Chapter I

, can be verified by anyone from his experience and observation (provided he is a reasonable person, and not the tiresome kind who would dispute the law of gravitation because he sees that a feather falls to the ground more slowly than a stone). But it can also be deduced as a corollary from the two preceding laws; and to regard it in this way will help us to appreciate its significance. Start, for instance, by supposing that demand is in excess of supply. Then the price will tend to rise. After the price has risen, the supply will become larger, while the demand will fall away. The excess of demand with which we started will thus clearly be diminished. But if there remains any portion of this excess, the same reactions will continue; the price will rise further, and for the same reason; demand will be further checked and supply further stimulated. In other words, these forces must persist until the entire excess of demand over supply is eliminated. If we start by supposing supply to exceed demand, the converse chain of sequences will operate. Now these very simple steps of reasoning illuminate the nature of the normal equilibrium of demand and supply. They reveal that the equilibrium is established and maintained by the agency of _changes in price_, and they enable us to lay it down as perhaps the most important thing that can be said about the price of anything that it will tend to be such as will equate demand and supply. But that is not all that they reveal. They reveal also the extreme dependence of both demand and supply upon price.

Now this is a fact which it is most important to realize vividly. It is apt to be obscured by customary modes of speech. In ordinary times the prices of most commodities and services do not change by very much, unless indeed over a long period of years; the amounts demanded and supplied may therefore seem to maintain a fairly constant level; and we may be tempted to speak of Great Britain producing so many million tons of coal, or America consuming so many millions of motor-cars per annum, almost as though these quantities were independent of price considerations. But we should never forget that there is no service or commodity produced by man, however essential it may seem, the demand for or the supply of which might not be reduced to nothing, if the price were sufficiently raised on the one hand, or lowered on the other. How easy it is sometimes to forget this simple truth may be seen from the mistake so commonly made of supposing, because the peoples of Central Europe were left, on the cessation of the war, starving and destitute of the means of life and the materials of work, that they must necessarily become heavy purchasers of imported goods; without pausing to consider whether the prices were such as they could afford to pay.

§2. _Diagrams and their Uses_. It will help to prevent mistakes like this and more generally to make sharp and clear the fundamental relations which exist between demand, supply and price, if we exhibit them pictorially in the form of a diagram. Such diagrams are of great service in many parts of economic theory, not because they can prove anything which could not be proved otherwise, but because, being really a simpler medium of expression than words, they enable the mind to grasp more readily and to retain more vividly the essential facts of complex relations.

Figure 1:

Y | | S' | * D | ** |* ** | ** * | ** * | * * | ** ** | ** * | ** * | ** ** | ** * | ** Q ** _l_|--------------*------------* R | |*** ** | | ** P ** _m_|--------------------*** | | *** |*** _k_|--------------***----+---** _r_ | _q_*| | *** | *** | | **** | *** | | **** | *** | | *** S |**** | | **** | | | ** D' | | | | | | | | | | | | 0+-------------------------------------------------------- X' N M. Figure 1

In Fig. 1 the curve DD' represents the conditions of demand. It is supposed to be drawn in such a way that if any point, Q, be taken on the curve, and the perpendicular QN be drawn to meet the base line, or axis OX, then ON will represent the amount that will be demanded at a price represented by QN (or O_l_). In other words, distances measured along OY represent prices, and distances measured along OX represent quantities of the commodity, or service, or whatever it may be. Clearly, then, the demand curve, DD', must slope downwards from left to right, since the lower the price asked, the greater will be the amount demanded. Similarly the curve SS' represents the conditions of supply. It is supposed to be so drawn that if any point _q_ be taken upon it, and the perpendicular _q_N be drawn to meet OX, then ON will represent the amount that will be supplied at a price represented by _q_N (or O_k_). Equally clearly this supply curve must slope upwards from left to right, since the higher the price obtainable, the greater will be the quantity offered. Take the point P where the two curves meet, and draw the perpendicular PM to meet OX. Then the third law enunciated at the beginning of this chapter corresponds to the statement that PM or O_m_ will represent the price at which the commodity or service will be exchanged.

It can readily be seen that no other price could be maintained. For suppose the price to be less than O_m_, suppose it to be O_k_, then, at this price, ON (or _kq_) will be the amount supplied, and _kr_ the amount demanded. The demand will thus exceed the supply, and the price will tend to rise, i.e. to move upwards towards O_m_. Similarly if we suppose the price to be O_l_, which is larger than O_m_, the supply (_l_R) will exceed the demand (_l_Q) and the price will fall downwards towards O_m_. Thus, again, we have deduced Law III from Laws I and II with the form and precision of a proposition in Euclid. Now, when once the eye has become familiar with this diagram, it ought to be impossible for the mind to lose even momentarily its grip on the fact that demand and supply are both dependent upon price. For these curves do not represent any particular amounts; they represent a series of _relations_ between amount and price; if the price is QN the amount demanded is ON, and so forth. The terms demand and supply in the sense, in which I have been using them, of the respective amounts demanded and supplied are, indeed, strictly meaningless without reference to some particular price. The reference may sometimes be implicit; but, whenever there is a chance of ambiguity, it should be explicitly made.

§3. _Ambiguities of the Expressions, "Increase in Demand," etc_. It is the more important to be precise upon this point, in that there is a further possible confusion which we have now to consider. Demand and supply, as we have seen, are dependent upon price; but equally clearly they are dependent upon other things as well. Demand depends upon the needs, tastes and habits of the people, as well as upon the length of their purse; supply depends upon such things as the cost of production in the case of commodities. None of these things are constant factors, all of them are liable to change, and it may well happen that we shall want to consider in some concrete problem the probable consequences of such a change. Now the most usual and natural way of describing such changes in the medium of words is to use the expression "increase" or "decrease in demand," and "increase" or "decrease in supply," the same expressions, which we employed before to describe the consequences of a change in price. This identity of language conceals a fundamental distinction between the phenomena described; and to make this distinction plain we cannot do better than revert to our diagrammatic presentation of the laws.

Figure 2:

Y | | _d_| |. | . | . _s'_ | . . D | . . |** . . * S' | ** .. . * | ** . . * | ** . .. * | * .. . ** | ** . . ** | ** .. .. ** | * . . * | ** . . * | ** .. . ** | ** .. .. ** | ** .. .. ** | ** . .. ** | ** p' .. ** | **.. .. ** | ..|**p **._p_ | .. | **** | .. | ... |**|** | .. | .. *| | *| .. | ..... *** | | |** . _s_|...... *** | | | ** .. | *** | | | ** ... | ***** | | | ** ... S |***** | | | ** .. | | | | *** .._d'_ | | | | *** | | | | ** | | | | **D' | | | | | | | | 0+--------------------------------------------------------- M' M _m_ Figure 2

In Fig. 2 we start as before with our demand curve, and supply curve, cutting one another at the point P. We then suppose that some alteration takes place in the conditions of demand; there has been a growth in the general taste for the commodity or service, and the demand, as we say, has increased accordingly. How is this fact to be represented in the diagram? Plainly not by taking another point on the curve, DD', at a further distance from OY. For this would merely indicate the larger amount that would be taken, if the conditions of demand had remained unaltered but the sellers had reduced their prices. The correct way of representing the change we have supposed is to construct a new demand curve (in the figure, the dotted curve _dd'_), lying at every point above the old demand curve. For this indicates that larger quantities will be purchased at the old prices, which is exactly what we want to represent. Similiarly if we wish to represent a change in the conditions of supply, such as might result, in the case of a commodity, from a tax imposed on its production, we must draw a new supply curve, _ss'_, which in the case supposed, must lie everywhere above the old supply curve. On the other hand, the decrease or increase in demand or supply, _resulting_ from a change in price, is represented simply by a shifting of the equilibrium from one point to another on the same curve. The striking pictorial contrast between a movement from one curve to another, and a movement along the same curve should help to make vivid to our minds the fundamental distinction between a change in the _conditions_ of demand, arising from new tastes, enhanced purchasing power, etc.; and a mere change in the amount purchased resulting from an alteration in the price which the sellers ask. Words, as this necessarily cumbrous sentence shows, are a clumsy instrument for the expression of abstract relations; it is not very easy to see which words in a sentence are the significant, commanding ones, and which are performing, as it were, ordinary routine duties. A diagram is not exposed to similar ambiguities of emphasis.

The particular distinction, to which attention has been called, is important. The reader who has grasped it clearly will be able to perceive many instances of the confusion arising out of its neglect in the ordinary discussions of economic questions which take place in the press and on the platform. It is not uncommon, for instance, for an argument to run something like this: "The effect of a tax on this commodity might seem at first sight to be an advance in price. But an advance in price will diminish the demand; and a reduced demand will send the price down again. It is not certain, therefore, after all, that the tax will really raise the price." A glance at the diagram will keep us out of such a bog of sophistry and muddle. For if we suppose the amount of the tax per unit of the commodity to be represented by S_s_, the curve _ss'_ (drawn, as it is, roughly parallel to SS') will represent the new conditions of supply after the tax has been imposed. The new position of equilibrium will be given by the point P', where _ss'_ cuts DD', the demand curve. Now P' lies to the left of P the old point of equilibrium; hence, since DD' _must_ slope downwards from left to right, it is clear that, if, as it is fair here to assume, the _conditions_ of demand have remained unaltered, the new price P'M', must be greater than the old.

§4. _Reactions of Changes in Demand and Supply on Price_. Having now made clear the meaning that must be attached to the terms, let us consider the question which naturally arises, whether we can lay down any general propositions or laws as to the effect upon price, of an increase or decrease in demand or supply. Another glance at the diagram suggests that we can. An increase in demand is represented in Fig. 2 by a movement from DD' to _dd'_, which cuts the supply curve, SS', at _p_, to the right of P. Since the supply curve (drawn, as it is best to draw it, to represent the amount which will be supplied in response to a given price) must always slope upwards from left to right, the new price, _pm_, must be greater than the old, PM. Conversely a decrease in demand is represented by a movement from _dd'_ to DD', and the new price is seen to be less than the old. We have already seen that a decrease in supply, which is represented by a movement from SS' to _ss'_ results in a higher price; and it is the obvious converse that an increase in supply will have the opposite effect. It would seem then that we might lay down quite generally that an increase in demand or a decrease in supply will raise the price while a decrease in demand or an increase in supply will lower it.

But here it is necessary to be cautious. All conclusions as to the effects of causes are necessarily based, implicitly, if not explicitly, upon the assumption "other things being equal." This method of reasoning, which some people appear to find so irritating in the economic sphere, and as they say so "theoretical" and "unreal," is one which they adopt readily enough in every other department of life. No one, for instance, objects to the statement that the sun, when it comes out, makes a room warmer, although it may very well happen, if a fire is dying at the same time, that the room grows colder in point of fact. For in our general statement we assume implicitly that "other things" such as fires, are unchanged. But assumptions of this kind are legitimate only when there is no reason to suppose that the cause, the effects of which are being studied, will itself produce a change in the "other things." If (as I have often been told; I really do not know if it is true) the rays of the sun help to put a fire out, the statement made above would be the better for some qualification.

Now we can only say that an increase in demand raises price if we assume the conditions of supply (as represented by the supply curve) to remain unchanged. But in practice, an increase in demand may cause a change in the _conditions_ of supply. An increase, for instance, in the demand for a commodity may give rise to a revolution in the methods of production, to the introduction of labor-saving machinery and so forth, which will eventually result in the commodity being produced more cheaply. It will certainly take a considerable time before reactions of this kind can exert an appreciable influence; and we can, therefore, feel reasonably sure that over a short period an increase in demand will raise the price. But we cannot be sure what the ultimate effect will be. A similar alteration in the condition of demand is less likely to result from an increase or decrease in supply; but it may conceivably occur. We must, therefore, be careful to qualify any general propositions which we lay down in this connection, by explicit reference to a short period of time. We can add the following to our body of laws:--

LAW IV. An increase in demand, or a decrease in supply will tend to raise the price for a short period at least. Conversely a decrease in demand, or an increase in supply will tend to lower the price for a short period at least.

This law, like the others, applies to commodities, services, capital, to anything which can be said, literally, or by analogy, to have a price. "A short period" is, however, a vague expression and, since precision is the hallmark of an important law, we must accord to this one a status inferior to that which the preceding three can rightly claim.

§5. _Some paradoxical reactions of price changes on supply_. Let us turn, though, once more to these earlier laws, and with a heightened critical sense let us submit them to the test of the whole gamut of our experience, and see if in any of them we can find the smallest flaw. The first of them will pass through the ordeal--let each reader prove it for himself--unscathed. The second will emerge with a few hairs, as it were, singed. It tells us, for instance, that a rise in price will tend to augment the supply. Now there are some things the supply of which cannot possibly be augmented; these are the capital resources of nature, of which land is the most important for our present purpose. Land is bought and sold, it commands a price. In a certain sense, it may be said to be possible to increase the supply of land, in response to a rise in price, by drainage and reclamation schemes; and it will certainly happen that a rise in the price which land can command for any particular purpose will increase the amount which is devoted to that purpose. But, speaking broadly, the supply of land available for purposes of every kind is a fixed unvarying factor, with an inertia which the cajolery of price-changes is powerless to disturb. This is a most important fact, and it gives rise to some peculiar features of the price and rent of land, which we shall have to consider later as a separate problem. It constitutes a limiting case rather than an exception to the general law. But we have not yet done with the reactions of price upon supply. In the case of capital, the nature of those reactions has been much discussed as a highly controversial question. That a rise in the rate of interest will cause some people to save more than before, is generally admitted; but it is pointed out that the effect upon others may be the exact opposite, because it means that they do not need to save so much to acquire the same future annual income. It is unwise to say dogmatically that the former tendency outweighs the latter; though upon the whole it seems highly probable that it does. We cannot, therefore, in this case feel confident that a change in price will react upon supply in the manner which our law indicates. Similarly it is possible to argue that a rise in the general level of real wages may reduce the supply of labor, even, or some might say particularly, if the term is used to denote not the number of workpeople, but the quantity of work done. For there may be a tendency for workpeople, when more comfortably off, to work less regularly or less hard. Here again we cannot be sure. In none of these cases, however, including that of land, is there any reason to doubt that a rise in price will diminish _demand_, or conversely that a fall will increase it. Since, therefore, in the reasoning by which we deduced the third law, the conclusion will hold good, even if the effects of price-changes on supply are of the above paradoxical kind, provided that they do not continually outweigh the effects upon demand, there is no reason to cast doubt on the solidity of Law III, which, indeed, as we suggested before, commends itself directly to experience. But Law II seems now, perhaps, somewhat the worse for wear.

The damage, however, is not considerable. For in each case the uncertainty arises only when we are dealing with one of the factors of production, land, labor or capital, _regarded as a whole_. If we are dealing with the capital available for a particular industry, a rise in the rate of profit in that industry will certainly increase the supply of capital available there; for it will tend to attract savings that might otherwise have been employed elsewhere. We can even be fairly sure that an increase in the general rate of interest prevailing in any particular country will increase the total supply of capital available for the businesses of that country, since capital has in modern times acquired a considerable migratory power. In the case of labor, we cannot go so far as this; but here, too, there is no doubt that an increase in the remuneration offered in any particular occupation will attract an increased labor supply (always supposing, of course, that "other things are equal"). No similar difficulty arises for land, labor or capital, as regards the effect of price-changes on demand; while for ordinary commodities there is no such difficulty on the side either of demand or of supply. Hence the only qualification which the strictest accuracy would require us in this connection to attach to our statement of Law II is the postscript:--

"Except that, in the case of land, the aggregate supply is unalterable; while in the case of capital or labor we cannot be sure how price-changes will affect the aggregate supply."

Much significance attaches to these exceptions, as later will appear.

§6. _The Disturbances of Monetary Changes_. But let us still keep a critical eye on Law II, and submit it to another flashlight from our practical experience. The recent world war made us all acutely aware of a remarkable rise in the price of almost everything, which yet did not seem to diminish appreciably the demand. The explanation of this paradox is not difficult to find. There was an immense increase in the volume of nominal purchasing power, due to a complex set of causes, of which "currency inflation" may be taken as the symbol. Now perhaps we are entitled to assume the absence of such currency changes as part of the "other things being equal" which is always understood as implied. But it is rash to take this particular assumption for granted, more especially in these days. Already people are too apt to speak as though the trade depression (which as these pages are written holds us in its grip) cannot pass away until pre-war prices are restored, ignoring altogether the great and probably permanent increase in nominal purchasing power which the war has left behind it. It would be safer, therefore, to add explicitly to Law II the reservation, "Assuming that there is no change in the general volume of purchasing power."

Monetary and allied questions will form the subject of the second volume of this series. It must not be supposed that our general laws have no bearing on them. On the contrary, Law I, which all this time has remained serene and undisturbed by the occasional discomfitures of Law II, is the gateway through which all questions of currency, banking and the foreign exchanges should be approached. It is well to note, as an inexorable corollary of Law I, that prices can rise _only_ if demand exceeds supply, and fall _only_ if supply exceeds demand; and hence that it is only through the agency of changes in the demand for and supply of commodities and services that an inflation or deflation of the currency can influence the price level. Further, since a condition of things in which supply generally exceeds demand spells what we know and fear as a trade depression, it may be well to note at once that falling prices and unemployment are inseparable bedfellows. For we are far too apt to shut our eyes to these unpleasant truths. But we cannot pursue them further here; and in the remainder of this volume we shall not be concerned (except, perhaps, incidentally) with questions affecting the general level of prices or of purchasing power; but rather with the relation which the price of one commodity bears to that of another, with the rate of interest (which being a rate per cent is not essentially dependent on the price level), with "real" wages (as distinct from money wages) and the like.

§7. _The Trade Cycle_. But our reference to trade depressions suggests a final comment on Law II. One small qualification was embodied in our original statement of it, namely the words "sooner or later." A rise in price may not check the demand immediately (even if the printing presses are standing idle in the Treasuries); it may actually stimulate it for a time. For people may fear that the price will rise further still, and hasten to buy what they _must_ buy before very long. Sellers may share the same opinion, and be reluctant on their side to part. When prices are falling the roles are reversed, and we are likely to see the sellers tumbling over one another in a frantic eagerness to sell, the buyers wary and aloof. Sooner or later, indeed, these tendencies must dissolve and disappear; but they may persist for a longer period than might seem probable at first. For the raw material of one trade is, as we say, the finished product of another. The demand for one thing gives rise to a demand for other things, for the labor with which to make them, and so on in an expanding circle. A sympathy, subtle and intense, unites the business world, and a wave of depression or animation arising in any quarter may spread itself far and wide, heightened by the gusts of human hope and fear, and continue long before its influence is spent.

Here we are upon the threshold of one of the most striking and formidable of economic facts, the regular alternation of periods of good and bad trade, each very widespread, if not world-wide, in its range, each comprising certain regular phases of acceleration and decay, and each infallibly yielding sooner or later to the other. The details of these phenomena are highly complex, some of them obscure; an immense literature has already been devoted to the subject, yet its systematic study is hardly more than begun. The account given in the preceding paragraph is incomplete and meagre. It is inserted here in the hope that it will impress the reader with a sense both of the fact of these alternations and of the deeply rooted nature of the causes from which they spring. They take a heavy toll of human happiness and wealth; and there is no object that more urgently calls for concerted human effort than that of mitigating them, and of alleviating the misery which they bring in their train. Still better, of eradicating them if that is possible; but let none suppose that it can be lightly done. Meanwhile, let us always remember that they form the atmosphere and medium in which the enduring tendencies of the business world must work themselves out. It is often convenient to speak of "normal conditions" in this trade or that; but hardly ever can it be truly said of a particular moment that conditions are normal. The normal is rather a mean level about which oscillations to and fro, round and about, are constantly taking place, but which itself is reached only by accident, if at all. Whenever we say that some new factor should in the long run lower the price of this or that commodity or service, the picture which these words should convey to our mind is one of the price rising less on times of boom, and falling more in times of depression than is the case with other things. And if ever our faith in some honored economic law is shaken by the apparent ease with which, perhaps, in times of active trade, sellers are able to advance their prices to whatever figure (so it almost seems) they choose to name, let us rally our sense of economic rhythm, and reserve our judgment until the trade cycle has run its course.

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