CHAPTER II
SUPPLY AND DEMAND, AND THE VALUE OF MONEY
The theory of the value of money is a special case of the general theory of economic value. To the layman, this would seem to go without saying. To the student of the literature of the subject, however, who has noticed the wide divergence between the method of approach to the general problem of value and the method of approach to the problem of the value of money, in most treatises which include both these topics, the proposition will sound unusual if not heretical. Most text-books in English to-day will offer the marginal utility theory as the general theory of value. The same books commonly present the quantity theory of the value of money. Whether or not the two theories are consistent may wait for later discussion, but that the quantity theory of money is a deduction from the utility theory of value, and a special case of the utility theory of value, will not, I believe, be contended by anyone. Certainly in its origin, the quantity theory is much the older theory. The same is true for those writers who seek to explain value in general on the basis of cost of production, and who at the same time offer the quantity theory to explain the value of money. The two theories may or may not be consistent, but in any case, they are logically and historically independent, neither being a deduction from the other. Older writers (as Walker and Mill), whose treatment of the general theory of value runs in terms of "supply and demand," have stated that the quantity theory is merely a special case of the law of supply and demand, and the statement is occasionally met in present-day writings, though one of the most recent and best known of the expositions of the quantity theory, Professor Fisher's Purchasing Power of Money, very explicitly repudiates this doctrine.[41] But it may be easily shown, and will be shown later, that the quantity theory, and the present-day formulation of the law of supply and demand, are in no way logically dependent upon each other. This lack of connection between two bodies of doctrine which should be in a most intimate and essential way related to each other, may well throw suspicion on the current treatments of both topics. In any case the lack of connection raises a problem, and calls for explanation.
Part of the explanation may be sought in the fact that the writers who have developed the general theory of value have not been, in general, the writers who have most elaborated the theory of the value of money. The theory of money has been for a long time a more or less isolated discipline. In Ricardo, we have an elaboration of the labor theory of value, and we also have the quantity theory of money. But it is not clear that Ricardo added anything to the quantity theory. He found it, in much the form in which he used it, in the writings of predecessors, among them Locke and Hume. Ricardo makes large use of the quantity theory as a premise, but apparently feels the theory to be so self-evident that it needs little exposition or defence at his hands. John Stuart Mill is a clear exception to the general statement. Cairnes, likewise, did treat both topics in considerable detail, but while his interest in the general theory of value was that of the theorist, his treatment of money was primarily in the spirit of the publicist, and his interest was less in the justification of the theory—which he again seems to feel needs little defence—as in its application. A similar statement may be made with reference to Jevons. He worked out his general theory of value for its own sake; his utterances on the theory of the value of money must be sought scattered through his practical writings on money. Alfred Marshall's Principles (Vol. I) says almost nothing about the theory of money; his opinions on that subject are to be found in some ex cathedra replies to questions from a Parliamentary Commission. The most important discussions in England of the value of money are to be found in the long polemic between the Currency and the Banking Schools, by writers who would not be listed among the makers of the general theory of value. In the United States to-day, with the exceptions of Professors Fisher and Taussig, the writers who have been interested in the general field of economic theory have done comparatively little with the value of money (e. g., Professors Clark and Fetter), and the writers who have been most interested in the value of money have usually not written largely on the general theory of value (e. g., Professors Laughlin, Scott, Kinley). Professor Kemmerer might well be included as an illustration of this last statement. His primary interest is in money, rather than general theory, even though he does precede his theory of the value of money with an exposition of the utility theory of value. In German, a similar situation obtains. Böhm-Bawerk has touched the theory of money scarcely at all. Menger has written an important article on "Geld" in the Handwörterbuch der Staatswissenschaften, but the important thing about this article is the theory of the origin of money, and the reader will find little on the problem of the value of money. Wieser has recently taken up the value of money (in articles published in 1904 and 1909), but no trace of his views has as yet manifested itself in the English literature on money, and the writer may here express the opinion that Wieser's contributions to the theory of money are not likely to be very influential, or to add to his reputation.[42] Austrian writers on the value of money, as Wieser and von Mises, have recognized more clearly than anyone in America or England, the essential dependence of the theory of the value of money on the general theory of value. The German writer on money who has attracted most attention recently, however, G. F. Knapp, troubles himself about the general theory of value not at all.
But the main explanation of the hiatus between the two bodies of literature and doctrine is to be sought in something more fundamental. Neither utility nor costs nor supply and demand furnishes an adequate basis from which the quantity theory, or any other theory of the value of money can be deduced. The cost theory, and the supply and demand theory, in their present-day formulation, are really not theories of value at all, but are theories of prices, theories which presuppose value, and money, and a fixed value of money. And the utility theory, as usually presented, is either a theory of barter relations, or else (more commonly) speedily settles down into the grooves of supply and demand, leaping by means of a confusion of utility curves and demand-curves (or sometimes by a deliberate identification of them, e. g., Flux and Taussig[43]) to the treatment of market prices. I shall take up these points in order.
A historical summary of the development of the notions of supply and demand will aid the exposition. It may be noticed, first of all, that supply and demand is really a very superficial formula even though an exceedingly useful one. By virtue of its superficial character, it antagonizes few other theories, and it has been the common property of almost all schools of value theory. Cost theories and utility theories, labor theories, or social value theories, all find use for it, in one form or another. It is really quite neutral and colorless, so far as the ultimate questions of value-causation are concerned. The more fundamental causal factors offered by one theory or another are commonly supposed to operate through supply or demand, in price-determination. Adam Smith seems to see this more clearly than does Ricardo. Ricardo, indeed, sometimes thought of demand and supply as forces antithetical to the forces of labor-costs which he was considering. In ch. xxx of his Principles of Political Economy and Taxation (ed. McCulloch, pp. 232ff.) he holds that his natural value ultimately rules, except (p. 234) in the case of monopolized articles. Supply and demand govern the prices of monopolized articles and of all articles in the short run. I do not find in Ricardo any clear statement to the effect that cost of production operates through influence on supply. Neither Adam Smith nor Ricardo felt the need of very much precision in the definition of supply and demand. Smith does, indeed, distinguish "effectual" from "absolute" demand, in a well-known passage (ed. Cannan, I, p. 58), defining effectual demand as the demand of the effectual demanders, i. e., these who are willing to pay the "natural price" of the commodity. The term "supply" he does not use in this passage, but speaks of the "quantity which is actually brought to market," and gives as the law of market price that it is determined by the "proportion" between this quantity and the effectual demand. That much is wanting in this analysis will be sufficiently clear when the views of J. S. Mill and Cairnes are considered. Ricardo offers even less than Smith in the way of definition. The reader may compare the pages in Ricardo's Works cited above, and the discussion of the demand for labor on p. 241 in the same volume.
In J.S. Mill, a clean-cut notion first appears. The doctrine that price is determined by a ratio between effectual demand (i. e., the wish to possess combined with the power to purchase) and supply (i. e., the quantity available in the market), is sharply criticised. How have a ratio between two things not of the same denomination? "What ratio can there be between a quantity and a desire, or even a desire combined with a power?" To make supply and demand comparable, demand must be defined as "quantity demanded," and then the difficulty arises that the quantity demanded will vary with the price, which seems to present a case of circular reasoning if demand is to be a determinant of price. The solution which Mill develops for this difficulty really gives us our modern conception, virtually complete except that Mill does not present it in the useful diagrammatic form and does not whisper the magic word, "margin." There is a demand-schedule, which, plotted, would give a demand-curve. At such and such prices, such and such quantities are demanded, or will be purchased. There is a supply schedule, presenting a supply situation of similar character (though not so clearly indicated). The price reached is that price which equalizes amount demanded and amount supplied. A higher price will lead to competition among sellers, forcing down the price, a lower price will lead to competition among buyers, forcing up the price. The notion of a ratio between supply and demand is replaced by the notion of an equation between them. The present writer wishes to remark, in this connection, that Böhm-Bawerk's elaborate analysis, with his "marginal pairs," etc., has not advanced one step beyond this conception of Mill's, that it is really less satisfactory than Mill's analysis, because of the impedimenta of pseudo-psychology it has to carry, and because of its confusion of utility schedules with demand schedules.[44] In our present-day expositions, as presented in the diagrams, we are accustomed to say that price is fixed when marginal supply-price and marginal demand-price are equal, putting the stress on the ordinate, rather than on the abscissa, on the identity of the dollars paid or received, rather than on the identity of the goods given or received. But this is merely another way of stating the same equilibrium which Mill perceived—when marginal demand and supply prices are equal, amount supplied and amount demanded will be equal, and conversely.
One point is to be added, making explicit what is implicit in the modern theory of supply and demand. Supply and demand doctrine assumes money, and a fixed value of money. That there should be a given schedule of money-prices for varying quantities of a good, is possible only if there be a given value of the money-unit.