Supply and Demand

by Sir Hubert Douglas Henderson

This statement is perfectly consistent with the paradox noted above that the most useful commodities such as bread, salt and water are very cheap. For when we say that these commodities are supremely useful, we mean only that their total utility is very great; that, rather than do without them altogether, we would offer for them a large proportion of our means. But we would not value very highly a small addition to the bread, water or salt that we habitually consume; nor would most of us feel it as a very serious deprivation if our consumption of these things were curtailed by a small percentage. In other words, their marginal utilities are small, and it is only the marginal utility that has any relation to price.

§4. The Marginal Purchaser. A possible objection to the preceding argument deserves to be considered. Some readers may find the picture I have drawn of the hesitating housewife entirely unconvincing. They may declare that her mind does not work at all in the manner I have indicated. She will have formed certain habits in regard to her weekly purchases of sugar, which are connected very vaguely, if at all, with any conscious processes of thought. She will buy so many pounds of sugar weekly without troubling her head over the specific utility of the last pound she buys. When the price falls she may, indeed, buy more; but it will not be because she separates out and considers by itself the extra utility of an additional pound. She may buy more, because she has formed the habit of spending so much money on sugar; and now that the price has fallen, the same amount of money will enable her to buy more pounds. Or, perhaps, she may be moved by instinctive and irresistible attraction to buy more of a thing when it is cheaper, similar to that which inspires so many people to face with ardor the horrors of a bargain sale. In any case the fine calculations I have imagined convey a fantastic picture of her state of mind. And how much more fantastic, the critic may continue, of the state of mind in which things of a different kind are bought by less careful people. When, for instance, one of us happy-go-lucky males (more liberally supplied, perhaps, than the housewife with the necessary cash), decides to buy a motor bicycle, or to replenish his stock of collars or ties, does the above analysis bear any resemblance to the actual facts? In the case of the motor bicycle, the purchaser may, indeed, weigh the price fairly carefully against the pleasure and benefit, though contrariwise he may be a rich enough gentleman hardly to bother about this. But, one motor bicycle is as much as he is at all likely to buy, and what becomes, then, of the distinction between total and marginal utility? In the case of the ties and collars, the vagueness of many of us about the price will be extreme. We probably have been uneasily conscious for some time of an inconvenient shortage of these troublesome articles and eventually will go off (or perhaps will be sent off with ignominy) to the nearest suitable shop to make good the deficiency. How can we speak here with a straight face of the relation between marginal utility and price?

These are very pertinent criticisms; but they do not make nearly as much nonsense of the notion of marginal utility as may seem at first. The last point, indeed, serves rather to give it a fresh aspect of much significance. Those of us who do not bother about the price we pay for our ties and collars owe a debt of gratitude, of which we are insufficiently conscious, to the more careful people who do; as well as to the custom which prevails in shops in Western countries (as distinct from the bazaars of the East) of charging as a rule a uniform price to all customers. If we were the only people who bought these things, an enterprising salesman would be able to charge us very much what he chose. He could put up his price, and we would hardly be aware of it. And, as by lowering his price he could not tempt us to buy any more, price reductions would be few and far between. But fortunately there are always some people who do know what the price is, even when they are buying collars and ties; and who will adjust the amount they buy in accordance with the price. It is these worthy people who make the laws of demand work out as we well know they do. It is they who will curtail their consumption if the price has fallen and it is they who constitute the seller's problem, and help to keep down prices for the rest of us. The rest of us—it is well to be quite blunt about it—simply do not count in this connection. We have no cause then to plume ourselves that we have disproved the truth of economic laws when we declare that we seldom weigh the utility of anything against its price. All that this shows is that our actions are too insignificant to be described by economic laws since they exert no appreciable influence on the price of anything. And this in turn shows the extreme importance of grasping clearly the conception of the margin. Just as it is the marginal purchase, so it is the marginal purchaser who matters. It is the man who, before he buys a motor bicycle, weighs the matter up very carefully indeed and only just decides to buy it, whose demand affects the price of motor bicycles. It is the utility which he derives that constitutes the marginal utility, which is roughly measured by the price.

As to the housewife, I am not prepared to concede that my picture is in essentials very fanciful. She may be a creature of habits and instincts like the rest of us, but most habits and instincts affecting household expenditure are based ultimately on some calculation, if not one's own, and reason has a way of paying, as it were, periodic visits of inspection, and pulling our habits and instincts into line, if they have gone far astray. I am not satisfied that the housewife does not envisage the utility of a sixth pound of sugar as something distinct from the utility of the other five; she may buy it, for example, with the definite object of giving the children some sugar on their bread, and she may have a very clear idea as to the price which sugar must not exceed before she will do any such thing. Possibly I may exaggerate. I have the profound respect of the incorrigibly wasteful male for the care and skill she displays in laying out her money to the best advantage.

§5. The Business Man as Purchaser. But if the reader still finds the picture unconvincing, let us shift the scene from domestic economy to commerce, and substitute for the careful housewife an enterprising business man. Now, as anyone who has a business man for his father will have often heard him say, the vagueness and caprice which characterize our personal expenditure would be quite intolerable in business affairs. There you must weigh and measure with the utmost possible precision. You must be for ever watching the several channels of your expenditure, careful to see that in none does the stream rise higher than the level at which further expenditure ceases to be profitable. You will not even engage typists or install a telephone in your office without weighing up fairly carefully the number of typists or the number of switches that it is worth your while to have. And in deciding whether to employ say, five typists, or six, you will not vaguely lump the services of the whole six typists together, and consider whether as a whole they are worth to you the wages you must give them. You will, in the most direct and literal manner, weigh up the additional benefit you would derive from a sixth typist, and if that does not seem to you equivalent to her wage, you will not engage her, however essential it may be to you to have one or two typists in your office. If on the other hand, the utility of having a sixth typist seems to you worth much more than her pay, the chances are that you will be well advised to consider the employment of a seventh. And so, where you stop employing further typists, the utility to you of the last one, of the "marginal typist" as it were, is unlikely to differ greatly from her pay.

Now this is not a fancy picture of some remote abstraction called an "economic man." Allowing for the over-emphasis which is necessary to drive home the central point, it is a bald account of the aims and methods of the actual man of business. To ascertain the margin of profitable expenditure in each direction, to go thus and no further, is the very essence of the business spirit, as the business man himself conceives it. When he condemns the extravagance of Government departments, it is their lack of just this marginal sense that he chiefly has in mind. "The lore of nicely calculated less or more" may be rejected by High Heaven and Whitehall, but no one can afford to despise it in the business world.

The transition from household to business expenditure involves an extended use of the word utility, which is worth noting. Commodities like bread, sugar, or privately owned motor-cars are sometimes called "consumers' goods" in contrast to "producers' goods," which comprise things such as raw materials, machinery, the services of typists and so forth, which are bought by business men for business purposes. The line of division between the two classes is not a sharp one, and we need not trouble with fine-spun questions as to whether a particular commodity should in certain circumstances be included under the one head or the other. But, broadly speaking, things of the former type yield a direct utility; they contribute directly to the satisfaction of our pleasures or our wants. Things of the latter type yield rather an indirect utility. Their utility to the business man who buys them lies in the assistance they give him in making something else from which he will derive a profit. The utility of these things is therefore said to be derived from that of the consumers' goods or services to which they ultimately contribute. This conception of derived utility leads to certain complications which we shall have to notice later.

§6. The Diminishing Utility of Money. But one important point must be emphasized in this chapter. The utility which a business man derives from the things which he buys for business purposes is the extra receipts which he obtains thereby. Derived utility, in other words, is expressed in terms of money, and the idea of its relation to price presents no difficulty. But the utility of things which are bought for personal consumption means the satisfaction which they yield, and this is clearly not a thing which is commensurable with money. When, therefore, it is said that the prices measure their respective marginal utilities, what exactly is meant? What was it that the argument of §3 went to show? That the utility of the marginal pound of sugar would seem to the housewife just worth the price that she must pay for it; in other words, that it would be roughly equal to the utility she could obtain by spending the money in other ways. The respective marginal utilities which she obtains from the different things she buys will thus be proportionate to their prices. But if she were to receive a legacy which gave her a much larger income to spend, she might buy larger quantities of practically every commodity; and, though she would obtain a greater total utility thereby, the marginal utility she would obtain in each direction would be smaller, in accordance with the law of diminishing utility. The prices might not have changed; the respective marginal utilities to her of the different things would again be proportionate to their prices, but they would constitute a smaller satisfaction than before.

Thus we can only say that the prices of commodities will be proportionate to their real marginal utilities, when we are considering the different purchases of one and the same individual. The amounts of money which different people are prepared to pay for different consumers' goods are no reliable indication of the real utilities, the amounts of human satisfaction which they yield. Here we must take account not only of varying needs and capacities for enjoyment, but of the very unequal manner in which purchasing power is distributed among the people. The cigars which a rich man may buy will yield him an immeasurably smaller satisfaction than that which a poor family could obtain by spending the same amount of money on boots, or clothes or milk. When, therefore, we compare commodities which are bought by essentially different consuming publics, their respective prices may bear no close relation to their real utility, whether marginal or otherwise. Thus the law of diminishing utility applies to money or purchasing power, as well as to particular commodities. The more money a man has the less is the marginal utility which it yields him; and, where the marginal utility of money to a man is small, so also will be the real marginal utility he derives in each direction of his expenditure. The extreme inequality of the distribution of wealth gives immense importance to this consideration. Its practical implications will be discussed in Chapter V. Meanwhile, we may express the conclusions of the present chapter by the statement that the price of a commodity tends to equal its marginal utility, as measured in terms of money, i.e. relatively to the marginal utility of money to its purchaser.