations of cause and effect even in their most intricate ramifications and make ourselves familiar with ex- isting conditions, we could predict all events with certainty. Our uncertainty is due to no inconsistency of Nature but to an ignorance of Nature that makes consistency sometimes appear to us like Incon- sistency. See Fisher, The Nature of Capital and Income, New York (Macmillan), 1906, pp. 265-269. IS Or pay 5c a bushel to the man with whom he made the contract. The Determination of Value. 31 who will promise, in advance, to sell at an agreed price, probably has some tendency to equalize prices. For if scarcity is feared, each intending purchaser (e.g. miller) would be likely to buy in advance and hold for his own future use a stock much larger than would satisfy his immediate needs. Such panic buying might make supply seem relatively short (say of wheat in the spring) and cause prices to rise unduly. But instead of thus purchasing in advance a large stock of the goods they desire, prospective users can arrange with speculators to be supplied with the desired goods as these goods are needed. It is, of course, the intelligent speculation of experts which thus tends over a period of con- siderable length to equalize prices. So far as the untrained public are lured into speculative use of funds by the prospect of large chance gains, the effect of their speculation is quite as likely to be greater price fluctuations as less. For the untrain- ed public are not unlikely to buy when prices are high, and to sell in a panic when prices are low thus causing them to go still lower. In short selling, also, they are as likely as not to make cor- responding errors of judgment. § 7 The Determination of the General Level of Prices Let us now apply the principles of demand and supply to the general level of prices. We shall see that much the same kinds of competitive forces which fix any one price (as above explained) in relation to other prices, fix the general level of 32 Earned and Unearned Incomes prices of goods in terms of money. We shall consider the supply of goods, including the services of labor and of "waiting" (i. e. investing, or putting capital into use, the service for which interest is paid) offered for money, and the demand for goods by those having money to spend. Where there is only fiat (inconvertible paper) money, the supply of goods in general, offered for money, at any level of average prices of those goods, would be just the same as at any other level of prices. This is very nearly true no matter what the money system.^** If wheat prices are higher than com prices, or vice versa, productive effort may be diverted from one line into another. But we are now not discussing changes in individual or relative prices. We are discussing only changes in the general level of prices, the average of prices. If the general level of prices should double, there is no reason to believe that the amount of goods produced for sale would on that account greatly increase. Supposing a community to be in reasonable prosperity and business activity at the lower prices, an increase of these prices would not make possible a very greatly increased production. It would not enable men to work longer hours nor would it make machinery more efficient. Neither would it stimulate the sales of goods by making such sales more profitable, since a general rise of prices simply means that money has a less value. If everything should sell for twice as much money as before, the sellers would gain nothing, for the 1^ See remainder of this section for explanation of why it is not always entirely true. The Determination op Value 33 things they desire to buy would also cost twice as much. Looking at the matter from any reasonable point of view, it must be admitted that the supply of goods in general, at a higher level of prices, would be no greater (or but slightly greater)^" than at a lower level. Likewise, at a lower level of prices, the supply of goods would be no less than at a higher one. A lower level of prices would not mean less activity or a smaller sale of goods. It would pay as well to sell goods at a low level of prices as at a high level, since at the lower level the money received would have correspondingly greater purchasing power. The lower level of prices would only decrease the supply of other goods and the higher level increase it, in one contingency, and then only to a very limited degree. When the currency system is based on a precious metal, e. g. gold, a lower level of prices means a higher value of gold as money. It might therefore divert some labor from the production of other goods to the production of gold for coinage. A higher level of prices might tend, in the same degree, to divert labor from gold production towards the production of other goods. To this extent only, a higher level of prices would tend to increase the supply of goods in general other than money, and a lower level of prices to decrease it. On the other hand, a higher level of prices of goods would tend to decrease the demand for goods by persons having money to spend. For with higher prices, and no greater amount of money to 20 See next paragraph. 34 Earned and Unearned Incomes spend, buyers of goods would be unable to purchase as much as at lower prices. Lower prices of goods would mean that the money of purchasers would go farther. Let us now suppose a doubling of the amount of money. Prices would tend to increase in nearly the same proportion. Suppose prices did not rise. Then purchasers of goods would buy all they were in the habit of buying and still have as much money left to spend as they formerly spent all together. This they would endeavor to spend at once. For in modern countries money is not hoarded away, but only enough is kept on hand for emergency requirements, and the rest is spent. Those who save are spending just as effectually as any others. The difference is in what they buy. Those who save buy factories, warehouses, railroads, farms, etc. Even though their savings are put into a savings bank, they are none the less spent for investment goods. It follows that a sudden doubling of the amount of money, if prices did not increase, would mean a demand for goods far exceeding the supply. The amount of land is practically constant. Doubling i;he amount of money would not enable people to work longer hours and so increase the products of labor. In a busy community the supply of goods to be sold simply could not be doubled except with an in- crease of population or invention. The increased money would therefore mean that at the old prices the demand for goods in general would exceed the supply. Purchasers would bid against each other. Prices would rise. Equilibrium would only be reached, supply and demand be The Determination of Value. 35 equal, at a general level of prices nearly (or, if fiat money, quite) twice that which had preceded.^^ 21 The quantity theory of money has recently been attacked by Professor B. M- Anderson, Jr., in his book on The Value of Money (New York — Macmillan — ,1917. We may profitably digress, per- haps, long enough to consider the bearing of three of his hypothet- ical illustrative cases. In the first (pp. 150, 151), Professor Ander- son supposes a paper money convertible not in gold but in varying quantities of silver such that the amount of silver receivable for a unit of the paper is always the equivalent of a definite weight in gold. Under these circumstances, he asserts: "The causation as be- tween quantity of money and value of money would be exactly the reverse of that asserted by the quantity theory. A high value of money would mean lower prices. With lower prices, less money would be needed to carry on the business of the country. Paper would then be super-abundant. But in that case, paper would rapidly be sent in for redemption and the quantity of money would be reduced." But is it not true that the paper money will not be presented for redemption? On the contrary, the conditions assumed by Professor Anderson are precisely those which would prevent the sending in of the paper money for redemption. If prices are in- deed lower, those who possess this money have a more urgent motive than before to expend it while it will buy much, rather than to have it redeemed. The paper money will not be presented for redemption so long as it is worth more in goods than is the silver in which it is redeemable. And if and when it is presented for redemption, this will be the result of a diminished purchasing power consequent on its redundancy. In other words, we find here an in- fluence of the quantity of money on the prices of goods. In the second hypothetical case which we shall examine (pp. 296- 299), Professor Anderson supposes an island the people of which are chiefly engaged in producing a single crop and to which comes by wire the news of a partial failure of the same crop in another part of the world. The island crop, Professor Anderson says, will rise in price and so will other goods in the island, which the prospec- tively prosperous planters now begin to buy. All this may be true but it furnishes no convincing refutation of the quantity theory of money, a theory which definitely asserts that both the quantity of money and the price level in a limited territory are largely deter- mined by prices outside of that territory. If, on the island, prices 36 Earned and Unearned Incomes. In a country which has a gold standard monetary- system prices are largely dependent upon the amount of gold mined and hence upon the number and richness of gold mines. If prices rose equally, this would mean a doubling in the money wages of labor for the same results produced and, similarly, a doubling in the rise before money floius in, this can be true only to the extent that the now potentially more valuable crop is held for higher prices and hence trade is decreased, or by virtue of increased rapidity of money circulation or, most importantly perhaps, by the ability of the banks, in anticipation of crop sales at a higher price, to expand circulating credit (if reserves will permit) somewhat farther than usual. The quantity theory of money, properly interpreted, does not assume money to act on prices in any other way than through the market and through human motives and calculations. In the third case (pp. 309, 310), Professor Anderson argues that reduction of some prices, if quantity of money and volume of trade remain the same, may not raise other prices but may leave a lower average of prices than before. He supposes that maid-servants who were receiving $20 a month have their wages lowered to $10 by a combination of employers and, having no better alternatives, con- tinue to act as servants. He then proceeds to contend that although the employers have $10 more each to spend per month, the servants have each $10 less, that these changes just offset each other and that, therefore, prices will not change except for the fall of wages, the net effect being an average reduction. The $10, according to Professor Anderson, is simply "short-circuited." The fallacy lies in the assumption that this $10 is expended only once, e. g. by employer to retail shoe dealer, in the same period of time during which it would formerly have been expended twice, e. g. by em- ployer to servant and by servant to shoe dealer. Why not assume that, if the servant fails to connect with the $10, it goes from the employer to the retail shoe dealer and from the shoe dealer to the clothier? On the latter assumption, the fall of servants' wages, with volume of money and credit and volume of trade unchanged, certainly ixiould mean a rise in some other price or prices. Pro- fessor Anderson has arbitrarily interpolated a decreased velocity of circulation of money- The Deteemination of Value 37 money interest received for "waiting." Aside from disturbing effects during the period of transition, the rate of interest ^vould be the same with the high prices as with the low. The money value of the sum waited for would be doubled and the money value of the interest would be doubled. The ratio between them would be the same as before. In other words, since prices have doubled, borrowers, for example, would require twice as many dollars as before and would also, of course, pay twice as many dollars in interest. In the light of the principles above set forth, regarding supply and demand, we can explain why the excessive amounts of inconvertible paper money sometimes issued by governments, issued particularly in time of war, have resulted in very exceptional rises in the price level. This in- creased amount of money means, at any level of prices, a greater demand for goods. Therefore, that the demand for goods may not exceed the supply, the level of prices must rise. There is another factor of importance at such times, viz., public confidence in the money issued. If there is a general belief that the money will become absolutely valueless or greatly decrease in value, then many who have goods to sell will refuse to sell them for this money, but will demand gold or silver or other goods in exchange. This decrease in the supply of goods, offered for money, will mean that only a higher level of prices than other- wise would result can equalize supply and demand. Thus is to be explained the high prices (and, reciprocally, the great depreciation of money) in such periods as the American Revolution, the Civil War, etc. 38 Earned and Unearned Incomes. § 8 The Relation of Commercial Banking to the General Level of Prices Credit instruments, or credit rights — for the paper is in each case but evidence of the underlying obligation — act as substitutes for money primarily through the intermediation of commercial bank- ing,22 and foreign exchange banking. Commercial banks constitute an important part of the mechan- ism of trade. Their work facilitates internal trade and, in connection with the work of foreign exchange banks and brokers, facilitates external trade as well. It is estimated that nine-tenths of the total business in the United States is carried on through the use of bank credit.^^ Bank deposits (rights to draw from a bank or banks), which circulate by means of checks, may come into being in any one of several ways. One may become a depositor by directly depositing money (or the right to draw money, received by check from some one else, but this merely registers a transfer of a deposit and does not create one). One may become a depositor by borrowing from the bank in which the deposit is to be. If A goes to his bank and leaves there $50,000 cash, he there- upon is said to have deposited such an amount in the bank and can draw on this sum at will by ^^ Savings banks and investment banks perform, of course, im- portant functions, but do not have a part in providing a substitute for money. 23 See Fisher, The Purchasing Power of Money, New York (Mac- millan), 1911, pp. 317, 318. The Determination of Value 39 issuing checks against it in favor of any persons to whom he wishes to make payments. But A may also go to the same bank, give his endorsed note or other satisfactory security, and borrow $50,000. This money he leaves on deposit. The bank is then said to lend its credit. What A has borrowed is not money but the right to draw money by check, at will. The bank is under as much obliga- tion to redeem his checks on demand as if he had directly put money into the bank. On the other hand, A is under obligation to pay the bank, when his note matures, the amount borrowed plus interest. Finally, one may also become a depositor by endorsing to his bank a note or draft payable by a third party who then is the real borrower. It should be readily apparent that a bank can, in ordinary times, redeem all checks presented for redemption, without keeping for that purpose a cash reserve which at all nearly equals its liabilities. The total value of deposits which a bank is under obligation to pay out on demand, may be $500,000. Yet it is certain that all the depositors will not call for their money at the same time. Instead of drawing it out, most of them send checks back and forth to and from others who do likewise. A cash reserve of $100,000 may be ample. Putting the matter in the opposite way, we may assert that if there is $100,000 in cash in such a bank, the bank can lend its credit, i. e. more deposits or rights to draw, to the extent of (say) $400,000. We have said that different depositors in a bank liquidate their obligations to each other by giving checks. There is, then, simply a change on the bank's books. Any amount of obligations can be 40 Earned and Unearned Incomes. thus balanced. Different persons are made success- ively creditors of the bank for larger or smaller sums. The situation is complicated, but the principle is not changed, when depositors of different banks have business dealings with each other. In this case, which is a decidedly usual one, the banks become successively each other's debtors and creditors and have to settle through a clearing house. Bank A may have accepted and paid cash for, or credited to depositors, many checks on Bank B. Bank B therefore owes Bank A. Similar- ly, Bank C may owe Bank B, etc. All of these complicated obligations are balanced by a clear- ing house, so that each bank pays what it owes net or receives what is owed to it net, and a great deal of flow of money is avoided. In other words, the principle of cancellation is applied whenever possible between banks, just as it is in any one bank to the depositors in it. The general level of prices is somewhat higher and the value of money is somewhat lower, because of the additional use of credit. The conditions of supply and demand require a somewhat higher level of prices, just as we have seen that they do when there is more money. Gold is cheaper. The demand for it is less. It does not need to be produced, and cannot profitably be produced, at such a low margin, i. e. from such unfavorable sources of supply, as would otherwise be worth while. But this bank credit is not altogether an addition to currency; it decreases the amount of gold money, and so is largely a substitution of a cheaper for a dearer currency. The Determination of Value 41 But if bank credit can thus take the place of money, is there any limit to such substitution? Why might not credit expand and prices rise, or money be pushed out, indefinitely? The answer is that the amount of bank credit is pretty definitely related to the amount of money. In the first place, a certain amount of cash is needed in the banks, to maintain confidence. The amount so needed bears a relation to the amount of bank credit, and must be some reasonable per cent of such credit. Otherwise, the public is likely to become frightened and demand cash, and this cash cannot be paid. A margin against such contingencies is always essential and, for national banks of the United States and Federal reserve banks, as well as frequently for State banks, is required by law. So the total bank credit is related to the total bank reserves or cash in the banks.^* Banks main- tain the proper relation between deposits and reserves, by adjusting their rates of interest (or discount) charged to borrowers. If the deposits are in danger of becoming too great, relative to the reserves, a higher charge to borrowers will discourage borrowing, and so will limit the in- crease of those deposits which originate in the borrowing of deposit rights (or in the discounting of notes and acceptances). The total bank credit is related, also, to the total cash in circulation.^^ Bank deposits passed by means of checks are absolutely unavailable for 2* White, Money and Banking, third edition, Boston (Ginn), 1908, p. 197. The reserves required of national banks now have to be kept as deposits in the Federal reserve banks- 25 Fisher, The Purchasing Power of Money, p. 50. 42 Earned and Unearned Incomes. very many transactions. They are unavailable when the maker of a check is unknown, and they are unavailable, practically, for small payments, such as street car fares. Even bank notes cannot fill up the entire circulation when, as is usually the case, the government allows them to be issued only in relatively large denominations. The smaller denominations are needed and government money is used. Business convenience, then, also compels a relationship between the quantity of bank credit and the quantity of government money. Since the quantity of bank credit is related in these two ways to the quantity of government coined and government issued money, changes in the latter tend to bring proportionate changes in the former. It is still true that prices depend upon the quantity of money, though the dependence is in part indirect. The demand for goods comes from those who have bank credit to offer as well as from those who have only money. § 9 Summary We began our study of value by assuming the simplest possible situation in which the principal value-determining forces might work, viz. a place inhabited by a single isolated man. Though in such a situation no exchanges are possible and, therefore, no value, in the sense of power in exchange, is possible, there may nevertheless be comparisons of utility. Such an isolated man may choose to produce one thing instead of another because its utility is greater to him than the The Determination of Value 43 utility of the other, in relation to the time and intensity of labor necessary to produce it. It is likewise true for a person so situated, as for a person in a modern community, that a given unit of any good has less utility according as he possesses many units. If one kind of good has, because he possesses little of it, greater utility to him than another, and is yet no harder to produce, he will devote his attention to producing it instead of the other until the relative utilities are as the relative sacrifices or costs of its production. But this ad- justment may be reached either because the utility of the desired good becomes less as more of it is possessed, or because the labor of producing it becomes greater in proportion when more is wanted, or for both reasons. Some wants will eventually remain unsatisfied because they are not important enough to warrant the sacrifices of production, sacrifices which are likely to grow greater in proportion to the results obtained, as more hours per day are devoted to labor. In a modern community, the relatively large production of the most desired goods is brought about through the influence of desire upon demand and of demand upon the profitableness of supplying these goods. The principle of diminishing utility still applies and each purchaser buys goods desired by him only up to the point where the last unit purchased has a utility equal to the utility of the money which must be paid for it, which will be equal to the utility of the most desired alternative purchase that might have been made with the money. The goods which are generally so desired in quantity that the average purchaser buys much 44 Earned and Unearned Incomes. before their utility becomes as low as the price, are goods which, therefore, it pays to produce in large amounts. Many persons and much land and capital are devoted to producing these goods. In a general way, we can state that producers carry on productive effort up to the point where its discomfort, weariness or disutility balances the satisfaction or utility which is the reward of that effort. But we cannot say that the disutility of productive effort, to the producer, equals the utility of the goods produced, to the consumer. A modern community is made up of specializing units; specialization requires exchange; and ex- change involves a rate or rates of exchange. In other words, exchange involves demand and supply. It is the forces of the market which fix the price of any good at the point where demand and supply are equal. At a lower price, demand would exceed supply and buyers would bid against each other, so raising the price. At a higher price, supply would exceed demand and sellers would bid against each other in order to dispose of the goods. Demand, supply and price have reference to a period of time which may be shorter or longer according as we are concerned with market, seasonal or normal price. Speculative buying and holding for a rise tends to keep up the prices of agricultural products when they first come upon the market and to prevent scarcity and high prices later. The selling of "futures" also tends towards equalization of prices. But speculation by persons inexpert in it may tend to increase price fluctuations instead of to diminish them. The Determination of Value 45 The general average of prices or price level is also determined by demand and supply and largely resolves itself into a relation between the volume of purchasing power in the form of money and bank deposit (checking) accounts on the one hand and the volume of trade on the other hand. CHAPTER II Ultimate Determinants of Value § 1 Supply of One Good Means Demand for Other Goods If our explanation of the determination of value is to approximate completeness, we must not stop with an analysis of the nature of demand and supply, but must bring into view the forces which lie back of each. We shall begin with demand. It was said in the last chapter that desire is not demand. Nevertheless, desire is related to demand as (part) cause to effect. Demand depends upon desire for goods coupled with ability to pay for them. O^her things equal, the greater the desire for any goods, the greater the demand for them. The desire of an isolated man for goods of any kind, expresses itself in his efforts to produce these goods. But where, as in a modern community, there is division of labor, each member of the community specializing in some one line, demand for any good on the part of producers of other things, expresses itself in their production of these other things for a market, in order that they may have the means to purchase what they desire. In effect, though the use of money intervenes, they buy the goods they desire with the goods they produce. If the farmer desires a piano, an automobile, good furniture and various other things, he works longer hours or more intensively and produces more wheat, cotton, corn or beef. (46) Ultimate Determinants of Value 47 Thus the goods of one kind, which he supplies, express and give effect to his demand for other goods. It is this fact which lay back of the contention of the classical economists, that there could be no such thing as a general oversupply, i. e. the supply of a larger amount of all kinds of goods than could be sold. There might be, through mis- calculation of producers, or other cause, an over- supply of one or a few kinds of goods compared to other goods. But this simply meant that the producers of the goods supplied in excess, say cotton, had plenty of those goods with which to purchase other goods. They had produced what, they believed, would be satisfactory means of payment for the goods desired. That is, they had intended to produce marketable goods. They had mistakenly produced too much of one thing (or a few things). But to assume that nothing they could have produced would have been accept- able to those with whom they traded, would be to assume that the latter had no wants remaining un- satisfied, for the satisfaction of which they were willing to pay. But if, in our system of division of labor, these latter, the purchasers of cotton, have produced any goods, it must be because they desire and, therefore, have a demand for, other goods, such as cotton. Though they do not desire (and, except at low prices, will not take) all of the cotton which has been too freely produced, they do desire other goods and have produced the wherewithal to pay for them. In other words, people produce goods in modern society chiefly as a means of getting other goods. Production of 48 Earned and Unearned Incomes. goods by a person who intends to sell them es- tablishes a strong presumption that he wants something else, that his wants are not satisfied. What he wants to buy may be factories, railroad shares, office buildings and tenements, but it is pretty certain that he wants to buy something. If he puts his money into a savings bank, the situation remains the same, for he merely makes the bank his agent. The bank invests, i. e. buys, for account of its depositors. General overproduction would mean, then, a more or less universal production of goods for sale, by persons who did not want other goods in exchange for the goods sold. It would mean a desire to sell goods but no corresponding desire to buy goods. Since, in general, men sell only that they may buy, such a situation as a general phenomenon is almost unthinkable. It may seem to exist temporarily, and for special reasons, during a panic and business disorganiza- tion, but it is very far from being a normal condi- tion of economic life; nor can general oversupply, though seeming to exist during such a business breakdown because merchants and manufacturers are afraid to buy the usual amounts of goods, raw material and machinery, be put forth as a cause of the breakdown. In fact, the refusal of dealers and manufacturers to buy does cause it to appear that there is a surplus of goods, discourages manufacturers of those goods, throws men out of work, deprives these men of the means of purchasing, and so accentuates the appearance of superfluity. But the condition is one of industrial breakdown rather than of too efficient industrial Ultimate Determinants of Value 49 functioning.^ Provided our economic machinery ^ Professor Davenport says {Economics of Enterprise, New York — Macmillan — , 1913, p. 362) that in a time of depression "goods are offering against present money, while money is offering only against promises to pay in later goods or in later money with which presumably to command later goods. . . . The offers of present goods are not for present goods, and the offers of present money are not offers for present goods." In other words, everybody seems anx- ious to sell for money and relatively few seem anxious to spend money. To this one might reply that, although it seems to picture fairly well the situation during depression, yet the difficulty is that sellers of goods, despite apparent eagerness to sell, are nevertheless asking prices higher in money than buyers are willing to give, and that a revaluation of their goods by sellers, on a lower basis, would en- able them to be sold. Professor Davenport contends, to be sure (ibid, p. 303), that falling prices may not terminate the glut, since if the purchasing power of money over present goods is thus rising, "so also is rising its putative future purchasing power." But this can hardly be true without limit. At some degree of lowness of prices, purchasers of goods must realize that a better time to buy can hardly be expected to arrive. There must be a scale of prices at which, could it be generally accepted, goods would exchange freely, not reluctantly, for other goods through the medium of money. Indeed, Professor Davenport goes on to mention such considera- tions by way of accounting for the eventual revival from depres- sion. But be this as it may, assuming, for example, that all persons who have money are unwilling to spend it at any set of prices of goods, while all holders of goods are anxious to dispose of them for money on any terms, does it not still follow that all who have or produce goods for sale are demanders of other goods? In the assumed case, they are demanders of money; and this means, in effect, in a gold standard country, that they are demanders of gold. Temporarily, at least, the value of gold — or other primary-money commodity — is raised. Could such a condition continue, it would stimulate the production of gold and lead to the employment of more men to find and to work gold deposits. So far from there be- ing an all-round oversupply of goods, we could say with truth that 50 Eaened and Unearned Incomes. works smoothly, we need not fear a superfluity of goods, and when we appear to have such super- fluity, the real difficulty is to be sought elsewhere. § 2 Influences Back of Demand Intensity of demand for goods shows itself, as has been above stated, in intensity of effort devoted to producing other goods with which to buy them. But intensity of demand for any one kind (or a few kinds) of goods, may show itself also in a smaller consumption of other kinds, and in using most of one's available purchasing power to buy the goods most wanted. In other words, our estimates of relative utility inevitably involve not one but two comparisons or sets of comparisons. We must compare the utility of goods desired with the cost of the goods in terms of what we produce to pay for them and, therefore, in terms of the dis- utility (of effort and other sacrifice) involved in producing the latter goods. We must also compare the utility of any special goods desired, with the there was a relative undersupply of gold. Perhaps it is better, in view of the above complex of considerations, not to assert absolutely that all-round overproduction is impossible. During depression there is a condition which often seems like all-round oversupply, or prac- tically that. And it is of too temporary a nature, perhaps, to war- rant a shift of surplus labor to gold production even if that were in less degree than is the case on aleatory industry. Of course, also, where the currency is of the fiat order a temporary apparent re- lative undersupply of it, of the kind here in question, could not give opportunity for much employment of idle labor in producing it. But that the difficulty, in its origin, is always one of maladjustment rather than of too much production everywhere, should be clear. Ultimate Determinants of Value 51 utility of other goods which might be purchased instead but which, because our earning power is not unlimited, may have to be sacrificed if the special goods most wanted are bought. To illustrate, a farmer's desire for a piano may cause him to work longer hours and cultivate his farm more intensively, in order to produce the extra amount of wheat necessary for purchasing the piano without greatly sacrificing his other needs. His sacrifice takes then the form of the extra effort required to earn the requisite money. On the other hand, his desire for the piano may, conceivably, cause him to work no harder but may induce him to give up owning an automobile. In that case, his sacrifice takes a different form, but may be regarded as none the less a sacrifice. The same principle applies to anything which one may purchase, — coal, shoes, sugar, etc. We have already seen^ that as a person has more and more units of any article, the utility or desirability of additional units declines. A pound of sugar, to a man who could never have but a single pound, would be highly prized. A second pound would be somewhat less desired but would yet have high utility. But to a man who regularly consumes 75 pounds of sugar a year, one pound more or less is of relative unimportance. In the case of some goods, utility would diminish rapidly as the amount owned increased. In the case of other goods, utility would diminish slowly. In any case, a person desiring the goods would purchase them up to the point where the last unit secured 2 Chapter I, §i. 52 Earned and Unearned Incomes. was just equal, in his mind, to the price paid. The purchaser of sugar would buy each year or each month such an amount that the last pound pur- chased would just about seem worth while getting at the price. The purchaser of coal would buy, each winter, such a number of tons that the last ton would just about seem worth the price paid. If the price were lower he might luxuriate in more heat. If it were much higher, he might endeavor to get along with one less heated room. The last ton purchased would just about seem to be the equivalent, in utility, of the money spent for it or (since money has utility only for what it can buy) of the other goods which could have been secured with the price of that ton but which are sacrificed in order to get the coal. This last ton, being just equal in utility to the money neces- sary for its purchase, would just compensate for the disutility (labor or other sacrifice) involved in earning that last addition to the year's income. This statement remains true in principle even when the assumed purchaser of goods finds labor a constant delight. For such labor still involves a sacrifice of sleep, or leisure or reflection, which may be no less or even more delightful to him. As to the person who gets all or nearly all his income from property, it can hardly be said that the last hour's work has any disutility at all. But, even so, goods may still be valued in terms of other goods foregone.'' The last ton of coal purchased is called the marginal purchase, its utility, marginal utility, the effort or other sacri- 5 See Davenport, Economics of Enterprise, p. 93. Ultimate Determinants of Value 53 fice necessary to earn that much more (e. g. the last and, therefore, hardest or most disagreeable hour's work, if work must be undergone) is the marginal effort or sacrifice, and its disutility is the marginal disutility. At the point where the coal ■ purchasing stops, the marginal utility of coal is just equal to the marginal utility of money or of the goods other than coal for which the money might be spent and, if the money had to be earned, is just about equal* to the marginal disutility ot earning that money. We may now restate the relation of demand to price, pointing out that demand rises as price falls and that this is true partly because a fall of price induces some to be purchasers who would not buy at a high price, and partly because those who would buy at a high price will buy more if price be lower. A further statement may be made, which has to do with both demand and supply. A great rise in the price of (say) wheat, would tend to de- crease the demand for wheat by persons producing other goods to get it, partly because it would induce some to give up producing the means of purchasing wheat and to produce, instead, the wheat itself. On the other hand, a great decrease in the price of wheat (resulting, perhaps, from the invention of better harvesting machinery and from improved methods of soil enrichment^), would tend to in- * Not necessarily exactly equal since the money may be earned at one time and spent at a later time, and since, therefore, its utility may be different from its estimated utility. 5 These improvements, other things equal, mean that fewer are required to produce wheat, and, therefore, unless some change 54 Earned and Unearned Incomes. crease the demand for it by causing some who had been producers of wheat, to produce other things and therewith buy wheat. Otherwise putting the matter, we may say that the amount which would be paid for wheat in terms of other goods, is roughly limited (if we have long periods and possible change of occupation, in view) to the amount of other goods which could be produced with the same (marginal) sacrifice as the wheat. A price of wheat so high that it is much more difficult to get the wheat desired, by producing other goods with which to buy it, than to produce the wheat itself, would mean a smaller demand for wheat,^ and demand and supply would only be equalized, in the long run, by a shifting of a part of the community's producing power into their occupation, prices will fall so far as to make wheat production relatively unprofitable. That is, prices will fall more than the im- provement in methods can permanently justify. * Unless we think of wheat producers as being demanders of wheat, directly or indirectly, from themselves. Considered as a group, however, the producers of wheat and wheat products are suppliers of wheat to the rest of the community. The part of the product that they themselves consume, they cannot be said (as a group) to demand, in the sense of buying it with other goods. Hence, if other producers are pushed or drawn into wheat produc- tion, because of high wheat prices, the demand for wheat may be said to be smaller. In a more detailed, and, therefore, perhaps, less philosophical sense, producers of wheat may be said to demand wheat, indirectly, if they sell their wheat and buy wheat flour. Their demand for the flour from the millers is, indirectly, a demand for wheat since it occasions demand for wheat by the millers. In this sense, the wheat producers may, often, literally buy back their own wheat. It is possible, in short, to conceive of the wheat consumed by the wheat producers themselves as entering into neither demand nor supply, or to conceive of it as entering into both. Ultimate Determinants op Value. 55 wheat production. There is a very real sense, then, in which the demand for an article, and the amount which consumers will pay for it, depends upon its cost of production. They will not, in the long run, pay more for it than the amount of other goods which the same sacrifice will produce. Normal or long run demand may therefore be said to depend on the (marginal) utility of the goods demanded, on the (marginal) utility of the other goods which will have to be sacrificed if these are enjoyed, on the (marginal) disutility or sacrifice of producing the goods necessary to pay for the desired goods, and, by way of comparison,^ on the disutility or sacrifice necessary to produce, instead of buying, the goods desired. Cost of production has often been spoken of as if it influenced only supply of goods and not demand. But this, if the position here taken can be justified, is not consistent with a broad philosoph- ical view of the phenomena in question. Conditions of cost influence demand no less than supply,^ even though their influence on demand is not obvious without a philosophical analysis of economic relations. This point has importance in the distinction between goods which have and goods which have not any cost of production, i. e. between goods which are reproducible and goods which are almost or absolutely fixed in quantity. Ordinary commodi- ' A similar comparison, amounting to the same thing, would be one of the utility of the desired goods compared with the utility of other goods producible at the same sacrifice. 8 If economists dislike this contention, they must, it would seem, abandon the traditional definitions of demand and supply- 56 Earned and Unearned Incomes. ties are in the first class. Land space is in the second class. The demand for ordinary commodities depends not only upon their utility, but in part, as we have seen, upon their cost of production, for the majority of people will not long pay for any good more than this cost, i. e. more than the amount of other goods which the same effort, etc., would produce.' But the demand for land space depends (assuming any given prices) solely on its utility, for it has no cost of production.^" At any set of prices for the different pieces of land in a community, the demand would be almost totally unaffected by any possibility of producing the desired land instead of buying it, for, on the whole, and with a few exceptions of made land, there is no such possibility.^^ Buyers of land would purchase it up to the point where its utility, for their purposes, equalled its price. At a low set of prices, more land would be bought than at higher ' The above statement is made in general terms and must be taken by the critical reader with the qualifications already made in this and the previous chapter as to difference of cost to different producers, marginal cost, and dependence of this cost on amount produced. But the statement as here made is sufficiently accurate for the purpose in hand. 1" Though improvements on it, of course, do have. But such improvements are to be sharply separated in thought from the land itself. ^1 It is not the intention to suggest that the buyer or renter of land space has no alternative- He may use a smaller piece of land more intensively instead of a larger piece less intensively. Thus, he may put a tvpenty-story building on a small area instead of put- ting a ten-story building on a larger area. He may choose a poorer site instead of a better one. But the buyer or renter of capital has alternatives of these kinds and has in addition the alternative of becoming himself a producer of th? sort of capital vpanted. Ultimate Determinants op Value. 57 prices. But if the land were sufficiently desired by purchasers, to make the prices high, their demand would not be likely to be limited by any alternative of shifting their industry and becoming producers of land. To an extent, land fertility can be produced by human effort but, practically speaking, land space cannot be. § 3 Influences Back of Supply Let us now analyze the supply side of the market in the same way. The supply of any good, e. g. cotton, depends, first, on the price that can be real- ized for it, per pound, i. e. ultimately on the amount of other desired goods obtainable in exchange for the cotton. A higher price would encourage larger production. Second, the supply of cotton depends upon the intensity of desire for these other goods securable in exchange by the producers of cotton. Supposing the intensity of desire for these goods on the part of cotton producers to be very great, they would produce large amounts of cotton with which to buy these other goods. Assuming their desire for other goods to be weak and easily satis- fied, they would care less to produce large amounts of cotton with which to buy these other goods. If the producers of cotton and of the other goods for which it is given are alike members of a single homogeneous population, able to change easily in large groups, from one occupation to another, the intense or weak demand of cotton producers for other goods will indicate an intense or weak de- mand in the whole community for goods in general. 58 Earned and Unearned Incomes. probably including cotton, and may not imply any special effect on the value of cotton in relation to other goods. But if, as is the case, cotton is only producible in certain climates, and if those who live and work in those climates are persons whose wants are slight and easily satisfied, the effect on the supply of cotton may be important. In trade between highly civilized countries on the one hand and primitive peoples on the other, the lack of de- sire upon the part of the latter for anything beyond a few simple necessaries of life, tends (assuming their labor to be wholly voluntary) to restrict the supply of the goods they produce and so to raise the prices of such goods. This result will not fol- low, of course, if the goods in question can be cheaply produced in the civilized country. Third, the supply of cotton may depend upon the disutility of producing it, i. e. the unpleasantness or difficulty of or disinclination to do the work or make the accumulations of capital used in pro- ducing the cotton. Thus, if exhaustion of the soil should increase the labor per pound of produc- ing cotton, this would discourage its production and, if only the same price as before could be se- cured, less and perhaps much less cotton would be produced than before. On the other hand, should improvements in machinery and in methods of soil culture make the labor cost per pound of cotton less than before, the production of cotton would be encouraged and, at the same price, a larger amount of cotton than before would be produced and sold. Summarizing our conclusions thus far and re- stating them, we may say that producers of cotton Ultimate Determinants of Value. 59 will supply it up to the point where the (marginal) disutility to them of producing it is just balanced by the (marginal) utility to them of the goods which they get in exchange. But in presenting the above considerations, we have failed to emphasize an influence to which the greatest importance should be attributed. This is the influence exerted by comparison, in the minds of producers, of the various ways of getting what they want as consumers. Thus, the producers of cotton are producing it, in large part, as the most effective way, for them, of securing wheat, bacon, sugar, etc. Should the price of cotton greatly fall or of these other things greatly rise, so that the produce of a year's labor in cotton raising would purchase much less than before of these other things, some of the cotton producers (or persons who would have become such), might instead turn their efforts to other lines, to producing goods other than cotton, which they could more profit- ably exchange for the various goods they desired, or to producing, themselves, some of these desired goods instead of buying them with cotton. We may, indeed, regard the cost of production of cotton as being the amount of other goods, of one and another sort, which the same effort and self denial would produce and the production of which the cotton raisers forego when they raise cotton. Assuming the possibility of an easy shifting of occupations, they will not care to produce cotton if they have to dispose of it for much less than that amount of other goods which the same effort and sacrifice would produce. To say that they must take less than this, is to say that some other 60 Earned and Unearned Incomes. line (or lines) of production is (or are) more profitable than cotton raising, and such a condition would tend to decrease the supply of cotton.^^ On the supply side then, as on the demand side of the market, in the case of any goods, the cost of production is an important consideration, cost of production being understood to mean the amount of other goods which the same effort and sacrifice would produce. Purchasers do not wish to pay more than this cost of production and will, in large part, change their occupations and cease to appear on the demand side of the market, if they do have to pay more. Sellers do not wish to take less than this cost of production and will, in large part, change their occupations, and cease to appear on the supply side of the market if they do have to take less. It need not surprise us that demand and supply are thus both so closely related to cost in the sense of the word here used. Let us remember that those who demand one kind or several kinds of goods, supply other goods, and that those who supply one kind of goods demand other kinds. The demander is a supplier and vice versa. Every person is at the same time a buyer of some things and a seller of other things. And every person, in a modem society based on indus- trial freedom, has the alternative of becoming a buyer of what he now sells and a seller of what 12 Another way to put the same thought is to say that the supply of cotton would decrease if the producers of it have to expend more effort and sacrifice in producing cotton as a means of paying for other desired goods, than would be required to produce these goods direct or to produce something other than cotton with which to buy them. Ultimate Determinants of Value. 61 he now buys. In fact, every industrial unit has many alternatives and all of them are determining conditions of his action as an economic unit in industrial society.^^ When buyers, taking them as a whole, refuse, in the long run, to pay for a good more than its cost of production, and when sellers, taking them as a whole, refuse, in the long run, to accept less, both groups are influenced, not only by their available alternatives of varying their consumption in amount or in proportions and of varying the intensity or degree of their pro- ductive efforts and other sacrifices, but also, and, for many economic problems, most importantly, by their alternative of shifting their fields of in- dustrial activity.^* On the supply side, as on the demand side, it is worth while emphasing the distinction between goods producible in indefinite amounts, in relation 13 Cf. Professor H. J. Davenport's discussion in his Economics of Enterprise, Chapter VI. 1* There is here no intention to deny, of course, that ar. individual concern can afford to charge a lovcer price if it can fully utilize its plant than if it is unable to secure business enough to utilize its plant to anything like full capacity. Such a concern might, there- fore, be willing to sell a larger amount of goods for as low a price as that for vyhich it would sell a smaller amount. Where the size of plant of maximum efficiency is large enough to supply the entire market for any article or service (e. g. electric light in a city), monopoly production is likely to be the cheapest. (For a fuller discussion of the conditions fixing the rates charged by a company whose facilities are not completely utilized, see the author's Principles of Commerce, New York — Macmillan — , 1916, Part III, Chapter I, §6 of Chapter II, and § i of Chapter III.) But it should be clear enough that where an increase of output is dependent upon the construction and maintenance of several plants, a higher price is more likely to increase supply than a lower price. 62 Earned and Unearned Incomes. to the world's need of them, such as wheat, corn, cotton, iron ore; and goods more or less fixed in quantity, such as original Greek statuary, the paintings of Michael Angelo, and, chief in impor- tance, land. It is true that producers of wheat, com and cotton will not engage in the production of these crops at a price below cost (in the sense and on the hypotheses herein set forth). But the sellers of land space do not have cost of pro- duction to consider, because land space practically speaking (though there is some "made land") can not be produced. The owners of land space there- fore, in selling it, consider only the utility to them of what they can get for it compared to the utility to them of the land. The producer of cotton, also, after he has produced it, considers only the utility of what he can get for it compared to the utility to him of the cotton — if he has any way of using it all. But cotton is constantly being used up and requiring to be resupplied and before producing it, the cotton farmer most certainly will consider its cost of production, nor will he go on, year after year, raising cotton for less than this. § 4 Labor Costs in Production Having made the foregoing general analysis of cost of production and its influence on de- mand and supply, we have now to enter into some of the more detailed aspects of cost. A larger supply of any good (assuming no im- provements in methods of production) involves Ultimate Determinants op Value. 63 either more labor by those already engaged in producing it or a larger number of such pro- ducers. Neither can ordinarily be had without higher price as an inducement. Let us first con- sider the possibilities as regards getting more goods of a given sort by engaging more per- sons for their production. In much of our pre- vious discussion, we have seemed to assume that the tendency, so far as change of employ- ment is easy, is for returns to workers to be about the same in one line of activity as in another, in proportion to effort and other sacri- fices. But we have not emphasized the fact that a given line of activity may seem much harder, much more distasteful, to some men than to other men. This fact may sometimes have an important influence on price. By way of illustration, let us suppose a change in occupations abroad of such a sort that far more American wheat was wanted than before, and this not temporarily owing to war condi- tions but more or less constantly. For a while this want might be very inadequately satisfied, but should the demand and the resultant high price continue, larger acreage in the United States would be sown to wheat, and a larger proportion of the American population would devote themselves to wheat production. Of those who changed from other lines into agri- culture, some would be persons with no train- ing for the work and others persons with com- paratively little taste for it. To make the large production continuous, the price of wheat must remain high enough to keep these persons in 64 Earned and Unearned Incomes. the work. After a period of a generation or two, new tastes and habits would have time to form, and a larger number of men than before might be willing to engage permanently in agriculture without much extra inducement. But during a short period, though a period of some years, a considerable inducement to wheat production, in the form of high prices, might be necessary. There is, however, in addition, the possibil- ity of securing more goods of a given sort, e. g. wheat, by getting those already engaged in its production, to work more intensively or to work longer hours. But additional hours of labor become progressively more and more a burden and there is a progressive disinclina- tion to perform such labor. At first thought we might suppose that a higher rate of pay per hour would encourage working longer hours, that a higher price of wheat, for instance, would cause persons already engaged in wheat production to work longer hours and thus pro- duce more wheat. But it is perhaps equallj- likely that the larger returns per hour, result- ing in greater prosperity, would make the long- er hours of labor seem less necessary as a means of getting a living^^ and would encourage the taking of more leisure. So there is no cer- tainty that a higher price would in that waj- add to the supply even temporarily. So far as agriculturists could change from other lines to 15 Cf. Jevons, The Theory of Political Economy, fourth edition, London (Macmillan), 1911, pp. 179-183. Ultimate Determinants op Value. 65 the production of wheat, a rise in wheat prices might induce them to do so, and event- ually it would bring more men into agriculture; but it very likely would not increase the in- tensity or the hours of labor and it might, conceivably, even decrease them. It does not follow that a lower price would cause more wheat to be produced than a higher. For though smaller returns from wheat and other farm products might necessitate somewhat more work to make a living, if agriculturists had no alternative, yet, as things are, lower returns than in other lines would divert many into these other lines and so almost of necessity decrease the supply of agricultural produce,^" just as higher returns would draw more men 1* Even if a lower price, c. g. for wheat, would actually bring a larger supply than a higher price — as it might if wheat producers were unable to change their occupation and simply had to work harder for a living — price would still be determined at the point where demand and supply were equal and, probably, there would be only one such point. Any other price would mean a position of unstable equilibrium and could not continue. The high price, though it might, on the present hypothesis, limit supply, would be likely to limit demand still more. The low price, though it might increase the supply, would presumably still more increase the de- mand. Competition would therefore operate to fix price at the point of equality. We are not here dealing with a supply which, at any price, is a certain amount or indefinitely more (see Fisher, Elementary Principles of Economics, New York — Macmillan — , 1912, pp. 317, 324) but with a supply which, though it increases as price falls, increases, for each lower price, only up to a certain limit. Some point of equilibrium there must be, unless we suppose supply to increase as price falls, and to decrease as price rises, more rapidly than demand ; and that, therefore, demand exceeds supply at the higher prices, and falls short of it at the lower, 66 Earned and Unearned Incomes. into wheat raising and increase the number of bushels produced. § 5 Land and Capital Costs in Production We have seen that to get a larger supply of any good may be expected, ordinarily, to require a larger amount of labor. Attention should now be called to the fact that it requires the use of more land or a more intensive application of labor and capital to land already used for the line of production in question, or both. Suppose, as before, that there is desired the production of wheat. Assuming other things to be equal, more wheat can not be produced unless the land already devoted to wheat pro- duction is cultivated more intensively, unless additional land not previously cultivated is brought under cultivation, or unless land pre- viously used for other purposes is diverted to the production of wheat. To get larger wheat production in any of these ways, requires a higher price. Assume that the price has been $1 a bushel. At that price the average producer will cultivate his land with whatever degree of intensiveness yields the greatest gain. He will increase the amount of labor devoted to cul- tivating his wheat land, as long as the wheat yielded pays the wages of this labor and a satis- factory return on the necessary capital. But the point is soon reached beyond which ad- ditional labor can not, without spreading over more land, produce wheat enough to cover Ultimate Determinants op Value. 67 the requisite wages. For it is impossible, on a given piece of land, indefinitely to increase the amount of labor and get a proportionately increased product. This fact is, of course, general- ly known to farmers, and, in its applications to urban land, is known to merchants and manufac- turers also. But if wheat sells for $1.20 a bushel, and money wages remain the same, or even advance somewhat,^' it may be profitable to cultivate a given piece of land more intensively than other- wise would pay. An additional man may be hired and, though the amount of wheat produced probably will not increase in anything like the same per cent as the labor, the increase, at the new and higher price, will be more likely to cover the additional wages paid and to yield some profit, than it would at the lower price. But the point to be emphasized is that, other things equal, it will not pay thus to cultivate the land more intensively unless the price to be received is higher. The higher price is a necessary means of bringing out the larger supply. The same principle applies to urban land. To increase the amount of manufacturing or of retail trading on a given area, necessitates more crowded quarters or else higher buildings, and the higher buildings are made the more solid must be their foundations. In other words, a point is eventually 1' To the objection that we have assumed wages virtually to fall since we assume wheat prices to rise in a greater degree than wages, the answer may be made that, if the prices of other goods do not rise at all, wages need not rise as far as does wheat in order that wage earners should be able to enjoy a larger amount of goods-in-general than before- 68 Earned and Unearned Incomes. reached where additional stories, and, therefore, additional production on the same land space, yields a less reward than would smaller production, proportionate to the labor (including the labor of building) expended. If all land had exactly the same capacities and advantages, an additional demand for wheat would not for any great length of time cause wheat land to be cultivated any more intensively than before, as compared with land used for other purposes. It would always be more profit- able, if a larger amount of wheat were wanted, to divert land from the production of other goods into the production of wheat. But in fact, land has not all the same capacities. Hence there would be some loss in turning into wheat produc- tion land previously used to produce (say) corn. The corn land is farther south, on an average; and rather than get all the extra wheat desired, by diverting former corn land into wheat production, it may be desirable to get part of it Dy cultivating more intensively the land already devoted to wheat raising. But it is also true that an additi