The price of a commodity is determined by the conditions of both supply and demand; and neither can logically be said to be the superior influence, though it may sometimes be convenient to concentrate our attention on one or other of them. The chief factor on which the conditions of demand depend is the utility (as measured in terms of money). The chief factor on which the conditions of supply depend is the cost of production (again as measured in terms of money). The prevailing trend towards an equilibrium of demand and supply can thus be expressed as follows:—
VI. A commodity tends to be produced on a scale at which its marginal cost of production is equal to its marginal utility, as measured in terms of money, and both are equal to its price.
Chapter V
Joint Demand and Supply
§1. Marginal Cost under Joint Supply. Several references have been made above to joint products, a relation which it will be convenient now to describe as that of Joint Supply. Our sense of symmetry should make us look for a parallel relation on the side of demand; and it is not far to seek. There is a "joint demand" for carriages and horses, for golf clubs and golf balls, for pens and ink, for the many groups of things which we use together in ordinary life. But the most important instances of Joint Demand are to be found when we pass from consumers' to producers' goods. There, indeed, Joint Demand is the universal rule. Iron ore, coal and the services of many grades of operatives are all jointly demanded for the production of steel; wool, textile machinery and again the services of many operatives are jointly demanded for the production of woollen goods (to mention in each case only a few things out of a very extensive list). Now we have already noted that, when commodities are jointly supplied, there is an obvious difficulty in allocating to each of them its proper share of the joint cost of production. There is a similar difficulty in estimating the utility of a commodity which is demanded jointly with others. Thus, the utility of wool is derived from that of the woollen goods which it helps to make. But the utility of the factories, the machinery and the operatives employed in the woollen and worsted industries is derived from precisely the same source. How much, then, of the utility of woollen goods should be attributed to the wool and how much to the textile machinery? Can we make any sense of the notion of utility as applying to one of these things, taken by itself? And, if not, how can we explain the price of a thing like wool in terms of utility and cost, since we cannot disentangle its cost from that of mutton, nor its utility from that of a great variety of other things?
Here the conception of the margin enables us to grapple with a problem which would otherwise be insoluble. For, while it is impossible to separate out the total utility and cost of wool, it is not impossible to disentangle its marginal utility and its marginal cost. The proportion in which wool and mutton are supplied cannot be radically transformed; but it can be varied within certain limits, by rearing, for instance, a different breed of sheep. Variations of this kind have been an important feature of the economic history of Australasia, where sheep farming is the leading industry. Before the days of cold storage, Australia and New Zealand could not export their mutton to European markets, though they could export their wool. Wool was accordingly much the most valuable product; the mutton was sold in the home markets, where, the supply being very plentiful, the price was very low. In the circumstances, the Australasian farmers naturally concentrated on breeding a variety of sheep whose wool-yielding were superior to their mutton-yielding qualities. The development of the arts of refrigeration led in the eighties to an important change. It became possible to obtain relatively high prices for frozen mutton in overseas markets. There was, therefore, a marked tendency, especially in New Zealand, to substitute, for the merino, the crossbred sheep which yields a larger quantity of mutton and a smaller quantity of wool of poorer quality. Now if we calculate the cost of maintaining the number of merino sheep which will yield a given quantity of wool, and calculate the cost of maintaining the larger number of crossbred sheep which will be required to yield the same quantity of wool (allowing for differences of quality) the extra cost which would be incurred in the latter case must be attributed entirely to the extra mutton that would be obtained. This extra cost we can regard as constituting the marginal cost of mutton. So long as this marginal cost falls short of the price of mutton, it will be profitable to extend further the substitution of crossbred for merino sheep. The process of substitution will in fact be continued until we reach the point at which the marginal cost is about equal to the price. Similarly by starting with the numbers of merino and crossbred sheep which would yield the same quantity of mutton, we can calculate the marginal cost of wool; and again the tendency will be for this marginal cost to be equal to the price.[[1]]
[1] It may be found difficult to grasp this point when stated in general terms. The following arithmetical example may make it plainer:—
Suppose a merino sheep yields 9 units of mutton and 10 units of wool.