That the modern doctrine of supply and demand necessarily involves the assumptions of value, of money, and of a fixed value of money, may be proved by the following considerations:
Supply-situation, represented by the supply-curve, and demand-situation, represented by the demand-curve, are conceived of as antithetical and independent causal forces, whose equilibrium determines both "supply and demand" (in the sense of quantities supplied and demanded) and price. Mill's doctrine that supply and demand determine price gets out of the circle that demand (amount demanded) is itself dependent on price, only by making both demand in this sense and price results, rather than causes, and by putting the causation back into the more complex factors which I call "supply-situation" and "demand-situation." The two independent causes, then, are summed up in the supply-curve and the demand-curve. But, first, these curves are expressed in money. And second, a change in the value of money would affect both of them proportionately. But a theory which is concerned with supply and demand as independent and antithetical must abstract from factors which give them a common movement, without modifying their relation to each other. A change in the value of money would lead the supply-curve to move to the right, and the demand-curve to move to the left, the change in each being proportionate, and the amount supplied, and amount demanded, would remain unchanged. Changes in the value of money must, therefore, be abstracted from.
Again, we must precise the notion of an increase in demand, or of supply. Increase in demand may mean mere increase in amount demanded, consequent upon a lower price, consequent, i. e., upon a lowering of the supply schedule. In this sense, increase in demand is a passive fact, a result rather than a cause. On the other hand, if the increase in demand is an increase in the amount demanded at the same price, if it means a change in the demand-situation, represented by the moving to the right of the demand-curve, we have a causal factor in increase in demand, a factor which raises the price and compels new supply to come into the market. We may distinguish these two meanings as increase in demand in the active and in the passive senses. Mutatis mutandis, we may speak of increase of supply in the active and passive senses. These distinctions have been made before, but it has not been clearly seen that these distinctions, and the connected doctrines, involve the assumption of a fixed value of money. But consider: it is the current doctrine that increase in demand in the active sense, the demanding of a greater amount at the same price, the moving of the demand-curve to the right, not only raises the price, but also tends to increase the supply. But this is true only if the cause of the increase in demand is not a cause which simultaneously works on supply, neutralizing that tendency. If the increase in amount demanded at a given price be due to a lowered value of money, then the same lowered value of money will reduce the supply available at that price pro tanto, and the new equilibrium, cæteris paribus, will be at a higher price, to be sure, but with the same amount supplied and demanded. "Demand" is a term which carries the connotation of motivating power in economic theory. Through demand run the forces which regulate production and supply. The function of increased demand is to induce increased supply. But the value concept, and the assumption of a fixed value of money, are needed to preserve this part of the doctrine. Without them we have no way of distinguishing a real increase in demand in the active sense, which does modify the adjustments in production, and alter the proportions of different supplies, from a nominal increase in demand in the active sense, which merely raises a money-price, without affecting supply.[45]
Another approach will lead to the same conclusion. Demand and supply-curves are not to be understood merely in terms of brute, physical quantities. They are rather curves expressing economic significances, manifesting psychological forces which lie behind them. No considerations of mere physical quantity will explain why one demand-curve should be "elastic" and another inelastic,—each curve has its own peculiarities, which are not mechanical in their nature. Demand-curves express the diminishing economic significance of goods as their quantity is increased. How economic significance is to be interpreted need not be argued here. I have elsewhere undertaken to show that the utility theory of value does not explain the economic significance which demand-curves express—that demand-curves are not utility curves. My own theory is that demand-curves are to be explained only in terms of a social psychology, that demand-curves are social-value curves. But my argument at this point does not rest on the particular type of causal theory of value one chooses. It is enough that the demand-curve be recognized as expressing economic significance, and diminishing economic significance.[46] But for the demand-curve to express variation in economic significance of a good, there is need for a unit in which to express that variation. That unit is the economic significance of the dollar, itself assumed to be invariable—as all measures must be assumed to be invariable if measurement is to mean anything. If the unit chosen vary in the course of a given investigation, the curve tells you nothing at all.
Another way of reaching the same conclusion is to say that an increase in demand in the active sense will lead to an increase in supply only if there be no corresponding increase in demand for the alternative employments of the sources of that supply, that, e. g., an increased demand for wheat will lead to increased production of wheat only if there be not a corresponding increase in the demands for corn and other crops which can be raised on land and with labor and capital that would otherwise produce wheat. This is only another phase of the argument that went before, that an increase in demand due to a falling value of money would lead to a corresponding shift in the supply-curve. It is not quite the same argument, however, because that was an argument concerned with short run tendencies, resting on the assumption that the holders of supply would immediately react to a change in the value of money, whereas the argument just presented rests on the longer adjustments, based on the law of costs, as worked out by the Austrians. This point will be made clearer in the next chapter.
Yet another, and perhaps simpler, approach to the same conclusion is by pointing out that an individual, deciding to buy, must take account of the prices of other things in his budget—that individual demand-schedules would be different if market prices of other things—which depend on the value of money—were different.
The doctrine that supply and demand (and cost of production, the capitalization theory, and other elements in the current price-analysis) presuppose a fixed value of money, must be sharply distinguished from the doctrine of Professor Fisher (Purchasing Power of Money, ch. 8), and others, that a fixed general price level is assumed by supply and demand, etc. I should deny that a fixed general price level is assumed. The point rests in the distinction between value as absolute and value as relative. For my theory, it is perfectly possible for the general price level to rise, with the value of money constant, because of a rise in the values of goods. In a later chapter, on "The Passiveness of Prices," I shall examine the doctrine of Professor Fisher more closely, and set these two views in clearer contrast. For the present, it is enough to point out one vital difference between a rise in prices due to a fall in the value of money and a rise in prices due to a rise in the values of goods, with the absolute value of money unchanged: in the latter case, there is an increase in the psychological stimulus to industry, an increase in economic power in motivation, which energizes and increases production. In the latter case, especially when the fall in the value of money is rapid, and the rise in prices is clearly due to that cause (as in the case of Confederate paper, or the French Assignats), we find a reverse effect on industry. Intermediate cases, where money is falling in value, but where goods are also rising, give us intermediate results.
In what follows, I shall from time to time refer to this distinction. In my own exposition, I shall always use "value of money" in the absolute sense, as distinguished from the mere "reciprocal of the price level,"—a practice which I have sought to justify in the chapter on "Value," and in other places there referred to.[47]
The modern theory of supply and demand, then, assumes money, and a fixed value of money. It is, therefore, obviously unfitted as an instrument to solve the problem of the value of money. If supply and demand concepts are to be applied to this problem, they must be of a different sort. This was pointed out by Cairnes[48] who criticised Mill's formulation, and pointed out that Mill departed from it in three capital doctrines: in the theory of the value of money, in the theory of wages, and in the theory of international values. By the demand for money, Mill means, not the amount of money demanded, but the quantity of goods offered against money—a very different conception. (Mill, Principles, Bk. III, ch. viii, par. 2.) In what sense a quantity of goods can equal a quantity of money, or in what sense there can be a ratio between goods and money, (to recur to Mill's former problem as to the ratio between things not of the same denomination) Mill does not make clear, nor is it defensible to speak of either a ratio or an equation on the basis of Mill's system, since Mill had no absolute value concept. Cairnes seeks to reconstruct the notion of supply and demand, in such fashion as to make it possible to apply it universally, and takes up the question of the comparability of supply conceived as a quantity of goods, and demand, conceived, not as a quantity of goods, but as desire combined with the ability to pay. He concludes that in both supply and demand there is a physical, as well as a mental, element. Demand he defines as the desire for a commodity backed by general purchasing power; supply as the desire for general purchasing power, backed by the offer of a commodity. Thus he thinks he has made the two of the same denomination, so that comparison may be instituted between them, and the ideas of equation, ratio, and proportion made legitimate. By "general purchasing power," Cairnes seems to mean money and the representatives of money. It is not an abstract power, since it is the "physical" element in demand, comparable with, and of the same denomination with, the physical element in supply, a commodity. Cairnes' solution of Mill's difficulty seems to me to be merely verbal, however. First, in what way is the desire for general purchasing power in the mind of one man comparable with the desire for a commodity in the mind of another man? I pass over the supposed difficulty that knowledge of other men's emotions is impossible,[49] and emphasize simply the point that price offer, either by demander or supplier, is no test of the intensity of desire where there are inequalities in the distribution of wealth. But second: in what sense is general purchasing power, money and money-funds, of the same denomination as a commodity? Cairnes emphasizes the physical character of both. But surely they are not comparable on the basis of any physical attributes—weight, bulk, etc. Certainly if we look at the concept of demand here given, the physical aspect is simply irrelevant—gold money goes by weight, but what of paper money and credit instruments? And in what sense is even gold money physically of the same denomination with, say, wheat, or hay or base-ball tickets? Not physical quantities, but economic quantities, are relevant here; not weight or bulk, but value. By means of a concept of value, as the homogeneous quality of wealth, present in each piece of wealth in definite, quantitative degree, could Cairnes bring about comparability between the "physical" elements in supply and demand. But not otherwise. Only significances, values, are relevant here. Supply and demand presuppose value.
It will be interesting to consider the effort to solve the problem of the value of money by means of supply and demand on the lines employed by Mill, where demand for money is defined as quantity of goods to be exchanged, and supply of money as quantity of money times rapidity of circulation, and where physical quantities are treated as the relevant factor, no value concept of the sort here contended for being presupposed. This is, essentially, Mill's method. There is, in this conception, first the difficulty that "quantity of goods to be exchanged" is not a true quantity at all, but is a mere collection of things of different denominations, dozens of eggs, pounds of butter, gallons of milk, etc., incapable of being funded into a quantity.[50] There is, second, the difficulty that increasing the amount of any one of the items in this heterogeneous composite need not increase the "demand" for money, in the sense that it increases the "pull" on money, or tends to increase the supply of money. Yet, under the general doctrine of supply and demand, an increase in demand should be a stimulus to increase in supply. Indeed, it is easy to construct a case where an increase in the quantity of one of the items in this composite, the others remaining unchanged, would actually tend to repel money, to reduce the supply of money. Suppose that one item in America's stock of goods, say cotton, is much increased in quantity, and suppose that cotton has a highly inelastic demand-curve, so that the increased quantity sells for less money than the original quantity.[51] Suppose, too, that cotton is our chief article of export, and that the bulk of our cotton is exported. Would not the "balance of trade" tend to turn against us, so that gold would tend to leave the country, and the supply of money be reduced? There is nothing in the situation assumed to raise the prices of other goods,[52] so that they could exert a counteracting "pull" on money. Europeans, to be sure, having less to pay for cotton, could demand more of other things, and Americans paying less for cotton could demand more of other things. But, on the other hand, American producers of cotton, receiving less for their cotton—receiving precisely as much less as the others had more—could then demand less of other things, exactly as much less as the others are able to demand more. The original tendency for gold to leave the country, and the tendency for gold to leave the money-form and be used in the arts, would remain unneutralized. An "increase of demand for money," in Mill's sense, would in this case present the remarkable phenomenon of driving money away. Physical quantities are irrelevant. Psychological significances are what count.