Supply and Demand

by Sir Hubert Douglas Henderson

Utility and the Margin of Consumption

§1. The Forces behind Supply and Demand. The laws enunciated in the preceding chapter constitute the framework and skeleton of all economic analysis; but they do not carry us very far. It is only through the agency of these laws that any influence can affect the price of anything: but what influences may so affect it is a question which we have still to consider.

Let us begin with ordinary commodities and ask ourselves, in the light of experience and common sense, upon what factors their price seems mainly to depend? Two factors spring to mind at once; their cost of production and their usefulness. As regards the former, the case seems clear enough. We may indeed sometimes grumble that the price of this or that commodity is unconscionably high in comparison with its cost; but this only goes to show that we conceive a relation between price and cost as the normal, governing rule. If one commodity cost only a half as much to produce as another, we should think that something had gone very wrong indeed, if the former commodity were sold for the higher price. But, when we turn to the usefulness of commodities, the case is not so clear. Usefulness has some connection with price, so much is certain; for an entirely useless thing, fit only for the dust-bin (and known to be such, it may be well to add) will fetch no price at all, however costly it may be to produce. But it is not easy to express the connection in quantitative terms. It seems reasonable enough to say that the prices of commodities are roughly proportionate to their costs of production. But directly we contemplate saying a similar thing of their usefulness, we are pulled up short. As we look round the world, and enumerate the commodities which by common consent are the most useful, salt, water, bread, and so forth, the striking paradox presents itself that these are among the cheapest of all commodities; far cheaper than champagne, motor-cars or ball-dresses, which we could very well get on without. As things are, of course, a ball-dress, or a motor-car costs more to produce than a loaf of bread or a packet of salt; and the common-sense explanation of the paradox seems, therefore, to be that the cost of production is a more weighty influence than the usefulness, or utility, as we will henceforth call it (so as to include the satisfaction we derive from not strictly useful things). We are thus tempted to conclude that, provided a commodity possesses some utility, its price will be determined by the cost of production, the degree of utility being unimportant. This was exactly how the position was gummed up for many years in systematic treatises upon Political Economy; and it was not until fully half a century after the Wealth of Nations that a discovery was made which threw a fresh light on the whole matter.

First of all, let it be clearly observed how very unsatisfactory is the above account. In Chapter II where we were treading surely, with a sense of solid ground beneath us, we drew no such invidious distinction between supply and demand. They seemed then to possess an equal status. But cost of production is the chief factor which, in the case of commodities, ultimately determines the conditions of supply. Utility, similarly, is the chief factor which ultimately determines the conditions of demand. Must not then the symmetrical relations between demand and supply be reflected in a corresponding symmetry between the utility and the costs which underlie them? Demand springs obviously from utility; the only motive for buying anything is that it will serve some real or fancied use. Can we then accord to demand so dignified and to utility so subordinate a place? There is here an inconsistency which we must somehow reconcile. It will not serve as a solution to distinguish between different periods of time, and to say, as economists used to say not very long ago, that price is governed over a short period by demand and supply, but in the long run by the cost of production. This still leaves our sense of symmetry unsatisfied. Moreover, the conception of cost of production, when we consider it as ruling over a long period, frequently seems to lose any precision, as an independent factor, which it may otherwise possess. Motor-cars, we have agreed, are more costly to produce than loaves of bread; but, as we know well, the cost of producing motor-cars varies enormously, accordingly as they are produced on a small or a large scale. By the methods of mass production they can be turned out at a relatively low cost per car. But this requires that they should be purchased in large numbers and this in turn throws us back to the demand for motor-cars, and plainly enough, to people's judgment as to their utility. In some cases, the opposite phenomenon occurs. In the case of British coal, for instance, the average cost of production would be much lower than it is if the output were reduced to a fraction of its present volume, and if only the richer seams of the more fertile mines were worked. Once again, therefore it is difficult to measure the cost of production until we know the magnitude of the demand, which in a manner, which we have still to elucidate, clearly depends upon the utility.

If we take the problem of joint products, the conception of cost of production fails us still more conspicuously. For what is the cost of producing wool, or the cost of producing mutton? We can speak of the cost of rearing sheep: but it is hardly possible to allot this cost, except quite arbitrarily, between the two products. How, then, can we explain the separate prices of these things by reference to cost alone? Instances of joint production are becoming so common in the modern world, or at least, with the growing attention to the utilization of by-products, are assuming so much more heightened a significance, that an explanation of price, which does not apply to them, is a very feeble one indeed.

§2. The Law of Diminishing Utility. Let us turn back, then, to the factor of utility, and see if we cannot put on a more satisfactory basis the relation between utility and price. The clue to the puzzle is to be found in a brief reflection on the implications of the second general law propounded in Chapter II. A rise in price, it was there stated, will sooner or later diminish the demand. This was asserted as a matter of fact, observed from and confirmed by experience. But what does it signify? To what causes is this familiar fact to be attributed? The first stage of the answer is very ample. The many individuals, whose purchases make up the demand for the commodity, will buy smaller quantities now that the price is higher. Possibly some of them may cease to buy it altogether; but as a rule it would be reasonable to suppose that most people continue to buy a certain amount though a smaller amount than hitherto. Let us turn our attention, then, to the individual purchaser, and ask ourselves why he (or let us say she) acts in the manner indicated. The obvious answer is that the more she already has of anything, the less urgently does she require a little more of it. If she buys 6 pounds of sugar every week when the price is 7 cents a pound, but only 5 pounds when the price is 8 cents, she shows by her action that she does not consider that the additional utility she will derive from buying 6 pounds a week rather then 5 pounds is worth as much as 8 cents. But she shows at the same time that she thinks it worth 7 cents. For, when the price is 7 cents, no one compels her to buy that sixth pound. She could stop, if she chose, at five; and it may serve to make the point quite plain if we suppose her actually to hesitate before she buys the sixth. She has hitherto, let us say, been buying 5 pounds a week at 8 cents. To-day she enters the shop and finds the price is down to 7 cents. She asks for her customary 5 pounds; then she pauses, and a minute later turns her order into six. What are the alternatives which she has been weighing one against the other in that momentary pause? Not the utility of the whole 6 pounds of sugar against the total price of 42 cents. For she has already ordered the first 5 pounds; and the decision to buy the sixth is taken independently and subsequently. She has been sizing up the increment of utility which a sixth pound would yield, and she decides that this is worth the expenditure of a further 7 cents. Again, when the price was 8 cents she need not have bought as many as 5 pounds. She could have stopped at 4 had she chosen, and the fact that she did buy 5 pounds shows that the increment of utility derived from buying a fifth pound, when she might be said already to have 4, was worth at least 8 cents in her judgment.

This trite illustration enables us to lay down two important laws relating to utility. To state them shortly, it is convenient to employ one or two technical terms, which, unlike every term employed hitherto, are not very commonly used in their present sense in everyday life. Their adoption is desirable not merely for the sake of convenience, but because they help to stamp clearly on the mind a most illuminating conception, that of the "margin," which supplies the clue to many complicated problems. The last pound of sugar which the housewife purchased, the fifth pound when the price was 8 cents, or the sixth pound when the price was 7 cents, we call the "marginal" pound of sugar. And the increment of utility which she derives from buying this marginal pound we call the "marginal utility" of sugar to her. We are thus able to state the fact that the more a person has of anything the less urgently does he require a little more of it, in the following formal terms:—

V. The marginal utility of a commodity to anyone diminishes with every increase in the amount he has.

The total utility will, of course, increase with an increase in the amount, but at a diminishing rate. This law is usually called The Law of Diminishing Utility.

§3. Relation between Price and Marginal Utility But this is not all. We are now in a position to perceive the true relation between utility and price. The relation is one which exists not between price and total utility, but between price and marginal utility. If we know only that a housewife will buy weekly 5 pounds of sugar at 8 cents per pound, but 6 pounds at 7 cents, we know nothing of the total utility of sugar to her. We do not know how much she might be prepared to pay rather than go without 3 pounds, 2 pounds, or any sugar at all. But we do know that, when she buys 6 pounds, the marginal utility of sugar is in her judgment worth something which does not differ greatly from the price. We can, therefore, say in general terms that the price of a commodity measures approximately its marginal utility to the purchaser.