Supply and Demand

by Sir Hubert Douglas Henderson

The real costs which the price of a commodity measures are not absolute, but comparative. Marginal money costs reduce themselves in the last analysis to the payments which must be made to secure the use of the requisite agents of productions. These payments tend to equal the payments which the same agents could have commanded in alternative employments. The payments which they could have commanded in alternative employments, tend in their turn to equal the derived marginal utilities of their services in those employments. It is thus the loss of Utility which arises from the fact that these agents of production are not available for alternative employments that is measured by the money costs of a commodity at the margin of production.

This conception of ultimate costs encounters an instinctive repugnance, arising from a mistaken sense of logical symmetry, which it will be well to examine. Cost, it is objected, so interpreted loses its character as an independent entity. It is merely something derived from utility. Now in the earlier chapters of this volume, we found reason to be impressed with the general symmetry which pervades the relations of demand and supply. Moreover, when we considered the case of ordinary commodities we found that at the back of demand and giving rise to it was utility; at the back of supply, and limiting it, was cost. The general symmetry between demand and supply thus seemed almost to imply a fundamental symmetry between utility and cost. If, then, cost in the last analysis is derived from utility, does not this make nonsense of the symmetry between demand and supply, or, if we cling to this last symmetry as a demonstrable truth, must we not refuse to admit that cost can be derived from utility?

This is one of those false dilemmas which supply the wiseacres of the world with a plausible case for distrusting the logical faculty. If we have good reason for believing that both of two apparently inconsistent things are true, the explanation is seldom that one of them is really false; it is more usually that they are not really inconsistent. So it is here. The symmetry between demand and supply is very great, and we should always look to see if it holds good, but it is by no means perfect, and it is in the last analysis that it most notably fails. It is most important to distinguish clearly between the utility and the cost of a commodity as two separate and independent things. In Chapter V, it will be remembered, we did not permit ourselves to derive the costs of producing cotton lint from the utility of cotton-seed. The refusal to do so was essential to clear thought; it led to some very useful practical corollaries. But to derive the cost of a commodity from the utility of something which is produced with it, as part of the same productive process; and to derive the cost from the utilities which the agents, which help to produce it, possess for other purposes, are two entirely different things. In works on International Trade, the reader will discover that the comparative nature of real costs is so unmistakable that a Doctrine of Comparative Costs is expounded with much formality at the outset. This doctrine is apt to prove somewhat puzzling, when we have to deal with it as an apparent exception to the general tenor of economic theory. Its difficulties disappear when we realize clearly that the real cost of anything is the curtailment of the supply of other useful things, which the production of that particular thing entails.

§2. The Allocation of Resources. However strange the above conception may seem, there should be no doubt that this cost is very "real." Here the irregularities and maladjustments of the economic world, the recurrence of trade depressions and the like, do much to obscure a clear vision of the essential realities. At a time when there is much unemployment, and much machinery standing idle, it is so clear to common sense that we could produce more of some particular thing without diminishing the supply of other things, that any apparent statement to the contrary may perhaps seem the height of academic pedantry. But let me ask the reader to consider with an open mind a familiar parallel. During the recent war there was inevitably much waste and muddle in the utilization of the military resources of the Allies. Some regiments would be kept inactive for long periods, not for purposes of rest or training, but owing to some defect of organization. In the manufacture of munitions, an insufficient appreciation of the principles of joint demand led to the piling up of excessive stores of certain materials, which were useless until commensurate supplies of the complementary factors could be obtained. It is unnecessary to multiply examples. The waste of both man-power and material was immense. But the allocation of these resources between, for instance, the various theaters of war was none the less a very real problem, which gave rise to much engrossing controversy. It was an axiom that the more resources you employed in Mesopotamia or in Palestine, the less resources remained available for France. No one thought of maintaining that, as long as there was any waste of these resources, so long as there remained any men to be "combed out" of unessential industries, you could pour troops and munitions into Salonika without stopping to consider the needs of other theaters of war. Such a notion would have been clearly imbecile, for the sufficient reason that the sending of armies to Salonika would do nothing in itself to secure (however much it might incidentally stimulate) the more efficient use of the resources which remained.

Now this is precisely analogous to the problem of the allocation of our resources for the purpose of peace. Notwithstanding all the wastes and maladjustments of the economic system, the use of resources to produce one commodity does in general curtail the production of others. The mere launching of a new business enterprise does no more than the sending of an army to Salonika, to eliminate waste in the remainder of the economic organism. Unemployment, broadly speaking, is a function not of the magnitude of the normal demand for labor (which affects rather the wage-level), but of fluctuations in the demand for labor; fluctuations from one day to another as at the docks, from one season to another as in the building trades, above all from one period of years to another as in the cycles of general trade boom and depression. Nothing will diminish unemployment which does not serve to diminish these fluctuations. A new business will not, as a rule, have any such effect. If it is launched during a trade depression (a most unusual proceeding), it may temporarily absorb unemployed labor and idle materials. But when the next boom comes, it will be using, though presumably to greater advantage, labor and materials which, but for it, would have been employed for other purposes. Meanwhile the causes making for unemployment will be unaffected. Miscalculations will still be made, the building trades will still become slack in the winter, the casual methods of engaging dock laborers will still continue, trade cycles will still recur, while beneath them, and concealed by them, some industries will expand and others will decay. Thus, like the armies at Salonika, the new business would in effect divert resources from elsewhere.

This truth needs to be firmly grasped in mind. It is this that makes it in general unsound policy to subsidize industries, either directly or indirectly, by means of a protective tariff. It is this, indeed, that supplies the answer to half the economic fallacies that are always current.

The allocation of resources so as to yield the maximum effect was rightly recognized as one of the most vital and difficult of our war-time problems. To cope with it, the Allied peoples devised one instrument after another, and finally evolved the Supreme Allied Council. The analogous problem in the economic world of peace time is no less important and far more difficult; but there is nothing to correspond to the Supreme Allied Council. There we rely upon a co-operation which, as was stressed in Chapter I, is unco-ordinated. That co-operation has been evolved by the mutual competition of innumerable business concerns, controlled by men largely animated by the motive of pecuniary profit. But it has not been evolved wholly by such means: and how far that competition or that motive of profit is essential to its efficiency are questions with which this volume has not been in any way concerned. The economic laws, the relations between utility, and price and cost, with which it has been occupied, are an entirely different matter; and these are essential to the efficiency of any system of society. For if the marginal utility of a commodity is equal to its marginal cost, and if this marginal cost is composed of payments to the various agents of production at least as great as they could have obtained if they had been used otherwise, this amounts to saying that the agents of production are so utilized as to yield the maximum utility; and this is the same thing as saying that they are so utilized as to produce the maximum wealth.

§3. Utility and Wealth. Upon this last point it is important to be quite clear. An increase in wealth seems a solid, tangible reality; something, which, however much we may scorn it in our more precious moods, we recognize, for a rather poor community, to be an important object of endeavor. But an increase in utility seems a vague, impalpable notion, hardly deserving the same practical concern. None the less the two things are identical. We greatly deceive ourselves if we suppose wealth to be an objective reality. It is true that, when we get behind the money in which it is measured, we come upon commodities, like food and clothes and houses and factories, which seem comfortably solid and objective things; but we also come upon many services, like those of gardeners and doctors and hospital nurses, which we are bound to reckon as part of our wealth, although they are not embodied in any tangible commodities. Moreover, although material commodities are objective realities in themselves, and in many of their properties, they are not objective realities in their property as wealth. A pair of boots is an objective fact; so is the number of pairs in existence at any time, so is their size, their weight, the quantity of leather or of paper which they happen to contain. But the wealth which those boots represent is not an objective fact. It depends upon the opinion which men and women entertain as to their utility; and these opinions take us into the subjective regions of human psychology. Let us suppose, for instance, that we calculated, on the basis of present prices, that the boots in existence at the present time represented 1/1000 part of our total wealth. Suppose, then, that a miracle were to happen; that the skies opened and rained boots upon us, of every size and shape and pattern, until we had 1000 times as many boots as we had before. Could we say that our total real wealth had been doubled? Clearly we could not. To obtain boots for nothing, and to wear a new pair every week, would make us somewhat better off, but not twice as well off as we were previously. In other words, the real wealth of a thousand times as many boots as we have now, is not a thousand times as great as the wealth of the present number of boots. We are, indeed, practically restating the Law of Diminishing Utility; and this perhaps is enough to show that wealth is fundamentally the same thing as utility.

Another point, however, is worth noting. Our real wealth would be somewhat increased in the case supposed; but if we were to turn to the money measure of wealth, the opposite result would be far more likely, For the price of boots would most likely fall to nothing, and the total value of boots, in the commercial sense, would accordingly be nothing also. This shows that money values may be a most imperfect measure of aggregate wealth; for what money values represent is the product of the quantity of the commodity and its marginal utility, while aggregate wealth is total utility, which is a very different thing. This, it may be observed, makes all attempts to compare the wealth of different countries or different times, and no less to construct Index Numbers of Prices, imperfect of necessity, and arbitrary in their foundations.

§4. Criteria of Policy. The point has now been reached at which we must take into account the very important fact which was mentioned at the close of Chapter III. The maximum utility which the laws of supply and demand tend to bring about is a maximum total utility indeed, but one still measured in terms of money. An unequal distribution of wealth destroys any necessary correspondence between that and the maximum real utility. This consideration, however, does not affect the general validity of the conclusion that the laws of supply and demand represent what is socially desirable now or under any system. For what is at fault here is the distribution of wealth; and it is that which should be changed, in so far as it is possible to do so. Now it is important to realize that whenever it is possible to supply a commodity to poor people below cost price, it is possible to alter the distribution of wealth, for that in effect is what is done. Purchasing power, which may be taken from richer people by taxation, or which may be obtained from "collective" profits on other trading, is in effect transferred to the poor people in question, though the transference is coupled with the condition that the purchasing power must be expended in a particular way. It is in general desirable that the transference should be made without this condition being attached. To this general statement, exceptions indeed exist so numerous and important as possibly to justify a great extension of social expenditure of this type. Education should certainly be provided free of charge, there are strong arguments for subsidizing housing; the provision of milk to expectant mothers, the feeding of school children, such instances can be multiplied into a very extensive list. But it is important to observe that in each case the justification of the policy rests in the presumption that the service supplied is one which it is particularly important that the beneficiaries should have, as compared with the other things upon which they might have preferred to expend the equivalent purchasing power, had it been transferred to them without conditions. Where there is no such presumption, as surely there is none in the case of the great bulk of commodities, the relation between price and marginal cost should be rigidly maintained; it is the distribution of purchasing power which we should rather seek to alter. How far is it possible to alter that?