It is quite true that in big undertakings, where there are large standing charges, and where the organization possesses some of the characteristics of an integral whole, it is not easy to measure accurately the specific costs which should be assigned to any particular portion of the output. But this difficulty is one of the most serious weaknesses of large undertakings; precise detailed measurement is the great prophylactic of business efficiency, and, where it is lacking the bacilli of waste will enter in and multiply. So clearly is this recognized, that the development of large scale business has led to the evolution of new methods of accountancy, designed to make detailed mensuration possible. We have most of us heard of them vaguely under such names as "comparative costings," but too few of us appreciate their full significance. It is hardly too much to say that the issue as to whether the size of the typical business unit will continue to become larger and larger, or whether it has already overshot the point of maximum efficiency will turn largely upon the capacity of accountancy to supply large and complex undertakings with more accurate instruments of detailed financial measurement.

Sec.4. A Misinterpretation. The price, then, of a commodity tends roughly to equal its marginal cost of production; and this marginal cost (in perfect symmetry with what we observed as regards marginal utility), may be conceived as applying either to the marginal producer or to the marginal output of any producer. In the former aspect it is open to a misinterpretation, against which it will be well to guard. Some advocates of socialism have argued, as one of the counts in their indictment of the present industrial system, that the price of a commodity is determined by the cost at which the least efficient concern in the industry can produce. They say, in effect, "Under the present competitive regime, you have to pay for everything you buy a price which far exceeds the necessary cost to a concern which is managed with ordinary ability. For, as economic theory has shown, it is the cost of the marginal concern, i.e. the concern managed by the most incompetent, and half-witted fellow in the trade; it is the cost incurred by him, together with a profit on his capital, that the price has got to cover. The producer of no more than average capacity is therefore making out of you a surplus profit, which would be quite unnecessary in any well-arranged society." Such an argument is a gross caricature of the marginal conception. The half-witted incompetent will, as we know well enough, speedily disappear under the stress of competition, and his place will be taken by more efficient men. There is an essential difference between him and the "marginal coal mine" of which we spoke above. For the probabilities are that of the coal resources, whose existence is clearly known, the more fertile and better situated parts will already be in process of exploitation; and there is not likely, therefore, to be a supply of substantially better seams which can be substituted for the worst of those in actual use. There is likely, on the other hand, to be available a supply of decent business capacity which can be substituted for the most inefficient of existing business men. The marginal concern, in other words, must be conceived as that working under the least advantageous conditions in respect of the assistance it derives from the strictly limited resources of nature, but under average conditions as regards managerial capacity and human qualities in general. Thus in agriculture we can speak of a marginal farm, which we should conceive as the least fertile and worst situated farm which it is just worth while to cultivate (of which more will be said when we come to the phenomenon of rent), but we must assume it to be cultivated by a farmer of average ability.

Sec.5. Some Consequences of a Higher Price Level. The foregoing controversy will be of service to us, if it makes clear the manner and the spirit in which the marginal conception should be handled. It should be regarded not as a rigid formula which we can apply to diverse problems without considering the special features they present, but rather as a signpost which will enable us to find our way, a compass by which we may steer between the shoals of triviality and sophistry to the crux of any problem with which we have to deal. Let us illustrate its practical uses by an example which is of great interest and far-reaching practical importance at the present day. As has been already observed, the war has left behind it in all countries a great and almost certainly permanent increase in nominal purchasing power. Since the armistice prices have moved upwards and downwards with unprecedented violence; and it would be very rash to prophesy the precise level at which they will ultimately settle (using that word with considerable relativity). But, for reasons for which the reader is referred to Volume II in this series, it is safe enough to say that the general level of post-war will greatly exceed that of pre-war prices. Now this will apply not only to consumers' goods like milk and clothes, or to raw materials like pig-iron and cotton, but in very much the same degree to things like factories and machinery. Things of this last type are sometimes called "capital goods," because it is in them that a large part of the capital of a business is embodied. Now the fact that it will cost much more than it did before the war to construct fresh capital goods, has a significance which very few people appreciate. An existing factory cost, let us say, $500,000 to build and equip with machinery before the war. To construct a similar factory to-day would cost, let us assume (it is probably a moderate assumption) $1,000,000. Suppose 10 per cent to be the gross profit that is necessary to attract capital to the particular industry. Then it will not pay to construct this new factory unless the trade prospects point to the probability of a profit of about $100,000 per annum. But if the old factory is equally well managed, it too should be able to earn this $100,000, which upon the capital actually sunk would represent a rate of 20 per cent. The particular figures given are, of course, purely illustrative; the conclusion to which they point is that, if new enterprises are to be undertaken, pre-war enterprises are likely to yield a rate of profit, on their fixed capital at least, increased in rough proportion to the price-level. Of course, in years when trade is bad, the factory which dates from pre-war times will not earn a profit of this kind, it may very likely make an actual loss. At those times it is very certain that few new factories will be erected. But it is difficult to reconcile a condition of trade activity, in which the constructional industries are busily employed, with a rate of profit to pre-war businesses on the fixed part of their capital of a lesser order of magnitude than has been indicated. It makes no difference, it should be observed, whether we suppose the new enterprises to take the form of starting of new concerns or extending old ones; in neither case will they be undertaken, unless there is reason to expect an adequate return on the capital which they require at post-war constructional prices. High profits (taking always good years together with bad) on capital sunk before the war in buildings and machinery are thus a likely consequence of an increase in the price-level.

This fact is, indeed, the counterpart or complement of another phenomenon with which we are more familiar. While prices are actually rising, profits, as we have come to recognize, necessarily rule high, because every trader or manufacturer is constantly in the position of selling at a higher price-level, stock which he purchased, or goods made from materials which he purchased at a lower level. He thus acquires an abnormal profit on his circulating capital, which is essentially similar to the profit on fixed capital, which we have just examined. The difference is that the former profit is crowded into the years when prices are actually on the increase, and thus is very noticeable indeed; while the latter profit continues to accrue in smaller instalments after prices have settled down, as it were, at the higher level, and is not exhausted until the buildings and machinery have become obsolete. But the two profits are essentially similar, and in the long run should be commensurate. In the one case, stock can be sold for a large profit, because it cannot be replaced except at a higher price; in the other case, plant and buildings yield a higher income because they cannot be replaced except at a higher price. Indeed, if the owners choose, the plant and building can, like the stock, be sold at their appreciated value, as has been widely done by the owners of cotton mills in Great Britain since the armistice.

There is nothing in these considerations that should surprise us, or even shock our moral sense. For what they have indicated is an increase of money profits in rough proportion to the price-level, so that the aggregate profits will represent about as much real income as before.[1] The conclusion therefore amounts to no more than this, that you cannot alter fundamentally the distribution of wealth between labor and capital by merely inflating the currency, or otherwise juggling with the price-level. And this is only what we should expect, if there are any laws of distribution of sufficient importance and permanence to justify the many volumes which have been devoted to them.

[Footnote 1: Assuming that the rate of interest has remained unaltered. In fact it has greatly increased since pre-war days, and this points to a still further increase of money profits, and an increase in the real income which they represent. See Chapter VIII, Sec.10]

But this somewhat tame conclusion does not make it any less important to grasp clearly the significance of the appreciation in the value of capital goods. A failure to realize it lies at the root of our bewildered muddling of many crucial problems of the day. In the matter of housing, for instance, we know we cannot build houses at less than two or three times their prewar cost, and yet we cannot endure to see the owners of pre-war houses obtaining a commensurate increase of rent. And so, in Great Britain, we pass Rent Restriction Acts, and Housing Acts, and then, in a fit of economy we suspend the latter, and let the former stand, while the housing shortage becomes steadily more acute. When we hand the railways back from State control to private hands, our horror at the idea of the companies receiving larger money profits than they did before the war leads us to lay down principles for the fixing of fares and freight charges, which take no account of post-war construction costs; and then, in alarm lest we may have thereby made it unprofitable for the companies to spend a single penny of fresh capital upon further development, we seek to provide for capital expenditure by cumbrous and dubious expedients. Doubtless we shall muddle through somehow with such policies: and, public opinion being what it is, they may perhaps have been about the best policies that were practicable. But the problems would have been easier to handle, if the public generally were a little less disposed to think in terms of averages, and a little more in terms of margins, if we all of us instinctively realized that the cost that really matters is the cost at which additional production is profitable under the conditions ruling at the time, or in the immediate future.

Sec.6. General Relation between Price, Utility and Cost. Let us conclude this chapter by summing up the conclusions which have emerged as to the relations of utility and cost to price.

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:—

LAW 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

Sec.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]

[Footnote 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.

Suppose a crossbred sheep yields 10 units of mutton and 8 units of wool.

Suppose, further, that a merino sheep and a crossbred sheep each cost the same sum, say, for convenience, L10, to rear and maintain; and that there are no special costs assignable to the wool and the mutton respectively, as, of course, in fact there are.

Then 10 merino sheep, yielding 90 units of mutton + 100 units of wool, cost L100; while 9 crossbred sheep, yielding 90 units of mutton + 72 units of wool, cost L90.

Hence you could obtain an extra 28 units of wool for an extra cost of L10, by maintaining 10 merino sheep rather than 9 crossbred sheep. The marginal cost of wool is thus L 10/28 per unit.

Similarly 8 merino sheep, yielding 72 units of mutton + 80 units of wool, cost L80; while 10 crossbred sheep, yielding 100 units of mutton + 80 units of wool, cost L100.

Hence you could obtain an extra 28 units of mutton for an extra cost of L20, by maintaining 10 crossbred sheep in place of 8 merinos. The marginal cost of mutton is thus L 20/28 per unit.

So long as the price obtainable for wool exceeds L 10/28, and that obtainable for mutton does not exceed L 20/28 per unit, it will pay to substitute merino for crossbred; and conversely. If the price of wool exceeds L 10/28 and the price of mutton also exceeds L 20/28, it will be profitable to expand the supply of both breeds, until as the result of the increased supply, one of the above conditions ceases to obtain. Conversely, if the prices of both products are less than the figures indicated, sheep farming of both kinds will be restricted. The resultant of the processes of expansion or restriction, and substitution, will be that, unless one of the breeds is eliminated, the prices of mutton and wool will equal their respective marginal costs. These marginal costs may, of course, alter as the process of substitution extends. For the relative cost of maintaining merinos and crossbreds will not be the same for every farmer. Here again it is the costs at the "margin of substitution" that matter.]

Sec.2. Marginal Utility under Joint Demand. On the side of demand there exist as a rule similar possibilities of variation. Some machinery, some labor, some materials of various kinds, are all indispensable in the production of any manufactured commodity. But the proportions in which these factors are combined together can be varied, and are frequently varied in practice as the result of the ceaseless pursuit of economy by business men. To produce pig-iron, you need both coal and iron ore; but, if coal becomes more costly, it is possible to economize its use. Machinery and labor must be used together, in some cases in proportions which are absolutely fixed. But there is in nearly every industry a debated question as to whether the introduction of some further labor-saving machine would be worth while, or some improved machine which would represent the substitution of more capital plus less labor for less capital plus more labor. A farmer can cultivate his land, to use a common expression, more intensively or less intensively; in other words, he can apply larger or smaller quantities of capital and labor (the proportion between which he can also vary) to the same amount of land. The problem is essentially the same as that of the substitution of the crossbred for the merino. We can take the various possible combinations of the factors of production, and contrast two cases in which different quantities of one factor are employed, together with equal quantities of the others. The extra product which will be yielded in the case in which the larger quantity of the varying factor is employed can then be regarded as the marginal product (or marginal utility) of the extra quantity of that factor; and we can say that the employment of this factor will be pushed forward to the point where this marginal product will be roughly equal to the price that must be paid for it. We can thus lay down the most important proposition that the relation between marginal utility and price holds good generally of the ultimate agents of production; that the rent of land, the wages of labor, and, we can even add, the profits of capital tend to equal their (derived) marginal utilities, or, as it is sometimes expressed, their marginal net products.

Whenever, therefore, the proportions in which two or more things are produced or used together can be varied, the relations of joint supply and joint demand are perfectly consistent with a specific marginal cost and marginal utility for each commodity.

Sec.3. A contrast between Cotton and Cotton-seed, and Wool and Mutton. But it sometimes happens that such variations cannot be made. Thus, it has not been found possible (so far as I am aware) to alter the proportions in which cotton lint and cotton-seed are yielded by the cotton plant. Roughly speaking, you get about 2 pounds of cotton-seed for every 1 pound of cotton lint (or raw cotton), and though this proportion may vary somewhat from plantation to plantation, it is upon the knees of the gods, and not upon the will of the planter that the variation depends. We cannot, therefore, speak with accuracy of the separate marginal costs of raw cotton and cotton-seed. It is true that some plantations are so far distant from any seed-crushing mill that it is not worth while to sell the seed as a commercial product; and it might seem, therefore, as though we might regard the entire costs of cotton growing on such plantations as constituting the marginal costs of raw cotton. But planters, so situated, derive a considerable value from their cotton-seed by using it as fodder for their live stock or as a manure. You can, of course, argue that proper allowance is automatically made for this factor, as a deduction from the costs of raw cotton, when you add up the expenses of the plantation. In the same way you can deduct the price which a planter who sells his cotton-seed obtains for it, from the total costs of the plantation, and call the remainder the costs of the raw cotton. But this is really to reason in a circle. For in either case the magnitude of the deduction depends on the marginal utility of the cotton-seed. And the notion of the cost of anything becomes blurred and blunted if we so use it that it must be deduced from the utility of something else, which is not an agent in the production of the thing in question.

This point is not merely an academic one. It means that we cannot explain the relative prices of cotton lint and cotton-seed in terms of cost at all, whether marginal or otherwise. The influence of cost will be confined to the sum of the prices of the two things. Upon this sum it will exert precisely the same influence as it exerts upon price in general, by affecting the total quantities of the two things that will be supplied. But upon the distribution of this sum between lint and seed, cost will exert no influence whatever, because it cannot affect the proportions in which they are supplied. It may assist some readers if I state the matter in more concrete terms. Cost of production will be one of the factors which will result in the production of an annual cotton crop in the United States of, let us say, 10 million tons of seed cotton. This crop will yield roughly 6-2/3 million tons of cotton-seed, and 3-1/3 million tons (or rather more than 13 million bales) of lint. The combined price received by the planter of (let us say) 14.4 cents for 1 pound of lint plus 2 pounds of seed should correspond roughly to the marginal joint costs of production. But the factor of cost has no influence at all in determining that this combined price is made up of a price of 12 cents per pound for lint, and only 1.2 cents per pound (or $24 per ton) for cotton-seed. To account for this we must rely entirely upon demand. We can say, shortly, that the respective prices must be such as will enable the demand to carry off 6-2/3 million tons of seed, and 3-1/3 million tons of raw cotton. Or we can go further and say that the marginal utility of a pound of raw cotton, when 3-1/3 million tons are supplied, is ten times as great as that of a pound of seed when 6-2/3 million tons are supplied.

If accordingly the demand for cotton-seed were to expand considerably owing, say, to the discovery of some new use for the oil, which is its most valuable constituent; the effect would be first a rise in the price of cotton-seed, and, subsequently, by stimulating cotton growing, a more plentiful supply and a lower price for raw cotton. And so far at least as the increased supply is concerned, this must necessarily be the effect, "other things being equal"; though, to be sure, it might be outweighed and obscured by other influences such as the boll-weevil. But it is not the case that an increased demand for mutton must necessarily increase the supply or lower the price of wool; and it is most unlikely to do so in any similar degree. For, here, the separate marginal costs of the two things exert their influence. An increased demand for mutton will stimulate sheep farming, but it will also stimulate the substitution of crossbred for merino breeds; and the resultant of these two opposite tendencies upon the supply of wool is logically indeterminate. As a matter of history we know that the development of cold storage in the eighties (which we may regard for the present purpose as equivalent to an increased demand for Australian mutton) caused considerable perturbation in the woollen and worsted industries of Yorkshire. They were faced with a dwindling supply and a soaring price of merino wool; and the adaptability with which they met the situation, and won prestige for the crossbred tops, and yarns and fabrics, to which they largely turned is a matter of just pride in the trade to-day. The fact, however, that this alteration in the supply of wool was a matter not only of quantity but of quality, while it takes nothing from the substance of the preceding argument, makes it difficult to draw a clear moral, bearing on the present issue, from this incursion into history.

Sec.4. The Importance of being Unimportant. The above contrast between cases in which variation is possible, and those in which it is not possible, is reproduced with a heightened significance when we turn back to joint demand. The cases are perhaps less common in which it is impossible to alter the proportions in which different commodities are jointly demanded, but there are many cases in which it is not nearly worth while to do so (and this amounts to very much the same thing). Cases of this sort are especially likely to occur when we are dealing with a commodity which accounts for only a tiny fraction of the costs of the industry which is its chief consumer. Sewing cotton, for example, is jointly demanded, with many other things, by the tailoring and other clothing trades; but the money which these trades spend on sewing cotton is so small a part of their total expenditure, that no ordinary variation in its price is likely to make it worth while to study the ways and means of using it in smaller quantities. When sewing cotton is bought by the domestic consumer, considerations which are fundamentally the same, though somewhat different in form, point to a similar conclusion. It is thus very difficult to assign to sewing cotton a specific marginal utility. This difficulty is of great importance in connection with the possibilities of monopolistic exploitation. For it means that the demand blade of the scissors upon which we rely to cut off excrescences of price is blunted, and if accordingly the producers constitute a strong enough combination to control the supply blade, they will possess an unusual power of advancing their selling prices as they choose. I am far from suggesting that Messrs. J. & P. Coats are to be condemned as an extortionate monopoly. On the contrary, during 1919, when the profits in highly competitive industries like the main branches of the cotton and woollen trades, soared exuberantly, the record of this concern seems to me one of distinct moderation. But the present point is that they possess an exceptional power to fix the price of sewing cotton as they choose, and that this is attributable in no small degree to the fact that sewing cotton constitutes an essential but relatively trifling item in the expenses of the processes in which it is employed.

Perhaps the point will be made clearer if we turn from the selling prices of commercial products, in regard to which there is a strong and not ineffective public sentiment against "profiteering," to the remuneration of different classes of labor. With an instinctive disposition towards megalomania, it is often claimed in Great Britain that the miners, being a very numerous and well-organized body of workpeople, were in a stronger strategic position than most workpeople for exacting the remuneration they desire. It is quite true that a stoppage of work in the coal industry causes us a high degree of inconvenience, and temporary concessions may thereby be obtained which might otherwise have been refused. But this is a dubious advantage, and we grossly exaggerate its real importance. The truth is that the strategic position of the miners in regard to wages questions is by no means strong. For their wages constitute a very large percentage of the cost of coal; and the price of coal in its turn is a most important element in the costs of many of the industries which are its principal consumers. Great Britain, moreover, is far from possessing a monopoly of coal. If, accordingly, the wages of the miners are temporarily pushed up to a high point, the result will certainly be a diminished demand for British coal, which will lead before long to their fighting a losing battle to maintain the concessions they have won. Contrast their position with that of the steel smelters, whose wages (high though the wage rates are) constitute a very small percentage of the costs of steel production, and we must agree I think that we have in this distinction the main reason why the steel smelters, though they hardly ever go on strike, have as a rule been able to do so much better for themselves than the miners.

When a commodity or service is such that an appreciable alteration in its price has only a slight effect upon the quantity demanded, the demand is said to be inelastic. Conversely, when a small change in price greatly alters the quantity demanded, we call the demand elastic. In the former case, it is worth nothing, a larger aggregate sum of money will be spent upon the thing when its price is high than when it is low, while the opposite is true in the latter case. This distinction is of considerable importance in connection with many problems (e.g. of taxation); and the terms, elastic demand and inelastic demand, are worth remembering. We may thus express the above conclusions by saying that the demand for sewing-cotton is highly inelastic, and that the demand for coal miners is more elastic than that for steel smelters.

Sec.5. Capital and Labor. Cases in which it is impracticable to make any variation in the proportions in which different things are used together are, however, the exception rather than the rule. Where variation is possible, we are confronted with an uncertainty as to the way in which an increased supply of one thing will react on the demand for another, similar to our uncertainty as to whether an increased demand for mutton would augment or diminish the supply of wool. It is, for instance, of the highest importance to give a clear answer, if we can, to the question whether an increased supply of capital will increase the demand for labor. The chief effect of an increased supply of capital is to facilitate the extended use of expensive machines: to some extent these machines will increase the demand for labor; to some extent they will be substituted for it. Which of these two tendencies will outweigh the other we cannot be absolutely sure. But fortunately we can be far more nearly sure than was possible in the analogous case of wool and mutton. An increase in the supply of capital increases the demand for the commodities, from which the demand for labor is derived, in both the senses discussed in Chapter II. First it makes them cheaper to buy, and thus increases the quantity that will be bought. It is this that is parallel to the effect of an increased demand for mutton in making it more profitable to breed sheep. But it also serves to increase the purchasing power with which to buy commodities, because it increases the aggregate real wealth of the community, and it thus serves to raise the whole demand curve. This last consideration is so important as to make it overwhelmingly probable, apart from the evidence of history, that an increase in the supply of capital (and the same may be said of an increase in the supply of the other agents of production) will on balance increase the demand for labor. The evidence of history points to the same conclusion. The history of the last hundred years displays an unprecedented accumulation of capital, and an unprecedented extension of machinery, associated with an unprecedented improvement in the standard of living throughout the whole community. This is powerful testimony in favor of the view that an increase in the supply of capital and the use of machinery will usually enhance on balance the demand for labor. Moreover, though this is not conclusive, there is little room for doubt that an obstructive attitude towards the extension of machinery in a particular country, or a particular district, is misguided. For its effect must be to make production more costly there than it is elsewhere, and to lead, slowly perhaps, but very surely, to the transference of the industry to other regions.

Sec.6. Conclusions as to Joint Supply and Joint Demand. Here, however, we are beginning to digress. Let us sum up in a general form our conclusions as to the way in which changes in the supply or demand of a commodity react upon the demand or supply of the other things with which it is jointly demanded or supplied. Everything turns, as we have seen, on the possibility of variation in the proportions in which the things are used or produced together; and this, it is also clear, is a matter of degree. Our conclusions, therefore, had best take the following form:—

LAW VII. When two or more things are jointly demanded, in proportions which cannot easily be varied, the tendency will be for an increase (or decrease) in the supply of one of them to increase (or decrease) the demand for the others. These results will be more certain, and more marked, the more difficult it is to vary the proportions in which the things are used.

Similarly, when two or more things are jointly supplied, in proportions which cannot easily be varied, the tendency will be for an increase (or decrease) in the demand for one of them to increase (or decrease) the supply of the others. These results again will be more certain and more marked, the more difficult it is to vary the proportions in which the things are supplied.

Sec.7. Composite Supply and Composite Demand. Joint Demand and Joint Supply do not complete the list of relations between the demand and supply of different things. Between tea and coffee, or beef and mutton there is a relation of a different kind. These things are in large measure what we call "substitutes" for one another. An increased supply, and a lower price of mutton, will probably induce us to consume less beef. This relation it is convenient to describe as Composite Supply. Beef and mutton make up a composite supply of meat; tea and coffee a composite supply of a certain type of beverage. For any group of things, between which the relation of Composite Supply exists, we can say, with complete generality, that an increased supply of one of them will tend to diminish the demand for the others. Parallel to the relation of Composite Supply is that of Composite Demand. There are frequently several alternative uses in which a commodity or service can be employed; and these alternative uses make up a composite demand for the thing in question. Thus railways, gasworks, private households and a great variety of industries contribute to a Composite Demand for coal. It is worth noting that there is frequently an association in practice between Joint Demand and Composite Supply on the one hand; and between Joint Supply and Composite Demand on the other. Wool and mutton, for instance, we have described as an instance of Joint Supply; but, in so far as the proportions of wool and mutton can be varied, we can regard these things as constituting a Composite Demand for sheep. And this conception may help us to retain a clearer and more orderly picture of the problems we have discussed above. We can regard the fact that wool and mutton are produced together as their Joint Supply aspect, and the fact that these proportions can be varied as their Composite Demand aspect; and the question as to whether an increased demand for mutton will increase the supply of wool turns upon whether the former aspect is more important than the latter. Similarly labor and machinery, employed together for the same purpose, form an instance of Joint Demand; but in so far as they can be substituted for one another, they constitute a Composite Supply of alternative agents of production.

These four relations of Joint Demand, Joint Supply, Composite Demand and Composite Supply are well worth remembering and distinguishing from one another. They are of immense importance in every branch of economic affairs. There are hardly any economic problems upon which we are fitted to express an opinion, unless we have a lively sense of the far-reaching ramifications of cause and consequence, of the subtle and often unexpected interconnections between different industries and different markets. To gape at these complexities in a confused stupor is as foolish as it is to ignore them. But confusion and stupor are only too likely to represent our final state of mind, if we attempt to deal with these complications, one by one as they occur to us, in a piecemeal and haphazard fashion. We need a clear method, a systematic plan by which we may search them out, and fit them into place. The four relations which we have enumerated supply us with such a plan and method. For they represent something more than a series of pompous names for familiar notions. They constitute a classification of the various ways in which the demand and supply of one thing can affect the demand and supply of others; a classification which is exhaustive when we add the relation of derived demand, and an analogous relation on the supply side which we must now notice.

Sec.8. Ultimate Real Costs. Just as the utility of "producers' goods" is derived from that of the "consumers' goods" which they help to make; so the cost of any commodity is derived from the cost of the things which help to make it. Moreover, just as we recognize that the utility of "consumers' goods" lies at the back of all demand, and constitutes the ultimate end of all production; so we cannot but feel, however obscurely, that behind the phenomena of money costs, there must lie certain ultimate costs, of which all money costs are but the measure. But when we try to explain what the nature of these real costs may be, we are plunged in difficulty. Wages, it may indeed seem at first sight, present no trouble. There is the effort and the fatigue, the unpleasantness of human labor, to represent real costs. But can we suppose that these things are measured with any approach to accuracy by the wages which are paid in actual fact? Is it true, even as a broad general rule, that the services which are most arduous and most disagreeable command the highest price? And wages are not the only ingredient of money costs. There are profits: to what real costs do profits correspond? More difficult still, to what does rent correspond? These plainly are not questions upon which he who runs may read. It will be necessary to devote the next four chapters to their elucidation.



CHAPTER VI

LAND

Sec.1. The Special Characteristics of Land. In the great process of co-operation by which the wants of mankind are supplied, Nature is an indispensable participant. She renders her assistance in an infinite variety of ways, of which the properties of the soil which man cultivates form only one; but the sunshine and rain which enable the farmer to grow his crops; the coal and iron ore beneath the surface of the earth, can be regarded for our present purpose as forming part of the land with which they are associated. We can thus concentrate upon land as the representative of the free gifts of nature, which are of economic significance. Land in modern communities is for the most part privately owned. It can be bought and sold for a price, and acquired by inheritance. Moreover, it is a common practice, particularly in the United Kingdom, for an owner who does not wish himself to cultivate or otherwise use the land, not to sell it to the man who does, but to lease it to him for a term of years for an annual payment which we term rent. It is therefore natural and convenient to envisage the problems, which we shall consider in this chapter, as problems concerning the price and rent of land. But, once again, the laws and principles which we shall state and illustrate in terms of the current systems of ownership and tenure, possess a much deeper significance than this terminology might suggest.

The fact that land is a free gift of Nature distinguishes it in various ways from commodities which are produced by man. The peculiarities which are most important from the economic standpoint are (1) that the supply of land is, broadly speaking, fixed and unalterable, and (2) that its quality and value vary, from piece to piece, with a variation which is immense in its range, but fairly continuous in its gradation. These are thus two aspects from which the phenomena of price and rent can be regarded; aspects which it is usual to call, (1) the scarcity aspect, (2) the differential aspect.

Sec.2. The Scarcity Aspect. The fact that the supply of land is fixed has the following significance. If the demand for land increases, the price will tend to rise. This is also true, for a short period at least, of an ordinary commodity. But, in the latter case, there would ensue an increase in supply which would serve to check the rise in price, and possibly, if production on a larger scale led to improved methods of production, bring the price down eventually below its original level. In the case of land, no such reaction is possible. There is nothing, therefore, to restrain the price (and the rent) of land from rising indefinitely, and without limit, if the demand for it should continue to increase. Conversely, if the demand for land falls off, there is nothing to check the consequent fall in price and rent. In the case of ordinary commodities, the supply would be diminished, because most things are either consumed by being used, or wear out in the course of time, and a regular annual production is therefore necessary to sustain their supply at the existing level. But land remains, whether it is used or not; and its supply is, broadly speaking, just as incapable of being diminished, as it is of being increased. Changes in the demand for land in either direction are thus likely to affect its price in a much greater degree than that in which the price of an ordinary commodity will be affected by a corresponding change in its demand.

For most purposes, however, it is of more interest to compare land with other agents of production, especially with capital and labor, rather than with ordinary commodities. Now, as we have already noted, there is some doubt as to the manner in which the supply of capital or labor is likely to be affected by alterations in demand price. But the supply of capital and the supply of labor, even if we suppose them to be as entirely unresponsive to price changes as is the supply of land, are at any rate not fixed. Not only may they vary for many reasons, but they are in fact likely to vary in direct proportion to the population. An increase in population implies an increase in the supply of labor; and it is likely to be accompanied by an increase in the supply of capital; in other words, the supply of these agents will expand, as the demand for them expands. But the supply of land will remain what it was. This fact is enormously important in connection with the broad problem of population, which will form the theme of Volume VI.

But it is important also in other connections. It has been the dominating factor in many absorbing controversies upon high policy regarding the ownership of land, or the taxation of land values, upon which we can touch but lightly here. It has seemed to many writers a reasonable proposition to lay down, that the ordinary course of the progress of society, the increase of population and industry, must mean, as a broad general rule, a constant increase in the demand for land. And, if that be granted, it seems to follow that the price and rent of land will tend constantly to increase. John Stuart Mill, accordingly, in the middle of the last century, asserted that "the ordinary progress of a society, which increases in wealth, is at all times tending to augment the incomes of landlords; to give them both a greater amount and a greater proportion of the wealth of the community, independently of any trouble or outlay, incurred by themselves,"[1] and upon the strength of this assertion, he justified the policy of imposing a special tax upon what we have come to call the "unearned increment" of land. But how far does actual experience bear his assertion out? In Great Britain we have seen in the last half-century an undoubted increase in urban rents; but over long periods at least, there was a marked fall in both the prices and rents of agricultural land, despite the fact that the country was "increasing in wealth" as rapidly as ever before. This was due, of course, in the main to the increased supplies of wheat and other foodstuffs coming from the New World: and if, accordingly, we choose to lump together not only our own urban and agricultural land, but the land of other countries as well, and to speak vaguely of the demand for land as a whole, it might seem as though we could argue that Mill's generalization still holds good. But even this is by no means certain and in any case such a generalization is of very little service: what the illustration should rather suggest to us, is the danger of speaking of land vaguely as a whole, and the importance of turning our attention to the variations in value between different kinds and different pieces.

[Footnote 1: Principles of Political Economy, by John Stuart Mill.]

Sec.3. The Differential Aspect. Most ordinary commodities are not produced on a single, uniform pattern. As a rule there are many variations of grade and quality, and consequently of price. But these variations are usually designed to meet the differences of taste among the purchasers, and we do not expect to find that any variety of an ordinary commodity will be produced, which is so poor in quality as to be entirely valueless. But since it is nature which has produced the land, without any assistance or guidance from man, there are many pieces of land which are so unfertile, or are otherwise so unsuitable for productive purposes, as to be quite valueless from the economic standpoint. Even in a densely populated country like Great Britain, there are considerable tracts of land which it is unprofitable to employ for any economic purpose whatsoever, and which possess no further value than what the mere pride of ownership may give them. This fact makes it possible to apply the conception of the margin to the case of land with particularly illuminating results.

In the first place, however, it should be observed that the value of any piece of land does not depend solely on the intrinsic fertility of the soil. The fact that land is an immobile thing makes its situation a factor of great importance. In the case of urban land, situation is, of course, the only thing that counts. The value of a site in Bond Street or the City is entirely unaffected by its capacity or incapacity for potato-growing purposes. But even for agricultural land, situation is a most important matter. A farm, which is so remote that considerable transport charges must be incurred to bring its produce to market, will be less sought after, and less valuable, than one which is much better situated though somewhat less fertile. In what follows, therefore, we must speak of the "quality" of a piece of land in a broad sense to include advantages of situation, as well as of fertility. Let us now, imagine the different pieces of land in Great Britain to be arranged in order of quality, so that we have a long series, with land of the best quality at one end, and of the poorest quality at the other. At the latter end, we will have such land as is found near the top of Snowden or Ben Nevis, which it clearly does not pay to cultivate at all. Somewhere, then, between these two extremes, we shall come to a point where the land is just, but only just, worth cultivating, or where, to revert to a form of words we previously employed, it is a matter of doubt, whether the land is really worth using for a productive purpose. Such land we can regard as the "marginal land"; and since the variety of nature is at once infinite and fairly minutely graduated we shall probably find that on one side of this margin there is much land which is only slightly superior, and on the other, much which is only slightly inferior, to the marginal land itself. What, then, is likely to be the value and the rent of this marginal land, this land which is just on the "margin of cultivation"? Some readers may find the answer startling. The rent of the marginal land will be nil, because it will not pay to cultivate it, if any appreciable rent is charged. A piece of land for which it is worth a tenant's while to pay an appreciable rent, will not be the marginal land, because there will be land just slightly inferior to it which it will also pay to cultivate if a somewhat lower rent is charged. And so we can pass to poorer and poorer qualities of land, with an ever diminishing rent, until at the margin of cultivation the derived utility of the land is negligible and the rent vanishes.

This certainly is a somewhat abstract conception; but it is by no means so remote from reality as may at first sight appear. The reader may protest that in the course of an extensive and varied acquaintance with landowners, he has not yet run across this peculiar marginal type, who lets his land for no rent at all. But there, if his experience is really extensive, I think he is mistaken. It so happens that the ordinary agricultural landowner leases out his land, not by itself, but together with a variety of other things such as farm buildings, which it costs him a considerable sum of money to provide. He will not as a rule be willing to go to this expense, unless he sees his way to obtain for the farm an annual payment, which represents at least a fair return on this capital outlay, as big a return as he could have got, for instance, by investing the same amount of money in some gilt-edged security. This annual payment will, it is true, be called rent; but the significance of this is that what we term rent in ordinary life is usually a complex thing, made up of two essentially distinct elements, viz. the normal return on the capital goods supplied together with the land, and what we may call the "net rent," or the "pure rent" attributable to the land itself. Now will any reader make so bold as to say that there is no land under cultivation, in respect of which this net rent is either nil or negligible? The landowners will not agree with him. It is not a question, it should be observed, as to whether the rent obtained represents more than a fair return on the purchase price paid for the land; that is quite another matter. The question is whether the rent obtained exceeds a fair return on the capital sum spent on the buildings, etc.; with which every farm must be equipped to let at all. In fact there are not a few farms where there is no such excess, and where accordingly there is no "net rent" or "pure rent" which can be attributed to the land.

The question whether it would be profitable to cultivate any piece of land, turns upon whether the receipts which would be obtained by selling the produce would exceed the costs of cultivation: and under these costs of cultivation we must include, of course, the remuneration of the farmer's services. Farmers, like other people, have to live; and they would not take on the troublesome job of farming, unless there seemed a prospect of making a living out of it. The remuneration of the farmer takes, of course, the form not of a salary, but of profits: and these profits vary very much from year to year, and from place to place, and from man to man. But they are essentially payment for work done, and an ordinary profit must be regarded therefore as part of the necessary costs of farming. Thus it will not be worth while to cultivate a piece of land, and the land will in fact lie unused, upon which a careful farmer might obtain a profit in the ordinary sense, of no more than $50 or $100 a year. The marginal land will be land which yields a decent profit to a decent farmer, as well as a gross rent to the landowner, sufficient to compensate him for his capital outlay, but nothing further.

What, then, will be the rent of a fertile and well-situated farm, about which there is no doubt that it is well worth cultivating? Part of the gross rent which the landowner receives must again be regarded as merely a return for the capital expended in equipping the farm for use; but in this case, there will be a residue left over, which constitutes the net rent of the land. The net rent will measure the derived utility of the land to its occupier, and will in general represent (very roughly, of course, in practice) the differential advantage of cultivating the land in question rather than land on the "margin of cultivation." This differential advantage may take either, or both, of the forms, of a larger produce per acre, or a lower cost of production and marketing. But, in any case, the extra profit, which, if no rent were charged, a decent farmer could obtain by cultivating the farm in question, rather than a marginal farm, will be roughly equal to the net rent which his landlord can exact from him, if his landlord so chooses. The landlord may, of course, not choose to exact a rent as high as this; and as a matter of fact, in a country like Great Britain landlords often content themselves with less. The traditions associated with the ownership of agricultural land, and with the relations between landlord and tenant serve to soften the edge of economic law, and to subject the rents which are actually fixed to the control in no small measure of the general sense of what is fair or customary. In such cases the landlord makes the farmer a present, for the time being, of part of the economic rent. On the other hand, as Irish agrarian history well illustrates, the landlord may sometimes expropriate under the name of rent, permanent improvements which are due to the labors or the expenditure of the tenant. This is, of course, particularly likely to happen, whenever it is the custom to leave to the tenant the obligation of providing the capital equipment of the farm, which in Great Britain is, for the most part, the recognized duty of the owner. Again, in the case of urban land in the South of England, expropriations of this kind are an essential and well-understood feature of the leasehold system. The owner grants a lease for a long period of time, usually ninety-nine years, for a ground rent, which is notoriously below the true economic rent of the land, subject to the condition that the leaseholder must erect upon the land and keep in good repair certain buildings, which on expiry of the lease will become the property of the ground owner. Here the nominal ground rent is only part of the total rent which is really paid; the ultimate transference of the buildings representing often the more important part. There is, in fact, a great variety of systems of land tenure, some of which are highly complex, the respective merits of which vary greatly, and which constitute a most important problem for statesmen and legislators. Considerations of this kind in no way diminish the importance of the general analysis of rent, which we are pursuing in the present chapter. Rather they make it the more important, because we cannot properly weigh the merits of any system of land tenure, until we have grasped clearly the principles governing the rent of land in the purest form. But certainly we must never forget that the rent we are discussing may differ very greatly from, though it will vitally influence, the money payments which are called rent in actual life. It is the pure economic rent, the rent which represents the full annual payment which it would be worth paying to obtain the use of the land alone, which will measure, as we have said, the differential advantage of the land in question over land on the margin of cultivation.

A clear grasp of this relation helps us to perceive that an increase in the prosperity of the community may sometimes influence rents in an unexpected way. It all depends on the causes which have given rise to the increased prosperity. An advance, for instance, in agricultural science will facilitate a more abundant supply of foodstuffs; but it will not necessarily increase the aggregate rents of agricultural land. For if it takes the form, say, of the discovery of some new artificial manure, it will very likely facilitate production on the less fertile soils far more than it will on the more fertile soils where artificial manures are not so necessary. It will thus tend to diminish the differential advantages of working on the more fertile farms, and their rents will accordingly fall, possibly by much more in the aggregate than any increase in the rents of the farms near the margin of cultivation. The point may, perhaps, be better understood if we pass from agricultural to urban land, and ask what would be the effect on site values of a great improvement in the facilities of internal transport. Push the case to an extreme, and suppose passenger transport to become so cheap and so quick that there ceases to be any advantage in living in a town so as to be near your place of work. Urban landlords would no longer be able to obtain the high rents they now receive for the sites of houses in or near a town. For most people would prefer to move out into the country where sites can be obtained at little more than an agricultural rent. The country covers so large an area relatively to the towns that the supply of rural sites would be still very plentiful as compared with the demand. Their rents would not, therefore, rise by very much, although the rents of the housing sites in towns would fall heavily. Of course, there are other factors to be taken into account before we could pronounce upon the effect on aggregate rents. Central sites for shops might, for instance, fetch a higher rental than before. The purpose of this discussion is not to generalize but to show the danger of generalizing about rents in the aggregate, or land as a whole.

Sec.4. The Margin of Transference. The last illustration may serve, however, to remind us of an obvious fact which we must now take into account. The same piece of land may be used for a variety of purposes. It may have been used for growing corn, and later it may be devoted to the building of houses, or, as at Slough, to a repair depot for motor vehicles. It need hardly be said that the land will, as a general rule, be put to the use in which its value is greatest; or to speak more strictly, in which the biggest rent, or the biggest selling price can be obtained. But the notion of the differential advantages which a piece of land possesses over the marginal land becomes decidedly more complicated when we take account of this variety of uses. Let us turn our attention, for instance, to the sites used for shop and office purposes, and consider what we can regard as the marginal site in this connection. Clearly it will not be the marginal land of which we spoke above, which it only just paid to cultivate, and which yielded no rent at all. For this will probably be agricultural land in an out-of-the-way district, where no one would dream of setting up an office or a shop. Any site upon which a sane man would contemplate setting up a shop will certainly possess value for other purposes, such as house-building. Hence the marginal site for shopkeeping purposes will not be like our marginal farm, a site which yields no rent.

As regards many pieces of land, there is no doubt as to the purposes for which they can most profitably be used. This piece will command a much higher rent as a shop site than in any other capacity; for that piece house-building is the obvious employment; for another, agriculture. But in quite a number of instances there is considerable uncertainty. It is not clear whether upon this site it will be better to erect a house or a shop, or if the latter, what kind of a shop. It is not clear whether it will pay to use that farm land for a building scheme; and, within the domain of agriculture, which of course comprises an immense variety of really different industries, it is often a very moot point indeed whether a certain field should be left under grass, or brought under the plow. Cases of this sort are not phantoms of the imagination; they emerge on every side as concrete problems with which some one or other is dealing every day, and it is these cases which constitute the marginal land for the purposes of a particular occupation. The marginal sites for shops are the sites for which it is only just worth while to pay rents sufficient to entice them away from houses. And the rent for a site in Bond Street, or elsewhere, which is so much more suitable for shop purposes that no alternative use would be worth considering, will exceed the rent paid for one of these marginal sites by, roughly speaking, the extra advantage it possesses for shop purposes. Or will fall short of it, it may be well to add, to the extent of its comparative disadvantage. For there may be many such marginal sites, some of which will fetch low rents, and others very high rents indeed; the same site being often of great potential utility for a large variety of occupations. Between any two occupations there will thus usually be a margin of transference, which we must conceive not as a point, but as an irregular line, upon or near to which there will be many pieces of land, differing greatly in the rents which they fetch. These variations of rent will correspond to the differences between the advantages or derived utilities which the sites possess for both the occupations in question. The position of such margins of transference will of course alter as industrial conditions change, and, when they alter, the rents of sites which are not near any margin of transference will be affected also. Thus an increased demand for the products of any particular industry will make it profitable for that industry to offer higher rents, and thus draw land away from other occupations. This will have the effect of raising, though possibly to a very slight extent, the rents of sites which still remain in other uses; for there will be fewer of them available; and their derived utilities will consequently be increased.

But here, as everywhere, it is upon the margin that our attention should be focussed, because it is round about the margin (wherever it is found) that the changes are taking place which really matter for society. When Mr. Mallaby-Deeley buys an estate in Covent Garden from the Duke of Bedford, the transaction hardly deserves the degree of public interest it excites. Nothing has happened which is of material consequence to anyone except the two gentlemen concerned; the various sites are still used for the various purposes for which they were used before; nothing has occurred that really matters. But when houses are pulled down for the erection of a cinema, or when a field is diverted from tillage to pasture, something has happened which affects for good or ill the interests of the whole community. Conversion from tillage to pasture represents, indeed, a tendency which has been very marked in Great Britain during the last generation, and has aroused misgivings in many public-spirited observers. Possibly for a variety of reasons, these misgivings may be justified; certainly the problem is well worthy of attention. But when in this way the issue is raised of tillage versus pasture, it is essential, if we are to discuss it rationally, that we should envisage it clearly as applying only to a limited portion of agricultural land, to the portion which lies somewhere near the margin of transference, as things are now, between the two forms of agriculture. It might be socially desirable to bring under the plow a field which the farmer finds it only slightly more profitable to lease under grass; but this would be highly improbable in the case of a field where the balance of argument to the farmer in favor of pasture is overwhelming. The position of the margin of transference between different uses may, in other words, be somewhat out of place from the social point of view, and it may be desirable by appeals and propaganda, even conceivably by the devices of State subsidy and compulsion, to push it forwards or backwards in greater or less degree. But it will be necessarily a matter of degree, and nothing could be more foolish than to speak as though there was, or could be, some ideal method of cultivation equally applicable to all lands, without regard to their climatic and other conditions. Needless to say, none of the agricultural experts who sometimes deplore the decline of arable farming are guilty of such foolishness. But the sense of the diversity of nature which is very vivid to them may sometimes be lacking in people who live in towns, and a firm grasp of the marginal notion may serve best to keep the latter from forgetting it.

Sec.5. The Necessity of Rent. Behind all such detailed applications there lies a more general consideration which deserves attention. The way in which the land of a country is used, the way in which it is apportioned between the countless alternative employments that are possible, is a most important matter, more important perhaps than any questions as to the size of the incomes which particular landowners receive by virtue of their rights of ownership. How is this apportionment effected as things are now? The answer is clear: mainly by the agency of either rent or price. The business which finds it worth while to offer the highest rent or the highest price for any piece of land will, as a rule, be able to command its use. And, with this as the governing principle, an apportionment is secured between shops, offices, factories, agriculture, between the immense variety of different employments covered by each of these broad headings; not a rigid unvarying apportionment, but one which constantly changes as economic circumstances change, and as the margin of transference between different occupations moves hither and thither. This apportionment takes place at present as the result of the independent decisions and bargains of many private individuals, who are thinking mainly of their own interests, and not of those of the community. But this state of affairs might be altered. The land might be nationalized and allocated to its various uses by the co-ordinated labors of a great State department, or some other agency of the collective will. However improbable such a change, it is perfectly conceivable. But what is not conceivable is that any State department should handle the job with a success even approaching that of the present system, unless it continued to use, as its main instrument, the criterion of either rent or price. That a piece of land would yield a higher rent in one occupation than in any other is not conclusive evidence that it is best to devote it to the former purpose, but it is very good evidence, and it should be allowed to prevail unless it is demonstrably outweighed, as it possibly might often be, by considerations of a different kind. That it would not be well for the community to employ land in the city of London for corn-growing purposes, however desirable might be a revival of home agriculture, is so obvious that it may seem to have no bearing on the present issue. But it is only an extreme indication of the absurd and wasteful use of our natural resources, which would grow up slowly but surely, if we dispensed with ideas of rent and price as sordid irrelevancies, and allocated our land on the basis of a balancing of the loftiest arguments of a vague and sentimental character. If you are prepared for the distribution of land to become stereotyped, for each piece to continue indefinitely in its present use, then indeed you might dispense with rent, as primitive societies very largely do. That would mean stagnation and, for an industrial country, decay. But if changes are ever to be contemplated, a simple quantitative measure is the only safeguard against utter chaos. Thus rent, like interest, will be found indispensable as a measure under any efficient system of society, even if it might not always represent the payment of sums of money to private individuals. And that is why the principles governing rent possess, as I indicated at the outset of this chapter, an importance more fundamental than our present system of ownership and tenure.

Sec.6. The Question of Real Costs. But we must not forget the preliminary question that started us upon our analysis of the agents of production. The rent which a manufacturer or farmer has to pay for his land he naturally includes in his cost of production. But does this money cost to the individual correspond to, and measure, any real cost to the community as a whole? Here let us note in the first place that if only we could disregard the variety of uses to which land is put, if we could suppose that all industry was agriculture, and that agriculture was a single industry with a single product, we could argue that rent does not enter into marginal costs at all. For we could regard the marginal producer as the one working on a marginal farm, whereas we have seen there is no pure rent. The rent which other producers have to pay would thus represent merely the destination of the surplus profits which arise wherever actual costs fall short of marginal costs. This way of looking at the matter has proved attractive to some thinkers, not in the least because of a desire to palliate the effects of landlordism, but because it fits in so well with our general sense of rent as a "surplus," and a surplus as something distinct from a necessary price. But it is clearly illegitimate in an economic theory which professes "to describe the facts." The marginal land for many purposes fetches, as we have seen, a considerable rent; and this rent is certainly part of the marginal costs and of the necessary price of the products of the particular industry. The answer to our question is, however, not now very difficult to see. Land, greatly as it differs in many respects from the other agents of production, resembles them in the very important respect that, being used for one purpose, it is not available for other purposes, and that the productive powers of the community in other directions are thereby diminished. This is the real cost to the community, which attaches to the products of any industry, in virtue of the land which it occupies; not any human labors or sacrifices required to produce the land itself, but the curtailment of the natural resources available for productive use elsewhere. This is the real cost of which rent is the money measure, and generally speaking an accurate measure at the margin of transference between one occupation and another. A somewhat fanciful use of the term cost, this may seem perhaps, one not quite in accordance with our instinctive sense of what real costs should be. But possibly the real costs represented by wages and profits may turn out to be not so very different, and we had best leave the matter there, until we have examined the nature of these other costs.

Sec.7. Rent and Selling Price. In this chapter we have spoken mainly of the rent rather than the price of land: the relation between the two things is fairly obvious and well understood, but it will be well not to close the chapter without a brief account of it. The price of any piece of land is affected by all the considerations on which its rent depends, but it is also affected by another factor which has no influence whatever upon rent. This factor is the rate of interest. The higher the rate of interest, the higher the return which a man could obtain by buying gilt-edged securities, the lower will be the price that he will pay for a piece of land which yields a given rent. We can express the relation more precisely by the formula Price = (Rent * 100)/(Rate of Interest), though we must be careful, in applying this formula in practice to allow for the possible deviations between the nominal and the true rent, and similar complications. The price, it must be observed, is derived in this way from the rent, not the rent from the price.[1] Rent is thus logically the simpler, price the more complex thing. It is well, therefore, to analyze in the first instance the principles of rent, if we live in a country where the practice of leasing land for annual rent is less common than it is in Great Britain, even if, for whatever reason, it is the price of land with which we are concerned in practice. The problem of price contains two distinct elements which it is not easy to handle when mixed up together. For the rate of interest represents in itself an important branch of economics, which will require a separate chapter to itself.

[Footnote 1: In this the rent of land differs fundamentally from that of other things, such as houses. For the price of a house is largely influenced by the costs of construction of new houses, and should correspond closely to them in the long run. The same relation between rent, price and rate of interest will hold good; but the rents will be affected by changes in the rate of interest, owing to the reactions of such changes on the supply of houses.]



CHAPTER VII

RISK-BEARING AND ENTERPRISE

Sec.1. Profits and Earnings of Management. The profits of a business, as they are ordinarily reckoned, whether for the purposes of income tax or of a balance sheet, comprise several elements which are fundamentally distinct. The relative importance of these various elements varies greatly from one type of business to another. The profits of a private business include, for instance, the remuneration of the work of management, which in the case of a Joint Stock Company is mostly paid for by salaries or directors' fees. It is to their profit that farmers, small shopkeepers, and the partners of a private firm look not merely for a return upon their capital, but for the reward of their own labors. "Earnings of Management," as they are usually termed (though in truth they often cover other and humbler forms of labor) are thus frequently one of the ingredients of profits.

Sec.2. The Payment for Risk-bearing. There is another element of great importance about which our ordinary ideas are apt to be so vague that it will be well to devote a chapter to its examination. This is the element of payment for risk, or rather the reward of risk-bearing. Risk is inherent in all business, as it is inherent in all life. The vagaries of nature and the vagaries of man are alike responsible. The farmer may find his harvest ruined by a drought or by a deluge; the coal or the gold, for the extraction of which you have perhaps set up an extensive mining plant, may come to an end which is unexpectedly abrupt. You may put your money into roller-skating rinks and find that cinemas have become the rage with the fickle public; sometimes "the market" may decline for causes which remain obscure but with consequences which are disagreeably plain. But while risk is always present in some degree, the degree varies enormously from one industry to another. Now, it is obvious enough that in an exceptionally risky industry, where there is a considerable possibility that the capital invested will yield no return at all, the profits of those concerns which succeed are likely to exceed the rate of interest on gilt-edged securities. But what is likely to be the magnitude of this excess? Is risk-taking rewarded if there is any such excess, however small? Or will it suffice that the gains and losses should average out to a fair rate of interest over the whole industry? To enable us to think closely let us suppose for a moment that we can measure accurately what the chances are.

Suppose, then, that there were a precisely equal chance of success on the one hand and failure on the other in any enterprise, failure involving a complete loss of all the capital invested. Suppose, further, 6 per cent to be at the time a fair return on a perfectly secure investment. What would be the return which must be expected from the risky enterprise, in the event of its succeeding, before it will be undertaken? The reader may be tempted to answer, 12 per cent. But 12 per cent would not suffice. An equal chance of 12 per cent or nothing, as compared with a certainty of 6 per cent, does not mean that the risk in the former case is paid for to the tune of 6 per cent. It means that it is not paid for at all. In each case what a mathematician would call the expectation is a return of 6 per cent. The odds are evenly balanced; in the long run, over a large number of cases, if the law of averages works as we assume it does, you would get just as much from the one type of investment as the other. Now, risky enterprises will not, as a rule, be undertaken on terms like these; investors and business men will not take risks with the odds precisely equal; they must have them, or believe that they have them, in their favor.

Sec.3. Monte Carlo and Insurance. To assert this is not to ignore the strength of the appeal which the gambling instinct makes to many, if not to most of us. The taste for gambling is, indeed, so deep and widespread that it would be foolish to leave it out of account in this connection. It is clear enough that at places like Monte Carlo people are prepared to have the odds unmistakably against them, apparently for the sheer pleasure and exhilaration of taking risks. Moreover, though for most people play at Monte Carlo represents a mere holiday indulgence, it would be unsafe to assume that what appeals to them there will not also appeal to them in their business affairs. But what exactly is the secret of the charm of Monte Carlo? It is the great attractive force of a small chance of a large gain, as compared with the deterrent force of a large chance of a small loss. People will readily pay $5 for one chance in a hundred of making no more, perhaps, than $400 or $450. And it is very likely that this holds good in the world of business. If, for example, we were to suppose that the promoters of a new enterprise were confronted with one chance in fifty of a profit of 50 per cent per annum on their capital, as against forty-nine chances of a profit of 5 per cent, this might well prove a more attractive prospect than a certain return of 6 per cent, although the strict expectation of profit would be smaller in the former case. But the risks of business enterprise are not often of this type. They conform more usually to the opposite type of a large chance of a relatively small gain, balanced by a small chance of serious loss or entire failure. Now for almost everyone the possibility of a great loss will count as a deterrent (just as the possibility of a great gain may count as an attraction) for much more than its strict actuarial value.

The truth of this proposition is demonstrated by the existence of institutions more impressive than Monte Carlo—the Insurance Companies, which play so large a part in the economic life of modern times. Every year, and upon an ever-growing scale, both private individuals and business concerns pay sums of money, which reach in the aggregate a colossal sum, as premiums to insure themselves against loss by Fire, Shipwreck, Burglary, Death, Death Duties, against every risk which Insurance Companies will cover. Now Insurance Companies are not, as we say, in business for their health. They find their business profitable, and pay good dividends to their shareholders. Moreover, they incur a considerable expenditure on offices, on clerical staff, on agents, and the like. All these payments must be defrayed out of the premiums they receive; so that it is plain that the premiums greatly exceed the expectation of the risks insured. The odds are heavily in favor of the Insurance Company—of that the stupidest person can have no shadow of doubt. Yet we continue to insure, as private individuals and as business men, and so far from being ashamed of our proceedings as a weak and nerveless folly, which somehow we are unable to resist, we blazon them forth in the strong accents of conscious pride. We preach insurance to our neighbors as the core of self-regarding duty, and, if ever we feel a twinge of uneasiness, it is lest we, too, may have omitted in some particular to practice what we preach.

The significance of this is unmistakable. Be our psychology what it may, however deep and irrepressible our taste for derring-do, however inadequate the scope which the dull routine of modern life affords for our adventurous impulses, we are most of us anxious to avoid the risk of great financial loss. We are very glad to find someone to take it off our shoulders if we can; so glad that we are prepared to pay him for the service, to pay him a sum which covers not only the actuarial equivalent of the risk, but something substantial over and above. In this we are entirely rational. Our conduct is justified by the law of the diminishing utility of money, which was noted at the end of Chapter III. It would be plainly foolish, for instance, to substitute for the certainty of an income of $2500 per annum an even chance of $5000 or nothing, since the utility to us of $5000 is not twice as great as that of $2500.

The majority of business risks are not of a kind against which it is possible to insure. Insurance companies confine themselves to risks which are mainly a matter of what we call objective rather than subjective chance, i.e. risks in respect of which knowledge of detailed facts peculiar to the individual case is of minor importance. But such knowledge is of paramount importance in the case of ordinary business risks. If, for example, a new enterprise is to be undertaken, the special knowledge and experience which its promoters possess is a vital factor in determining their estimate of the risk involved. An outsider with no special knowledge would necessarily require to estimate the risk far more highly if we were to form a rational opinion on the basis of his knowledge. So great, indeed, would be the risk to him, that we can lay it down as a sound maxim that people are extremely rash who invest their money in risky undertakings about which they know very little. This subjective aspect of business risk has a significance to which it will be necessary to revert.

But, though most business risks are not and cannot be a matter for premiums and policies, the principle, which the practice of insurance illustrates, applies none the less. In the light of their knowledge and experience, the promoters of a new undertaking must weigh up the chances of failure and success, though they will not do so by the precise methods of an actuary. They will require that any chances of serious loss should be balanced by such chances of exceptional gain, as would raise the expectation of profit well above the normal return on secure investments. The more risky the project seems the greater, generally speaking, must be the expectation of profit required to induce people to undertake it.

If we suppose business men to calculate reasonably, it follows that the average profits in any industry over a long period of years, reckoning in the losses of the concerns which disappear altogether, are likely to be higher, the more risky is the industry. Such a result will not, of course, occur in every case. Even when the calculations are reasonable, they may be entirely falsified by the event. Moreover, business men may not calculate reasonably on the information which they have. But, unless we suppose their judgment to be subject to a prevailing bias in one direction, i.e. to be unduly optimistic as a general rule, we should expect, and in any case they must expect, profits above the ordinary in a risky industry.

This conclusion is sufficiently important. Far too many people, though they admit it when it is expressly stated and dismiss it even as a tiresome commonplace, are apt to neglect it when the occasion for applying it arises. For example, the great importance to any industry of good management is generally recognized, and the consequent desirability of paying adequate salaries to the managerial staff. The importance of securing a supply of capital is very widely recognized, and the practical necessity of paying a fair rate of interest is thus, however grudgingly, conceded. But the "residuary profits," as they are called, which accrue at present to the owners of a business, are denounced in some quarters in a sweeping fashion, which seems to ignore altogether the all-pervading element of risk. People speak as though you might appropriately limit profits in every industry to some uniform percentage on the capital employed, without making it clear whether you would even be allowed to make up in good years for the losses incurred in bad. The effect of introducing any such crude device into our present industrial system could only be to paralyze enterprises of an unusually risky kind, which, so far from being pushed to an excess at present, are more probably curtailed unduly from the standpoint of what is socially desirable. Like the fixing of a low maximum price for a commodity it would cause the supply to wither up and disappear.

Sec.4. Risk under Large-scale Organization. While this is true of the present economic system, the question is worth considering whether it represents a fundamental necessity, whether, for instance, under our world socialist commonwealth the factor of risk-bearing need play so important a part as it does in the actual business world. This question cannot be answered with a conclusive simplicity; opposing considerations present themselves, between which it is not easy to strike a balance. On the one hand, in accordance with the law of averages gains and losses tend to cancel out over a large series of transactions, when reasonable calculations have been made. Thus Insurance Companies, while they take heavy risks off the shoulders of policy-holders, incur relatively trifling risks themselves; they can predict the aggregate sums which they will be called upon to pay within a small margin of error. In the same way it might seem that every enlargement of the scale of business would make for an automatic insurance and a consequent economy of risk; and thus that if all businesses were comprised in a single financial unit, gains and losses would cancel out over so wide a range that the degree of risk remaining would be almost negligible.

This might indeed happen, if business risks were mainly of that objective kind in which the insurance companies specialize; for then we could assume that the chances of success or failure would be estimated reasonably. But, in fact, most business risks, not being of this kind, must be estimated by processes of human judgment, which are very fallible. And here we must take account of the law of averages in another aspect, with a different bearing on the argument. When an industry comprises a large number of separate concerns, and the decisions accordingly are taken by many men, acting independently of one another, the errors of calculation will tend to some extent to cancel one another out. The undue optimism of one man will be balanced by the undue pessimism of another; and, if there is no prevailing bias in either direction, the errors of judgment will not affect the results for the industry as a whole. But where the effective decisions are taken by very few men, the chances are far greater of a preponderating balance of error in one direction. The risks dependent on the factor of human judgment tend therefore to increase.

This truth can be illustrated by a phenomenon which is fairly familiar. It is recognized by intelligent persons that the risks of speculation in a particular commodity market or stock market increase more than proportionately to the scale of operations. A man who sets out as a "bull" upon a small scale can buy without sending up the price against him in the process, and, if he decides later that his judgment is mistaken, he can at any time cut his losses and sell out without much difficulty. But a "bull" on a very large scale cannot complete his purchases except at a price which has been raised in consequence of his own action, and he cannot count on being able to "unload" at or near the market price, should he decide to do so. If, accordingly, he miscalculates, he cannot save himself from serious loss as a smaller man might do by a prompt discovery of his error. His difficulties spring from the fundamental fact that the effects of his calculations are too great to be offset by those of the different, and often opposite, calculations of other men.

Upon the issue whether a growth in the size of the business unit is likely to diminish risk, the law of averages thus cuts both ways. The risks arising from the element of pure chance are more likely, those arising from miscalculation are less likely, to cancel out. Upon these grounds alone, it would be unsafe to conclude that there would be on balance an economy of risk under any system of national or world socialism.

Sec.5. The Entrepreneur. There remains, however, an aspect of the problem which is perhaps more important than those discussed above. It is probable that risks would be estimated and undertaken more wisely or less wisely under a different system of society or of industrial organization? Upon this issue, methods of precise analysis are out of place, but we may have something to learn from the emphatic testimony of tradition. It has become an axiom of business men that, while Governments can manage with more or less competence a safe and routine business like a Postal Service, their success would be unlikely to prove conspicuous in undertakings where the element of risk is great. There, it is said, we owe everything in the past to the enterprise of individual men (for even joint-stock companies have not been notable as pioneers) adventuring their own fortunes in accordance with their own unfettered judgment. This contention, however much we may desire to qualify it, has unquestionably a large measure of truth, and the explanation is not difficult to discover. For the wise taking of risks in industrial development of an experimental character, peculiar conditions and special qualities are required. First, it is necessary to envisage distinctly the promising though risky opportunity, and this calls not infrequently for imagination of a none too common order. Then it must be studied with insight and expert knowledge and weighed by processes which are as much intuitive as intellectual. The reasons for or against taking a particular business risk are seldom such as can adequately be expressed in terms of arithmetic, or even by clear arguments the soundness of which is proportioned to their logical cogency. The mysterious faculty of judgment enters in; and from mental processes which defy analysis there emerge ultimately conviction and the will to act. But it is precisely here that Government Departments are apt to fail. It is here that the individual, who need consult no one but himself, has a pull over any form of organization, where decisions are reached by the method of debate and agreement among a heterogeneous committee. Hence it is that we have come to regard exceptional risk-taking as the peculiar province of individual enterprise. It is probable that these deficiencies of corporate organization are tending to diminish, and it is an interesting question how far it may be found possible to eliminate them in the future.

Meanwhile the above considerations have an important bearing on the rewards which can often be obtained from risky enterprises. The number of individuals who are in a position to envisage a business opportunity, and to assess with some confidence the chances of success and failure is very limited. Not only must they possess special knowledge, ability, imagination, confidence in their own judgment, and the capacity to act on it; they must also have at their disposal considerable financial resources. To combine all these advantages represents a union of circumstances which is distinctly rare. The fortunate few, who do combine them, are thus generally able to extract in the form of profits a high price for their services, a price which covers not only the strict reward of risk-bearing, and the necessary remuneration of their own service, but a handsome payment for the special qualities and advantages which have been indicated. Profits, moreover, may vary between one industry and another, not only in accordance with the real risk which is entailed, but with the degree to which the supply of special knowledge, etc., is scarce or abundant.