Economic Theory 9781136506123, 9780415313179

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ECONOMICS

Routledge Lib~a~dlry Editions - Econonzics ECONOMIC THEORY & ECONOMETRICS In 6 Volumes I I1 I11 IV V VI

Fiscal Policy & Business Cycles Macrodynamics: Fluctuations and Growth Optimisation in Economic Analysis Economic Theory Money, Income and Employment Pricing and Equilibrium

Hansen Heizin AIills Richardson Schneider Schneider

ECONOMIC THEORY

G B RICHARDSON

Routledge Taylor&Francis Croup LONDON AND NEW YORK

First published in 1964 Reprinted in 2003 by Routledge 2 Park Square, hfilton Park, ,lbingdon, Oxon, OX14 4RN Transferred to Digital Printing 2004

Routledge is an imprint of the Taylor G. Francis Groztp Printed and Bound in Great Britain

O 1964 G B Richardson All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. The publishers have made every effort to contact authorslcopyright holders of the works reprinted in Rozttledge Libl8aly Editions - Econonzics. This has not been possible in every case, however, and we would welcome correspondence from those individualsicompanies we have been unable to trace. These reprints are taken from original copies of each book. In many cases the condition of these originals is not perfect. The publisher has gone to great lengths to ensure the quality of these reprints, but wishes to point out that certain characteristics of the original copies will, of necessity, be apparent in reprints thereof.

British Library Catalogzting in Pztblication Data A CIP catalogue record for this book is available from the British Library Economic Theory ISBN 0-415-31317-1 ISBN 9781136506192 (ePub) Miniset: Economic Theory & Econometrics Series: Routledge Library Editions - Economics Prlnted and bound b j Anton] Roue Ltd. Eastbourne

E C O N O M I C THEORY G. B. R I C H A R D S O N Fellow of St. John's College, Oxford

HUTCHINSON UNIVERSITY LIBRARY LONDON

HUTCHINSON & CO. (Publishers) LTD 178-202 Great Portland Street, London, W.I London Melbourne Sydney Auckland Bombay Toronto Johannesburg New York

First published 1964

0 G. B. Richardson

1964

This book has been set in Times New Roman, printed in Great Britain on Antique Wove paper by The Anchor Press, Ltd., and bound by Wm. Brendon & Son Ltd., both of Tiptree, Essex.

Contents Preface 1 Introduction 2 The logic of choice 3 Capital, technology and time

4 The decentralization of decisions 5 Private ownership: the system in outline

6 The long-run adjustment of supply to demand

7 The short-run adjustment of supply to demand 8 The general level of employment,output and prices 9 The role of money

10 Conclusion

Preface By giving to this short volume the form of a continuous argument I have endeavoured to enable the reader to acquire both some knowledge of the several topics and techniques of economic theory and some sense of the structure of the subject as a whole. My aim has been to keep him constantly aware of where he is going and of what it is all about. Each introductory textbook has its own particular order and distribution of emphasis. I have thought it important that the reader should first understand what is meant by the efficient use of resources for society as a whole. The f i s t part of the book is therefore concerned with the logic of choice, or of 'economizing', in this context. Only after learning what is meant by economic efficiency, and how to recognize it, can one appreciate the purpose of economic organization, and only then can one begin to comprehend and compare the alternative forms of economic organization for which central planning or competitive private enterprise provides the basis. On only one issue could the doctrine I seek to expound be said to be unorthodox. I have expressed the view elsewherel that the theory of perfect competition is logically unsound and that much harm is done by using it either as an introductory explanation of the working of actual systems or as a standard by which to judge their efficiency. The theory's specious simplicity and coherence make it easy to teach; students are therefore often exposed to it at the earliest and most impressionable stage in their instruction, with the result that many are unable, thereafter, to free their thinking from its categories. Although I have endeavoured faithfully to expound the doctrine of perfect competition, I have also taken trouble to expose its deficiencies and to shift it from the centre of the stage.

r. In Information and Investment, Oxford University Press, 1960, 7

8

PREFACE

My intention has been to write an introduction to economic theory which, although unusually short, is not unduly superficial. Inevitably, therefore, the presentation has had to be concise and the style terse. Although I have tried very hard to write clearly and simply, the reader's active attention will be required throughout. I am grateful to several of my pupils for reading parts of the book and saving me from errors and obscurities. My colleague, Mr J. F. Wright, was kind enough to work through the whole manuscript and make helpful suggestions. That the deficiencies of the book are less grievous than they might have been is chiefly attributable to the detailed help generously given to me by Sir Roy Harrod. I am heavily indebted to him for carefully reading and re-reading all the chapters both as they now stand and in earlier versions. The confusions still embedded in them, which are my own, cannot be put down to the lack of good advice. G.B.R. St John's College Oxford

I

Introduction Economics is concerned with the way in which we make use of scarce resources. A resource in this context is taken to mean anything, whether in the form of physical objects or human services, that can be used directly, or through conversion into other things, to satisfy our wants. A resource is said to be scarce when the existing supply of it is insufficient to meet all our requirements. If resources are scarce we are faced with a problem of how to use or 'administer' them. First we have to ensure that scarce resources are all in fact employed, for otherwise wants will be met less fully than they could be. Secondly, it is desirable that resources are employed efficiently, in the sense that they could not be employed, in any alternative way, so as to satisfy wants more fully. This requirement, we say, relates to the proper allocation of resources. If a scarce resource is fully employed, then more of it can be used for one purpose only if less of it is used for another. Choices have therefore to be made between the different ways in which resources can be used. Thus, in the production of, say, food, would it be better to use more of one resource, say labour, and less of another, say land? Should more resources be used to produce food and less to produce clothing? Would some people be better off if they had less food and more clothing, and others if they had less clothing and more food? These, we say, are all problems of resource allocation. If the scarce resources available to a person or to a community would permit wants to be met more fully than they in fact are, then this unnecessary sacrifice is called waste. Waste can result, obviously, from unemployment of resources, and, less obviously, from their inefficient allocation. The wealth of nations is attributable in great measure to the division of labour. In all but the most primitive societies the work of applying resources to meet needs is divided into very many different 9

I0

ECONOMIC THEORY

functions, in the performance of which different people specialize. By this means each man can make the best use of his particular talents, special skills can be developed and complex processes can be split up into operations for which it is possible to employ laboursaving machines. The division of labour entails the need for an appropriate organization by which all the specialized functions, undertaken by different people, can be effectively knit together. In the most primitive economies, where each family provides directly for most of its own needs, little co-ordination is required, but economic advance, and the increasing differentiation of function which goes with it, demand the existence within society of a highly sophisticated organization capable of integrating a wide and varied range of individual activities. The forms which such organization can take are various and differ, according to circumstances, from time to time and place to place. In this book I shall discuss two broad classes of economic organization to be distinguished according to whether the ownership of productive resources is vested in public or in private hands. In economies based on public ownership (or collectivist economies, as they are sometimes called) economic decisions are taken by the central government, or by those to whom it has expressly delegated its authority. The co-ordination of these decisions is generally brought about by means of instructions, issued by the government and based upon its national plan. In some such centrally planned systems the government may endeavour to cover, in its plan, almost all the important decisions which those responsible for production have to take; in others central directions leave more scope for particular issues to be decided, independently, by those directly concerned with them. In economies based on private ownership the use made of resources generally depends upon decisions taken by private persons and groups owing no responsibility to the government and free to pursue their own interests. Long familiarity with this state of affairs may well blunt our perception of the problem which it poses. The very notion of organization, on the face of it, is difficult to reconcile with the freedom of each man to go his own way. If decisions are taken by a multitude of private persons and private businesses, acting independently and in the furtherance of their own interests, there would seem to be no very obvious reason to expect an orderly administration of the society's resources ever to result. Yet we know that economies based on private ownership, and free from central

INTRODUCTION

II

direction, can in fact become rich and powerful, and that the allocation of resources which they achieve, even to the superficial observer, exhibits elements of order and rationality scarcely characteristic of a confused welter of unco-ordinated individual strivings. The tasks which are successfully accomplished are of enormous complexity; the production of a motor car, for example, requires the prior undertaking of a bewildering variety of production decisions: iron ore has to be mined, rubber trees have to be planted, electric generating stations built, oil wells sunk and numerous special skills acquired. These manifold activities are not undertaken on the instructions of any single co-ordinating authority, but the fact that they form a related and coherent system of production can scarcely be attributed to accident. The first thing to realize, therefore, is that there is a problem to be solved. We have to ask ourselves what spontaneous forces are at work which, at least to some extent, perform the tasks that might seem to require the existence of a central planning authority. The co-ordination of individual economic decisions is normally achieved, in a system based on private ownership, chiefly through exchange. At the most primitive level this may take the form of barter, according to which men specialize and rely on exchanging their own products, of which they have more than they desire, for products, made by others, of which they are in need. Even with this arrangement each man will find himself able to further his own interests by promoting those of others, and there will be some reason to expect that different goods will tend to be made available in such quantities as are required. Advanced economies, in which exchange is faciliated by the use of money, operate on essentially the same principle. A manufacturer, for example, may wish only to obtain the greatest possible profits for his firm, but if he is to succeed in doing so he will have to cater to the particular desires of those to whom he hopes to sell his products. The particular process of manufacture which he adopts will in turn help to determine the kind of raw materials which it will be profitable for other people to produce, as well as the nature of the skills which it will pay workers to acquire. Thus under private ownership the multitudinous activities of producing and consuming, buying and selling, and borrowing and lending are all part of a complex network of relationship and interaction of the kind that we are entitled to call a system. Each man finds the opportunities available to him, for the pursuance of his own interest, closely circumscribed by the interests and actions of very many others; in this way individual economic activity can be

I2

ECONOMIC THEORY

made subject to a regulation less personal, but not necessarily less effective, than that exercised by a central planning authority. Economies of this type, in which the administration of resources is effected through spontaneous organization, based on free exchange, are referred to as market economies, the term market denoting, originally, the place where exchanges were carried out. Alternatively, we may use the term private enterprise, thus stressing that resource administration depends on the initiative of private persons or businesses. I have chosen to associate state ownership with central planning and private ownership with an unplanned organization based on exchange. This accords with the situation, as we generally find it, at the present time. Centralized direction, while naturally harmonious with public ownership, is difficult to reconcile with the fragmentation of ownership (and normally therefore of control) in many private hands. We shall later have occasion to observe, however, that even under state ownership there may be much reliance upon co-ordination through exchange. Producers, even although agents of the government, may sometimes be instructed to act on the same principles as would a private business man, free from detailed control, in a market economy. Under private enterprise, on the other hand, individuals may sometimes be subject to much centrally imposed regulation. To own resources normally implies the right to decide upon how they are to be used; in some countries, at some times, however, the effective scope of this right has been greatly attenuated by government control. Full private ownership, one can safely say, is incompatible with full central direction, but attenuated private ownership co-exists with some central planning in most of the private enterprise economies of the present day. Economists may study systems of resource allocation from two distinct points of view. They may endeavour merely to explain how the system in fact operates and how resources come to be allocated as they do; alternatively they may endeavour to develop, and to apply, criteria by which the efficiency of the resource allocation may be judged. Positive economics deals with the former problem; normative or prescriptive economics deals with the latter. The greater part of positive economics is devoted to a systematic study of the spontaneous organization that arises under a system of private ownership. What will determine, in such a system, the kinds and quantities of goods that are produced? What determines relative amounts of goods that different people enjoy? Why do some goods command a higher price than others? Under what circum-

INTRODUCTION

13

stances do men and material resources fail to find employment? Upon what factors will depend the rate of growth of a country's wealth? It is with questions such as these that positive economics attempts to grapple. Prescriptive economics is concerned not with how things are but with how things ought to be. But this must not be taken to imply, as might at first appear, that economists are so arrogant as to lay down the aims that members of a community, either individually or as a body, ought to pursue. On the contrary, the reasoning of prescriptive economics can be applied only when the ends desired, and the means available, are both known. The first stage in resource allocation must be the framing of objectives, in the form of a system of priorities, and the assessment of the range of opportunities which the existing endowment of resources, taken in conjunction with the known technological possibilities, makes available. Only after these questions are settled does it become possible to isolate the purely logical problem, associated with the choice of the most efficient course of action, upon which the principles of prescriptive economics can be brought to bear. Frequently the first stage in the process may represent much more than half the battle; the problem of choice that then remains may have an intuitively obvious solution. Thus a housewife will be concerned mainly with judging her family's needs and with ascertaining the quality and prices of the goods that are on sale; in finally choosing the best way in which to spend her income she will follow no very elaborate chain of conscious reasoning. But the problems of resource allocation that confront a large business concern, or, above all, a state planning authority, will rarely be thus capable of intuitive solution; a special logical framework, such as prescriptive economics seeks to provide, may then be necessary. The principles of prescriptive economics, to which the reader will presently be introduced, may therefore be said to represent a logic of choice, specially devised for use in the problems posed by resource allocation.1 I . Problems of choice are not confined to resource allocation, as ordinarily understood. A man has to choose a wife, a prime minister a cabinet and a military commander a plan of campaign. But it is only in the economic sphere, in relation to the production, distribution and consumption of goods, that the problems of choice have been formulated in terms sufficiently precise and measurable to permit a specially adapted logic to be developed. We should not rule out the possibility of fruitful extension of these techniques in other directions; military strategy, for example, appears to lend itself, to some extent, to this treatment.

14

ECONOMIC THEORY

A problem of resource allocation will assume, characteristically, either of two forms. In the fist form the available resources are fcied whereas the objective desired is capable of different degrees of fulfilment; our aim is then to decide which particular way of employing resources would ensure the maximum fulfilment of the objective. Given, for example, a fixed amount of money capital, and various opportunities for its investment, how can it be made to yield the highest rate of return? Or, given a fixed income, and a range of goods with particular prices, what pattern of expenditure would provide the maximum satisfaction? In its second form the problem presupposes that a precise objective, which does not admit of different degrees of fuliilment, has to be attained; we have then to determine how to attain it with the minimum use of resources. In order to illustrate the nature of this way of posing the problem the examples which have just been quoted need merely to be reformulated. Given the desire to obtain a certain rate of return, what particular investment policy-on the basis of the opportunities available-would require the minimum amount of money capital? Or given the desire for a certain level of satisfaction, what pattern of consumption expenditure would procure it at lowest cost? The relationship between these two alternative formulations is clear; in the former case the means are fcied and the maximum fulfilment of the end is desired; in the other the end is fixed and the use of means is to be minimized. In either case the aim, succinctly stated, is to reduce waste in terms of an unnecessary sacrifice either of means or of ends. Prescriptive economics, in other words, is to do with economizing, for this word, in its proper sense, denotes not the deliberate forgoing of desired objectives but the avoidance of waste in attaining them. When we apply an economic criterion, or judge an activity from an economic point of view, our aim is to decide whether there has been any unnecessary sacrifice in terms either of objectives desired or of means used for their attainment. In saying that a particular policy is uneconomic we mean that the expenditure of resources contemplated is not justified by the objective to be secured; we imply, in other words, that there are alternative policies which would achieve the same end with less resources, or which would permit the same amount of resources to obtain a more valued objective. Thus, in this sense, for example, it would be uneconomic for Britain to produce all her food at home, in that some of the men and materials reauired to do this. if used instead to uroduce manufactured goodsfo;export, could indirectlyenableus to import agreater quantity of food than they could produce directly within these islands.

INTRODUCTION

15

It is evident, therefore, that allocative problems may exhibit both similarities of form and differences of content and of scope. Thus we may endeavour to set up principles with which to judge the efficiency of the choices made by an individual, whether as consumer or investor or manager of a firm; alternatively, we may seek criteria with which to judge the efficiency with which resources are allocated within the community as a whole. Welfare economics is the name given to that part of our subject which has this latter aim in view. As the term implies, it seeks to identify criteria for the efficiency of resource allocation where the relevant objective is-in some carefully defined sense-the welfare of the general public. Welfare economics will, in effect, form the essential subject matter of the following two chapters. In order to facilitate the exposition of its fundamental principles I shall consider a hypothetical economy based on state ownership in which all allocative decisions are taken by a Central Planning Authority. By first supposing that the Authority has unlimited knowledge and unlimited administrative capacity, we shall be free to concentrate exclusively on the pure logic of the problems of choice that will confront it. In chapter 4, while still confining the discussion to an economy based on public ownership, I shall recognize that inevitable limitation in the knowledge and administrative capacity of any Central Planning Authority will oblige it to delegate some authority and decentralize some decisions. At this stage, that is to say, our interest will extend beyond the criteria of efficient allocation (the pure logic of choice) to the ways and means by which efficient allocation might be secured in practice. In chapters 5 to 9 I shall be concerned with the explanation, and the appraisal, of the working of private enterprise. Can the full and efficient employment of resources be promoted automatically, through spontaneous organization based on free exchanges? And, if it cannot, in what ways, and to what extent, must spontaneous co-ordination be supplemented by planned co-ordination, whether by the government or by the concerted action of several firms? Such, then, is the general shape of the argument that I shall present. The reader will not expect to derive from this very short volume an acquaintance with all the major issues with which economists interest themselves. My aim has been to take up certain central questions, and, by discussing them in terms of a connected argument, to endeavour to impart an understanding of the structure of the subject as a whole. Although I have striven, at the cost of much time and effort, to write as clearly and simply as a complex subject

16

E C O N O M I C THEORY

and a limited space would permit, it has not proved possible to spare the reader from exertion. A command of economic analysis implies not so much the knowledge of facts as the ability to apply certain specialized techniques of thought; inevitably, therefore, its acquisition demands more than passive attention. One limitation in the scope of this volume is so important as to require explicit mention. I shall be concerned with the analysis of a closed economy, with an economy, that is to say, without commercial links with the rest of the world. In fact, of course, and not least for the United Kingdom, these links are of vital importance; rarely, whether in the explanation of events or the formulation of policy, can they be ignored. My omission of international trade is not therefore to be taken as indicating its relative unimportance. Given the limited space available, some topics had perforce to be excluded, and international economics proved one of those most readily severable. Let-it be said in extenuation that the study of a closed economy leads us to formulate principles which also apply, with appropriate modification, to economies linked by external trade. An introduction to the theory of a closed economy is therefore also an introduction to economic theory as a whole. Finally it should be emphasized that this is an introduction to economic theory rather than to economics as a whole. It is designed not to set down facts about this or that economy, past or present, but to provide a set of ideas without which economic facts cannot be fruitfully organized and interpreted. It was observed by the great economist Alfred Marshall that the part played by theory in the production of knowledge resembles that which machinery plays in the production of goods. As part of the process of manufacture, it may be necessary to perform certain routine operations over and over again; whenever this is the case it is usually possible to devise a machine which will do the work. Similarly, within the field of intellectual enquiry, we frequently have to attend to very much the same kind of problems in very much the same way, so that great advantage can be obtained from the construction of an engine of thought-in the form of an appropriate method of selecting and presenting the relevant facts--expressly designed to deal with them. Anyone who sets out to explain, for example, changes in the price of typewriters will have to gather a good deal of factual information; he will not, however, need to learn every known fact about the history, manufacture, current use, etc., of these articles; it will be necessary to select those aspects of the situation which are relevant to the problem in hand and to devise some way of organizing or

INTRODUCTION

17

presenting them which will enable a solution to be found. Investigations into the prices of shoes, or eggs, or steel, would have to be conducted in a similar manner, and it would be found that very much the same general ideas and principles of presentation were common to them all. This would make it possible to set out a generalized account of the determination of the prices of goods which could be used to guide the investigation of particular instances. Such an account would consist of certain relevant ideas, such as that of demand and cost, and of the relationship between them. Different problems, of course, require the construction of different frameworks of thought, but it is found that these frameworks (or 'models' as they are sometimes called) are themselves inter-related, just as are the particular economic phenomena for the elucidation of which they were designed. It therefore becomes possible to weld them together into a single coherent body of theory which enables us to study the whole complex of interconnected activities which make up an economic system. Despite its many serious limitations, which I shall not seek to mask, economic theory is a powerful machinery of thought without which we should find many important problems much more difficult, and others impossible, to solve.1 He who follows the ways of thought constituting economic analysis ought to be aware of their limitations; merely by comparing his own understanding of economic affairs with that of a layman, however, he can assure himself that a command of economic theory, with all its imperfections on its head, is an asset for the lack of which neither intelligence, nor experience, nor common sense can fully compensate.

I. Cf. Marshall, Principles, p. 780. 'Ideas, whether those of art or science, or those embodied in practical appliances, are the most "real" of the gifts that each generation receives from its predecessors. The world's wealth would quickly be replaced if it were destroyed, but the ideas by which it was made were retained. If however the ideas were lost, but not the material wealth, then that would dwindle and the world would go back to poverty.'

The logic of choice 1 The problems of choice Let us begin by considering a purely hypothetical economy in which the problems of choice take their simplest possible form. We shall assume that all decisions relevant to the production and distribution of goods are taken by a supreme Authority, which is in possession of all the information upon which the decisions have to be based and which has the power to secure obedience to all its commands. The Authority has at its disposal productive resources, in fixed supplies, which can be combined, in various alternative ways, to make goods. The Authority is benevolent in that it seeks to promote the material welfare of the community; at the same time, however, it is assumed to know, better than the citizens themselves, what kinds and quantities of goods they ought to be given. The reader may be inclined to wonder why he is invited to consider such a wholly imaginary situation rather than the more familiar world of his experience. This procedure, I believe, is amply justified. By assuming that there exists an Authority furnished with all necessary knowledge, and able to implement its decisions as by the waving of a wand, attention can first be focussed exclusively on the logic of choice, as contrasted with all problems of information and practicability. Our approach will enable us to identify the criteria of efficient resource allocation; it will lead us, more directly than might at first appear, to an understanding of the problems which are common to all economic systems, and it will arm us with a set of ideas, or mental equipment, without which we could scarcely hope to deal with the more realistic issues which will confront us later. For these reasons the reader is asked to curb his impatience with what must inevitably be a highly abstract, and an intricate, line of argument. I shall fully recognize, in due course, that, as the real I8

THE LOGIC OF CHOICE

19

world lacks the benefit-if so it be-of an omniscient Authority, economic decisions have to be taken by human beings, numerous and imperfectly informed. In order to facilitate the exposition I shall make the following very highly simplifying assumptions. The Authority will have at his disposal only two resources, or factors of production. These we may call land and labour on the understanding that they are only partly equivalent to the resources to which we give these names in the real world. The labour force in our model economy will consist of a fixed number of workers all of whom are of equal efficiency in all employments. The term land must be taken to denote a composite of all the natural, non-human resources, such as actual land itself, the minerals which lie beneath it, water power, etc., with which the country is endowed. We shall assume that land, like labour, is measurable in terms of units which are wholly identical from the point of view of their usefulness in production. In technical terms, that is to say, both factors of production will be taken to be perfectly homogeneous; they will also be presumed to be perfectly divisible, in the sense that it is possible to vary the amounts of each of them in employment by as small quantities as we please. Only two commodities, or products, will be made-food and clothing-both of which will be perfectly homogeneous and divisible in the above senses. There will, however, be a variety of alternative processes by which they can be manufactured. These processes of production will differ in two respects. First, although all will require both some land and some labour, the proportions in which these can be combined will admit of variation. Some processes, that is to say, will use much land and little labour, and others much labour and little land. Secondly, the production processes will differ according to the time required to carry them through; they will be, in other words, of variable duration. Land and labour may be called the inputs of the processes of production; food and clothing are the two outputs. Let us now set out the problems of choice which will confront the Authority in charge of our imaginary economy. (i) What output targets should be fixed for food and clothing? Given that only limited amounts of land and labour are available, the quantity which can be produced of either one commodity will be limited by the amount required of the other. (ii) For what dates should outputs be made available? (iiil What methods of production should be chosen? These will

ECONOMIC THEORY

differ both in respect of the proportions in which they combine land and labour and in respect of the time they take to carry out. (iv) How should the outputs of food and clothing be distributed among consumers? In what quantities, for what dates, by what means, and to whom -these are, then, the four decisions which the Authority has to take. It will soon become apparent that they are interdependent and cannot be taken each in isolation from the others; the proportions in which the two factors should be combined, for example, will depend on the output targets set as well as on the dates at which outputs are required, and these in turn will depend upon how the products are to be distributed among consumers. The Authority is confronted, in fact, with one single complex problem of resource allocation of which these four sub-problems can be distinguished. We shall begin by separating out the four sub-problems for individual consideration; only at a later stage of the argument shall we endeavour to work out a co-ordinated solution. It will be convenient to leave to the last those problems related to the dimension of time; thus I shall temporarily ignore the fact that production takes time and that decisions have to be taken as to the dates at which outputs are to be made available. With this reservation in mind, let us turn first to the choice of production processes. This we can best do by assuming that output targets for food and clothing have already been fixed, so that we can give our exclusive attention to the general principles which determine the optimum proportions in which labour and land can be combined in their manufacture. We shall first be concerned, that is to say, with the efficiency of factor combination, or, more shortly, with productive eficiency. Our second task will be to work out the principles which should govern the way in which particular quantities of food and clothing, assumed to be given, should be distributed among consumers. This is the question of efficiency in distribution, or distributive eficiency. Finally we shall turn to the problem, hitherto assumed away, of how to decide upon the particular amounts of food and clothing that ought to be made; this is the problem of the optimum assortment of goods. Full economic efficiency will require the conditions for productive and distributive efficiency, and for the optimum assortment of products, all to be met. It will imply, in other words, that correct amounts of food and clothing are being produced by the best means and are being distributed in the best way.

THE LOGIC O F CHOICE

2 Productive ejiciency

Let us first decide what we mean by productive efficiency. Common sense suggests that the most efficient production processes will be those which enable us to manufacture a stated output combination with the minimum use of scarce factor inputs, or, alternatively, which convert given factor supplies into the maximum possible quantities of output. As it stands, however, this definition is ambiguous. It will generally be possible to produce stated outputs of food and clothing in various alternative ways, some of which use much land and little labour and others much labour and little land. Without some indication of which factor is the more scarce, and therefore in most need of being economized, it may not be possible to decide which of the processes to choose. Similarly, given amounts of land and labour can be transformed by a variety of processes, some of which yield much food and little clothing and others much clothing and little food. Here again, without an indication of the relative importance to be attached to either of these commodities, one may not be able to decide which processes are to be preferred. One can say, however, that whatever the relative scarcity of each of the factors, production is efficient only so long as it is not possible, by means of alternative manufacturing processes, to obtain the same output combination with less of one factor but no more of the other. And similarly, whatever the relative priority given to food and clothing, production will be efficient only so long as there is available no alternative process able to transform the same factor supplies into more of one commodity but not less of the other. Productive efficiency will henceforth be given this precise, if limited, significance. As the reader will have observed, productive efficiency can be studied from two points of view: either we can take the factor supplies as given and endeavour to maximize the outputs of food and clothing, or we can take the output targets as given and endeavour to minimize the factor requirements. We maximize output in this context when we make as much food as possible consistent with producing a particular quantity of clothing as well; and we minimize input when we use as little land as possible in conjunction with some particular amount of labour. Let us first take the output targets for food and clothing to have been fixed and enquire how the use of factors can be minimized. For the production of the target quantity of food, which we shall call F, there will be available a whole range of alternative production processes, each of them requiring a different combination of inputs.

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ECONOMIC THEORY

Input combinations can be represented on a graph, as in fig. i. On the horizontal axis we measure quantities of land, referred to as L, and on the vertical axis quantities of labour, referred to as W-for 'work'. The 'co-ordinates' of any point lying within the two axes, such as P, are the corresponding distances marked off on either axis such as OM and ON. As these distances represent, respectively, a quantity of land and a quantity of labour, the co-ordinates of the point P stand for a particular input combination. For every possible input combination it will be possible to associate some point on the graph. Now it is clear that there will be input combinations with

Fig. i which it would be physically impossible, given the known techniques of production, to make the required output F. There will also be factor combinations which, although they could be used to produce F, would nevertheless be clearly wasteful, in that they contain more of both inputs than do other combinations which would also produce F. A final choice will have to lie between the factor combinations which fall into neither of these two classes. All such combinations can be set out by means of a curve, known as an equiproduct curve, drawn as shown in fig. ii. This curve, which has been labelled F1, indicates the minimum amounts of one factor that have to be combined with various alternative amounts of the other in order to produce the specified output of food F: the co-ordinates of each point lying on the curve indicate one of the combinations of land and labour between which a final choice has to be made. It

23

THE LOGIC OF CHOICE

is possible to construct a so-called 'family' of such equiproduct curves, each of them indicating the minimum amounts of land and labour required to produce different quantities of food, F,, F,, F,,

Fig. ii

L

Fig. iii etc. As drawn in fig, iii, F, represents a quantity of food greater than F,, F, a quantity greater than F, and so on. The production processes associated with points on these curves are such that if less of one factor is to be used, more will have to be used of the other; the curves will therefore all slope downwards from

I

L

0

Fig. iv left to right. It is easy to show, moreover, by means of a reductio ad absurdum, that none of them intersect. In fig. iv the equiproduct curves for different amounts of food, F, and F,, are drawn so as to intersect at the point X. This implies that the maximum amount of food that could be produced by the quantities of land and labour given by the co-ordinates of the point X isequal both to F, and to F,. By hypothesis, however, F, and F, are not equal. It follows that the equiproduct curves for different amounts of the same product cannot intersect. It is convenient at this point, before proceeding further with the examination of the nature of equiproduct curves, to introduce an important concept. We often find it necessary to have a measure of the extent to which, in the production of a particular good, one factor can be substituted for another without affecting the volume of output obtained. Such a measure is provided by the concept of the marginal substitutability between two factors, this being defined as the number of units of one of the factors that can be replaced, in the production of a particular good, by one small additional unit of the other, it being assumed that the output of the good is to remain the same. The term 'marginal' makes it clear that we are considering only very small changes in the amounts of the two factors employed. Thus the marginal substitutability between land and labour, in the production of a stated quantity of food, is the number of units of labour that one small additional unit of land is able to rep1ace.l I. Marginal substitutability,as I have defined it, is frequently referred to as the marginal rate of substitution' between two factors. The reader may expect to find both terms employed in the literature. 24

THE L O G I C O F CHOICE

25

As we shall have to make extensive use of the notion of marginal substitutability, it will be helpful to refer to it by the symbol MS qualified by a two-letter suffix. The first letter will indicate the factor of which the employment is to be increased by one small (or 'marginal') unit and the second letter will indicate the factor that is to be replaced. Thus MS,,, will indicate the marginal substitutability between land and labour, this being the number of units of labour that can be replaced, in the production of a stated amount of some particular commodity, by a marginal unit of land. (The reader will find it useful to remember that marginal substitutability is always measured in terms of the factor being replaced, as given by the second letter of the suffix. Thus if MS,,, is 3, this means that three units of labour can be replaced, without affecting the volume of output, by one small additional unit of land.) Let us now return to our examination of equiproduct curves and consider the geometrical interpretation to which the idea of marginal substitutability lends itself. We can begin by supposing that an amount of food F is being produced with a combination of land and labour given by the co-ordinates of the point P on the appropriate equiproduct curve (fig. v). The quantities of land and labour being employed are then OL and OW respectively. Now let us suppose that we decide to replace labour by land, while keeping food output constant, so that the amount of land is increased to OL' and the amount of labour is reduced to OW'. If food production is to be unchanged, L' and W' must be the co-ordinates of a point, say P', lying on the equiproduct curve. An amount of land equal to LL'

26

E C O N O M I C THEORY

has been able to replace an amount of labour equal to WW' without affecting food production. The amount of labour replaced per unit of the land additionally employed is therefore WW'/LL'. If we now assume that the land in use has been increased by one small additional unit only, so that the point P' is very close to the point P, then we can say that the ratio WW'/LL' measures the marginal substitutability between land and labour (as defined above) corresponding to the factor combination given by the co-ordinates of P. Now the ratio WW'/LL' is equal to the 'slope' of the straight line passing through the points P and P', as the slope of a straight

Fig. vi

Ime, by definition, is the number of vertical units that the line rises or falls for each horizontal movement of one unit along it. Provided that the employment of land is increased by only a very small additional unit, so that P' is very close to P, then the slope of the straight line through these two points is approximately equal to the slope of the straight line (or tangent) touching the equiproduct curve at P (fig. vi). This latter slope is referred to simply as the slope of the curve at P. Thus we may say that, for a factor combination given by the point P, MS,,, is represented by the slope of the equiproduct curve at that point. Now it is reasonable to suppose that in the production of-sayfood, MS,, will differ according to the proportions in which the factors are already being combined. A farmer will in general be able to produce the same amount of corn with less labour, provided that he uses more land, but it will clearly not be possible for the replace-

THE LOGIC OF CHOICE

27

ment of labour by land to proceed, on the same terms, indefinitely. As more and more land is used to replace labour, the ability of successive units of land to replace labour will diminish. After a point, indeed, further reduction in the amount of labour used would make it impossible to maintain food output regardless of the quantity of additional land brought into use. Thus we may say that MS,,, will diminish as the amount of land employed, relative to labour, increases. Generalizing, this corresponds to the principle of diminishing marginal substitutability, according to which each successive unit applied of one factor will be able to replace decreasing amounts of another, it being assumed that output is kept constant. The geometrical counterpart of the principle is the fact that equiproduct curves are convex to the origin; this implies that the slope of the curves decreases as we move from left to right along them so that MS,, gradually falls as we use more land relative to labour.1 In the same way as we can construct equiproduct curves for food we can construct equiproduct curves for clothing. These will indicate the minimum quantity of land (or labour) which would have to be combined with various alternative quantities of labour (or land) in order to produce certain specified amounts of clothing. And they will have the same properties as the equiproduct curves for food which we have been discussing. Let us now return to the problem facing the Authority, that of producing stated quantities of food and clothing with the minimum use of factors. Let us assume that the target outputs for food and clothing are 5 and C,, and that the corresponding equiproduct curves are those drawn in figs vii and viii. Let the factor combinations being employed in food and in clothing production be represented by the points P and Q on the respective equiproduct curves. It is clear that, considered in isolation, each commodity output is being produced efficiently, in the sense that it would not be possible to use less of one factor without using more of the other. The fact that the factor combinations being employed are represented by points on the equiproduct curves implies that this is so. But can we say that the techniques of production are efficient when taken in conjunction? Is the pair of factor combinations being employed ideal in the sense that there is no alternative pair, represented by other points on the equiproduct curves that would permit a saving in land, or labour, or both? I. I shall assume, throughout the analysis, that equiproduct curves are always convex towards the origin over their whole length. A fuller treatment would consider the implications of exceptions to this general rule.

28

ECONOMIC THEORY

It is not difficult to see that if the factor combinations were in fact those given by the points P and Q in the diagrams, then production would not be efficient in this sense. It is evident that the slope of the

Food

Fig. vii

Fig. viii

equiproduct curve for food, at point P, is not equal to the slope of the equiproduct curve for clothing at point Q. From this it follows that MS,,, is not the same in the production of both goods. It might be that a marginal unit of land could replace 3 units of labour in the production of food and 2 units of labour in the production of

T H E L O G I C OF C H O I C E

29

clothing. (This would be to assume that the slopes of the equiproduct curves for food and clothing were equal to 3 and 2 respectively.) But were this the case then it would be possible to maintain the output of both goods while economizing in factors. It would be possible, that is, to take 1 unit of land from the production of clothing and use it to replace 3 units of labour in food production; only 2 of these 3 units of labour would be necessary to replace the 1 unit of land originally taken from clothing production, so that 1 unit of labour could be set free. It is evident, therefore, that so long as the marginal substituta-

Fig. ix

bility between the factors is not the same in the production of both commodities it would be possible, by a marginal reallocation of the factors, to economize in their use. It should be noted that our condition for productive efficiency does not specify two particular combinations of land and labour uniquely appropriate for the production of the required amounts of food and clothing. There are an infinite number of pairs of factor combinations such that M S , , is the same for both of them, just as geometrically there are an infinite number of pairs of points at which the equiproduct curves corresponding to the required outputs will have the same slope. We can therefore construct a combined equiproduct curve indicating the total amounts of labour and land which would be required to produce the specified quantities of food and clothing on the assumption that production is efficient. Thus the curve in fig ix

30 E C O N O M I C THEORY represents the minimum amount of one factor which has to be combined with different amounts of the other in order to reach the C1.This combined equiproduct curve combined output target F, has been drawn, as were the single equiproduct curves, convex to. wards the origin. This once again implies that in the production of the combined output there will be diminishing marginal substituta. bility between the factors employed. The condition for productive efficiency now established relates to the attainment of fixed output targets with the minimum use of inputs. But it is easy to show that it applies with equal validity to

+

Fig, x

the converse problem of employing fixed amounts of the two factors in order to produce the maximum output. We have seen that if MS,, is not the same for the production of both food and cloth. ing, then it is possible, by a marginal reallocation of the two factors, to economize in one of them; this is tantamount to saying, however, that it would be possible to produce more of one commodity without less of the other, for the factor released could be used to this end. Whether we are concerned, therefore, with maximizing outputs, or with minimizing inputs, the same criterion of productive efficiency is relevant. It is now possible to construct a curve which shows the maximum amount of food which could be produced in conjunction with varying amounts of clothing, on the assumption that the available supplies of both factors are fixed. This curve, fig. x, is called a production frontier; all the points on it represent quantities of food

THE LOGIC O F C H O I C E

31

(on the vertical axis) and clothing (on the horizontal axis) which could be produced if the available factor supplies were used efficiently; points inside it represent quantities which could be produced without using these supplies in their entirety, or by using them inefficiently; and points outside it represent output targets which cannot be reached with these supplies. As I have drawn it, the production frontier slopes downward from left to right. This implies, economically, that, assuming given factor supplies, we can have more of one commodity only at the cost of having less of another. Let us define the marginal opportunity cost of clothing, in terms of food, as the amount of food that has to be given up in order to free resources sufficient to produce a marginal (i.e. small, additional) unit of clothing. (The opportunity cost of anything is, quite generally, the alternative that has to be forgone in order to have it.) We can conveniently refer to marginal opportunity cost as MOC associated with a two-letter suffx, the first letter standing for the good obtained and the second letter for the good given up. Thus the marginal opportunity cost of clothing, in terms of food, is MOC,,. The geometrical counterpart of MOC,, is the slope of the production frontier at the point corresponding to the output combination being produced. (This can be proved in precisely the same way as we proved the equality between MS,,, and the slope of an equiproduct curve.) As drawn, the production frontier is convex away from the origin, so that the slope of the curve increases as we move from left to right along it. Economically, this would correspond to increasing marginal opportunity cost of one good in terms of another. The more clothing we already have, for example, the greater will be the cost, in terms of food forgone, of having a further unit of it. It may appear reasonable to assume that one good will have increasing marginal opportunity cost in terms of another, but it is not in fact possible to prove that this is the case merely on the basis of our present assumptions. One further important assumption has to be made. It is that of constant returns to scale. We say that a production process shows constant returns to scale when an x% increase in the amount of each factor employed (irrespective of the size of x) yields an x% increase in output. (Thus, for example, starting with a given factor combination, we will obtain double the output if we double the amounts of each factor employed.) Were an x% increase in each factor to yield an increase in output greater than x%, we should say that the production process was showing increasing returns to scale. Were the resultant increase in output to be less than

32

ECONOMIC THEORY

x%, we should say that decreasing returns to scale were in operation. Given our earlier assumption that factors of production were both homogeneous and divisible (p. 19), there may appear to be no obvious reason why returns should be other than constant, but it is not possible to assert that this will be so in every case. For my present purpose I shall simply assume that production processes do show constant returns to scale. I t will be necessary, at a later stage of the argument, to examine the alternative possibilities. If we do assume constant returns to scale, then it is possible to show that there will be increasing marginal opportunity cost of one good in terms of the other. As, however, the proof is rather cumbersome, I have relegated it to a footnote. Those readers who do not wish to be diverted from the main channel of the argument may be prepared to take it on trust.1 I. Readers who wish to persist in the matter are offered the following argument, which, although lacking in rigour, will suggest the nature of the proof available. We assume that there are constant returns to scale in the production of both food and clothing. In addition, we take for granted that the proportions in which land and labour are combined in the production of food will not, if production is to be efficient, be the same as the proportions in which they are combined in the manufacture of clothing. Let us assume that all the community's resources of land and labour are at first devoted to the production of food only. In fig. xi, food is repre-

Fig, xi sented on the vertical axis and clothing on the horizontal axis. The point A indicates the amount of food produced when all resources are devoted

THE

LOGIC O F CHOICE

33

Before leaving the question of productive efficiency it should be mentioned that, although our discussion has proceeded in terms of only two factors and two products, the principles established by it are valid even when this restriction is removed. We can say, quite generally, that, if production is t o be efficient, then the marginal substitutability between any two factors must be the same in the production of any commodity for which these factors co-operate. Our other simplifying assumptions are, of course, less easily dispensed with. I t is still necessary t o assume, in particular, that both exclusively to its production. Now let us suppose that 10% of each of the factors land and labour is transferred from food production into clothing production. The resultant output combination is now that given by the point P. Food output will have fallen by IO%,to OF (given our assumption of constant returns to scale), while clothing output will be OG. Now assume that 20% of the total supplies of both factors is moved to clothing production. The resultant output combination will now be given by the co-ordinates of the point Q. Food output will be 20% smaller than it was initially, while clothing production will be 01. As I have drawn it, the points A, P and Q all lie on a straight line. Why is this so? If there are constant returns in the production of food, the output of food obtained by transferring 20% of each factor must be twice that obtained from transferring 10% of each factor. Thus 01 is twice OG, so that OG = GI. Similarly, considering reductions in food output, AF= FH. It follows then from the geometry that A, P and Q must all lie on a straight line. If we proceeded to transfer more resources from food to clothing production, the output combinations obtained would, by similar reasoning, all lie on the straight line through A, P and Q, which would cut the horizontal axis at B, this point corresponding to the clothing output that could be obtained by transferring all resources to the production of this good. Thus it is evidently possible for clothing to be substituted for food merely by transferring equal percentage amounts of land and labour from the production of the one good to the other. If this is done, the substitution possibilities will be indicated by the straight line AB. But is this the best that can be done? At any point on the curve, except the end points A and B, land and labour are being combined in the same proportions in the manufacture of both food and clothing. No attempt is being made to allocate factors so that MSL,w is the same in the production of both goods; production, in other words, is not efficient. By deliberately allocating factors between the two goods so as to ensure productive efficiency, more of either good could be produced. Therefore, although the production frontier begins at A and ends at B, all the other points on it must lie above the straight line AB. This clearly suggests that the frontier must be convex upwards, although it does not strictly prove that it is uniformly convex as we have drawn it. The argument can be extended to provide such a proof, but I shall not take up more space by providing it. B

34

ECONOMIC THEORY

factors and products are homogeneous and divisible, for otherwise we cannot legitimately talk in terms of very small, or marginal, changes.

3 Distributive eficiency Commodities are not desirable for their own sake, but for the satisfaction, or material well-being, which they afford. The level of econoinic welfare attained by any consumer will depend on the particular collection of goods which is placed at his disposal; it can be increased, not only by giving him more of some, or all, goods, but also by making the proportions in which they are combined more suitable to his requirements. How then should the Authority distribute food and clothing to consumers? This is a problem closely analogous to that which we have just considered; for whereas, previously, we took factor supplies as given and sought to determine how they could most efficiently be converted into products, now we shall assume that there are given quantities of food and clothing which have to be distributed so as to provide the maximum amount of welfare. For simplicity, we shall begin by assuming that there are only two consumers, A and B. In our discussion of productive efficiency, the reader will recall, we said that the output from given factor supplies would be increased if more were obtained of either one commodity without reducing the production of the other. In a similar way we shall say that welfare has been increased if either consumer is enabled to attain a higher level of welfare, without the other being made worse off. It might at first be thought, in this case, that 'output' could be measured merely by adding together the welfare provided for each consumer. But there are two objections to this procedure. In the first place it is at least debatable whether the economic welfare of even one consumer is measurable, in the sense that it can be said to equal so many welfare units. We may be able to say that the material well-being of a person is greater, or less, or the same, with one collection of goods as compared with another without being able to attach numerical measures to the two states. In the same way it may be possible to rank the competitors in a beauty competition in order of first, second and third place without implying that beauty is capable of numerical measurements as is, for example, height or weight. If, however, we can only rank levels of welfare, and not measure them, then it is difficult to see how the welfare of different people could be added together.

THE LOGIC O F C H O I C E

35

Even if we were to dissent from this last proposition, and believed that it was possible to add together the welfare of A and B, we have still to recognize that it is by no means evident that the Authority would wish to maximize welfare thus aggregated. It might consider, for example, that A was more entitled to material satisfaction than was B and seek to adjust the distribution of goods accordingly. Thus it is important to distinguish between distributive efficiency and distributive justice. Economics is primarily concerned with distributive efficiency, in that it endeavours to prescribe ways in which any unnecessary sacrifice, or waste, of material welfare can be avoided. Distributive justice is achieved when people enjoy the comparative levels of material welfare which they are judged to deserve. It is preferable, therefore, to define distributive efficiency in a way similar to that followed in our analysis of the process of production. Distribution will be said to be efficient so long as it is not possible, by altering it, to ensure the same levels of welfare for both A and B while using less of one product and not more of another. Alternatively, given amounts of food and clothing will be said to be efficiently distributed so long as there is no alternative distribution which would permit either person to attain a higher level of welfare without impairing the position of the other. Let us now consider how the welfare of one of our consumers, say A, will be affected by the amounts of food and clothing which he consumes. There will be a variety of combinations of food and clothing which ensure that he reaches a fixed level of welfare. This is shown in fig, xii which indicates the minimum amount of one commodity which, if combined with varying amounts of the other, will ensure the required level of welfare. The close analogy with the analysis of production will now be clear; just as previously we referred to the minimum factor requirements for a given amount of a commodity, now we refer to the minimum product requirements for attaining a given level of welfare for a consumer. And, as before, it is possible to construct a 'family' of curves to indicate the different commodity requirements for different welfare levels, such as U,, U, and U, (fig. xiii). U, represents a higher level of welfare than U,, and U, a higher level than U,. The term equiwelfare curves could be used to describe them, but we shall use the commonly accepted name of indifference curves. Provided a consumer were able to estimate the welfare that any particular collection of goods could provide, then he would be indifferent between any of the collections of food and clothing represented by the points on any one such curve; points

36 ECONOMIC THEORY lying above the curve would be considered superior, and those lying below it inferior, to any of these collections. The further a curve from the origin, the higher will be the level of welfare which it represents.

1

C

0 Fig. xii

Fig. xiii

A system of indifference curves, such as those drawn in fig. xiii, can be shown to have properties similar to those of the equiproduct curves discussed in the previous section. Their downward slope, from left to right, indicates that if the consumer is to have less food, then he will have to be given more clothing in order to ensure that

THE L O G I C O F C H O I C E

37

his welfare level is maintained. It is easy to prove, by means of the familiar reductio ad absurdum, that they do not intersect. In fig. xiv two indifference curves, representing different levels of welfare U, and U,, are drawn so as to intersect at P. This implies that the combination of food and clothing represented by the point P affords two different levels of welfare to the same person. Only if the curves do not intersect can the possibility of such a contradiction be ruled out. We frequently find it necessary to have a measure of the extent to which, in any particular product combination, one product can be

Fig. xiv

substituted for another without affecting a consumer's welfare. Such a measure is provided by the concept of the marginal relative utility of the goods concerned, this being defined as the number of units of one of the goods that can be replaced, in a man's consumption, by a small additional unit of the other, on the assumption that the man's welfare is to remain unchanged. Thus the marginal relative utility of clothing and food, in any particular combination of these two goods, is the number of units of food that can be replaced by a small additional unit of clothing without altering the welfare of the person consuming them. As the reader will doubtless have observed, the concept of marginal relative utility, which we shall use to measure the substitutability between products in consumption, is formally equivalent to the concept of marginal substitutability, which we used to measure the substitutabilitybetween factors in production. In order,

38 ECONOMIC THEORY however, that there should be no ambiguity as to the kind of substitition being considered, I have chosen to employ both terms1 In accordance with our previous practice, I shall refer to the marginal relative utility of goods by the expression MRU qualified by an appropriate suffix. The first letter of the suffix will stand for the product, the consumption of which is to rise by a marginal unit, while the second letter stands for the product being replaced. Thus MRU,, is the number of units of food that a marginal unit of clothing could replace without affecting the welfare of the person consuming them. Let us now return to the indifference curves drawn in fig. xiii. It can be seen that, as drawn, the curves cut neither axis, the underlying economic assumption being that neither commodity can replace the other entirely, while maintaining the consumer's welfare constant. The curves are also drawn convex towards the origin, so that their slope diminishes as we move along them from left to right. This property has an economic interpretation closely analogous to that of the corresponding property of equiproduct curves. By reasoning similar to that employed in our examination of equiproduct curves, it can be shown that the slope of an indifference curve, at any particular point lying upon it, measures the marginal relative utility of the goods in the combination given by the co-ordinates of this point. Thus the fact that the slope of the curves diminishes, as we move from left to right along them, implies that there is diminishing marginal relative utility between the goods. It implies, in other words, that if a man is given one good in exchange for another, each successive unit of the good thus given to him will be able to replace ever-diminishing quantities of the good withdrawn. With the assistance of these ideas, we are now in a position to determine the criterion for efficient distribution. I shall assume I. If we regard the utility of a good as its power to create welfare, then the marginal utility of a good can be defined as the additional welfare afforded to a particular person by a small additional unit of the good. Thus the ability of a marginal unit of one product to replace another in consumption will depend upon the ratio of their respective marginal utilities. But the notion of marginal utility, although very convenient, has to be interpreted with care. If it is in fact impossible to measure welfare, then it is likewise impossible to measure utility, as the power to provide welfare. For our present purposes, however, the concept of measurable utilitywhether or not it is legitimate-is unnecessary. The concept of marginal relative utility is all we need and this can be defined, as it has been above, merely in terms of the power of one good to replace another.

THE LOGIC OF CHOICE

39

that the Authority desires to bring two people, A and B, to the levels of welfare represented by U, and U, on their respective indifference maps (fig. xv). This could be accomplished by giving to A the quantities of food and clothing represented by the point P on the

Fig. xv

curve U,, and by giving to B the quantities represented by the point Q on the curve U,. But this can be shown to be an inefficient procedure. As drawn, the slope of the curve U, at P is different from the slope of the curve U, at Q, so that MRUC,, is not the same for both persons. Let us suppose, for example, that M R U , , is 3 for A and 2 for B. Then, by giving one unit of clothing to A, in exchange for three units of food, it would be possible to leave him

40 ECONOMIC THEORY as well off as before. Two of these three units of food could then be given to B in exchange for one unit of clothing, so that his material well-being would remain unaltered. The net result of this marginal reallocation would be to economize in one unit of food, while leaving both parties as well off as before. It is clear therefore that efficient distribution requires that MRU,,, should be the same for both consumers. This criterion has been developed on the assumption that given welfare levels had to be reached with the minimum use of goods. But i t applies equally to the problem of reaching the highest welfare

0

Welfare of B Fig. xvi

levels possible with given amounts of each commodity. Unless MRU,,, is the same for all those who consume food and clothing, then it will be possible to raise the welfare level of one consumer without reducing that of any other. We can therefore construct a particular welfare frontier with a significance analogous to that of the production frontier which we considered previously (fig. xvi). This will indicate the maximum level of welfare that can be obtained by the one consumer, given fixed commodity supplies, while securing various levels of welfare for the other. The term 'particular' is applied in order to make it clear that these are the best welfare combinations to be reached from a particular, given collection of products. (It can be distinguished from a general welfare frontier, the significance of which will concern us presently.) Once again, our criterion, although established for the case of two

THE L O G I C OF CHOICE

41

products and two consumers, is valid also when both products and consumers are numerous. What is required is that the marginal relative utility of any two goods should be the same for all those who consume them. The applicability of this rule to realistic conditions is limited by some of the other simplifying assumptions implicit in our discussion. It is not possible, for example, for all the goods in any economy to be distributed among its members as can food and clothing. Some goods, such as defence, drainage and roads, represent a benefit which all the inhabitants, or at any rate large groups, enjoy in common, and their distribution cannot always be adjusted so that one person consumes more, and another less, of them. Nor is it true that goods provide welfare only for those who directly consume them. The wearing of fine clothes by some may give feelings of pleasure, or of envy, to others, and a gramophone may give enjoyment to its owner and annoyance to his neighbour. But these, and many other complications, will be neglected in this discussion.

4 The optimum assortment of commodities We have now succeeded in establishing criteria-which proved to have great formal resemblance-which enable us to judge the efficiency of the transformation, fist, of factors into products, and secondly of products into welfare. We were able to set out, in terms of a production frontier, the various combinations of food and clothing which fixed factor supplies, if used efficiently, could produce; and in terms of the welfare frontier we set out the combinations of A's and B's welfare which could be obtained by the efficient distribution of fixed amounts of food and clothing. But the analysis so far would not enable the Authority to decide which of the output combinations on the production frontier to choose, or to decide which of the various efficient distributions of these products was the most appropriate. It is to these remaining problems that we must now turn. It can be taken for granted that the output combination to be chosen by the Authority will be one of those which lie on the production frontier determined by the amounts of land and labour which are available; for all points beyond the frontier are unattainable, while those inside it all contain less of both products than some point actually on the frontier. The welfare potentialities of each of the combinations on the production frontier are represented by the particular welfare frontier corresponding to this combination; it represents the best that can be done, from the welfare point of view, by

42

ECONOMIC THEORY

efficiently distributing this particular collection of food and clothing. There will, in fact, be an indefinite number of such welfare frontiers corresponding to all the output combinations which lie upon the production frontier; and all the welfare combinations which, taken together, they represent are accessible to the Authority. The potentialities of all these different particular welfare frontiers can therefore be summed up so as to provide a general welfare frontier, which will indicate the best combinations of welfare which can be obtained, not from any particular combination of food and clothing, but from the whole range of accessible combinations given by the production frontier (fig. xvii). This general frontier sets out the highest welfare

0

Welfare of B

Fig.xvii level which can be obtained for A subject to ensuring various different levels of welfare for B, given the limited resources of land and labour which are at the Authority's disposal. Now, in order to reach a point on this general welfare frontier, food and clothing will have to be produced and to be distributed efficiently in the sense that we have come to use this term. But although productive and distributive efficiency are necessary conditions for reaching the frontier, they are not, when taken together, a suficient condition for doing so. It is evident, on reflection, that there are some output combinations on the production frontier which, however distributed, would never permit a point on the general welfare frontier to be obtained. The point which represents, for example, the maximum production of clothing consistent with a zero output of food is of this kind; on the assumption that consumers

THE LOGIC OF CHOICE

43

require some of both commodities, it would offer no welfare potentialities whatsoever. And there will be other output combinations which, although efficiently produced and distributed, would offer welfare possibilities which could always be surpassed by making use of some of the other available combinations. In more technical language, each point on the particular welfare frontier corresponding to these inferior output combinations will lie inside the particular welfare frontier corresponding to some other output combination. What then is the additional criterion required to ensure that the Authority does reach a point on the general welfare frontier? Let us suppose that the available land and labour have been combined efficiently to make one of the combinations of food and clothing which lie on the production frontier. And let us further suppose that they have been distributed efficiently, so that the marginal relative utility of food and clothing is the same for all consumers. Let us suppose that MRU,,, is in fact equal to 3. Let us also suppose that the marginal opportunity cost of clothing in terms of food is 2. If this is the case, can we say whether the Authority has succeeded in bringing the economy to a point on the general welfare frontier? A little reflection shows that it has not. The fact that MOC,, is 2 implies that one more unit of clothing could be produced at the sacrifice of 2 units of food. This one more unit of clothing, however, is capable of replacing 3 units of food in an individual's consumption. Thus a marginal transfer of factors from the production of food to the production of clothing would enable the Authority either to economize in factors or to make one consumer better off. Here then we have the condition for the optimum assortment of output; it is necessary for the marginal opportunity cost of any one product in terms of another to equal the marginal relative utility of these products. If this is not the case, then the composition of the commodity output is not as appropriate as it could be to the requirements of consumers. This condition is necessary, but not sufficient, for full economic efficiency, which demands, in addition, that the conditions for both productive and distributive efficiency are being met. Our analysis has provided us with the conditions which have to be met if the economy is to attain a point on its general welfare frontier, so that each consumer is as well off as he can be, subject to the condition that the other is not to be made worse off. But it has not told us which point on the frontier, and therefore which distribution of welfare, the Authority should choose. This is as it should be, for

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ECONOMIC THEORY

this final choice is one of ends, whereas our principles have had to do with the selection of the means best suited to attain given ends. The logic of choice cannot prescribe ultimate objectives, but it can help us to reach them. The ideal configuration of production and distribution will be one of those which correspond to a point on the general welfare frontier and the Authority's opinions regarding distributive justice will decide which one it is. Once again, our final condition for economic efficiency, although more easily demonstrated for the case of two goods and two consumers, is equally valid irrespective of the actual numbers of these. Many of our other simplifying assumptions-such as that relating to the homogeneity and divisibility of products-have to be maintained. One of them, however, relating to the supply of labour, can conveniently be removed at this stage.

5 The optimum supply of work Both of the factors of production in our simple economy-land and labour-were presumed to be available in fixed supplies. In the case of labour, however, this assumption is unreasonable, and unless we abandon it, one of the most important decisions to be made by the Authority will not have been considered. At any particular time, the size of the labour force in the economy may be fixed-although even here there will be some question of whether some particular people should work or not-but the actual supply of work done will depend both on the size of the labour force and on the number of hours for which each member of it is employed. It will be possible, moreover, to vary the amounts of food and clothing enjoyed by consumers merely by varying their hours of work. Labour differs from land not only in that its supply can be varied, but also in the fact that the welfare of workers will be related directly to the amount of it that they supply. Some kinds of work, which are boring, dirty or otherwise disagreeable, probably reduce a man's welfare however little he does of them. Other kinds, which are interesting, will, if done in moderation, increase welfare. By assuming that the labour in our model was of one kind only, we have excluded these distinctions. It will therefore be necessary for us to think in terms of the elements common to most forms of work. Up to a point, we may assume, people's welfare would be increased by working, irrespective of whether they obtain goods in compensation. So long as work contributes positively to welfare (and therefore-if consumers know their own best interests-is desired for its own

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sake) the Authority has no problem in deciding how much work people should do. As any man increases his hours of work, however, a point will come at which additional work ceases to provide, directly, any welfare. Once this point is passed, additional work becomes a burden, so that welfare will fall unless some compensating amount of goods is provided. It is only at this stage that a problem of choice arises, the problem of balancing the loss of welfare, occasioned by work, against the gain in welfare provided by the goods that work helps to make available. The iirst problem for the Authority is to find the 'optimum distribution' of work. Assuming, in other words, that the total amount of work to be done (and therefore the total output) within the economy is already decided upon, how is the Authority to decide how much work one man should do as compared with another? This question can best be handled if we talk in terms not of work, but of its converse, leisure. As leisure contributes to welfare, we can regard it as a 'good', like food and clothing. Thus we may define the marginal relative utility of leisure, and, say, food, as the number of units of food that a marginal unit of leisure can replace without any effect on a man's welfare. Writing E ('ease') for leisure, this may be expressed as MRU,,. Let us suppose that MRU,,, is 3 for consumer A and 2 for consumer B. Then clearly it would be advantageous for A to do one less unit of work and B one more. The total work done, and the total output of food, would remain the same. But it would be possible to take 3 units of food from A without reducing his welfare, only two of which would be required to compensate B for his extra work. The unit of food made available could be used for whatever purpose the Authority thought fit. Thus we may say that, for an optimum 'distribution' of work, the marginal relative utility of leisure and any particular commodity should be the same for everyone. It should be borne in mind that this rule does not dictate any one distribution of leisure. There will be an infinite number of distributions which will meet the condition for efficiency, the final choice between them having to depend upon the canons of equity by which the Authority is guided. The fulfilment of our condition ensures the exhaustion of all the opportunities of making one man better off without reducing the welfare of others; it does not ensure that each member of the community is enjoying the particular welfare level that he, relative to others, deserves. The Authority's second choice relates to the total amount of work

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to be done. Let us suppose that distributional efficiency has been secured and that MRU,, is the same for everyone and equal to 3. And let us further suppose that a marginal unit of labour produces 2 units of food; i.e. that it is possible for one more unit of leisure to be had at the sacrifice of 2 units of food. Employing our usual symbol, MOC,,, = 2. Now allow one man to reduce his work by one unit, thus causing food output to fall by 2 units. Were this man to be deprived of 2 units of food, he would be left better off than before, as the additional unit of leisure was worth to him 3 units of food. Neither the goods nor the leisure enjoyed by anyone else need be altered, so that total welfare has increased. Generalizing, we may say that the optimum amount of work will be performed only if the marginal relative utility of leisure and any particular good equals the marginal opportunity cost of leisure in terms of that good.1

6 Conclusions Provided that we interpret the term 'good' to cover leisure as well as food, clothing etc., the conclusion of this chapter can be summed up by these three statements. (i) Productive efficiency requires that the marginal substitutability between any two factors be the same in the production of all goods for which the factors are employed. (ii) Distributive efficiency requires that the marginal relative utility of any two goods be the same for everyone who consumes both these goods. (iii) Optimum assortment requires that the marginal relative utility of any two goods, as well as being the same for all consumers, be equal to the marginal opportunity cost of the one good in terms of the other.

I. It would be possible to amend this condition to take account of the fact that there are various kinds of work, which differ both in their contribution to output and their effect on welfare. But I shall not further complicate the analysis by working out this amendment.

Capital, technology and time 1 The process of production The purpose of this chapter is to bring our previous analysis, in two important respects, nearer to reality. Hitherto, we have been content to assume, first, that land and labour could be converted into commodities directly and instantaneously, and, secondly, that all the possible ways of doing this were already known. Netiher of these assumptions is at all realistic, but they helped us to identify, in a simplified context, certain fundamental principles of rational choice. The time has now come to abandon them. We have now to recognize, first, that production is indirect and time-consuming. It is indirect in that the original factors of production-labour and land-yield final consumable output only after transformation into a variety of intermediate products. And production is time-consuming in that the flow of output in any particular period is the consequence of a process of transformation that reaches back into the past. It is necessary, secondly, to take account of the fact that the level of a society's scientific and technical attainment, and therefore the production processes open to it, changes with time and can be raised by measures specifically directed to this end. In the early part of this chapter I shall examine some of the more important consequences of the fact that production takes time; having done this, I shall refer to some of the further complications introduced by changing technology. The indirect or roundabout nature of the production process becomes immediately apparent if one considers the various stages in the manufacture of any ordinary commodity-say, a loaf of bread. In the ultimate analysis we may say that this has been made from labour and land, where the latter is interpreted to mean natural 47

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resources in general. But the actual process of transformation comprises an immensely complex and ramified chain of activities stretching out over a long period of time. A van had to be built to deliver the bread to the door; ovens had to be constructed for the bakery; land had to be tilled and irrigated, and wheat had to be sown; railways and ships were required to transport the grain to the ports and across the seas; and for these steel had to be made, iron ore to be mined and men trained in metallurgy and engineering. Such a list could be extended all but indefinitely, and the chain of connection could be followed back into the furthest past. Factors of production which were employed years, decades or even centuries ago make some contribution to output consumed today. I n any economy, therefore, the commodities which are being consumed in the present are the fruits of productive activities carried out in the past and sometimes in the remote past; and the labour and land which are being employed in the present will yield output only for the future. Current production is sustained by a stock of goods inherited from the past. Part of this stock consists of consumers' goods, such as food and clothing, which meet our wants directly; were there not a sufficient supply of these already in existence, with which to meet its current needs, the labour force could not devote its energies to producing output for the future.1 The other part is composed of prod~icers'goods. Goods of this kind, such as wheat and ovens, are the output of intermediate stages of the production process; they do not meet our wants directly, but enable manufacturers to produce the commodities which will do so. Both consumers' and producers' goods can be classified as either single-use or durable-use, according to whether they afford either a I. In this respect it must be admitted, the distinction between original inputs and final outputs is really less clear cut than might at first appear; food and clothing, which we have represented as final output, can also be regarded as necessary inputs without which the labour force could not live and work. Except in the poorest economies, however, only a part of final output will be required to ensure the minimum standard of living consistent with the health and efficiency of the working force; there wilI usually be a surplus of consumers' goods over and above those which could be regarded as an input necessary for current production. The essentially circular nature of the process of production, and the implied ambiguity of the concepts of input and output, were recognized by some of the earliest writers on our subject, but, as countries grew richer, and the problem of providing the working population with the minimum requirements of life became less acute, this aspect of the economic process tended to receive less attention.

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49

single service or a flow of services over a period of time. Consumers' goods of the f i s t category such as food, release all their services immediately they are used, while those in the second category, such as clothing, release them only gradually over the whole period of their useful life. Single-use producers' goods are represented by stocks of raw materials, such as rubber and iron, and of semi-finished products somewhere in the pipeline of production; they will later be used up in some single process of transformation. The durable-use producers' goods consist in tools, machines, factory buildings and all manner of fixed installations employed in manufa~ture.~ It is convenient to refer to the stock of all goods in existence as the capital with which, at any particular time, the economy is endowed. Part of this stock will be formed by consumers' and producers' goods of the single-use variety, for which the term circulating or working capital is sometimes used. The remainder will be the durable-use goods, otherwise known as fixed capital. All of this stock will, sooner or later, be used up or worn out, so that, if the present is to hand on to the future an endowment equivalent to that which it has received from the past, resources will have to be devoted to maintenance and replacement. If, over some particular period of time, the stock is increased, then we say that net investment has taken place; if it has been run down, there has been net disinvestment. Investment, therefore, represents the change in the stock of capital over a period of time. The stock itself can be likened to the quantity of water in a lake; it is run down by use, just as the lake is depleted by those streams of which it is the source; but, at the same time, it is constantly fed by the flow of fresh resources which enter it. The quantity of capital, like the volume of water in the lake, will rise or fall according to whether the inflow exceeds or falls short of the outflow. This analogy, like all of its kind, is imperfect. The stock of capital is a heterogeneous assortment of goods of immense variety and, this being so, it is exceedingly difficult to define, far less to measure, changes in its size. Its composition will be for ever changing; the passage of time may witness a reduction in the stock of ships and an increase in that of aircraft, and the ships and aircraft of one period will themselves differ in kind from those of another. Under these conditions, it is difficult to say what precisely we mean by changes in the quantity of capital. Difficulties of this kind are I. The terms I have employed are those used by Professor Hicks in his book The Social Framework (vide,especially, chs. 2 and 8). The reader is referred to this discussion for a fuller analysis of these distinctions.

50 ECONOMIC T H E O R Y endemic to our subject, and we shall find ourselves constantly wishing to refer, in quantitative terms, to aggregates, which because of their altering composition are recalcitrant to measurement. Although ways and means can sometimes be found for giving an exact significance to changes in their magnitude, the examination of these techniques would take us too far afield. Let us now return, once again, to consider the general nature of the process of production. In the ultimate analysis, commodities are derived from the services of labour and from land, land being interpreted widely to mean natural resources. More immediately, we have now recognized, they are the products of labour and capital. Capital can be regarded as compounded of natural resources worked on by labour in previous periods. Labour itself, however, is capable of further analysis. It is the embodiment of a stock of knowledge and a variety of skills, acquired by the efforts of both past and present generations. Just as the productivity of the soil is increased by the work of drainage and cultivation, so that of labour is augmented by education and training. Thus the training of an electrician or an engineer represents a form of investment comparable to the construction of a railway or a machine. For, in both cases, resources which could be used directly in the production of consumer goods are used instead to create something which will facilitate production over some extended future period of time. The skills and knowledge which have been acquired by the engineer incorporate the past efforts of both himself and of those who taught him, and they will remain available for productive purposes over the whole of his working life. We should therefore regard the economy as possessing a stock of educational capital in addition to the stock of physical capital considered hitherto. From some points of view it is convenient to distinguish between educational capital and the state of science and technology; the latter can be taken to refer to all the knowledge and techniques, possessed by anyone, which are relevant to production, while the former represents the degree to which this knowledge and these techniques are diffused among the working force. Productive efficiency can be improved by a more widespread command of the skills and technical information already known to someone, as well as by technical progress in the form of fresh discovery. In practice, of course, both forms of advance go hand in hand, and both can be promoted by deliberately devoting resources to the purpose. The wealth of a country is greatly influenced by its stock of educational capital. Indeed much of the difference in prosperity

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between rich and poor countries in the world today is very largely to be attributed to their varying endowments in this respect. The immense importance of educational capital is strikingly illustrated by the fact than an economically advanced country has often been able to recover, in a matter of years, from the devastation wrought by a war upon its stock of buildings and machines. This resilience is chiefly due to the high degree of skill and training possessed by its manpower. In order to gauge the extent to which advanced economies invest in education, one has to think not only of the men employed as teachers, and the material used to build schools, but also of the large proportion of his potential working life during which the average citizen receives formal instruction. In England until not much more than a century ago the children of poor parents might enter directly productive employment at the age of ten, or even earlier, now they would not do so before they are fifteen years old; notwithstanding this, or rather partly in consequence of it, our wealth has immensely increased. It should scarcely need to be said that, although from our present point of view, education figures as a means of increasing the output of commodities, this is not its only, or even its principal, value. The terms capital and investment, the reader will have observed, have in ordinary usage a sense quite different from that which has been given to them here. By a man's 'capital', we frequently denote the money value of his wealth, and 'investment' may refer to the purchase of securities or the deposit of money in a bank. It is definitely not in these senses that the words will figure in our analysis. Economics, very frequently, has borrowed its terms from the market place, but normally imposes upon them, in order to avoid ambiguity, a special and restricted meaning. Indeed, the construction of a theoretical framework is to a considerable extent the development of a vocabulary appropriate to a particular subject. Production may be called 'capitalistic', in that it is carried out with the assistance of the products of past exertions, in the form of physical equipment or of education, as well as with original resources. Very frequently the distinction between original resources, which do not embody the work of past labour, and capital, which does, will be difficult to draw; almost all labour has benefited from education, and almost all land owes some of its fertility to work done in the past. But the distinction between gifts of nature and the fruits of past effort is a useful one nevertheless. We must now consider the ways in which the fact that production is capitalistic oblige us to modify, or at any rate to amplify, the

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conditions for efficient allocation which were set out in the previous chapter. In order to do so we shall have to look rather more closely at some of the properties of capital goods. First, one should notice that capital, whether in the form of machines or of acquired training and skills, is frequently specific in two respects. It has been designed to produce a particular kind of output and cannot readily, if at all, be used for any very different purpose. A loom, for example, if it is not used for making textiles, is useful only as scrap metal. And the particular skills of, let us say, a dentist, will be more or less wasted if he works in some other employment. But capital goods are specific with respect not only to the kind, but also the quantity of the output which they were designed to produce. A machine, or fixed installation of any kind, will normally have a specific capacity which determines the volume or rate of output which it will efficiently produce. There will be a maximum number of ships which can conveniently use a harbour, or number of cars which can be assembled on a conveyor belt. Frequently it will be possible to raise the actual rate of output above that for which the fixed capital was designed as machines can be made to run faster and men to work for longer hours. But the increase in output obtainable by these means is likely to be small, quite apart from the risk of overstraining the plant or the labour force. Similarly, although an industry's fixed equipment may be used to produce an output smaller than that planned for it, the process of production will thus be made less efficient than it could have been; had the desired rate of output been correctly foreseen, a smaller plant would have been constructed and resources thereby saved. In addition to being specific, fixed capital is, as we have already observed, durable. By this we do not mean that it can withstand the ravages of time; many single-use goods, such as raw materials, can do this; we imply rather that it will produce services over an extended period. The flow of these services cannot be accelerated beyond a certain point; the benefits from constructing a building or a machine, or from training a man, will be fully exploited only when they come to the end of their working life. This being so, there will generally be some minimum economic life for which plant can efficiently be designed. Finally, fixed capital assets are frequently more efficient if constructed to produce a large output rather than a small one. The economies of scale or mass production are attributable, in part, to the fact that certain types of equipment cannot readily be constructed for small volumes of output. This would be the case, for example, for

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53

an assembly line used in the manufacture of vehicles. Similarly, a certain minimum amount of resources would be required to link centres by a railway, which, although only up to a certain point, would be as able to deal with large as with small volumes of traffic. Thus, capital assets have frequently a minimum economic scale, in that they are more efficient if designed to produce not less than some particular rate of 0utput.l Now the fact that production is carried on with the assistance of capital equipment possessing these particular properties profoundly influences the opportunities available to the Authority. In the previous chapters we considered the problem of allocating resources given a fresh start and untrammelled by any particular inheritance of specific and durable equipment. But it is more realistic to envisage the economy as being taken over by the Authority when it is already a going concern, with a particular composition of output and capital stock. Given this situation, it is useful to distinguish between those productive opportunities which could be exploited without changing the amount and character of the stock of capital and those which become available o@y provided new equipment is constructed. This distinction is related to that between opportunities which are available in the short-run and in the long-run respectively. Essentially, we are concerned with two different ways in which the size and composition of output can be altered to meet different requirements; in the f i s t case, we take the stock of buildings, machines, trained labour, etc., as given, while in the second we assume that the Authority is free to build up whatever stock of capital it wishes. But this essentially qualitative distinction, which refers basically to the extent to which production processes are modified, is also associated with different time periods. In the immediate future the Authority's hands are tied, for it has inherited a particular stock of equipment, the nature of which cannot be changed overnight; but, as the durability of this equipment is a matter of degree, its freedom to vary the composition of final output in the more distant future will be limited only by the basic resources-land and labour-at the disposal of the economy. Needless to say, the distinction is only a rough one, as different kinds of equipment have different working I. Both the minimum economic life and the minimum economic scale of capital goods are aspects of the fact that large volumes of output may have proportionately smaller input requirements than small volumes. Large volumes are obtained, in the former case, by sustaining production over a substantial period of time, and, in the latter case, by maintaining a high rate of output per unit of time.

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lives; the network of roads, or the harbour installations, with which the country is endowed is likely to be a very permanent feature of the economic landscape, whereas some types of machinery may have life of only a few years. The usefulness of the distinction to our analysis, however, will be very considerable. 2 Productive opportunities in the short-run

Let us now consider, therefore, the range of productive opportunities which are open to the Authority on the assumption that it is not to add to the economy's fixed equipment. We shall assume that the particular quantities of, let us say, food and clothing currently being produced are those for which the capital equipment was designed and that the Authority now decides that, from now on, more food and less clothing are required. Basic resources, in the form of labour and materials, have already been incorporated, or locked up, in a variety of durable and specific equipment. Some of them have been embodied in textile machinery, others in the equipment with which this machinery is made, and yet others in the special skills possessed by men in the industry. These assets will continue to yield a flow of services until the end of their working life, but they can do so-or at any rate can do so fullyonly in the manufacture of clothing. Should therefore the Authority give the order that the production of clothing be immediately cut by say 574, these fixed assets will no longer be fully employed and only a limited quantity of resources will be released for transfer to the production of food. Unskilled labour, or labour with skills of use in the production of both commodities, can be switched from one industry to the other, as can those materials and services--such as coal, electricity and transport-which are not specific to one use. But a 5% reduction in the output of clothing will free less than 5% of the resources originally devoted to producing this commodity, as some of these resources have been invested in specific durable equipment from which they cannot now be unscrambled. Not only will the amount of resources released from the production of clothing be proportionately less than the cut in the volume of its output; they will also be unable to raise the production of food by more than a very limited extent. Part of the labour released can be put to work on the existing farmland, part of it can be employed to raise the output of fertilizers by employing the fixed plant in this industry more intensively, and so on. But on the assumption that no new land is to be drained and irrigated, that no

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more fertilizer plant and no more tractors, etc., are to be built, these expedients will prove less and less efficient the greater the increase in food output the Authority endeavours to obtain. The opportunities for changing the composition of output under these conditions will, therefore, be much more limited than those given by a production frontier of the kind employed in our earlier analysis. Fig. i shows the production frontier, AB, giving the amounts of food and clothing which could be produced if the economy's stock of fixed capital equipment were always appropriate, in composition, to the output combination chosen. This we may call the

Fig. i

long-run production frontier. The point P represents the outputs currently being produced with appropriate fixed capital, and the dotted line CD indicates the output combinations realizable without changing this capital. This is the short-run production frontier. Each of the points on it, other than P itself, lies within the long-run production frontier and represents amounts of the two commodities which are less than could have been produced had the fixed equipment been appropriate to current requirements. The extent to which one commodity can be substituted for another, in the community's output pattern, is much smaller in the short-run than in the long-run; and it is likely to decrease sharply as the output combination is made more and more different from that for which the stock of fixed capital was designed. It is therefore evident that a stock of capital-both physical and

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educational-gives an economy a kind of inertia which makes it difficult to alter, at short notice, the rates of output of different commodities.In much the same way fixed capital limits the scope for qualitative variation. Part of the equipment in the motor-car industry, for example, may be able to be used in the production of vehicles other than passenger cars, while part of it may be serviceable only for the manufacture of one particular model of passenger car. Without fairly substantial alterations in the capital stock it will generally be possible to introduce only small modifications in the character of the commodities being produced. Granted, then, that it is inefficient to manufacture particular kinds and quantities of goods without adjusting the fixed capital stock, why should the Authority ever fail to do so? Why should it ever exploit the short-run opportunities for the variation of output when the long-run opportunities are, in some sense, superior? For this there are several reasons. It should be remembered, in the first place, that the decision to construct durable capital will commit the Authority to produce a certain kind and quantity of output for some time to come. This commitment is not irreversible, in that the equipment need not be used at its full capacity for the whole of its working life; but if it is not so used, then the resources which were invested in it will not have been fully exploited. Even for an omniscient Authority, the problem of maintaining the capital stock in perfect adjustment to the levels of output required would be very formidable. Let us suppose that, for some time, 1000 tractors have been used to produce food, the output of which the Authority now decides to raise by 10%. Currently, the tractor-producing industry is working only to provide replacements; if each tractor lasts ten years, the annual output of them is 100. In order to ensure that the higher level of food output is produced with the appropriate capital stock (i.e. with 1100 tractors) the Authority now orders another 100 tractors. If these were to become available quickly the output of the tractor industry would have to be doubled. It is conceivable, but hardly likely, that this could be done without increasing the fixed equipment used in their manufacture. If, however, the fixed equipment were itself doubled, in order to produce the extra tractors under conditions of long-run adjustment, it would be fully employed for only the first year of its life. For if the production of food were to be stabilized at the new level, the number of tractors required each year, in order to mainiain the stock at 1100, would settle down to only 110, rather than the 200 for which the capacity was designed. Thus even in the case of a once-and-for-all increase in

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the output of a commodity, the Authority would be unable to arrange for the capital stock to be made appropriate to the output requirements of both the immediate and the more distant future. If we were to assume that the economy's food requirements fluctuated frequently, then the problems of adjustment would be yet more intractable. The Authority is likely to have to strike a balance, therefore, between refusing to alter the composition of output in response to temporary changes in requirements, on the one hand, and reconciling itself to producing output from an inappropriate capital stock, on the other. Once we abandon the assumption that all economic decisions are taken by an omniscient Authority, the likelihood that many sectors of the economy will be working with an excess, or a deficiency, of fixed capacity is much increased. Individual business men will never be perfectly informed about the extent and duration of the future demand for their goods and they will often be uncertain about the investment decisions which are being taken by others in their field. Inevitably, therefore, the fixed equipment in existence at any particular time will reflect the limitations, and errors, of their foresight. Where demand proves to be less in the long-term than that for which firms, in their totality, have planned, not only fixed equipment, but, to some extent, also men, are likely to be left idle. For even although the men originally at work in the industry may have abilities which are not specific to it, their re-employment elsewhere may be hindered by their unwillingness, or inability, to move to another locality--especially if it lacks that other form of fixed capital, housing. Unemployment of this kind is usually called structural, it being implied that the structure of the capital stock is not appropriate to the pattern of demand. Although, as we shall see later, this is not the only, or even perhaps the most important, cause of unemployment, it may nevertheless frequently be severe. The coal, shipping and textile industries, for example, suffered grievously from it during the period between the two world wars. In any economy, in fact, some disharmony between the pattern of output and the structure of the capital stock, as manifested by excessive or deficient capacity in different industries, is likely to be endemic. It is worth noting, in this connection, that such maladjustments will be more easy to deal with in a growing, as contrasted with a stagnant, economy. In an earlier example the Authority had the problem of altering the proportions in which clothing and food were being produced. This implied, we assumed, that the output of clothing had to be reduced absolutely, so that there would be an

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excess of capacity left in this industry. The difficulties of adjustment would have been much less, however, had the Authority been able merely to increase the output of food while leaving the output of clothing unchanged. Had we assumed that the resources of the economy were continually growing, then this would in fact have been the kind of adjustment more likely to be called for. If the population of a country is expanding rapidly, then industries can be reduced in relative importance without being contracted absolutely; other industries, moreover, can be expanded merely by channelling towards them the natural increments in the labour force. These matters lead us, however, to the question, shortly to concern us, of productive opportunities in the long run. Enough has now been said to make it clear that, in conditions of rapid or unpredictable change, the specificity and durability of capital assets make it difficult to maintain an efficient adjustment of supply to demand. But it may sometimes be possible, it is fair to add, to choose production processes which, by making less use of specific and durable equipment, offer greater versatility at the sacrifice of some economies of manufacture. Thus a producer may be able to choose between the use of 'special-purpose tools' that can do one job very well but can do no other, and 'general-purpose tools' that, although less well suited to any one job, can yet do several tolerably well. A compromise will have to be made between economy in the manufacture of one particular good and the ability to adapt production processes to make alternative goods. There may also be plants which, although they produce one rate of output very efficiently, cannot be used, without much waste, to produce greater or lesser outputs. If demand is fluctuating or uncertain, it may be rational to prefer a plant which, at the sacrifice of some scale economies, permits a wider range of rates of output to be produced with tolerable efficiency. These same considerations apply to educational capital; a balance has to be struck between the gains and the limitations of specialization in training. Flexibility, therefore, can often be bought at the cost of reduced efficiency in the production of specific kinds and quantities of goods. But there would seem to be little doubt, given the general character of modern technology, that the amount of flexibility obtainable in this way is much less than we should ideally desire; beyond a point, the price of increased flexibility, in terms of the sacrifice of production economies, becomes too high. If we try to be a jack-of-all-trades we become master of none. Inevitably, therefore, a changing economy will experience some unemployment of men and machines.

C A P I T A L , T E C H N O L O G Y AND T I M E

3 Capital accumulation without technical progress We now come to consider the opportunities which exist for varying the quantities and kinds of output on the assumption that the capital stock of the economy can be changed. As far as the present and immediate future is concerned this stock can be taken as given; but if we envisage a period of time long enough for old equipment to wear out and for new equipment to be constructed, both its quantity and structure may be varied at will. In the previous section the Authority had to decide how much to produce of various commodities from given plant; now we shall assume that he is taking investment decisions-that he has to decide, that is to say, not how intensively to use given industrial capacity, but upon the kind and quantity of new capital to lay down. It is legitimate to assume that in the long-run the Authority will be free to choose whatever composition of output it pleases subject only to the restrictions imposed by the ultimate resources of land and labour available. The production frontier which was employed in our previous chapter on the conditions for rational allocation has much more relevance to this situation than to shortrun adjustment. Ignoring as it does, however, all question as to the time which is required for commodities to be produced, it is still inadequate for our present purposes. It implies that, provided that the factors are efficiently combined, and irrespective of the time taken by the process of production, there will be a unique set of quantities of food and clothing-given by points on the production frontier-which indicate the best that can be done with the resources available. We have now to recognize that the amount of food, or of clothing, which can be obtained from particular quantities of land and labour will depend upon the time allowed for the process of production. Time will be required first, for the construction of the fixed equipment, and, secondly, for this equipment to deliver all the services of which it is capable. Thus some processes can be described, rather loosely, as 'slower', or more 'indirect', or more 'roundabout' than others. They can also be classed as more or less 'capitalistic' according to the quantity of resources, for any given rate of final output, that has to be locked up in durable equipment. Now it is an undoubted fact of the world we live in that by making processes more indirect or capitalistic, we can often make them more productive. We are often able, in other words, to obtain a larger output from given resources if we are prepared to wait a longer time for

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this output to become available. This is a fact which must have imposed itself on the minds of even the most primitive men. Our earliest ancestors obtained their food and clothing by hunting animals and gathering the fruits and berries which grew wild. At a certain stage in their development they came to realize that they could hunt more effectively if armed with crude weapons of wood and stone; but time and effort had to be devoted to the fashioning of these implements, of which the full benefit was spread out over the whole of their working life. At a much later date our nomadic forefathers came to realize the superiority of yet more indirect methods of production; animals were domesticated and crops grown from seed. This change permitted very substantial increases in output eventually, but, on the other hand, it required the deliberate sacrifice of current consumption. Animals, once caught, could not straight away be killed and eaten, but had to be kept in order that they could reproduce their kind. Some corn had to be set aside for seed. Even at these early stages, therefore, the essential character of indirect is evident; the output obtainable from given processes of resources is augmented. but at the same time deferred. In a modern economy productive techniques are much more complex, but the same principles apply. It may be, for example, that future production can be increased by improving the transport system of the country; not only might this reduce the amount of labour currently required to perform a particular amount of transport services, it might also make it practical to exploit fertile land which was previously too remote from the large centres of population. The construction of a network of canals, and later of railways, achieved, for many countries, precisely these ends. But such services demand a heavy prior investment in resources, the full yield from which cannot be exploited fully until much time has elapsed. Future output can be increased by replacing labour with machines which can do the same work; the number of men required in agriculture has been drastically cut by the use of tractors, mechanical harvesters and the like. Or machines can themselves be replaced by other machines which need less labour to tend them; even the ordinary moving assembly line for the manufacture of cars can be replaced by a system of fuller automation. Not only manual labour, but clerical and computational work also, can be rendered unnecessary by the installation of electronic computers. With respect to educational capital, similar principles apply. The Authority may decide that the school-leaving age should be increased and that a larger proportion of the population should go to a university. As a result,

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the country's wealth will eventually increase but only at the cost of a sacrifice in living standards for the time being. It is clear, therefore, that by choosing more indirect methods of production, and accepting the consequent greater deferment of output, the whole production frontier of the economy may be pushed outwards. Productivity, however, is not necessarily always increased by greater capitalization of the processes of manufacture; a point may be reached where greater roundaboutness offers no further advantage. It remains true, none the less, that the most productive processes will usually not be the quickest and most direct. The choice of employing more or less time-consuming or more or less capitalistic methods of production obliges us to weigh up the relative benefits of consumable output available at different periods. Just as food may be transformed into clothing by transferring resources between the two lines of production, so can the food, or output in general, of one period be transformed into the output of another. Men, who could produce food directly by adding to the labour force on the farms, can be diverted to the production of mechanical equipment, fertilizers, etc., by which the output of food in future periods could be indirectly augmented. In order to decide upon the degree of capitalization appropriate for processes of production the Authority would require to know, on the one hand, the terms on which such inter-temporal substitution could be carried out, and, on the other, the relative priority of having consumable output at different future dates. It is with the former of these considerations, with the magnitude of the opportunities for inter-temporal substitution, that we shall now be concerned. We shall assume, provisionally, that the state of technology is given; output may be increased, that is to say, by adding to the stock of equipment, or by training more men in known skills, but not by the discovery of new ideas relevant to production processes. It will be useful to use our by now familiar concept of marginal opportunity cost as a measure of the extent to which output available at one particular period can be replaced by output available at another. Let us suppose that if the output of food in year 1 were to be reduced by a marginal unit, then the output of food in year 2 could be increased by 1.1 units; if this were to be so we should say that the marginal opportunity cost of food in year 1, in terms of food in year 2, was 1-1. This provides us, at a very high level of abstraction, with a measure of the opportunities which are available for 'inter-temporal transformation'. The actual process of transformation itself, one should bear in mind, may be very indirect. It might

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be, for example, that the gains to be had from increasing the degree of capitalization were much greater in the clothing industry than in the production of food. In that case the resources released from current food production would be transferred not to the construction of more tractors but to producing looms; they would be used, in other words, to build up the capital stock of that industry in which the rewards from doing so were the greater. By this means some of the labour and materials which would otherwise have been used at a later date to make clothing will now be spared and made available for the production of food by the normal means. Thus, if the output of one industry were to be reduced at one period in order to increase it at a later date, the most advantageous procedure would be to channel the resources released through whatever industry offers the best gains from increased capitalization, thereby permitting it in turn to release resources for the production of the original commodity whose output it is desired to increase. This may, I fear, seem a complex procedure, but it implies merely that capital should be put into those industries where its effects on productivity are greatest, not necessarily in order that the output of these industries should be increased, but in order to economize in resources as a who1e.l Let us now consider the factors on which the magnitude of the opportunities for inter-temporal substitution will depend. This is an important but also, it must be admitted, a difficult question. We are assuming that the Authority can hope to increase the annual output of the economy only by exploiting the superiority of more indirect processes, by adding to the average amount of capital with which each worker is assisted. In order to do so, as we have seen, current consumption will have to be forgone in order to release the resources required for additional capital construction. (This is to assume, of course, that the Authority wishes to raise the rate of future output; I shall in fact not consider the possibility that it may wish to run down the capital stock in order to sacrifice future output for increased consumption here and now-but the arguments could I. One might suppose, for example, at some particular time that greater capitalization would have a greater effect on productivity in the steel industry than in retail distribution-that mechanization, in other words, could more profitably be introduced into the former. Were this so, it would pay to devote resources for investment to the steel industry rather than to retailing, even although it was desired to increase retail services rather than steel output; for the men released by the mechanization of the steel industry could be employed in shops.

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easily be put into reverse.) Once the capital stock of the country has been increased, the Authority will expect the higher rate of output to be maintained permanently in the future. It is true that no part of the stock will last for ever, so that resources will have to be devoted to its replacement. Nevertheless, the greater productivity of the more capitalistic methods will ensure that, even after this has been taken into account, more output will be obtainable from given ultimate resources than was previously. The question before us is therefore this: can anything be said, in general terms, about the factors which determine the permanent increase in future output which a once-and-for-all sacrifice of current consumption would make possible? Under the very limiting assumption upon which our present analysis is proceeding (i.e. the absence of technical progress) the answer can be shown to depend on two principal considerations. The first of these is the size and structure of the capital stock which has already been accumulated, and the second is the rate at which the Authority decides to add to this stock. These I shall now consider in turn. Let us suppose that the economy already possesses a certain amount of capital and consider the effect, on future output, of adding to it by a small amount. Any question of how the additional capital is to be provided can be set aside for the time being. It will be convenient to refer to the net increase in the rate of output made possible by having an additional unit of capital the marginal net productivity of capital. This will measure the increase in the future flow of output which would be permanently maintainable, after allowing for the resources required to maintain and replace the additional equipment-hence the qualification 'net'. Now there is an obvious reason for expecting that, as more and more additions are made to the stock, the gain to be had from yet further additions will gradually decline, that the marginal productivity of capital, in other words, will be inversely related to the size of the stock. It is reasonable to suppose that the benefits from increased capitalization will be greater in some lines than in others, and that each increment of capital will have been directed to the best available use; as the stock is built up, therefore, the opportunities for increasing productivity will become less and less attractive. The gain from additional investment in technical education and training will likewise diminish as it is diffused among men naturally less able to benefit from it. Ultimately the gains from further capitalization will reach vanishing point, for there is no reason to suppose that the output to be obtained from given resources will be capable of indefinite increase merely by using

64 ECONOMIC THEORY the resources in more and more indirect processes of production. Although the best meals may take a long time to prepare, it does not follow that they can always be made better by taking longer. Thus we seem to be entitled to represent the relation between the stock of capital and its marginal productivity as shown in fig. ii:

0

Quantity of capital Fig, ii

Once the opportunities for further capitalization have been exhausted, so that the marginal productivity of capital is zero, the economy's production frontier will have been pushed to its outer limit, as determined by the supply of ultimate resources, human and material, and the fixed level of technology. This analysis, therefore, tells us something about the gains in future output which can be obtained by sacrificing current consumption. But, on several grounds, it is open to question. Its most serious deficiency, of course, is due to the assumption-later to be relaxedthat new ways of combining resources can never be discovered. But, apart from this neglect of technical progress, it has weaknesses which result from the implicit assumption that capital can be regarded as perfectly divisible and homogeneous. In order to be fully efficient, it was argued previously, an item of capital equipment may have to be designed so as to produce some minimum rate of output. Any Channel Tunnel would have to be at least as long as the minimum distance between the French and English coasts, nor would there be any point in building a harbour which was too small to accommodate the ships which wished to use

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it. Thus it follows that the schedule of the marginal productivity of capital will not be the smooth curve indicated on the diagram. The effect on future output of devoting a small amount of resources to provide an addition to the capital stock may be small, if they do not permit the construction of equipment of the minimum economic scale; a larger amount of resources, which did permit this, might yield an increase in output, per unit of resources, which was much greater. If then the effect on output of additions to capital were, up to a certain point, greater than in proportion to the size of these additions, the marginal productivity of capital would actually rise over this range. The importance of this consideration is much enhanced by another special property of the capital stock. Capital, as we have previously had occasion to observe, is a heterogeneous aggregate made up of many diverse items of equipment. Moreover, the ability of particular items of equipment to raise output-their productivity, in other words-is dependent on whether certain other particular items, with which they naturally work in conjunction, are also in existence. Large ocean-going liners will be of much greater service if there are harbours large enough for them to berth; the benefits to be had from the construction of a Channel Tunnel would be much greater if suitable improvements were made in the communications which linked either end of it to centres of population; a railway line stretching into the interior of a country might make it profitable to invest in growing crops, or in tapping mineral resources which were hitherto unused; and this in turn would provide a justification for building houses, streets and so on, in the area opened up. Investments in different directions, that is to say, may be mutually supporting or complementary, in that their contribution to increased output, taken together, is much greater than the sum of their independent contributions would be. Adding to the capital stock in one direction might therefore increase, and not reduce, the gains from a further addition; the marginal productivity of capital would therefore rise over this range. Were it not for the fact that generallycapital items have a minimum economic scale, complementarity of this kind would be easy to reconcile with a smooth and diminishing schedule of the marginal efficiency of capital. If individual investments may be as small as we please, then any quantity of resources devoted to increasing capital can be distributed among the several complementary directions. But if capital assets, as well as being complementary, have a minimum efficient scale, then only a large addition to the stock will ensure C

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that the yield from investment reaches its full value. This being so, the marginal productivity of capital will not vary continuously with the quantity of capital in the way illustrated in fig. ii. This has the consequence, in practice, that the return from additional capital may be larger in countries rich enough to make substantial and simultaneous investments over a fairly wide front. Thus it is in the poorer ,countries of the world today that the rewards for investment may seem small. Modern technology presents them with a great scope for raising output through the installation of capital, but at the same time causes the size and variety of capital assets which have to be constructed, in order properly to exploit the available opportunities, to require a total volume of investible resources much greater than these economies can command. Thus it may not seem profitable to construct a harbour, as there are no railways leading to the coast; without these installations, investment in manufacturing industry may not be worth while; and-to take a very important form of complementarity-this investment might in any case be useless without appropriate investment in training the labour force in the skills required. For all the possible advantages to be obtained from capital construction, therefore, investible resources would have to be deployed on a large scale and over a wide front. Investment in one particular direction alone might not prove worth while, because the ,complementary capital was not there. In this sense, therefore, the marginal productivity of capital may be low, not because the stock of capital is large but because it is small. This may indeed be one of the reasons why investment is sometimes considered to be less profitable in poor countries than in rich ones, a fact which, if true, apparently contradicts the principle of a diminishing marginal pro,ductivity of capital, but which is quite consistent with the dependence of the profitability of one particular investment with the presence or absence of the appropriate complementary capital, whether in the form of physical installations or of skills and training. How then are we to sum up these considerations? In the absence of technical progress, the increase in output permitted by an addition to the capital stock will depend both on the size and the structure .of the existing stock. If the addition takes the form of an asset which complements those already possessed, so that the stock thereby becomes more balanced, the resultant increase in output may be very substantial; if, on the other hand, an investment is made in one direction without simultaneously investing in the forms complementary to it, then the yield may be small or even negative until these other investments are undertaken. But despite the fact that the

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gains to be had from additions to capital may, for these reasons, vary considerably, there still seems no great reason to doubt, given our assumptions, that, as the total stock accumulates, they will gradually decline to vanishing point. The above analysis of the relationship between the size of a capital stock and its marginal productivity provides only part of the answer to the question which we originally posed. Our aim, it will be remembered, was to find out what general circumstances would affect the gains to be had, in terms of an increase in future output, from the diversion of resources from current consumption to investment. One such circumstance, it now appears, is the magnitude and composition of the existing capital stock, as this will affect the increase in output provided by particular additions to that stock. Another, so far neglected, will be the amount of current consumption which has to be forgone in order to make this addition. The first of these two factors is to do with the usefulness of having more capital, the second with the cost of providing it. It is possible to identify a relationship between the cost of additional capital and the current rate at which capital is already being accumulated. This is most obvious if one considers first the cost of increasing the rate of accumulation of any one kind of capital asset, such as, for example, a tractor. It would be possible to increase the rate of output of tractors without any augmentation of the capital equipment which is required in their manufacture, merely by using the existing capacity more intensively, by doing more assembling by hand, and so on. But, as we have already seen earlier, in our discussion of the short-run productive opportunities available to the Authority, an adjustment of supply brought about in this way is inefficient, in that the equipment is being used for a different volume of output than that for which it was designed. Thus, if the annual production of tractors were to be increased by these means, the cost of doing so-in terms of the men who had to be drawn from current production-would rise rather sharply with the extent to which investment in tractors was being augmented. If these rising costs were to be avoided, the investment programme would have to be widened to cater for an increase in the manufacture of tractor-making machinery and other equipment on which, directly or indirectly, tractor production relied. Here in fact we have complementarity, similar to that discussed earlier, in a different form. Previously we noted that the value of the services which would be provided by a capital good might depend on whether other related capital goods were also in existence; now it appears that the cost of producing

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capital equipment also depends on the availability of the related equipment which is used in its production. This consideration coupled with the fact that some kinds of capital equipment will also be indivisible, implies, taken by itself, that an investment programme is likely to be more economical, in terms of consumption forgone, if it is large enough to increase the rate of production of a group of related capital goods simultaneously. Only by expanding the production of steel, machine tools, tractors, etc., as well as increasing the number of trained engineers, etc., as a co-ordinated effort, will it be possible for all these different forms of capital to be produced at the lowest possible cost. If the amount of resources devoted each year to investment is very small, then either it will not be possible to increase output over the full range of complementary capital assets or else the equipment which is constructed will not be large enough to take advantage of all the possible economies of scale. A low rate of investment will give a higher increase in output, no doubt, than no investment at all; but it would seem that it may fail to exploit all the economies of large-scale production, under conditions of long-run adjustment, which a higher rate would afford. This consideration is on the side of a fairly rapid rate of capital accumulation; we must now turn our attention to one which points the other way. It was established, in a previous chapter (p. 32), that the marginal cost of one commodity in terms of another increases with the amount of the commodity being produces. The increase is more sharp in the short-run, when the capital endowment of the economy is presumed fixed in size and composition, than in the long-run, when capital can be altered. What can be said, however, about the marginal opportunity cost of one good in terms of another can equally well be said about the marginal opportunity cost of capital equipment in terms of consumer goods. It is reasonable to suppose that the production of capital goods will make use of different resources in different proportions than that of consumer goods; the former, for example, might require more steel and more highly skilled men. As more and more current consumption is sacrificed in order to increase the rate of production of capital goods, therefore, the factors being released by it will become progressively less suitable for the purpose to which they are now being applied. The cost of the additional output of capital goods will rise, that is to say, with the level of the rate of investment. An equiproduct curve, drawn to indicate the maximum output of consumer goods consistent with given outputs of capital goods (or rates

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of investment), will therefore have the shape shown in fig. iii. The faster the rate at which the Authority decides to add to the physical capital stock, and therefore to increase the rate of future output, the greater will be the sacrifice in terms of current consumption. There is good reason to believe that investment in educational capital will also be subject to conditions of increasing opportunity cost. Any rapid expansion in the provision of education, at school or in university, is likely to be checked by a shortage of trained and experienced teachers. Either the quality of teachers, or their number in comparison to pupils, will be reduced. At least in the short-run,

0

Capital goods Fig. iii

therefore, the marginal return from investment in education will fall as the ratio of investment is increased. Given a period sufficiently long for more teachers to be trained, this tendency will of course be much weakened. How then are we to sum up the factors which will determine the opportunities for inter-temporal substitution open to the Authority, on the basis of the simplifying assumptions which have been made? As a background determinant, we have the capital stock already possessed by the economy. The smaller this is, the greater will be the gains to be obtained from adding to it. The gains to be obtained from a balanced addition to this stock will be greater than those which would result from increasing the quantity of one kind of capital good only. And if the stock is already out of balance there will be special benefits to be had from investment which supplies the missing complementary assets.

70 E C O N O M I C THEORY Secondly, the gains to be had from diverting resources to capital formation from current consumption will depend on the rate at which resources are already being diverted.The rate of investment will have to be sufficiently large to permit the simultaneous installation of complementary equipment, if all the available economies are to be obtained; but beyond this point higher rates of accumulation will demand progressively greater reductions in the current standard of living. The value of these results is limited by the restrictive nature of our assumptions. One of these assumptions-that of a fixed supply of labour-will now be relaxed. The other-that of no technical progress-will be abandoned in the next section. It is not difficult to see that an increase in the labour force of an economy will augment the gains to be had from adding to the capital stock. Productivity, we have seen, depends on the amount of equipment by which the working force is assisted, and upon its education and skill. Were the size of the working force to increase, while the stock of capital, either in the form of machines or of acquired skills, were to remain the same, the degree of capitalization, and therefore the productivity of labour (i.e. the rate of output per man-hour), would fall. If productivity were to be maintained the additional workers would have to be fitted out with the same amount of equipment and given as much training as those already employed. Thus a growing working force strengthens the motives for capital accumulation, and a declining working force reduces them. An increase in the supply of factors other than labour-in the form let us say of fresh mineral resources-would give much the same scope for additional capital formation as would population growth, for it is clearly on the relation between the capital stock and the volume of the economy's human and material resources, rather than on the size of this stock in itself, that the gains from capital accumulation depend. When capital is accumulated in an economy with a fixed supply of labour and other resources the capital intensity of production is, by definition, increased. Productive processes will have become more indirect, in the sense that a higher proportion of the labour force is being employed in the repair and maintenance of equipment. But if capital accumulation goes hand in hand with an increase in the supply of labour and other original factors, the degree of capitalization need not increase; if the stock of capital has risen in the same proportion as the supply of original factors, capitalization will remain the same. Where accumulation results in a higher degree of

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capital intensity, capital deepening is sometimes said to have taken place; where it causes the capital stock to grow no more than the labour force, the term capital widening is sometimes used.

4 The logic of inter-temporal allocation Let us now endeavour to relate this analysis of capitalistic production and of the gains to be had from deferring consumption, to the theorems about rational choice which were elaborated in the previous chapter. In order to simplify this task, there are two unrealistic assumptions which-for the time being-have to be retained. The first is that of a constant state of productive technique; the second that of perfect knowledge. These two assumptions are of course closely related for, if techniques are improving, then, in one sense at any rate, the Authority's knowledge is not initially complete. The element of time adds a new dimension of choice to all the decisions which have to be taken by the Authority. So long as we ignored it, there were only two output targets to be fixed, one for food and one for clothing. But now the Authority has to decide how much of each of these commodities to produce for each of the different time periods which will elapse up to the limit of its planning horizon. It will be necessary to weigh up, not only the claims of food against clothing, in any one particular period, but also the relative importance of adding to the supply of these in one period rather than another. This choice of output targets for different time periods is closely bound up with the choice between methods of production which differ in the time they take to carry through. In general, it will be possible to obtain a particular quantity of food, or clothing, with smaller inputs of land and labour by selecting a more mechanized, capitalistic and time-consuming production process; if this is done, additional resources will have to be committed to the construction of fixed equipment, the length of life of which will determine the period which must elapse before the full output is secured. Thus, in considering the choice between different techniques of production, land or labour available at different periods have to be regarded as effectively distinct inputs. The labour available in one time period is essentially a different input from similar labour available in another, in that their marginal substitutability, in the production of any particular commodity available at any particular time, will not generally be equal to 1. If all the gains to be obtained from increased capitalization (from more time-consuming methods) are not exhausted,

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then an additional unit of labour applied at any one period will be able to replace more than 1 unit of labour applied in any later period. Similar considerations affect the choice as to the distribution of the two commodities among final consumers. It is perfectly evident that the contribution which an additional unit of food makes to a person's welfare will depend on when it is given him; from the point of view of their value to consumers, therefore, commodities available at different times will have to be regarded as distinct. It will be no compensation for a man to be glutted with supplies at one time, if he is to be starved at another. How then can our principles of rational allocation be modified in order to take account of the pervasive influence of time? Formally, at any rate, the required modification is very simple; all we need do is regard the factors and products available at different times as economically distinct, and the optimum conditions retain their validity. This I shall now endeavour to explain. Consider, first, the condition for productive efficiency,according to to which the marginal substitutability between any two factors should be the same in the production of all goods. To adapt this condition to inter-temporal allocation we have to regard factors and products as economically distinct if they are available at different times; only when associated with particular dates is their specification complete. Thus we have to pay attention not only to the marginal substitutability between land and labour but also to that between labour applied at one date and labour applied at another. What then is the practical significance of our condition for productive efficiency when applied to factors which, although physically identical, are applied at different times? Let us assume, for example, that more food is to be made available by some specified date in the future. This can be done, let us further suppose, by employing more labour either directly on the farms or, less directly, to make tractors. If all the gains from using more capitalistic or time-consuming processes are not yet exhausted, the latter procedure may be more productive, in that fewer men will be employed to provide the desired amount of extra food, but it will require men to be available at an earlier date. Let us suppose that the MS between the labour employed at the earlier and the later dates is 1.1, which is to say that 1 extra unit of labour employed earlier, to make tractors, is able to 'replace', in the production of food for the required date, 1.1 units of labour employed later directly on the land. Now if the MS between these two economically distinct factors is 1.1 in the production

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of food for the specified date, then our condition for productive efficiency requires that their MS is likewise 1.1 in the production of any other commodity likewise specified both as regards physical character and date of availability. If it were not, then it would be possible, through the substitution of factors, to economize in the use of either of them without any reduction in the output of the commodities in question. In less formal, and more familiar, terms the condition implies that it should not be possible to economize on the inputs of any period merely by increasing the degree of capitalization in one line of production and decreasing it in another. It would evidently be stupid to install complex automatic looms in the production of clothing while farming was undertaken with the assistance of little or no capital equipment. The condition for productive efficiency, interpreted so as to treat the factors and products of different time periods as economically distinct, gives us a test (albeit of a highly formal and abstract character) for ensuring that this sort of error is not made. Let us now turn to distributive eficiency, which required the marginal relative utility of any two commodities to be the same for everyone who consumes them. This condition remains valid provided commodities available at different dates are treated as economically distinct. Thus the marginal relative utility of food in one period and clothing in another must be the same for everyone. The practical relevance of this highly formal condition is reasonably evident; if the most is to be made of an output stream of food and clothing, the Authority will have to arrange for each man's time pattern of consumption to be appropriate to the time pattern of his requirements. Finally, the condition for optimum assortment has to be adapted to take account of time. It was necessary for the marginal relative utility of any two goods to equal the marginal opportunity cost of the one in terms of the other. Here again factors and products with different dates must be regarded as different. What is the significance of this condition? Substitution, we have come to realize, is possible not only between food and clothing but between the output of one period and that of another. The idea of optimum assortment, therefore, has to be extended to relate to the most appropriate pattern of consumable output over time. Provided that an economy's capital stock has not already been built up to the point at which its marginal productivity is zero, a given sacrifice of current consumption will permit consumption to be increased by a greater amount in the future. If maximum

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consumption, regardless of when it took place, were the objective, investment would be pushed to the point at which the gains from postponing consumption were exhausted. In fact, however, the Authority would have to take account of the fact that the marginal relative utility of present consumption and future consumption would rise progressively with the reduction of the former. Just as food is an imperfect substitute for clothing, so is the consumable output of one period an imperfect substitute for that of another so far as welfare is concerned. Given that the Authority's aim is to maximize welfare rather than output, investment will be carried only to the point at which welfare cannot be increased by any further sacrifice of current for future output. This will be so when the marginal opportunity cost of the output of one period, in terms of that of another, is equal to the marginal relative utility of the outputs of these two periods. 5 Technicalprogress

The preceding discussion of the logic of inter-temporal allocation was based on the assumption that all possible modes of transformation were already known to the Authority; technical progess, in other words, was ruled out. How have the conclusionswhich were reached to be modified once this highly unrealistic assumption is given up? I endeavoured to show. in the ~revioussections, how the Authofrontier of the rity could push outwards the whole economy by taking advantage of the fact that there may be techniques already known which are more productive, although more time-consuming, than those already in use. By adopting them, the rate of output obtainable in the future could be permanently raised, but only at the cost of having a lower level of consumption in the present. Once we admit that all conceivable processes of production are not already known, a second way of increasing the rate of maintainable output presents itself-that of devising wholly new processes which use less resources irrespective of the time required to carry them through. There can be little doubt that it is by this means, rather than by changing over to the more capitalistic processes among those already known, that the wealth of the world, during the last two centuries, has been so dramatically increased. Improvement in the techniques of manufacture can be obtained in many different ways. Even without any increase in scientific and technological knowledge, care and ingenuity may frequently permit existing processes to be made more efficient; and improvement may also

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result from the perception that the existing body of knowledge has a relevance to a particular process of production which had not previously been appreciated. The more massive advances, however, are likely to depend on fundamental scientific discoveries. We should first take note that activities designed to increase the stock of knowledge useful in production themselves constitute a form of investment requiring the relinquishment of immediate, in exchange for deferred, benefits. New ideas do not generally fall from heaven; technical advance does not take place automatically without effort and merely with the passing of time. Some new ways of improving particular processes may come to men, without special application, in the course of their ordinary work; but, for the most part, it is necessary to devote to the purposes of research men and materials which could have been employed more directly in making commodities. Even Sir Isaac Newton had to be provided with leisure and a room of his own; and in modern times, research, as carried out by the government, private business and the universities, has become an industry in itself. The diversion of resources to the discoverv of new ideas which. however indirectly, will permit improvements to be made in productive techniques, is therefore analogous to the accumulation of physical capital or to education and training. In each of these cases consumption in the near future is sacrificed in order that the rate of future output may be increased. But, at the same time, there are differences sufficiently significant to dissuade us from regarding the building up of the stock of knowledge and techniques as just another form of capital accumulation. New ideas, unlike most physical capital and trained men, have no limited working life and do not need replacement-although they will have to be transmitted from one generation to another. And however great the difficulties of measuring a stock of physical capital, or the extent of the dissemination of technical education, they dwindle to insignificance beside those of measuring knowledge itself. Moreover, the connection between input and output, however measured, is much less reliable in the case of research than it is either in material production or in education. Discovery will depend, at least in some measure, on chance; and the insights of a Rutherford or a Pasteur are not to be manufactured simply by the application of a sufficient amount of supposedly homogeneous human and material resources. Notwithstanding this, even in the field of fundamental research, and perhaps to a greater extent in the application and development of fundamental ideas in relation to productive

76 ECONOMIC THEORY processes, there will be some broad correlation between the volume of resources allocated and the result achieved. There would seem to be nothing, with regard to the accumulation of knowledge, which parallels very closely the diminishing marginal productivity of capital, physical and educational, discussed previously. Very little can probably be said, in general terms, about how the gains to be had from investment in research and development vary with the amount of scientific knowledge which has already been accumulated. Much will depend on whether there has recently been some major scientific break-through, which has opened up a large vein of potential developments which further work can exploit. The discovery of the steam engine, or of electricity, or of the structure of atoms, did precisely this. It is probably the case, however, that the relationship previously discussed between the cost of making an addition to the physical capital stock and the rate at which investment is already proceeding does have its counterpart in the field of research and development. No doubt there will be some minimum efficient scale to the size of the research effort which the Authority should mount, but if the volume of resources devoted to it is progressively increased it seems likely that the results will not increase in similar measure. Work of this kind requires talents of a rather specific kind, which are found only in a limited number of people, so that, as the programme is expanded, it will become necessary to recruit people who are less and less suited to advance knowledge. In this rather loose sense, therefore, there will be diminishing returns, or increasing costs, to investment in this direction as in others. How then is the Authority to decide upon the amount of resources to devote to research and development? According to the formal logic of choice previously elaborated, investment should be pushed to the point at which the marginal opportunity cost of present output in terms of future output is in line with their marginal relative utility. Investment in the discovery of new productive techniques is peculiar in that the gains, in terms of increased future output, will extend out over an indefinite future period, will be diffused and will be uncertain. This being so, an estimate of the proper level of investment in this direction can never be grounded on precise calculation; the Authority will have to content itself with endeavouring to judge, in a fairly rough and ready way, when the increase in output obtainable from the diversion of an additional unit of resources to technical improvement just compensates for the sacrifice incurred in foregoing immediate for prospective benefits.

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It is necessary to consider not only the return from investment in technical progress itself, but also the ways in which technical progress affects the return from investment in its more familiar sense-from the application of resources, that is to say, to increasing the physical capital stock or the number of trained men. It is perfectly clear that new methods of production will require the construction of new equipment and the acquisition of new skills. But from this it does not follow that the Authority will now find it rewarding to devote a larger proportion of its total resources to capital formation than he would have done had there been no technical advance. New equipment can be obtained without additional or 'net' investment merely by using the resources which would have been required in any case for the replacement of the old equipment; and workers who would otherwise have learned the old skills can learn the new ones instead. Whether the return from devoting additional resources to investment (i.e. from the adoption of more capitalistic methods of production) will in fact rise or fall, will depend on the nature of the inventions forthcoming; it may be that they are such as require more resources to be locked up in the form of durable fixed equipment than previously, but this need not be so. It does, however, seem likely that, with steady growth in scientific and technical knowledge, more men will have to be trained and for a longer period; the gains from educational investment, in other words, will be increased. In deciding upon the most appropriate method of production, the Authority, whether or not there is technical progress, will have t o weigh up the increased productivity of the more capitalistic processes against the deferment of output necessarily associated with them. Technical progress itself, however, introduces one fresh complication. In deciding whether to invest in some particular plant for the production of, say, clothing, the Authority has to consider not only the range of alternatives which are currently available, but also-in principle at any rate-those alternatives which may become available in the near future. If it were to judge that revolutionary techniques of manufacturing clothing might very soon be perfected, then it might appear worth while either to postpone the investment decision or, at any rate, to avoid locking up resources in equipment of a highly durable nature. Highly capitalistic methods of production will normally oblige the Authority to continue to employ durable equipment for some considerable time after technical advance has made them out of date. Such methods, therefore, have the disadvantage of inflexibility, in that they cannot generally be modified so as to take account of improved technical possibilities. The gains from a

78 ECONOMIC THEORY high degree of capitalization have to be set against the gains from being up to date. In practice the more capitalistic process may have such marked productive superiority that it continues to be worth while to adopt them even although it is believed that they may become obsolete before the end of the physical life of the fixed equipment which they embody. Technical progress, therefore, may entail the scrapping of much fixed capital before it is worn out. These complications can only be mentioned, but not further explored, in a book of this kind. It would be wrong to rush to the conclusion that, because of the uncertainty about future productive opportunities which technical advance opens out, the optimum conditions of allocation worked out in the context of unchanging methods of production are wholly useless. Provided that the rate at which techniques are developed is not too high, and provided that most fixed equipment is not such as would last for very many years, then the complications just mentioned may not be too serious. The optimum conditions may enable us to make a first estimate of the rationality of a particular way of allocating resources, even although other special qualifying considerations have to be taken into the final account.

The decentralization of decisions 1 The working of a price system: a preliminary account (a) Th 7 need for decentralization Having now identified the conditions for economic efficiency, it remains to consider how they might be realized in practice. So long as we assumed the existence of an omniscient and all-powerful Authority, the question of practicability did not arise; we were concerned exclusively with the pure logic of choice. From now on we must recognize that all the circumstances relevant to selecting an efficient allocation of resources can never be known by any single individual or small group; information regarding them is inevitably dispersed among the minds of very many different people. Similarly just as one man can never know everything, he can never decide everything. No single person can specify the work to be done in every factory, and the goods that each man has to consume. Thus the fact that the relevant information is dispersed and that there are limits to the capacity of any human mind makes it inevitable that economic decisions have to be taken by very many different people. The practical problem of economic organization as contrasted with the purely logical problem considered hitherto is to arrange that these many inter-related decisions are coordinated in such a way that an efficient pattern of allocation is the result. I shall continue, in this chapter, to deal with that type of economy in which all ultimate authority to allocate resources rests with a central government. But I shall assume that those in charge, realizing the limits to their knowledge and administrative capacity, wish to delegate two important sets of decisions. The choice between 79

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alternative combinations of factors, in the manufacture of each good, is delegated to the manager of the industry which produces the good; and the choice of product combinations for each particular consumer is left to that consumer himself. This course is adopted by the government on the ground that a manager is likely to know best about production techniques and each consumer is likely to be in the best position to judge his own material requirements. Neither managers nor consumers, however, are given the freedom and power to do whatever they please. The managers of each industry are each given an output target for the particular product the manufacture of which is their responsibility and in choosing between different factor combinations they are made subject to a general control the nature of which I shall shortly explain. Consumers are to be limited in the total amount of goods which each of them can acquire and as regards the terms on which they can acquire them. It is through the exercise of these general controls that the government seeks to co-ordinate the activities of managers and consumers in such a way as to provide an efficient allocation of the community's resources. The reader must not expect that the following account of the working of decentralization under public ownership is relevant, directly and in detail, to any economy actually in existence. What we shall be examining is a hypothetical economy or model, in which certain key elements common to a variety of actual systems are thrown into relief. I shall assume that there are still only two commodities, food and clothing, and two factors of production, land and labour, notwithstanding the fact that it is the very multiplicity of products and factors that makes decentralization necessary. At first, the supply of both labour and land will be taken to be fixed, but I shall later allow for the fact that the number of hours worked by the labour force can be varied. At this stage of the analysis one further, and very fundamental, simplification will be made; the fact that production takes time, and that techniques can employ more or less capital, will be neglected. (b) Productive eficiency Once again it will be convenient to break up the problem of allocation into distinct parts, and I shall begin by considering productive efficiency in isolation. This required, first, that in general the total supply of all factors should be employed. Secondly it required that the marginal substitutability between any two factors should

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be the same in the production of all goods for which they are employed. Let us now set out a method by which the conditions for efficient production could be realized in practice. Let us assume that the government begins by setting output targets for food and clothing which it estimates, more or less by guess-work, will be likely to ensure the full utilization of all the resources available. It then attaches to each of the factors of production a particular 'price', which is chosen arbitrarily. Now prices, in the ordinary sense of the word, represent the amounts of money for which something is bought or sold. At this stage of our analysis, however, prices feature as a mere accounting device. By giving prices to land and labour, a measure can be obtained of the cost, in terms of some arbitrarily chosen unit of account, of any factor combination. This will be equal, of course, to the quantity of land used, multiplied by its unit price, plus the quantity of labour used, multiplied by its unit price. Let us assume the government instructs the industrial managers to work out production programmes which will ensure the attainment of the output targets in the government's plan, but which at the same time will minimize the cost, on the basis of the published factor prices, of the inputs required. The managers will now submit to the government their total requirements, as they arise from the production programmes chosen, for land and labour. Should these exceed the available supply of both resources, then it is clear that the output targets were originally set too high; should they fall short of the available supply, then the government's estimate of the country's productive potential was too conservative. In either case the targets will have to be set again and the managers asked to repeat the exercise on the revised basis. It might then turn out that, whereas the supply of land exceeded the amount of it required by the two industries, the supply of labour was insufficient. In this case the managers will have to be induced to alter their production programmes so as to use more land and less labour; to do this the government will set a higher price for labour and a lower price for land and invite the managers to prepare fresh production programmes which continue to minimize cost, but on the basis of the new factor prices. Once again, the implied factor requirements will be submitted and compared with the available supply. If they remain inconsistent, prices can again be altered and fresh production programmes drawn up. It should ultimately be possible, by means of such successive revision, to find production programmes which are consistent with the resources

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available, in that these resources are sufficient, but no more than sufficient, to enable the programmes to be implemented.' Productive efficiencyrequires that factors should be combined in such a way as to ensure that the marginal substitutability between any two of them is the same in the production of all goods. It can easily be demonstrated that, in seeking to minimize costs, managers will automatically bring this about. Costs will be at a minimum if they cannot be reduced by any replacement of one factor by another. MS12,wis the amount of labour that could be replaced by one marginal unit of land. The money saved by dispensing with MS,, units of labour would be w x MS,,, where w is the price of one unit of labour, and the money cost of employing one more unit of land would be I, where I is the price of a unit of land. For the cost of producing either food or clothing to be minimized, every opportunity of saving money through the replacement of land by labour (or labour by land) will have to be exhausted. Once this is done, the cost of a n additional unit of land will just equal the cost of the labour that this unit can replace. In the production of both goods, that is to say, w x MSL,, = I, i.e. MS,, = I/w for both goods. As, however, the prices to be paid for land and labour are the same irrespective of the goods they are to be used to make, it follows that MSL,, in the production of food must equal MS,,, in the production of clothing. Thus managers will unwittingly secure the fulfilment of the condition for productive efficiency merely by minimizing their money costs. This result can be illustrated graphically as in fig. i. Land is measured on the horizontal axis, and labour on the vertical axis. F represents the equiproduct curve for the required food output. The curve M, is drawn so that each point on it represents a combination of land and labour costing the same amount of money MI. The curves M, and M, represent, similarly, factor combinations requiring the greater money outlays of M, and M, respectively. It is easy to see that such curves, which we may call equicost curves, are I. If a country has very unequal endowments of the two factors, it may be that the price of one of them has to be set at zero. This would be so, for example, if the country had an abundance of land and little labour. On the assumption that beyond a certain point land could not be further substituted for labour in the production of either food or clothing, land supplies would exceed requirements at any positive or zero price. Land would therefore become a 'free good' (like air in the real world) for which no price is charged. Similarly, if labour were in abundance, it might not be possible to employ it all economically, whatever its price.

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all straight lines of equal slope. By the way in which they were defined, their slope at any point must measure the amount of labour that would have to be given up-in order to keep constant the cost of the factor combination-if a further marginal unit of land were to be employed. But the terms upon which labour can thus be exchanged for land are given by the ratio of the prices of the two factors, which we assume fixed. Thus the slope of each curve is the same at any point upon it and equal to I/w. Now it is clear from the diagram that none of the factor combinations costing MI, or any other sum of money less than M,, will be

Fig. i

able to produce the required food output F. Factor combinations costing more than M,, such as those given by the equicost curve Ma, would be able to produce F, but it would be wasteful to use them. There exists one factor combination costing M,, and represented by the co-ordinates of the point P at which the curve M, touches the curve F, which would be able to produce F. This is clearly the lowest cost factor combination and it is such that the slope of the equiproduct curve, MS,,, is equal to the slope of the equicost curve l/w. Our condition for lowest cost is therefore that MS,, equals I/w in the production of food. As this holds equally for the production of clothing, it follows that cost minimization will ensure that MS,,, is the same in the manufacture of both goods. Here then we have found a method of ensuring that the coi~ditions for productive efficiency are met. It is true that if the government began with no notion of what suitable output targets and factor

84 ECONOMIC THEORY prices would be, then the process of trial and error might be laborious, as provisional production programmes might have to be submitted, and factor prices revised, many times. But it must not be thought that the government would be experimenting with successive output targets and factor prices merely at random, in the hope that it might ultimately be lucky enough to hit on the right ones. When provisional programmes are drawn up, and the factor requirements implied by them are compared with the supplies available, the directions in which targets and prices should be moved will become apparent, so that the government should be able by successive adjustments to feel its way nearer and nearer towards a solution. This procedure, although it might try the patience of the government, has the merit of making no exorbitant demands on its knowledge. It permits the choice of production processes to be made by those--the industrial managers-who know most about them, while ensuring that these choices are made in such a way as to meet the condition for general productive efficiency. All the government has to do is set factor prices and instruct the managers to minimize the cost of attaining their output targets. So long as we limit ourselves to the case of two products and two factors, then the advantages of this procedure are scarcely apparent, for there would then be no great difficulty in the central government itself acquiring all the information necessary to arrange directly an efficient combination of factors. But the more numerous the products required, and the factors available, the more difficult would the centralization of the relevant information become. With the number of products and factors which would have to be dealt with in the real world, some procedure akin to what I have described would have to be adopted. (c) Distributive eficiency Once efficient factor combinations have been selected, the government knows that the economy is operating at some point on its production frontier; there is no waste of resources, in the sense that it would be impossible to make more of any one commodity without making less of another. The ultimate objective, however, is to reach a point on the general welfare frontier, so as to rule out the possibility that any one consumer could be made better off without impairing the lot of another. For this to be done, two further steps are required. First, the right outputs have to be produced, and secondly, they have to be efficiently distributed. We shall concern ourselves, in this

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section, with the second of these. We shall assume, that is to say, that the government, having succeeded in producing particular amounts of food and clothing efficiently, wishes to find a means of ensuring their efficient distribution among consumers. Distributive justice, it will be recalled, has to be distinguished from distributive efficiency. Justice demands that each citizen's share of the economy's wealth should correspond to his deserts, however these be estimated. Efficiency demands that any particular welfare distribution should be obtained with the minimum use of resources, or that maximum welfare be obtained from given resources. All the distributions which correspond to points on the welfare frontier are efficient, but not all of them may be just. In order to focus exclusively on the question of efficiency, I shall simply assume that the government is in a position, by weighing up the claims of one person as against another, to decide upon a just distribution of welfare. I shall also assume, however, that it is unable to decide upon the best composition of each citizen's consumption, in that it lacks the necessary information about how, for any individual person, different combinations of food and clothing are related to different levels of material well-being. The government believes, quite reasonably, that consumers themselves know most about their own requirements, so that it is desirable to give each person the right to decide upon his own pattern of consumption. At the same time, however, a way has to be found of making consumers' decisions consistent both with distributive justice and distributive efficiency. How, in practice, can these objectives be attained? The indispensible device, as with the promotion of productive efficiency, is a system of prices. The government begins by fixing prices for food and clothing. If these are fixed arbitrarily at, say, f and c, and if the monthly rates of physical production of each of these commodities are F and C, then the money value of the economy's rate of total output is Ff Cc. This will be the amount of money, in other words, which is just sufficient to buy the goods produced in any one month. Now let us suppose that this sum is distributed monthly, by the government, according to its own ideas of justice, among the several members of the community. Each of them is then permitted to buy food and clothing at the published prices, in whatever amounts they choose, subject to the condition that they spend the whole of each month's income, but no more than this, during the month in which they receive it. The prices of consumer goods are therefore real prices at which the goods are actually bought and sold; in this they differ from the notional prices of factors, which

+

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were devised purely for accounting purposes in the drawing up of provisional production programmes. Having now seen how the government sets the stage, let us look at the position in which consumers will find themselves. Both the incomes at their disposal and the prices at which they can buy goods are outside their control; it remains for them to decide upon the amounts to be spent on food and clothing. Each consumer will take this decision on the basis of his own beliefs about the way in which different combinations of commodities affect his material welfare. I propose to assume that these beliefs are correct, in that every consumer knows what is good for him. It can then be demonstrated that, in order to attain the highest level of welfare, each consumer will choose a combination of goods such that the marginal relative utility of any two of them equals the ratio of their prices. He will endeavour to arrange his purchases, that is to say, to ensure that MRUCsp= c/f. The validity of this condition becomes readily evident if we consider the implications of its non-fulfilment. Suppose that for a particular man MRUc,p = 3 and c/f = 2. Were he to consume one more unit of clothing, this man could give up 3 units of food without being worse off. But, as the price of clothing is only twice that of food, he would spend less money on the one extra unit of clothing than he would save on the 3 units of food given up. If MRU,p differs from c/f, the consumer is not spending his income to the maximum advantage. This result can be illustrated graphically, as in fig. ii by setting out a consumer's indifference map, indicating, as before, the welfare levels attainable with different commodity combinations. Let the curve MM represent all those combinations of food and clothing that could just be purchased out of the consumer's income M. This curve will be a straight line with slope equal to the ratio of the prices of clothing and food, c/f. (This can be established by reasoning identical to that employed in discussing the shape of equicost curves.) Now it is clear from the diagram that U, is the highest level of welfare that the given money income M will permit the consumer to reach. In order to attain this level of welfare, quantities of food and clothing corresponding to the co-ordinates of the point P, at which the line MM is tangential to the indifference curve U,, must be bought. At this point the slope of the line MM, which we may call the income line, is equal to the slope of the indifference curve. The slope of the income lines, it has just been shown, is c/f. The slope of the indifference curve, as was said earlier (see p. 38), is equal

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to MRUc,F.Thus we have the condition that, in order to make the best use of a given income, purchases must be such that the marginal relative utility of any two goods equals the ratio of their prices. Now if all consumers did in fact succeed in purchasing the particular quantities of food and clothing which afforded the highest attainable levels of welfare, the condition for efficient distribution would be met. For the MRU,, must be the same for both A and B, if both of them have brought it into equality with the common price ratio c/f. We cannot take it for granted, however, that consumers will in fact be able to carry out their purchasing plans. Although the

0

Clothing Fig. ii

M

total of consumers' income, and therefore their aggregate demand for goods, has been deliberately made equal to the money value of the goods for sale, this does not ensure that the demand for any particular good will equal the rate at which it is being produced. The government might find that, while the demand for food could not be met, clothing supplies could not all be sold. Were this to happen, it would be clear that the prices chosen were not such as to bring consumers' demand for each commodity into balance with the output targets set. In the succeeding period, therefore, the government would increase the price of food, and reduce that of clothing, while continuing to arrange that the total money income given to consumers was equal to the total money value of output at the prices to be charged. By successively revising prices in this way, it should be possible ultimately to induce consumers to make purchasing plans consistent with the outputs being produced.

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(d) The optimum assortment of goods

I have endeavoured to show how the government, through the use of prices, can arrange for all available factors of production to be fully and efficiently employed, and for the products obtained from them to be distributed efficiently among consumers. A means can be devised, that is to say, of ensuring that the existing resources are used to produce the maximum output, and that the output actually produced is distributed so as to provide the maximum welfare. But there remains the question whether the resources might not be used so as to produce a different assortment of goods, with welfare potentialities greater than those of the actual output combination. Should the original output targets, the government must now ask, be revised? According to the principles of rational choice, which were set out in the previous chapter, an optimum assortment of goods is such that the marginal opportunity cost of any one good, in terms of any other, equals the marginal relative utility of the goods for all consumers. If, as we assumed, goods are being distributed efficiently, then consumers will have equated the marginal relative utility of any two goods to the ratio of the prices charged for them (e.g. MRU,, = c/f). If the assortment of output is optimal, therefore, the marginal opportunity cost of the one good, in terms of the other, will also equal this price ratio. Symbolically, for example, we wish MOC,, to be equal to c/f. If different goods are not being produced in the quantities necessary to ensure this correspondence between marginal opportunity cost and price ratios, then an optimum assortment has not been achieved. We must not forget, however, to consider the requirement relating to the optimal supply of work. It was ideally necessary, the reader will recall, for the marginal relative utility of leisure and any particular good to be the same for everyone. At the same time, this common marginal relative utility had to equal the marginal opportunity cost of leisure in terms of the good in question (e.g. MRU,, = MOC,,,). How, in practice, might this be achieved? For simplicity, I shall continue to assume that there is only one kind of work and that everyone can perform it with equal efficiency. Let us imagine that the government decides to give its citizens full freedom to choose the number of hours which they wish to work, believing that, by so doing, individual preferences will best be catered for. It therefore fixes a wage rate which is now not merely a notional price for accounting purposes, but represents the actual amount of money that industry will pay for an hour's work. From

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now on, a man's income will depend upon the work which he chooses to do. Let the wage rate be w, and the prices for food and clothing, as before, be f and c. It is evident that workers, being free to choose their own hours, will endeavour to bring the marginal relative utility of leisure and any particular good into equality with the ratio of the price of leisure (i.e. the wage rate) to the price of that good. They will endeavour, for example, to make MRUE,, = w/f. In this relationship, we regard leisure simply as yet another commodity; what is implied, in non-technical language, is that everyone will wish to work up to the point at which the sacrifice of an additional hour's leisure is just compensated by the amount of the good that the money paid for an hour's work will buy. Now we have said that it is necessary, in order to have an optimum supply of leisure (and therefore of work), that MOCE,F = MRUE,F. Thus if workers succeed in making MRU,, = w/f, we require MOC,, = w/f. This condition, relating to leisure and food, is strictly analogous to that given above for optimum amounts of food and clothing. Leisure features simply as a 'good', which can be 'bought' at a price equal to the wage rate for an hour's work. The condition MOC,, = w/f enables us to be more precise as to the prices that will be consistent with optimal allocation. This can be seen more readily if we start with the condition in the alternative form MOC,,E = f/w. (The nature of the equality is clearly unaffected by whether we think in terms of the marginal opportunity cost of leisure in terms of food or of the marginal opportunity cost of food in terms of leisure.) If then

f

MOC,, = f/w = w x MOCP,E

But the marginal opportunity cost of food in terms of leisure is simply the extra amount of labour sufficient to produce a marginal unit of food. This amount of labour, multiplied by w, is therefore the money value of the additional labour sufficient to produce a marginal unit of food. It represents, in other words, the additional money cost incurred by producing a marginal unit of food through the employment of extra 1abour.If optimal allocationwere achieved, therefore, the price of food would have to equal this money cost. A marginal unit of food need not be produced, however, through the employment merely of additional labour. We could equally well have kept theemploymentoflabourconstant andusedmoreland. Orwe might have used a little more of both factors. Had these alternative

90 ECONOMIC T H E O R Y methods of production been adopted, would a different value for the money cost of a marginal unit of food have been obtained? The reader will recall that if production is being carried on efficiently, there will be no scope for cost reduction by means of any marginal substitution between different factors. This implies that if we are contemplating only a very small, or marginal, increase in output, and therefore only very small, or marginal, changes in the amounts of each factor employed, it will not matter, from the point of view of costs, whether production is augmented by using more labour or by using more land. To put the matter more precisely, we know that, if production is efficient, MS,, = w/l so that w = 1 x MSW,,, We have already established that optimal allocation requires that so that, substituting from the previous equation This apparently formidable expression has a very simple economic significance. MOCF, is equal to the number of units of labour needed to produce a marginal unit of food. M S W ,is the number of units of land that, for marginal changes, is equivalent, in the capacity to produce food, to one unit of labour. Thus the product of the two terms is equal to the number of units of land necessary to produce a marginal unit of food. This amount of land, multiplied by the price of land I, gives us the money cost of the additional land necessary to produce a marginal unit of food. It appears, therefore, that the price of food has to equal the money cost of the additional input necessary to produce a marginal unit of food, this having the same value irrespective of whether the marginal unit is produced through the use of more labour or of more land. The price of food, in other words, must equal the cost of the marginal input required to make it, which we may refer to symbolically as the CMI of food. Generalizing, we may say that the price of every good should equal the cost of the marginal input required to make it. This is a simple, but very important, relationship. All we have done so far is to specify the prices at which goods would have to sell if a fully efficient allocation in fact existed. By what practical procedure, however, is such an optimum to be promoted? Let us assume that the government begins by setting prices for the available inputs. Output targets are then chosen, and,

THE D E C E N T R A L I Z A T I O N O F D E C I S I O N S

91 in the way previously described, reconciled with the full and efficient employment of the given land and of the labour supply which the government estimates will offer itself. Prices will be fixed, for food and clothing, equal to the respective CMI's. If everything is to go according to plan, citizens will have to be given incomes sufficient to enable them to purchase the output to be produced. The money value of this output will be FfSCc. The incomes which workers will receive automatically, in payment for their labour, will be Ww, where W is the number of hours' work done and w the hourly wage rate. Assuming, for the present, that the money value of output exceeds the wage bill, the government will then plan to distribute to the population, according to whatever canons of equity it considers appropriate, an amount of money equal to the difference between the two sums. This extra payment will be gratuitous andunrelated t o the amount of work performed by any individual person. If the system of prices is to work effectively, then people will be induced to work up to the point at which MRU,, = w/f. This they will endeavour to do if the amount which they are offered for an hour's work is equal to the published wage rate, but not if their total income is made to vary, in some other way, with the total work they do. If the government is very lucky efficient allocation might be produced. The amount of work which people wish to do, at the published wage rate, might prove equal to the amount budgeted for in the production programmes and the demand for each commodity, at the prices set, might equal the supplies available. Only by a miracle, however, wilI these results be achieved at the &st attempt. In all probability the demand for either good will differ from the supply of it, or the amount of work which people are willing to do, at the published wage rate, will differ from its estimated magnitude. These imbalances can be remedied, in the first instance, by price changes. Thus the government can vary the wage rate, from month to month, until people are willing to work the number of hours required for the fulfilment of the production p1ans.l Similarly, any disharmony between the rate of production of I. Generally, it will be possible to induce a man to work longer hours by offering a higher wage rate. But this need not be so. It may be that once the man's material standard of living reaches a certain level, he prefers more leisure to more food and clothing. If wage rates are raised, he may therefore work less, as his material requirements can now be met by working fewer hours. A decrease in the wage rate would induce him, correspondingly, to work more.

92

E C O N O M I C THEORY

either commodity, and the demand for it, can be corrected by changes in price sufficient to induce consumers to adjust their purchases appropriately. I n the process of such price revision, the government would have to see to it that consumers' total income (inclusive of the wages which they receive for their work) was just sufficient to buy the total output. Price variations of this kind would remove surpluses or shortages, and as everyone is enabled to adjust their purchases and their hours of work according to their own preferences, distributive efficiency would be ensured. (Prices which thus equate demands to available supplies may be called market prices.) The very fact that prices have to be changed, so that they no longer equal the corresponding CMI's, implies, however, that an optimal assortment of goods, including leisure, has not been obtained. If then the government wishes to bring the economy nearer to a position of optimal allocation, production programmes will have to be revised. The output of those goods of which the market price exceeds the CMI will have to be reduced. Assumptions regarding the available supply of labour will have to be brought into line with the volume of work which, at current wage rates, the community will willingly perf0rm.l (e) Short-run and long-run efJiciency The reader may already have noticed an ambiguity in the proposition that, for efficient allocation, the price of a good should equal its CMI. He will recall, from our earlier discussion (pp. 53), that a change in the composition of output can be brought about in two distinct ways. Short-run, or partial, adjustment can be achieved by I. There is a further, very important, practical difficulty which deserves mention. Production is a co-operative activity requiring fairly large groups of men to work together during the same period of time; a modern factory could not operate if its workers felt free to come and go as they chose. Thus if production is to be efficient, some sacrifice of the extent to which personal preferences are to be catered for has inevitably to be made. It is possible, therefore, that the government of our collectivist economy might consider the appropriate choice of hours of work to be a matter better suited to centralized than to decentralized decision. Although it might endeavour to sound public opinion-or the opinion of workers' organizations-about the best length for the working day, and be guided by this opinion in issuing its decrees, it might be unwilling to allow each person to work as little or as much as he wished. I chose to adopt the extreme assun~ptionthat citizens were given the right to make their own individual decisions about how many hours to work in order more easily to demonstrate how, by means of prices, these decisions could be co-ordinated.

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93

varying the degree of utilization of the different items which make up-the existing fixed equipment; long-run, or total, adjustment, requires that the fixed equipment itself be made fully appropriate to the outputs being produced with it. Given that demand conditions will be changing and imperfectly foreseen, the government cannot hope to keep all fixed equipment continuously appropriate to the current pattern of output. Its immediate aim, therefore, will be to secure short-run efficiency, by adjusting the output of each good to the level at which its market price equals its short-run CMZ. We define the short-run CMI of any output as the cost of the additional inputs required to raise output by a marginal unit from existing fixed equipment. If this objective is attained, allocation will not be fully optimal, but the best use will be made of the fixed equipment at the economy's current disposal. In the long run the government will wish to ensure that all fixed equipment is fully appropriate to the outputs being produced. This requires an amount of equipment, in the production of any good, that will equate normal market price to long-run CMZ. If the total cost of producing x units of output, from fixed equipment specifically designed to produce x units, is C,, and the total cost of producing x +I units, from equipment designed to produce x+ I units, is C,, then long-run CMI is defined as C, - C1, these costs being calculated on the basis of the same input prices. One further, and important, question must now concern us. If price is in fact equated to CMI, in either the short or the long run sense, what will then be the relationship between price and unit costs (UC), where UC is defined simply as the total cost of production divided by the number of units of the commodity produced? Let us fist study these relationships under conditions of long-run adjustment. The greater the output of a commodity, the greater will be the total costs of production; it is a fact, however, that with many processes of manufacture, the cost of larger outputs is proportionately less than that of small. We have already noted that items of fixed equipment may have a minimum economic scale, in the sense that, if designed to produce an output less than some critical level, unit costs will not be as low as they could be. This circumstance is itself sufficient to provide economies of scale in production, so that unit costs fall, up to a point, with the rate of output planned. On the other hand, there are no obvious reasons to expect diseconomies of scale; management will not normally be obliged to use machines and factory buildings which are uneconomically large when they can duplicate smaller ones. Let us therefore take it for

ECONOMIC THEORY 94 granted, for the time being, that, under conditions of long-run adjustment, unit costs will first fall with large volumes of output and then remain the same. Thus, for given factor prices, the unit costs of a commodity, as a function of its rate of output, will typically be as in fig, iii. The output OX is the critical level at which scale economies become exhausted. For outputs less than this, CMI will be less than UC, as the fact that unit costs are falling implies that the cost of an additional unit of output is less than the cost per unit of the output

I

Long-run a d j u s t m e n t

CM I \

\.\-/' I

I

\

0

X Output Fig. iii

being augmented. For outputs equal to or greater than OX, total costs will rise strictly in proportion to total output so that CMI and UC will be equal. In so far as outputs large enough to ensure the exploitation of all scale economies are concerned, therefore, we can say that long-run allocative efficiency requires that market prices are equal to unit costs as well as to CMI's. This is an important conclusion. It implies that, were a full optimum to be realized, and in the absence of unexploited scale economies, the receipts which an industry obtains from the sale of its output (i.e, the number of units sold multiplied by their price) will equal the total production costs incurred (i.e. the number of units produced multiplied by their unit cost). In familiar terms, that is to say, long-run allocative efficiency implies that industries are making neither profits nor losses. It remains to consider the case where the scale of output is below

THE DECENTRALIZATION O F DECISIONS

95

the level needed to minimize unit costs, so that CMI is less than UC. Under these conditions we cease to be able to decide upon the optimum rate of output of a good merely by comparing its CMI with its market price. If price exceeds CMI, we can safely conclude that a marginal increase in output would result in a net increase in consumers' welfare; what we cannot judge is whether or not the good should be produced at all. This kind of problem cannot be handled without extending our analysis in a way which the narrow scope of this introductory volume does not permit. We shall therefore be obliged to assume, throughout our discussion, that sufficient of each good is produced to exploit all scale economies. Let us now turn to the relationship between price and unit costs when only short-run adjustment is secured. There will clearly be some level of output, for any given fixed plant, for which unit costs are a minimum. If output is reduced below this level, unit costs will rise, as a smaller number of units of output will bear the same fixed costs attributable to buildings, machinery and permanent staff. If output is raised above it, unit costs will again rise. Although fixed costs will be spread over more units of output, this advantage will be offset by other circumstances. Once the limits to the output of particular machines are reached, processes which were previously done with their aid will now have to be done-if they can be done at all-by hand. Machinery employed continuously at full stretch, with no time left for maintenance, will be more likely to break down and men will get tired if they are obliged to work abnormally long shifts. For these reasons, unit costs will rise as output is pushed beyond the plant's normal capacity, the extent of the rise varying with different technical conditions of manufacture. The relationship between unit costs and the volume of output is therefore as shown in fig, iv. The dotted line corresponds to the variation in CMI; when UC is falling, CMI must be less than UC; when UC is rising, CMI will be greater than UC; thus the curve of CMI cuts the curve of UC at its lowest point, where output is OX. Given prices for all factors are assumed throughout. It is evident that, if there is short-run efficiency in allocation, so that price is equal to short-run CMI, then price will exceed UC for outputs greater than OX and fall short of UC for outputs less than OX. In familiar terms, the industry will make a profit if its output is greater than that which minimizes unit costs and will make losses if output is less than this amount. If allocation is to be perfectly efficient, and on the assumption that output is large enough to exhaust the scale economies, then

Short-run adjustment

0

X

Output

Fig. iv

u

c

2

UC (long-run)

(short-run) \ v U C ( s h o r t - r u n )

\

\,=-

[CMI (long-run)

UCtlong-run)

# r r'

I

P

z

= CMl(long-run) Output

Fig. v

price will equal both CMI and UC, in both their short-run and long-run senses. Fig, v shows the variation of UC with output under conditions of long-run adjustment. It also shows the variation in UC with different rates of output obtained from a plant designed to work at an output OZ. PZ measures both CMI and UC, short- and long-run, and if it is also equal to market price the situation is compatible with a fully optimal allocation. To end this section, let me make two observations, one of which will serve to warn the reader, the other to reassure him. Optimal allocation requires that the market price of every product equal its 96

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CMI. From this it does not follow that it is desirable that the price of any one good should equal its CMI, irrespective of whether the same equality holds for all other goods. If, for some reason, the price of more than one good diverges from its CMI, then we cannot conclude that the elimination of any one divergence, the others remaining, will necessarily increase welfare. In practice, it may sometimes be important to know whether the output of one particular good should be adjusted to make its price equal its CMI, even when divergences are to remain elsewhere; but our analysis does not enable us to deal with this problem. As I have described them, the means by which a government would promote efficient allocation may appear so clumsy and laborious as to lead one to doubt whether they would ever work. In practice of course actual collectivist economies would never adopt these precise procedures, which were invented to illustrate, in a reasonably simple fashion, how a system of prices could be used to promote allocative efficiency. But one should remember that the government's trial and error policies have been made to appear particularly impracticable partly because our notional economy had to start from scratch. In the real world no government would ever be presented with a clean slate and have to face the task of producing some optimum pattern of resource allocation wholly unrelated to the actual pattern currently in existence. The practical problem will take the form, not of bringing order out of chaos, but of effecting limited modifications in particular output targets and productive techniques. The changes to be imposed on the existing allocation are likely to be marginal rather than radical, except in special circumstances, such as when men and materials have to be mobilized for war. Normally, no very time-consuming series of revisions would be necessary to bring the pattern of allocation into approximate conformity with the idea. Approximate conformity, it may be said, is probably as much as we can hope for; given that circumstances are for ever changing, and that our knowledge of them is limited, approximate conformity is certainly as much as we can ever get.

2 The role of interest rates (a) Productive ejiciency It has so far been convenient, in our discussion of how decisions could be decentralized, to ignore the fact that production always takes time, and that the length of time allowed will affect the output D

98 ECONOMIC THEORY obtainable from any given input combination. We must now abandon this simplification and amend our analysis accordingly. I shall continue to assume that, although time passes, the known techniques of production re~nainthe same. This assumption is unreasonable, but if our analysis is to be manageable we shall have t o retain it for the time being. Let us for a moment recall the general character of the procedures previously discussed. If for no other reason than the government's limited knowledge and capacities, many allocative decisions had to be decentralized. The choice of factor combinations was therefore left to industrial managers, that of final products to those who would consume them. The co-ordination of these very many decentralized decisions was obtained by setting prices to fix the terms upon which factors or products could be obtained. Any divergence between the final market prices of products and the corresponding CMI's indicated that an ideal allocation had not been realized and that output targets required revision. Time, in that it adds an extra dimension to allocative decisions, greatly complicates these procedures, but it does not alter their essential character. I now propose to give a very abbreviated account of the modifications which this new element obliges us to introduce. I shall assume, as before, that the government begins by setting provisional output targets which now relate to the quantities of food and clothing to be made available during each of the years which make up the total planning period. It then invites the industrial managers to work out their factor requirements for all the relevant years. As before, provisional prices could be set for each factor and managers could be instructed to choose those processes of production which minimized the cost of the factors to be employed. The managers will be aware that the amount of land and labour required to produce a given quantity of output will depend upon the time allowed and that, by choosing more capitalistic processes of production it will be possible, up to a point, to reduce input requirements. They would therefore be led, in following the government's instructions, to choose productive processes of whatever degree of capital intensity minimizes costs. In more familiar language, they would choose the process with the lowest unit cost of production, irrespective of the relative importance of initial capital cost (on machinery, etc.) and subsequent running cost. This, however, might well be socially undesirable. The government might find that managers, in order to meet heavy requirements for initial capital construction, wished to employ more labour and materials

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in the earlier years of the planning period that were then available. At the same time it might find that, because of the low running costs of highly capitalistic processes, the demand for factors in the later years fell short of the supply. Some way has therefore to be found of ensuring not only that the demand for labour and the demand for materials at any one time is consistent with their relative availability but also that the time pattern of industry's demand for resources as a whole is such that can be met by the supplies becoming available each year. The simple instruction to minimize costs will provide managers with no incentive to economize on initial costs, relative to running costs, and therefore no incentive to moderate their demand for labour and materials at the beginning of the planning period. How then are managers to be induced to spread out their demand for resources in accordance with the supplies forthcoming each year? It would of course be possible for the government to permit industry to choose the lowest-cost processes, irrespective of their capital requirements, provided output targets could be set so as to bring the demand for input in each year into balance with their supply. If the dates at which the greater part of output were to become available were pushed far enough into the future, then the strain on resources more immediately available would be relieved. But it is unlikely that consumers would be willing to pay the price of this deferment of their satisfactions just in order to ensure that none of the gains from capitalization were left unexploited. A more sensible course would be to find some means of inducing managers to adopt production processes which, by having lower initial capital costs and higher subsequent running costs, would reduce the pressure of demand for resources available earlier rather than later. Precisely this result can be obtained by introducing into the system a n additional price--called a rate of interest-which will lead managers to economize in the use of fixed equipment. I n order to introduce this new price, let us suppose that the following arrangements are made. Managers, as before, are instructed to minimize costs. They are left free to hire workers, and to buy materials from the government, as and when they choose, but all the money with which they do so has now to be borrowed from a state bank. These borrowings are charged a particular rate of compound interest which, in computing costs of production, managers are told to take into account. Each industry's debt with the state bank will be gradually liquidated as the output, which it is enjoined to produce, becomes available. Given these arrangements, it is clear that the costs of producing a good, by different

I00

ECONOMIC THEORY

methods, will depend both on the quantities of each factor which have to be acquired and upon the dates of their acquisition. Managers will have now to distinguish between the price of a particular factor and the ultimate money cost, including accumulated interest, of purchasing it at a particular time. A penalty will be attached to processes which, although they have low running costs, require a heavy initial capital outlay. A surcharge, in effect, will be placed upon the prices of resources available at earlier dates. An incentive will be provided to economize in the use of time.1 How will this affect production plans? The condition for cost minimization, as previously elaborated, was that no marginal replacement of one factor by another could reduce costs. For this to be so, the marginal substitutability between any two factors had to equal the ratio of the prices of the two factors. In the world of compound interest, within which our managers now have to operate, this simple rule requires modification. It is necessary now to take account of the fact that money can be saved by deferring a purchase and that costs will be incurred by advancing one. The expenditure of a sum P now will cost management more than an expenditure of P a year hence, the difference being the interest payable over the year. If this interest is r%, then the cost for the year will be P -- . That is to say that an expenditure of P now ( .1 3,

')

is equivalent, in terms of cost, to anexpenditure of P;O:' ( - a year hence. It is also equivalent to the expenditure of P

(lOyg

years hence, to P --r)3 three years hence, and so on. Thus the going rate of interest effectively determines an exchange rate between money at one time and money at another. We can therefore always calculate the equivalent, in terms of money now, of a sum of I. In order to exert the maximum influence on the time pattern of industry's factor requirements, it would, in principle, be desirable to have a different rate of interest ruling in each time period. But a government might well shy at the complexity of such an arrangement. A single rate can be used to provide a general deterrent against excessive capital intensity and any remaining imbalance between the demand for inputs and their supply, within any particular period, can be met by causing the general level of input prices to differ from one period to another.

THE D E C E N T R A L I Z A T I O N O F D E C I S I O N S

I01

money in the future. Let us take a sum of money A to be spent n years hence. This will then be equivalent, in terms of cost, to a sum P spent now, the relation between the two sums being given by the formula

or, alternatively P = A --; :01( rIn P is then said to be the present value, or the discounted value, of A. By employing the technique of discounting we can therefore always compare, from the point of view of cost, expenditures made at different times. The relative cost of spending one sum at one period of time, and another sum at another, is given simply by the ratio of their discounted values. In particular, the cost of purchasing a particular input at one time, as compared with the cost of another input at another time, is given by the ratio of the discounted values of the prices of the inputs, or, more shortly, by the ratio of the discounted prices of the inputs. This permits our rule for cost minimization to be amended very easily in order to take account of the time factor. Managers will succeed in minimizing the cost of attaining a particular output when the marginal substitutability between any two factors equals the ratio of their discounted prices. It is essential to bear in mind that the 'factors' thus referred to may differ, not only in kind (land or labour) but in date of application. Similarly the output target in question must be defined both as to kind and as to date of availability. The achievement of a set of programmes which ensure that all factors are employed both fully and efficiently can be a result only of some process of successive revision along the lines previously indicated. Output targets, factor prices, and the rate of interest will all have to be varied until managers have produced a set of plans which are both efficient and consistent with the resources available. (b) Distributive ejiciency The distribution of goods is efficient, by definition, only when there is no change in distribution which would increase the welfare of any one consumer without impairing that of another. For this to be so, the MRU of any two goods has to be the same for all who consume them. This condition has now to be interpreted so as to deal also with the time pattern of personal consumption: goods have to be

I02

ECONOMIC THEORY

regarded as economically distinct, even though physically similar, when available at different times. Distributive efficiency was obtained, in our early model, by permitting consumers to buy goods freely at common prices; as each of them sought to equate the MRU of any two goods to the ratio of their prices, which were the same for all, the MRU became the same for all. Prices had to be adjusted to achieve consistency between the demand and supply of each commodity, and incomes, in total, had to be made equal to the money value of available output. In what ways has this procedure to be modified in order to take account of the element of time? Consumers were enabled to adjust their relative consumption of food and clothing by being left free to choose between them. Similarly if the time pattern of a man's consumption is to be appropriate to his particular requirements, he will have to be given some freedom as to when to buy goods. Previously, consumers were obliged to spend all their current income during the period within which they received it. Now I propose to assume that they are enabled to save and to borrow, so that, within any particular period, their spending may differ from their income. When they do not spend their whole income, consumers are assumed to deposit the excess in the state bank and to obtain thereon a rate of compound interest equal to that which enters into the calculations of industry. Expenditures greater than income are financed by money borrowed, at the same rate of interest, from the state bank. By virtue of these facilities, any person will be able to bring the time pattern of his consumption into greater harmony with the time pattern of his needs. I shall assume that his borrowing rights are not unlimited, but depend upon the amount which his future income will enable him to repay; thus he is not able to live permanently beyond his means. Under these arrangements, a fully rational consumer, perfectly informed as to future prices, his future income and his future requirements, would adopt a pattern of consumption such as would bring the MRU of any two goods into equality with the ratio of their discounted prices. The relative cost of two goods, when the goods are bought at different times, is no longer given simply by their prices, for the date at which a purchase is made will affect the interest which the consumer earns or owes. For the reasons given in the previous section, the relative cost of the goods is given by the ratio of their discounted prices. If all consumers were to succeed in bringing marginal relative utilities into line with relative discounted prices, then efficient

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distribution would have been achieved, for, as product prices and the rate of interest are the same for all, the marginal relative utilities of different people would then be the same. For this to happen, many very stringent conditions would have to be fulfilled. Prices would have to be adjusted in each period, by trial and error, in order to bring the demand for each commodity into balance with its supply, so that all purchasers could carry out their plans. This being so, consumers could not be given advance information as to what future prices would be and could not hope to draw up very precise long-term purchasing plans. Secondly, the government would have to see to it that the aggregate money demand for all commodities taken together was appropriate to the money value of all the commodity supplies available. It would therefore have to give consumers incomes which would induce them to spend the correct amount. To do this an estimate would have to be made of the total spending to which various levels of income would give rise; the government would have to judge, in other words, how much consumers would save or (by borrowing) dis-save. Here again a process of trial and error would have to be adopted, so that consumers would not know in advance precisely what their incomes would be. Finally, consumers would rarely be able to predict with confidence the nature of their own future requirements. For all these reasons, the freedom given to consumers would scarcely result in fully efficient distribution. All that can be said is that welfare would be likely to be greater if consumers have some freedom to vary the time pattern of their consumption than if they have none at all. Provided that prices and incomes do not have to change too much consumers will be able to plan ahead at least to some extent. (c) The optimum assortment of goods How is the government to know whether its original output targets were such as to provide for the highest possible level of welfare? Our basic criterion for an optimum assortment was that the marginal relative utility of any two goods should equal the marginal opportunity cost of the one in terms of the other. Consumers, under our present arrangements, seek to equate the MRU of any two goods to the ratio of their discounted prices. For an optimum assortment, therefore, we wish the MOC of any one good in terms of any other to equal the ratio of the discounted prices of the two goods. Let us assume, for example, that F now represents food available at some specified time, and f' its discounted price. Similarly, let E represent

104 ECONOMIC THEORY leisure available at a specified time and w' the discounted value of the corresponding wage rate. Then we require that .

This is to say that the discounted price of food should equal the amount of labour necessary to make a marginal unit of food multiplied by the discounted price of that labour. (It is to be remembered that the food and labour in question are associated with particular dates.) More briefly, the discounted price of food should equal the discounted value of the required marginal inputs, or, symbolically, its discounted CMI. Our requirement for optimal assortment, therefore, is that the discounted price of each good should equal its discounted CMI. In one important respect, however, this simple test is defective. It will still indicate whether the government has produced, for any particular time period, too much of one good and not enough of another. What it will not show is whether it would have been better to have produced more output in total at one time and less at another. Individual purchases can, in aggregate, indicate whether, let us say, too much food has been produced and too little clothing; this they do through their effect on the market prices which the government, in order to equate supply and demand, has to set. But consumers cannot indicate, in the same way, that too much was produced for one period and too little for another, for I have assumed that in each period the government deliberately sets total incomes at a level such as to provide just the right amount of total demand to purchase the total value of output currently available. Thus if in any particular period the aggregate demand for goods should prove to be deficient, this would merely indicate that the government had incorrectly estimated the volume of spending that the incomes which it distributed would produce. It would not imply that more goods should have been made available. I have talcen it for granted, in fact, that the government will not be guided, in fixing the shape of the output stream over time, by the effect on prices of consumern' decisions in the aggregate. This is not to say that the government need be unresponsive to the desires of the majority of the population, which can be registered by votes in elections as well as by the willingness to buy goods at different prices. But there are several reasons why the time pattern of outputand therefore, in effect, the appropriate level of investment-should be left to the centralized decision of the government.

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First, there are the reasons to do with inadequate information possessed by consumers. If a consumer is to allocate his total spending between different periods, then he has to know what his total income, up to the planning horizon, will be; reasons were given above why he cannot be expected to have this knowledge. He would also need to be able to predict the future prices of goods and the extent of his future requirements; while he may be able to make some reasonable estimate of both of these, he can scarcely know them with precision. Secondly, there is the fact that in deciding how much to save or dis-save many consumers may act irrationally. They may be constitutionally shortsighted, and underestimate their future needs. Or they may be miserly, and wish to save, not in order to spend in the future, but merely in order to accumulate money. If one takes the view that a government may sometimes know the interests of its subjects better than they do themselves, and that this justifies its intervention, then this constitutes another reason for a centralized decision regarding the optimum level of investment. Thirdly, there is the fact that the membership of an economy is constantly changing. The generations succeed each other and it could be maintained that the government, in fixing the time pattern of output, must arbitrate between them. A final and fundamental difficulty is the fact that consumers' preferences, in so far as they are registered in their purchases, refer to a past period. If, in order to sell all current output, the government has to raise the price of food above its CMI, and reduce the price of clothing below its CMI, then it will know that it has produced too little of the former and too much of the latter commodity. It can then alter its plans for the next period, on the fairly reasonable assumption that consumers' preferences will not change much in the short run. But a man's wishes regarding the best time pattern of consumption over his life, or even over some shorter number of years, could at best be registered by actual spending only at the end of the full period in question, by which time the information provided, though of historical interest, could scarcely form the basis of future plans. These considerations oblige us to conclude that the time shape of the community's output stream, unlike its commodity composition, cannot be left to be determined, through the mechanism of prices, by consumers' choices. The government can be guided, in allocating resources between, say, food and clothing, by the way in which prices react to consumers' demand; but the optimum level of total

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investment, and therefore the balance between present and future consumption, will be a matter for centralized political decision. Enough has been said to make it evident that an optimal allocation of resources is an objective which no government, in the world as we know it, is ever likely to attain. The explicit introduction into our analysis of the element of time, and of all the difficulties associated with it, of looking ahead into the future, make the possibility of success seem more remote. The government cannot hope to proceed miraculously, in one move, to a pattern of production and distribution, in which goods are selling at prices which both equal CMI's and equate demands with supplies. But a process of informed trial and error, of the kind previously described, will bring it nearer to this goal. The degree of success achieved will depend, in part, on whether the basic determinants of the optimal allocation, corresponding to the available resources, the state of productive technique, and the requirements of consumers, change only gradually over time. It is harder to hit a rapidly moving target. Perfect allocation is impossible in a world of imperfect knowledge. A system of prices, such as I have described, ensures that the most can be made of the limited information available notwithstanding its dispersion among many minds. The allocative result is no doubt still far from ideal, but it is better than chaos, and the best that we can hope for. We must again recall that the economic problem in reality is, in one important respect, simpler than that posed in our model. In any actual centrally planned economy, the government would not have to draw out the main lines of efficient resource allocation on a perfectly clean slate; its task will be, not to produce order out of chaos, but to modify an already existing pattern of economic activity in particular ways. Although, for convenience of exposition, our discussion has dealt with two goods only-food and clothing-the principles which have been established retain their validity after this simplifying assumption has been removed. It is necessary, however, to make special mention of those goods which, because of their very nature, cannot be purchased by consumers in the ordinary way. Such public goods, as we earlier observed, usually benefit the community as a whole, or some large part of it; the appropriate investment in roads or drains, or in the training of soldiers or policemen, must be a matter for direct government decision, unguided by any effect of consumers' demand on prices. It will still be possible to make use of prices in ensuring that public goods are produced efficiently; those who are given the responsibility of producing them will be instructed to

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choose the combination of factors which minimize money costs. But it will no longer be possible to decide whether the appropriate volume of resources is being devoted to them merely by comparing a CMI with a market price. In many cases, but not in all, it will still be possible to use the measuring rod of money. Thus the government can endeavour to estimate, as best it can, the money value of an addition to the supply of some public good, such as roads, and compare this with the money cost of making this additional supply available. But in deciding whether to lay out a public park, or to erect a statue, any monetary estimate of the benefits to be derived can be no more than a guess. In estimating the aggregate incomes to be distributed to consumers, the government will seek to provide a level of total spending just sufficient to buy up the total available output of private goods only, for these alone are saleable to individual persons. (d) Technicalprogress The whole of the preceding discussion has presumed that the state of technical and scientific knowledge, which determines the methods of production available to industry, is fixed and unalterable. Once we abandon this highly unreasonable assumption-as now we must -it becomes much more difficult to define the notion of an optimum allocation and to prescribe the best way of attaining it. The fact that, until now, we have ignored this vitally important, but analytically awkward, element in real life, ought not to lead us to repudiate our conclusions out of hand as wholly worthless for practical purposes. Provided that the rate of technical progress is not too fast, there being only a small number of important inventions made within the period set for production programmes to be carried through, then our previous analysis will be far from useless. And it is surely better to have some guide as to how best to employ society's resources, even if an imperfect one, than to have no guide at all. Nevertheless the matter cannot be allowed to rest there; although our existing economic theory does not offer a fully developed logic of allocation under conditions of changing techniques, something can be said about the way in which the procedures set out above require supplementation and amendment. It is easiest to consider fist how methods of production can be improved by what we might entitle extensive investment in technical knowledge; by arranging, that is, for more people to acquire the knowledge and skills already developed. In important formal

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respects, a trained engineer represents intermediate output; like a machine, he forms part of the capital stock of the country. This at Grst suggests that decisions about the appropriate amount of investment in technical education and training could be decentralized, that they could be left to those responsible for the management of particular industries. Managers are instructed, it will be recalled, to produce at minimum cost; if they decide that it is cheaper to train a man in a skill required for a particular job, rather than to use unskilled labour to do it, then they might be prepared, it seems, to obtain the money necessary for this particular investment from the government bank. But only limited amounts of training could be suitably provided for in this way. An engineer, or an industrial chemist or an accountant, may be expected normally to remain in their chosen career for the whole of their working life; it does not follow, however, that they will remain in the same industry. Thus, if people are to be allowed to change their jobs, the management of a particular firm may be reluctant to incur the cost of training a skilled man when there is a risk that he will leave their employment before the returns from the investment have fully accrued. Here we have an example of how the benefit to society of a particular investment may be greater than its benefit to one particular industry. In this situation the government has a choice of policies to pursue. It might permit individual persons, or families, themselves to go into business, to the extent that they were allowed to purchase an education in some particular branch of industry in the expectation that, by afterwards enabling them-or their children-to obtain a better paid employment, this would prove a profitable form of investment. But there would be no guarantee, unless special methods of selection were devised, that those with funds to spare for this purpose would be those most likely to profit from the education. Alternatively, the government could itself undertake centrally the 'production' of technically trained men; the wage that industry were prepared to pay for labour with some particular skill would indicate whether (at least under reasonably stable conditions) resources would be profitably invested in enabling people to acquire this skill. The government, by being able to take the long view, ought to be better able than any one particular industry to judge the optimum level of such investment. The education of the community, we must remind ourselves, is not, however, a matter to be considered only in the light of such economic criteria; the diffusion of knowledge is not merely a way of increasing wealth, but also an end in itself to which wealth should be devoted.

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On the face of it, investment in research ought to pass the same economic tests as investment in education or, indeed, in plant and equipment. It ought to be pushed to the point at which the cost of the marginal inputs being applied equalled the discounted value, in money terms, of the saving in resources which the discovery of new techniques is expected to make possible. But any precise estimate of the returns from such intensive investment in knowledge is very difficult-if not in fact strictly impossible-to make. The precise outcome of any project of research cannot be predicted in advance; and even after a new scientific or technological principle has been established, the extent of its possible application my still be by no means clear. Work which is highly specific to the improvement of particular processes of production may be undertaken by the industry concerned-just as is any other investment-in fulfilment of the instructions given to it to minimize costs; but research of a more strategic character, which may augment the economy's stock of basic scientific knowledge, is likely to offer gains which are too uncertain and too widely diffused for it to be undertaken on this basis. It would be impracticable, moreover, for the new ideas and techniques which are the fruits of fundamental research work to be given a price by the government, and bought, like factors of production, by industries which wished to make use of them; they will have to be provided free, so that the government cannot, in the ordinary way, compare prices with corresponding CMI's. In helping the government to decide upon the optimal volume of resources to be devoted to fundamental research, therefore, the price mechanism will be of very limited service. It remains to consider how technical progress, itself the fruits of investment in education and research, affects the returns to be expected from investment in equipment and skills. It is perfectly evident that the gains to be expected from investment, and the forms which investment should best assume, will depend upon the level of technical competence which the economy has attained; this was taken for granted in our previous discussion in which this level was assumed to be fixed. Less immediately evident, perhaps, is the influence which the expectation of technical progress will exercise on production programmes. An industry may be invited to submit a production programme designed to attain, at minimum cost, a series of output targets which have been set for some years ahead. On the assumption that factor prices are to remain the same, and that a particular rate of interest has been fixed, it should be possible to identify, on the basis of the technical possibilities available at the

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time the plans are made, a minimum cost production programme. Once we take into account that there may be significant improvements in technology in the near future, however, it does not follow that this will be the production programme to adopt. It might entail the construction of very long-lived equipment such as would prevent, for many years, any substantial alteration in the method of production; to choose factor combinations offering minimum costs on the basis of the present state of technology would deprive the industry of the opportunity of taking full advantage of subsequent technical improvement. Highly capitalistic or time-consuming methods of production, if they cannot readily be modified, would be less attractive, therefore, in conditions of rapid technical advance than they would be in its absence. The importance of this consideration will be highly variable; the technological frontier will be pushed out more rapidly in some directions than in others and in some industries the minimum cost method of production, on the basis of current technology, may not require so much durable fixed equipment as will result in resources being committed, in some fixed combination, over any very long period. Nevertheless, given any significant rate of technical advance, one would expect that industry's preference for capitalistic processes of production would be somewhat diminished. Two opposing influences will now be at work. The longer the interval between the investment of resources and the availability of final output, the greater will be the opportunity to benefit from the superiority of those methods of production which require much durable capital; but the shorter this period, the greater will be the opportunity to profit by the latest known techniques. Thus there are gains, of quite different kinds, both from processes which take a long time to carry through and from processes which do not. With a steady improvement in techniques, the cost of production in terms of real resources will continually decline; so also, if the general level of factor prices is kept the same, will money costs per unit of output. Thus the price level of commodities will fall in comparison with the price level of factors. As the incidence of technical advance will be uneven, production costs will fall more for some goods than for others; the relative prices of goods will alter, and as the demand for them will thereby be affected, the pattern of output will itself have to be changed.

Private ownership: the system in outline 1 Private property

In the centrally planned economy with which we have been concerned until now all the authority to dispose of resources resided with the government. I n our first, and very simplified, model this authority was exercised directly by the government, which was presumed to be furnished with all the necessary knowledge and capacity. Our second model, which made a greater concession to human limitations, postulated the delegation of some authority to producers and consumers. Producers were told what to make and in what quantities, but they were authorized to choose the particular combination of inputs which they themselves thought would minimize costs. Consumers were left free to spend their incomes on whatever goods they chose. By thus decentralizing these decisions the government was able to ensure that they were taken by the people best informed about the relevant circumstances, producers being assumed to know about processes of manufacture and consumers about satisfaction yielded to them by alternative patterns of consumption. The essential difference between a private enterprise system, which will from now on concern us, and the alternative forms of the planned economy considered hitherto lies in the location of the ultimate authority to allocate resources. In the former system this authority is parcelled out among many different people, while in the latter it ultimately resides entirely with the government. The institution peculiar to private enterprise is private property, which confers on individual persons the right to devote particular resources III

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to whatever purposes they choose, provided only that these are not prohibited by the laws. Such a right, even in a planned economy, may be granted to men in respect of their own labour, in that they are permitted to work in whatever job they prefer, and for hours of their own choosing, at wage rates fixed by the government. They may also be free to make whatever use they care of their personal, household effects. But ownership of the material means of production, in a system of full and detailed central direction, will be vested in the state. So long as we were concerned with the collectivist economy, in which there is uniiied control over the whole of society's resources, the economic problem could be conceived in terms of drawing up and implementing a single master plan designed to provide for a pattern of allocation consonant with the criteria for economic efficiency previously adumbrated. Confronted, as we now are, with an economy in which the power to take allocative decisions is fragmented according to the distribution of private property, a different conception is appropriate. Our first problem must be to enquire whether, under such conditions, it would ever be possible to predict the pattern of allocation which would ultimately emerge, there being no immediately obvious reason for believing that, with each owner of productive resources allowed to do as he pleases, anything other than general chaos could ever result. Only if such prediction is possible can we go on to estimate the extent to which the allocation of resources which would emerge under private enterprise might meet our tests of efficiency. Of all the possible types of organization based on private property, the most primitive would be that in which each man or family used the resources which.he himself owned, and these only, to produce goods for his exclusive personal use. (Even today, in economically backward countries, agricultural production sometimes takes this form.) But the limitations of such a system are very clearly evident; the range of possible outputs, and the choice of techniques of production, would be narrowly determined by the composition and amount of the resources at each family's disposal so that there would be little chance of everyone being able to keep themselves alive, far less realizing the conditions either of productive or distributive efficiency: At this stage the gains to be had from exchange, even if in the primitive form of barter, would be enormous; each family would then be able to specialize in the production of those things most suited to its human and material endowments, in the expectation of

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being able to exchange the greater part of them for other commodities. Some processes of manufacture, however, would require the combination of many different resources on a large scale. One way of achieving this would be for a large number of families to pool their property and run their affairs conjointly, electing some authority to manage this miniature collectivist economy. In private enterprise economies as we know them, however, manufacturing is undertaken typically by 'firms', 'companies' or 'enterprises' (as they are alternatively called) which purchase inputs of labour and materials, and sell outputs made by their transformation, for money. Within each lkn, considered in isolation, there is a regime of central planning, in the sense that the use to which the M s resources are put is the responsibility of its management; it is characteristic of private enterprise, however, that there is no ultimate authority to which lirms are subject. The existence of companies of this kind complicates the relationship between property rights and actual productive resources. Part of the economy's resources are owned directly by private persons; a man certainly has the sole right to dispose of his own labour and he may own directly a house, or a farm, or the equipment of a factory. But the greater part of the country's capital equipment is likely to be managed by, and be the property of, not private people, but companies. In order to acquire these assets, the directors of the companies will probably have obtained money from private people to whom they have given, in return, money claims. Very broadly, these claims are of two kinds; they may promise the purchaser some iixed rate of interest on his money as well as its repayment at some specified future date, or they may entitle him to some share in the profits of the company which issues them. The former type are called bonds or debentures, whereas the latter are referred to as ordinary shares or as equity capital. In most cases, the ordinary shareholders of a company (but not the bondholders) are entitled to vote in the election of its directors, but in fact they rarely exercise this right, preferring to allow the directors in effect to decide themselves who their successors should be. Financial securities (as the totality of these claims are called) can be bought and sold freely, so that anyone dissatisfied with the financial return which they offer can, if he chooses, part with them. Thus, in private enterprise economies as they now exist there are men in control of real resources-buildings, machinery, etc.-who cannot be said to own them, and there are men who have property in financial assets-money and claims-who have no direct control

I 14 ECONOMIC THEORY over the use to which real resources are put.1 But this fact has less influence on the way in which the resources are allocated than might at first appear. A man who has direct ownership of productive resources-such as a farmer or the owner manager of a small firm -will use them so as to obtain the best possible financial return; his motivation is therefore clear. It is less evident that the directors of a large company, who receive a fixed salary, and whose own shareholding in the company may be very small, will pursue the same objective; but in fact there are pressures at work to make it likely that they will. First, the extent to which the company can be expanded will depend partly on the ease with which the directors can raise money by selling ordinary shares; this will in turn depend on the return which the company pays shareholders and thereby on the profits being made-these being defined as the excess of the receipts from selling output over the money costs incurred in its production. Secondly, if a company fails to make much money, and therefore to pay much to its shareholders, the shares which it has issued will become unpopular, will be sold, and will therefore fall in price; a large wealth owner may then be able to purchase a large quantity of these shares, and, by using the voting power which they carry, but which is seldom used, to turn out the existing directors and take over the control of the company. Despite the lack of correspondence between ownership and control, therefore, it is safe to say that the main preoccupation of those who allocate resources in a private enterprise economy will be making money. Quite literally, as critics of the system have not failed to point out, production is undertaken for private profit and not for the public good. Self-interest, in the extended sense of the interest of the family or the firm, is the guiding principle of business decisions. In fact however the dichotomy between private and public benefit is much less sharp than a superficial analysis would suppose, if only for the reason that in order to make money in business it is necessary to produce things which other people want to buy. But it will be convenient to defer consideration, for the time being, of the crucial question regarding the extent to which, under alternative sets of conditions, the private pursuit of profit will automatically result in a pattern of resource allocation which is satisfactory from society's point of view. I. The fundamental difference between wealth in the form of real assets and wealth in the form of money or claims to money is obscured by the use of the word 'capital' to describe them both. This ambiguity of the terms 'capital' and 'investment' has already been referred to.

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In the type of economy with which we are now concerned, the way in which productive resources are employed is determined, not by industrial managers acting under government instructions in fulfilment of a central plan, but by a vast number of independent, but inter-related, investment decisions taken by private persons, or private companies, in pursuit of their own interest. It is worth while distinguishing between people who play a passive role and those who play an active role in the process of allocation. Many who own resources are content to take advantage, in a straightforward manner, of the objective opportunities before them, in that they will work for whosoever offers the highest wage, or sell their land to the highest bidder, or buy their house in the cheapest market, without much thought for how opportunities may change in the future. Behaviour of this kind is to be distinguished from the purchase of resources for the purpose of being able to sell them later at a higher price, or in order to transform them, through some process of manufacture, into commodities which can be sold for more than their cost of production at some future date. Clearly, the distinction cannot be too finely drawn; even the purchaser of consumer goods may consider whether he could buy them cheaper if he were to delay his purchases, and even the man who lends someone money will generally give some thought as to whether future conditions are likely to permit the borrower to repay the loan. Given, in any economy, that production takes time, and that the consumer demands to which investment decisions are related cannot usually be known with certainty in advance, it is clearly necessary for someone to take a view about what the economy's future requirements will be. In the collectivist economy which we considered hitherto, it was the government that performed this function, setting out targets on the basis of current trends in the demands for various goods. Under private enterprise this role is played by all those who take investment decisions on the basis of their own personal view of future prospects. Chief among those are the directors of companies who have to decide what to produce and in what quantities; they are the undertakers-or, to employ the more common French equivalent, the entrepreneurs-who are responsible for arranging that current productive activities are in line with future demands. But the entrepreneurial function, interpreted widely, is performed, in differing degrees, by many others besides; the shareholder who decides to place his money in the clothing industry, rather than in the food industry, or in one clothing firm rather than in another, takes a view about the future and cannot but affect the direction in

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which the country's resources will flow. The speculator, despite the perjorative associations of the word, works to the same end; by buying, say, raw materials at one time in the hope of selling them for a higher price at another, he causes resources to be diverted from present to future uses. No sharp boundary can be drawn, therefore, between those who play an active role in the process of allocation and those who do not: almost everyone with control over resources will, from time to time, take a view about the future in deciding upon their disposal, and will stand to lose or gain according to the quality of their foresight. The difference is one of degree; for many, activities of this kind will be incidental, for some, they will be the stuff of their business. To make profits, foresight, a reasonable measure of luck and some initial command over investable resources are all required. The extent of a firm's command over resources will depend on its wealth, in the form of either actual physical assets or the money to purchase them, and on its reputation among those who are prepared to put up money. Taken together, the two factors will set a limit, at any one time, to the firm's business operations; they determine, in other words, the extent of its mandate to control the use to which productive resources are put. Should its operations be 'successful', in the limited sense of making profits, then the firm's wealth and reputation, and therefore the size of its mandate, will be enhanced; should they fail, the firm's mandate will correspondingly shrink. Thus it appears that the distribution of ownership within a private enterprise economy is not fixed once and for all; it changes, not only through inheritance, but according to whether different persons and firms make, or lose, money. Those that can allocate resources profitably will be enabled to enlarge the scope of their activities, while control over resources will pass away from those that lose money. There exists, therefore, in the private enterprise economy, a selective mechanism which acts so as to transfer control over resources to those who employ them profitably (in their own interest) from those who do not. The need for a system of selection, by which the power to allocate resources is distributed among men, is not peculiar to private enterprise. In any workable form of state ownership there has to be some procedure according to which the authority to take decisions is delegated to industrial managers. The authority given to any one man will be determined by a conscious decision of those superior to him in the hierarchy, this decision being guided by assessments of ability and past performance. Private enterprise

differs in that the process of selection will be automatic rather than planned. The realization of profits and losses, and the growth and decline of reputations, rather than the conscious decision of a higher authority, will determine the people upon whose knowledge and foresight will depend the use to which resources are put. 2 Competition and prices

What will determine, in a system such as has been described, the prices at which inputs and outputs will be bought and sold? In discussing the process of selection under private enterprise-the process by which the control of resources passed from one entrepreneur to another--effective competition was being assumed. Firms can be said to be in competition when each of them is striving to increase its share of the same profitable market. Their efforts may be directed to securing both the use of scarce productive resources and the custom of purchasers. Thus in order to obtain the input which he desires, an entrepreneur will offer its owner a higher price than that offered by his rivals; in order to attract custom for his product, he will offer a lower price or a superior quality or service. The ultimate objective, in either case, is to increase his share of some lucrative trade. The forms which competition can assume are various; the most obvious way in which to increase the market for a good is to reduce its price, but a firm may also seek to gain custom by massive advertisement, or by promising quick delivery or generous credit terms, or by rendering more attractive the character --or at any rate the appearance-of what he has to sell. It is convenient to make a distinction between competition which is in terms of price and competition which takes other forms; even when price competition is absent, non-price competition may be strenuous and effective. Now, under private enterprise, producers and the owners of productive resources are permitted to offer to sell the commodities, or raw materials, or labour at their disposal at whatever prices they choose. Given competition between them, however, the price which any particular seller can hope to get for a commodity or resource will depend upon the prices at which other people are prepared to sell the same or similar things. The terms on which he can hope to sell for any length of time, moreover, will depend not only on the actions of competitors already in the field, but also upon whether other firms could, if they chose, set themselves up in the production

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of goods similar to his own. It is clear therefore that, under competition, an individual seller's ability to set his own price is in effect very circumscribed, in that there will be an upper limit to what he can charge without losing custom to his rivals. Precisely the same considerations impose a discipline upon buyers; the price at which they can purchase an article will have a lower limit set by the offers made by others. Provided therefore that buyers are unimpeded, either by ignorance or the costs of communication, from approaching a number of competing sellers, then similar goods will command similar prices. If any one seller persists in charging more than the others, he will lose custom to them; if he persists in charging less, and is able to meet the demand which accrues, others will be forced to retaliate by coming down to his price level. No single price will diverge for long from that uniform level which, for convenience, is termed the market price. Competition can account not only for the existence of common market prices, but for their actual level. Here it is convenient to distinguish between the prices of factors and of products. If a particular scarce resource is in completely fixed supply, then its price will tend to the level at which purchasers are just prepared to take up the whole of it. At a market price greater than this, one or more sellers would be unable to dispose of all their holding, and, on the assumption that there is price competition, would charge less to draw custom. If market price were such that demand exceeded supply, then any seller could raise his price with impunity until these were in balance. Labour represents a productive resource of which the supply is variable; in this case, active competition between employers and between workers in the buying and selling of any particular kind of labour would tend to raise or lower the wage paid for it to the level at which the amount demanded was just equal to the amount willingly supplied. Were the level higher than this, one or more workers would offer their services for less in order to get employment; were it less, workers could ask for, and obtain, a higher rate.l Active competition, therefore, causes the price of any productive resource to gravitate to a particular level-defined as the equilibrium level-at which the demand for the resource equals the supply of it forthcoming. I. In reality, in advanced economies, individual workers rarely compete with each other by offering their services at lower rates and wages do not therefore continuously adjust themselves to keep demand and supply in balance; the implications of this fact will concern us in a later chapter.

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In the case of manufactured goods the price which any entrepreneur can hope to obtain, in the long-run, will be controlled by the cost, to rivals, of increasing the supply. The conditions which must hold for price to gravitate towards this equilibrium level, and the actual processes of adjustment, will have to be examined carefully in the following chapter; but the essential principle is easily perceived. So long as entrepreneurs expect a good to fetch a price greater than the cost of producing more of it, there will be an incentive to increase the supply. If, on the other hand, price is expected to fall short of costs, supply will be reduced. The cost of adding one unit to the supply of a good, in competitive conditions, is the relevant CMI. In this connection, CMI has to be defined as the cost of the marginal inputs to a firm of appropriate scale, together with a normal rate of profit. The scale of production will be appropriate if it is large enough to exploit all technical economies but not so large as to strain the firm's managerial talent or exceed its financial resources. A normal rate of profit is that which will just persuade an entrepreneur of average efficiency to enter the trade; it therefore represents the payment for the entrepreneur's own input of service. We are now in a position to see, if only in broad outline, how the automatic movement of prices, in a system of private enterprise, can produce allocative results similar to those achieved by the deliberate manipulation of prices in a planned economy. The reader will recall how under central direction the price system was operated to promote efficient allocation. First, the prices of factors were made the same for all managers and were deliberately adjusted until the demand for each factor was made equal to the available supply. Given suitable conditions-such as effective competition-these results can be produced automatically under private enterprise. Secondly, managers were instructed to choose those particular input combinations which, on the basis of the current prices for inputs, minimized the money costs of attaining their output targets. Under private enterprise, entrepreneurs, impelled by the profit motive and the threat of competition should seek to minimize costs without having to be told to do so. Thus it appears, on the basis of this preliminary inspection of the matter, that the conditions for productive efficiency-the efficient use of i n p u t s 4 a n be met in a system of competition. Distributive efficiency was secured, under collectivism, by fixing prices for goods which were the same for all consumers and which equated demands with supplies. Enough has been said to suggest

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how the free movement of prices, given competition, might bring this about. Finally, as a condition for an optimum assortment, there was the need for the prices of goods to equal their CMI-the cost of the marginal inputs necessary to produce them. Provided entrepreneurs are able to predict future prices, competition between them, we have seen, will work to this end. The reader will not expect to draw, from this very cursory account of the working of a competitive system, anything more than provisional and tentative conclusions. What our argument so far does suggest is that the adjustment of prices to promote efficient allocation need not be deliberately engineered, as under central planning, but may occur spontaneously as the by-product of free competition between buyers and sellers. A fuller examination of this proposition, and of the many important qualifications by which it must be hedged, will now engage us.

The long-run adjustment of supply to demand 1 Introductory

No more was attempted, in the preceding chapter, than to give the reader a very general impression of the working of the private enterprise economy and to suggest to him that, under appropriate conditions, resources might come to be allocated efficiently, without deliberate government planning, merely through the pursuit of private gain. Let us now consider this allocative process in more detail, with the aim of identifying the conditions most favourable to its success. Our attention will be concentrated, in this and the following chapter, on the adjustment of the supply of an individual product to the demand for it. Let us begin by recalling that our criterion of efficient adjustment -the equality between the price of a good and its CMI-is ambiguous. In our discussion of centrally planned allocation we found it necessary to distinguish between different kinds of adjustment, each corresponding to different periods of time. Long-run adjustment relates to the quantity of capacity-plant, buildings, skilled men, etc.-which is appropriate to a particular demand. Short-run adjustment has to do with the appropriate utilization of this capacity, i.e. with the amount of output which at any particular time the capacity should be employed to produce. When both capacity and the current rate of output are given, there remains the question-hitherto ignored-of how much output should be sold and how much added to stocks. All of these three allocative problems relate to the adjustment of supply to demand, but they each refer to a different kind of adjustment and a different period of time. A valid criterion of efficiency, in each case, is that the market price I21

I22

ECONOMIC THEORY

of the commodity should be equal to the cost of the requiredmarginal inputs, where this is measured in a way appropriate to the circumstances. In considering the optimum investment in capacity, it is the cost of all the inputs applied, whether embodied in fixed equipment or used in co-operation with it, that is relevant. It is necessary that the average price which the commodity will fetch, over the life of the equipment, should be equal to the cost of all the additional resources required to produce a unit increase in output capacity. If we assume that all scale economies have been exhausted, so that unit costs do not vary with output and are equal to CMI, we can say that the price of the commodity should equal its unit cost of production, costs being taken to include the minimum profit normally necessary to induce entrepreneurs to invest. Once fked capacity has been installed, then costs have been incurred which are independent of the intensity with which the capacity is used. This is true whether we speak of money costs, borne by a private entrepreneur, or opportunity costs to society as a whole. The entrepreneur, once he has installed fixed equipment, can no longer devote it to alternative uses. Thus, in measuring the cost, either to the firm or to society, of increasing the rate of output obtained from given equipment, we ought to consider only that additional employment of resources which can be attributed to the increase in output. Thus only the cost of the 'variable' inputs, and of that part of depreciation which depends on wear and tear rather than the mere passing of time, is to be counted. It is short-run CMI, rather than the long-run CMI appropriate to capacity adjustment, which, when related to the price at which the commodity will eventually sell, gives us our criterion for efficient adjustment in this case. Finally, we have the allocative decisions associated with a period of time sufficiently short for not only productive capacity, but also the rate of output which it is being used to produce, to be regarded as fixed. (It will be recalled that the rate of output at one particular time is the consequence of a decision taken previously; the variable inputs which it embodies may have been applied weeks or months earlier.) There remains, in this case, the choice as to whether the rate of current sales should be greater or less than the rate of current output-of whether, that is, there should be disinvestment or investment in stocks. The opportunity cost of consuming a unit of the commodity in one period is simply the alternative of consuming it at some other time, together with the storage and interest charges incurred by carrying the commodity over time. Stocks will have

L O N G - R U N ADJUSTMENT O F S U P P L Y TO D E M A N D

I23

reached the optimal level when the price at which the good is expected to fetch in some future period is equal to the current market price of the good together with the cost (including interest) of storing a marginal unit.l There exist therefore three different senses, associated with three different time periods, in which supply can be adjusted efficiently to demand. In each of these cases, adjustment can be brought about, under private enterprise, only as a result of the decisions taken by individual entrepreneurs. To study the process of adjustment, therefore, we have to focus attention on the circumstances by which these decisions will be determined. This we can do by considering, first, the supply potential of the individual firm, and secondly, the particular market opportunities of which it is aware. By the supply potential of a firm I wish to refer, rather broadly, to the range and quantities of goods which it is able to produce, within a particular time period, and the costs which it would incur in doing so. By market opportunities I refer to the kinds and quantities of goods which the firm believes could be sold profitably. The adjustment of supply to demand in any particular market will take place as a result of investment decisions taken by firms with the appropriate supply potential in response to market opportunities which they believe to exist. If we are to discover the conditions most favourable to efficient adjustment, where this is to result from the several decisions taken by independent entrepreneurs, two different requirements will have to be borne in mind. It is clear, in the first place, that if an entrepreneur is to know how much equipment to install, or how much output to produce from given equipment, then he will have to be able to form a reasonably good estimate of the likely future demand for his goods. From this it follows that he will have to be in a position to obtain the information upon which such an estimate has to be based. This represents the informational requirement for efficient adjustment; although quite fundamental, economists very frequently neglect it. Secondly, there is the need for competitive I. This criterion of the optimal investment in stocks is a good deal less helpful than might at first seem. Firms hold stocks, not only because they may expect market price to be higher in the future than in the present ,but in order to deal with the fluctuating and uncertain nature of demand. In order that our tests of optimal allocation should prove a useful guide to investment policy, they would have to be revised so as to take account of the uncertainty of expectations relating to costs and the prices; but such a revision is beyond the scope of this summary treatment.

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control. Such control has two distinct functions; the first is to prevent firms from earning unduly high profits, the second to ensure that they cannot continue to produce, for long, with unduly high costs. If private profit seeking is to promote the public welfare, then conditions must be such as permit business men to predict their future markets while subjecting them at the same time to competitive control. This chapter will deal with the adjustment of capacity to demand; in the following chapter we shall consider the adjustment of output and sales.

2 The conditions of supply Our present concern being with decisions to install productive capacity, we must direct our attention to the long-run supply potential and the long-run market opportunities of individual firms. A firm's long-run supply potential is taken to refer to what it could produce if given time to install the appropriate fixed equipment. Long-run market opportunities are those that appear to offer the prospect of selling output profitably over a period long enough to justify the installation of fixed equipment and the employment of managerial and technical staff. The long-run supply potential of any particular firm, whether in existence or yet to be formed, is best regarded as depending upon two different sets of factors. First, there are those general determinants, independent of the particular circumstances of the firm, that regulate the costs of producing different articles; and, secondly, there are those circumstances, peculiar to the firm itself, that determine the limits, and the most appropriate directions, of its investment. Each set of circumstances will now be explained in turn. The general determinants of production costs consist of the prices which have to be paid for inputs and the manufacturing techniques generally known at the time. Let us begin by assuming that the prices that have to be paid for inputs are outside the control of any single firm and remain the same irrespective of the amounts being bought. I shall endeavour at a later stage to specify the conditions under which this would in fact be the case; fixed input prices can be postulated meanwhile in order to isolate the effect, on costs, of production techniques. Given these conditions, the cost of producing a commodity, in so far as they depend on factor prices and known manufacturing techniques, will be related to output in the way shown in fig. iii (p. 9 4 , and for the reasons there given. Unit costs, that

is to say, will first fall with output, until all scale economies are exploited, and then remain constant. It is important to bear in mind the limiting assumptions upon which the validity of this relationship-a commodity's long-run cost curve-depends. The prices of all inputs have been taken as independent of whatever quantities of them the firm decides to purchase. If in fact these prices tended to rise with the firm's demand for inputs, then the cost curve would turn upwards after a certain point. If, on the other hand, inputs could be obtained more cheaply the greater the amounts purchased, then unit costs would continue to fall even after technical scale economies, within the firm, had been exhausted. Finally, and importantly, the relationship which we have been examining abstracts from those determinants of a firm's productive potential which vary with individual circumstances. It is to these that we must now turn. The information incorporated in the long-run cost curve for a particular commodity does not enable us to say how much of the commodity any individual firm will be able to produce; nor does it tell us anything about the relative advantages, in this line of production, of different firms. These aspects of supply potential will be influenced by three considerations. In the first place inputs cannot be purchased without the necessary finance, and the finance at the disposal of different firms will be subject to different limits. Secondly, the rate at which a firm can safely and profitably expand is controlled by managerial and organizational considerations, the nature of which we shall presently examine. And, thirdly, information about productive techniques, and experience in their application, is far from being possessed by all firms in an equal degree. These considerations affect the supply potential of existing firms, and of newly created firms, in two ways; they set an upper limit, at any particular time, to the amount by which each firm can expand, and they make each firm more qualified to expand in some directions than in others. The availability of finance is one of the factors which limit a firm's expansion. An entrepreneur's mandate, as we might entitle it, depends upon his company's own wealth and upon its credit standing. The first of these, at any particular point of time, is clearly iixed. And there is also a limit, although a less rigid one, to the extent to which any firm is willing, or is able, to raise money from outside sources. Of the variety of ways in which a firm can obtain funds, it will suffice to distinguish between futed interest borrowing and the issue of new ordinary shares. An entrepreneur's willingness to borrow at fixed interest will be checked by the fact that the servicing

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of the debt will represent a contractual money outgoing which he will be obliged to make whatever the conditions in which his business may, for a time, find itself. Given the inevitably uncertain and fluctuating nature of a firm's receipts, any fixed outgoing of this kind will increase the risk that the firm may prove unable, at some future period, to meet its commitments. A prudent business man, therefore, will keep fixed-interest borrowing within safe limits. But the effective check may be provided not by his willingness to borrow, but by the willingness of others to lend. Some people may be prepared to lend to the entrepreneur, at fixed interest, merely on the strength of his future prospects, as they see them; but the majority will wish their loan to be provided with some security, such as the assets already in the firm's possession. In this way the amount which a firm can borrow will be controlled by the resources it already has. If the entrepreneur raises finance through the sale of ordinary shares he no longer exposes himself to the risk of being able to meet a fixed contractual obligation, as the dividends to be paid on the shares will depend upon the profits being made; but he will have now to consider a risk of a different kind, the risk that the control of the company passes to outside interests. Unless the shares which he offers carry with them a right to vote in the election of the directors of the company, it will prove difficult to sell them; but, if they do carry this right, and if the bulk of them comes to be held by one, or a few, outside interests, then there is a danger that the voting power may be used to unseat the existing management. Once more, however, it is quite likely that the firm's ability, and not its willingness to sell shares, may be the limiting factor on the size of an expansion. Equity capital can be raised most easily from those who have knowledge of, and confidence in, a firm's prospects, but the number of such people, and the amount of money which they are prepared to put up, will be limited. If an appeal is made to the wider circle of wealth-owners who have little or no direct knowledge of the firm's likely future profits, a specially high dividend will have to be offered, and even then it may not prove possible to obtain the desired financial support. These considerations make it evident, therefore, that the availability of finance will provide an ultimate check to the supply which can be obtained from any one firm. It does not follow, however, that an entrepreneur will always choose to invest up to the limits thus imposed; expansion, if pushed too far, may strain the planning and co-ordinating powers of the existing management, particularly as

construction of new organizations requires talent superior to that which is able to administer existing ones. The firm can, of course, take on additional managerial staff, but there will be a limit to its willingness to do so. It may not be easy for those in charge of the company to find enough people whom they know to possess the proper qualifications; and, in addition, it will take time for newcomers to become conversant with the business and to form efficient working relations with the existing personnel and with each other. It is clear therefore that a firm's rate of expansion will be checked by either financial or organizational constraints, or by both. Although these constraints will provide no sharp and precise limit to expansion, they will cause expansion to be associated, after a point, with decreasing profitability and increasing risk. The more outside money is obtained, the higher will be its cost and the greater the threat either of losing control or of being forced, by temporary difficulties, into bankruptcy. The greater the strain on management, the less efficient will be the firm's production and marketing. These factors set no ultimate boundary to the size which the firm can attain; funds can gradually be accumulated, a firm's standing with potential lenders can grow, and managerial capacity can steadily expand; nevertheless, there will be a limit to the expansion which can prudently be planned at any one time. Once we admit that the supply potential of a firm depends on circumstances peculiar to itself, as well as on the general determinants considered previously, it is clear that the firm's unit costs of producing a commodity will, after a point, rise with the volume of output produced. Thus a commodity's long-run cost curve, for any particularjrm taking into account the limiting factors just discussed, will have a shape similar to either of those shown in figs. i and ii. In both cases the height of the curve will vary with the degree to which the firm is qualified to produce the good in question. The existence of scale economies will ensure that unit costs will at first fall with increasing output. In fig, i it is assumed that financial or managerial checks are encountered by the firm only after these economies are fully exhausted, where in fig. ii the checks cause unit costs to rise before all the potential gains from large-scale production have been reaped. It is perfectly possible for a firm, at any particular time, to find itself in the one situation or the other. In the long run, however, one might expect the process of competition to promote the survival of firms with resources great enough to permit the full exploitation of scale economies without undue financial or managerial strain.

The long-run cost curve for a particular f i r m

I

I

0

Output

Outp

0

Fig. i

Fig. ii

Let us now turn to those circumstances which, in the production of a particular commodity, will favour some firms as against others. There is likely to be differences in efficiency between firms merely from the fact that some managements show more energy and initiative, whatever the work they are engaged on, than do others. In addition, there are reasons for expecting different firms to have special advantages, or qualifications,in different lines of production. We have already had occasion to note that the knowledge and experience possessed by society as a whole is widely distributed among many minds. Each firm, or rather its personnel, will be the embodiment of detailed and particular information, experience, skills and 'tricks of the trade', which fit it to operate more advantageously in certain directions. The importance of such acquired advantages is greater in some trades than in others, but negligible in none of them. As a result, some firms will be more qualified than others to respond to an increase in the demand for a certain class of commodity. It will be by no means impossible for a firm to break into new fields, especially if they depend on the same basic technology as those with which they are already familiar, but if it does so, it will suffer a disadvantage-at least for a time--in comparison with others more immediately qualified to invest in this direction. 3 The demand for a commodify

Let us now turn from the conditions which regulate costs and supply to those which determine demand. Our concern, in this 128

section, will be with the demand for a particular commodity-say, shoes-rather than with the demand for the output of any single producer. If we say that, under certain specified circumstances, the demand for a commodity will be x, then we imply that this is the amount of the commodity that consumers will plan to buy. Demand, in our sense, is therefore different from desire, or need or entitlement. Poor people may desire, and indeed deserve, more shoes; but to the extent that they lack the means to purchase them, the demand for shoes is unaffected. Demand, moreover, is taken to refer to planned purchases rather than purchases actually carried out; if the available supply of shoes is less than the quantity demanded, then this quantity will not in fact be purchased. Upon what circumstances will the demand for a good depend? Of obvious importance will be the requirements and preferences of consumers, and the incomes that they have at their disposal. In addition, the demand for a good will vary with its price, and with the prices of other goods that consumers may choose to buy instead. It is useful, for many purposes, to consider one of these relationships in isolation, to enquire, that is to say, how the demand for a good will vary with its price, on the assumption that the prices of all other goods, the preferences of consumers, and their incomes, are unchanging. This relationship can be set out in terms of a demand curve, such as that set out in fig. iii. The curve has been drawn so as to slope downwards from left to right, it being assumed that, as the price of the product is reduced, consumers will plan to

L

0

Demand Fig. iii

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purchase more of it. On the basis of ordinary experience, this is the relationship that we should usually expect; at the same time, it accords with the analysis of rational choice presented earlier. A man's optimal pattern of expenditure will be that which makes the marginal relative utility of goods equal to their relative prices; if the price of one good is reduced, then, in order to re-establish the relationship between MRU's and relative prices, it will generally be necessary to consume more of this good and less of others. Exceptions to this rule do in fact exist, but they are not of sufficient importance to justify our leaving the main highway of our argument in order to deal with them. The extent to which a fall in the price of the good will stimulate demand for it (or a rise in price curtail demand) will depend upon the availability and price of such other goods as can act as substitutes. Thus, if the price of whisky were to rise, the demand for it would be likely to fall materially, in that people would turn to brandy or to gin, given that their prices were unchanged. If, however, the price of salt were to rise, there might be little or no fall in the demand for it, there being no satisfactory alternatives to which consumers can turn. The sensitivity of the demand for a good to changes in its price can conveniently be expressed in terms of the elasticity of demand for it at a particular price. This is assessed by considering a small proportional change inthe price of the good and estimating the resultant vroportional change in the volume of it demanded; the latter proboriional change, divided by the former, defines the elasticity of demand at the price considered. By thus comparing proportional changes, rather than absolute changes, we obtain a measure of the sensitivity of demand to price changes which is independent of the units in which either of these are measured. By considering the effect of a change in price which is very small, we are enabled to obtain an unambiguous measure of the elasticity of demand at a particular price; if the changes considered were not very small, then the measure obtained for the elasticity would depend upon their magnitude. 4 Perfect competition

Were a producer the sole seller of a particular good (i.e, a monopolist), then the possession of the information summed up in the position and shape of the demand curve for the good would enable him to deduce how much of it, at various alternative prices, he could hope to sell. In general, however, a producer will find that

LONG-RUN ADJUSTMENT OF SUPPLY TO DEMAND

I31

the demand for his own output will depend upon the policies pursued by competitors in the field. The market for his own output, that is to say, will depend not simply on the consumer's demand for the good in question, but on the balance between this demand and the volume of competitive supply brought forward by others. Can we therefore say anything about the price and output decisions that will be taken by a producer thus subject to competition? In particular, is there any reason to expect that the decisions taken by competing producers will, in their aggregate effect, secure the efficient adjustment of supply to demand? These questions can be answered, many economists have maintained, if we postulate a hypothetical system known as perfect competition. This claim, the reader should be warned, is disputed by the present author, but we are nevertheless obliged to consider it carefully, if only because of the central position which the theory of perfect competition is now allotted within the body of economic doctrine. I therefore propose to set out the conditions of perfect competition and explain why they are frequently regarded as sufficient to ensure efficient adjustment. Having done this, I shall endeavour, in the following section, to explain the deficiencies of the theory as I see them. The market structure known as perfect competition is defined, essentially, by these conditions. First, the number of fbns producing a commodity is sufficiently large for no single firm to make more than a negligible contribution to output. Secondly, the commodity is homogeneous, in the sense that consumers have no reason to prefer the commodity as produced by one firm as against the commodity as produced by any another. Thirdly, resources must be able to move freely from one employment to another. And, fourthly, there must be full and free contact between buyers and sellers within the market. Given these conditions, it is clear that no one seller will have any significant discretion as to the price which he must charge for his goods. At any one time, therefore, it is argued, there will be a uniform market price at which consumers' demand for the good equals the total supply brought forth. By endeavouring to charge more than this, a seller would lose all his trade to others; he will have no incentive, on the other hand, to charge less than the market price, at which he is already able to sell all he wishes. A rise or fall in demand will cause the market price to change. If, for example, demand falls, then some producers, finding they cannot sell all they wish, will reduce their prices, but only by the almost imperceptible amount necessary to persuade purchasers to transfer their custom.

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All other producers, if they are to sell their goods, are forced to reduce price likewise, so that price will fall until a new uniform level is established at which planned purchases equal planned sales The demand for the output of any one firm in this situation will be infinitely elastic, in the sense that the smallest reduction in price would enable him to sell as much as he could produce, and the smallest increase in price would cause him to lose all his custom. Thus the relationship of the sales of any one firm to the price it charges can be set out, as in fig, ivyin terms of a horizontal straight line. It would seem, therefore, that in deciding how much of a good to produce, an entrepreneur, if working in a perfectly competitive

Quantity

0 Fig, iv

market, will wish to know the market price that will rule at the time his output becomes available. He will know that this price, which is determined by the relationship of demand to total supply, will be unaffected by whatever output and sales decisions he may take. Price, from his point of view, is a 'given' factor in the situation, given, however, in the sense of being beyond his control rather than known in advance. The current price of a good will clearly be known by its producers, but current production decisions will have to be based not on this price, but on expectations as to the price that output will fetch once it is ready for sale. Whether in fact an entrepreneur operating in a perfectly competitive market would be able to forecast price correctly is a key question to which we shall soon have to give close attention; meanwhile we shall conline ourselves to asking how an entrepreneur would make an output

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13.3

decision on the assumption that he believed himself able to predict future prices with accuracy. It seems reasonable to assume that the firm will choose to make whatever volume of output will provide the maximum profit-the maximum excess, that is to say, of revenue over costs. This particular output can be identified in terms of the concepts of marginal costs and marginal receipts. We define the marginal cost (MC) of some particular level of output as the increase in total costs that would be incurred if that output were to be one small unit greater. If for example the cost of producing x units were C, and x 1 units C,, then C, C, would be the marginal cost of an output of x units. Similarly ~fthe total receipts from selling x units were R,, and from x $. 1 units R,, R, - R, would be the marginal receipts (MR) from the sale of x units. Now it is clear that any output for which MR exceeds MC is not such as to maximize profits, in that an output one unit greater would raise total receipts more than total costs. Similarly, an output for which MR was less than MC would not maximize profits, in that an output one unit smaller would reduce total costs more than total receipts.1 It follows therefore that profits will not be maximized unless MR = MC. Under perfect competition, any individual entrepreneur will always be able to sell a further unit of output without reducing price; in these conditions, MR will be equal to price and independent of the amount sold. MC, however, will vary with the amount of his output. The nature of this variation can be deduced from the relationship, described in section 2 of this chapter, between unit costs (UC) and output. This latter relationship is reproduced in fig. v; UC iirst falls with output, because of scale economies and then rises because of the limited financial and managerial resources currently available to the firm.Over the range within which U C falls with output, marginal increases in output must be bringing down the level of UC; MC will therefore be less than UC. Where UC is rising, on the other hand, marginal increases in output raise UC, so that MC must be greater than UC. If, as I have assumed in drawing the curve, the checks to expansion set in only after scale economies are exhausted, then U C will be constant over a certain range; within this range, MC must equal UC. I. I am assuming that the difference in total receipts from (or costs of) x - I units and x units is the same as the difference between the total receipts from (or cost of) x and x I units. Provided that we confine ourselves to small changes in output and sales, this will be approximately true.

+

+

T h e v a r i a t i o n of U C and MC w i t h o u t p u t (long-run adjustment)

CC O

Output Fig. v

If we assume that the entrepreneur can predict the relevant future market price with confidence, the most profitable scale of output will be that which equates this price (which is equal to MR) with

X

Output

Fig. vi

MC. In fig vi this output will be OX. The firm's total receipts (volume of output multiplied by price per unit) will be OXBC; its total costs (volume of output multiplied by unit costs) will be OXAD, and its total profits DABC. I34

L O N G - R U N ADJUSTMENT O F S U P P L Y T O D E M A N D

135

Provided, therefore, that we assume an entrepreneur believes himself to know the relevant costs and future prices accurately, it is possible to identify the scale of production that he will choose. It will be that which equates the marginal cost of output to the price output is ultimately expected to fetch. So much, then, for the output decisions of a single entrepreneur. What we must now ask is whether, as a result of many output decisions taken in this way, the supply of a commodity will come to be adjusted to the demand for it. According to the theory of perfect competition, this will in fact happen-given sufficient time for the process of adjustment to be carried through. Provided that existing firms are free to expand or contract output, and new firms free to enter or leave the industry, then the market price of a good cannot for long be such as to yield a producer of average efficiency a rate of profit on his capital either greater or less than the rate of profit which is normal for the economy as a whole. The normal rate of projit can be defined as that rate which is sufficient to induce a firm of average efficiency to set up production; it can therefore conveniently be regarded as an element in costs, in that it is the sum required to compensate entrepreneurs for the services they provide. Thus, if normal profits are included in unit costs, a firm in the situation depicted in fig. vi would be earning abnormal profits. Were it of no more than average efficiency, there would be an incentive for other firms to increase output in this industry. New firms would enter the industry and existing firms would expand as soon as the growth in their financial and managerial resources permitted them to do so. This process would come to an end only when the relationship between demand and total supply was such as to afford a firm of average efficiency no more than normal profits. In a similar way, losses would result in a gradual curtailment of supply and the restoration of normal profits. Thus there is a tendency under perfect competition, it is claimed, for the supply of a good to vary until its price comes into equality with the unit costs of a firm of average efficiency. Such a firm, moreover, will have to be sufficiently large to exploit all available scale economies, but not so large as to run into the financial and managerial limits which cause UC to rise. Were this not so, then the firm would eventually have to give ground to competing firms with the advantages of optimum size. The tendency is therefore to an equilibrium at which price equals the UC of a firm of average efficiency and optimal size. Given that the scale of production is optimal, it follows that price must also equal MC, for when UC is at

136 ECONOMIC THEORY a minimum, it is also equal to MC. In addition, provided that perfect competition exists in the buying of factors as well as in the sale of products, MC must equal CMI, as previously defined. For if no single firm buys an amount of any factor which is significant in relation to the total demand for that factor, then factor prices will be independent of the scale of operations of any one firm. Thus the addition to total costs resulting from a unit increase in output will simply be the cost of the additional inputs needed to produce that unit. MC, that is to say, will equal CMI. If this theory of perfect competition is correct, then it would appear to present us with a blue-print for an ideal market structure, which could be relied upon to ensure the eventual equality between the market price of a product and its CMI. Within such a framework, it might seem, private profit seeking would automatically bring about the efficient adjustment of supply to demand. But we are obliged to recognize that the theory offers no very conclusive proof that the long-run equilibrium position, at which market price equals both UC and CMI, would in fact ever be attained, or even approached. Entrepreneurs, in perfect competition, are presumed to base their output plans on their expectations of the relevant future market prices. We were obliged merely to assume that they would in fact feel able to form confident expectations of these prices, no explanation being given, by the theory, of why this should be so. Nor are we told why the supply plans of all the producers of a commodity should, in the aggregate, be neither more nor less than sufficient to eliminate abnormal profits, thereby securing efficient adjustment. How can we be sure-whatever the price expectations held by entrepreneurs-that supply might not chronically over-shoot or under-shoot the target? At the heart of these inadequacies is probably the fact that the theory of perfect competition pays no regard to the informational requirement for adjustment which was referred to at the start of this chapter. A fuller examination of this requirement, and of the conditions in which it is likely to be fulfilled, will shortly concern us. Meanwhile, there is one further, and rather more obvious, limitation to the theory of perfect competition to which we should give our attention. For the conditions which define perfect competition to be met, a commodity must be made by many producers, none of whom is large enough to provide, on his own account, a significant contribution to supply. This must rule out, straight away, the possibility that, in order to exhaust all possible scale economies, a firm's output has to be substantial in relation to the total supply of the good. Given scale

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economies which are substantial in this sense, production could not be efficient unless concentrated in a small number of firms, and it is this result that one would expect competition to bring about. Perfect competition would therefore never obtain in branches of manufacturing characterized by substantial economies of scale. But even where scale economies are not substantial, there is no guarantee that firms will not be large enough for their output to be significant in comparison with total supply. It was argued in section 2 of this chapter that a firm's unit costs of production would eventually rise with the scale of its output because of the limited financial and managerial resources at its disposal. But the limits set by these factors may continuously recede as time passes; a firm can accumulate funds and can improve its reputation with those with money to advance, and its managerial organization can gradually be built up to deal with greater amounts of business. Thus there is no permanent check to the size of the firm and no reason to expect that, even where scale economies are unimportant, there will necessarily be many small producers of each commodity. The defining conditions of perfect competition come nearest to being met in the production and sale of food and some raw materials. The output of any one producer, in these fields, is often very small in comparison to the total supply of the product, partly because scale economies are soon exhausted and partly because of fragmentation in the ownership of agricultural land. It has to be admitted, however, that markets of this kind, when they operate freely, do not exhibit the properties of an ideal system. On the contrary, they are often associated with much unwanted instability of price and output, so much so, in fact, that measures which deliberately regulate supply are often adopted by producers or imposed upon them. The analysis upon which we are now about to embark will explain how this result comes about; in the light of the criticisms of the theory of perfect competition just suggested, it may already appear far from surprising.

5 The availability of information Under what conditions will an entrepreneur be able to form estimates of the likely future demand for his output sufficiently secure to enable him to choose an appropriate scale of production? This is the question which must now concern us. The demand for the output of any one producer will depend upon two distinct circumstances: first, the extent of consumers' total demand for the

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good in question, and, secondly, the quantity of the good that competitors will put on the market. The producer will find it profitable to contribute to the supply of a good only if his own output, together with the output of all his competitors (the volume of competitive supply), is not greater than the amount of the good that can be sold at a price sufficient to cover unit costs of production. If he is to be persuaded to set up capacity to produce the good, an entrepreneur will wish to be assured that the volume of competitive supply is not likely to be excessive in comparison with the trend in consumers' demand. So long as consumers are allowed a free choice in the goods that they may purchase, the extent of their future demand for a cornmodity is unlikely to be amenable to perfectly precise prediction. This circumstance is likely to afflict those who set production targets in a centrally planned economy as well as individual entrepreneurs under private enterprise; in both cases, future trends will have to be estimated on the basis of a careful examination of past experience aided, in some cases, by schemes of market research. The need to make some estimate of the likely volume of competitive supply is, however, peculiar to the fully decentralized system of private enterprise in which the output of any commodity is generally determined by the production decisions of a number of independent entrepreneurs. The question before us can therefore be put in this way; under what conditions will an entrepreneur be able to estimate whether, when he comes to sell his own output, the likely volume of competitive supply is, or is not, given the expected trend in demand, likely to be excessive? I now propose to argue that the possibility of making such estimates will depend upon the precise market conditions or market structure within which the entrepreneur operates. Alternative market structures will be considered, for the time being, purely from the point of view of whether they permit information about the future volume of competitive supply to be obtained. It will be necessary in the following section to evaluate these alternative structures from the point of view of favouring effective competitive control. Let us begin by considering that market structure known as perfect competition. We shall suppose that the demand for a product is about to rise, and remain at, a higher level. An entrepreneur, knowing this fact, will realize that there is scope for a profitable increase in the production of the good; at the same time, however, he will realize that if the additional supply is excessive, all producers will make losses. Before himself deciding to invest in the

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further production of the good, he will therefore wish to make some estimate of the supply plans, in the aggregate, of his competitors. But, under the circumstances postulated, it is by no means clear that such information could be obtained. There is no machinery, in the system of perfect competition, which ensures that producers are kept informed about the supply plans of their competitors. Indeed, the very interdependence of these plans creates a barrier to obtaining information about them. hoducer A will not wish to take an investment decision until he has some knowledge of the total supply that his competitors, B, C, D et al., have decided to produce. But B, C and D are each in the same dilemma and do not want to make their own plans until they know what is being planned by A and all their other competitors. How, then, given this circular relationship, might it be possible for any one of them to take an informed investment decision? The solutions to this problem are of broadly two different kinds. The first kind requires the existence of circumstances which limit the number of firms able, at any one time, to respond to the market opportunity created by the postulated increase in demand; whether such solutions are compatible with perfect competition is at least doubtful. The second kind of solution is clearly incompatible with perfect competition, as it requires some measure of concert or cooperation, whether formal or informal, between the producers of the good in question. Each of the two classes will now be considered in turn. The first circumstance which could effectively limit the number of firms in a position to respond to the increase in demand would simply be widespread ignorance of the fact that it,would come about. It is quite likely, in fact, that some firms will come to learn sooner than others that a profit opportunity has arisen. Those first to appreciate the situation might then be able to invest in additional production confident that their slumbering rivals would not be doing likewise. In this way it is at least conceivable that there could take place a gradual building up of the industry's capacity, as the result of investment decisions taken successively, and independently, by individual entrepreneurs, as and when they learned of the opportunity available. But although differences in the rapidity with which different firms learn of an increase in demand could alone prove sufficient to make it possible to take informed investment decisions, there is no good reason for believing that, in practice, they would very frequently do so. Adjustment would be facilitated if, on beginning to install additional capacity, firms immediately

140 E C O N O M I C THEORY announced full relevant details, in order that other prospective suppliers could compare the likely future demand with the capacity both in existence and under construction. Arrangements to this end, for various reasons, do not normally exist. There is, however, a second circumstance likely to provide a natural check to the number of firms able to respond to the postulated increase in the demand for a commodity. It became apparent, from our discussion of a firm's long-run supply potential, that some firms are likely to be more able to invest in one particular direction than in others. Firms, for example, that are already established in the industry, or who have knowledge and experience of similar processes of manufacture, will have an advantage over complete outsiders. And even among these more qualified firms, not all, at any particular point of time, will have the funds and the managerial capacity to initiate an immediate expansion. It is possible, therefore, that those firms which are able to set up capacity in response to the increase in demand will find themselves with a relatively clear field; knowing that competitive investment by their rivals will not exceed some safe limit, they will themselves be prepared to invest. In this way differences in the ability of firms to respond to a profit opportunity, just as differences in their awareness of it, can make for an orderly build-up of capacity. The third circumstance favouring adjustment is the likelihood that firms will not have equally good access to potential buyers. Actual markets often differ from perfectly competitive markets in that each established seller within them has a group of customers normally inclined to buy from him rather than from anyone else. Self-interest alone can justify this kind of loyalty. If a buyer deals consistently with one seller, he may expect to obtain better service in reward; in a time of general scarcity, for example, his orders may be given priority. Even the fact that a buyer has been satisfied with the quality of a producer's goods in the past may induce him to give this producer preference over those with whom he has had little experience; this consideration will carry most weight where the merits or weaknesses of the goods concerned are not immediately apparent to prospective buyers. Inherent conservatism of this kind, which need not be irrational, can give to each firm in an industry a 'particular market', or group of customers to whom it will expect to sell more easily than can its rivals. But it is not the only force working to this end. In many markets, the product being sold will be differentiated; each firm, that is to say, will produce a version which is different, in appearance

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or in reality, from those of other firms. If this is so, any single firm may be in close competition with only a few others. The manufacturer of limousines will not have to pay much attention to the investment plans of those who make only bubble cars. In such a market, an increase in demand, such as we have postulated, will be differentiated; it will represent the aggregate, that is to say, of increases in demand for particular varieties of the product in which existing firms have established positions. Protection of a different kind may be afforded by transport costs, which, if they form a significant part of the price of an article, will cause any one producer to be in effective competition with only those others who have plants located not far from his own. The fact that there are differences in the ability of different lirms to sell their goods.,in addition to the other differences between them previously mentioned, will tend to limit the number of firms that are qualified to respond to a particular profit opportunity. As a result, it is much more likely that a producer contemplating investment will be enabled to set some upper limit to the potential supply of his qualified competitors and thus to have the kind of assurance he requires in order to invest. But there is no guarantee that, in any particular market, this will be so. All our analysis can do is enable us to say something about the circumstances in which, without planned co-ordination of the investment decisions of competing firms, the informational requirement for adjustment is likely, or unlikely, to be met. It is clear that the larger the number of firms already in an industry, or able rapidly to enter it, the more difficult it will be for any one firm to estimate the volume of capacity being installed by the others. This difficulty will be enhanced if many firms become aware of the existence of a profit opportunity at the same time. And it will be greater still if the products of different firms in the industry are sufficiently the same for consumers not to differentiate between them, and if there are no bonds, between buyers and sellers, of loyalty or custom. These considerations suggest that the informational requirement would be unlikely to be fulfilled, for example, in agriculture. Even within a single country, there will usually be a large number of farmers who currently produce wheat, eggs or pigs, or who could readily switch resources into their production if this appeared worth while. As all producers will have very much the same information, or lack of it, upon which to estimate future trends in ultimate consumer demand, they are likely to hold rather similar expectations. Because of the fact that the decision to increase the output of

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a n agricultural commodity may have to be implemented at some particular season of the year, much investment may take place simultaneously, thus ruling out the possibility of a gradual build-up of supply. And as at least a year will usually have to elapse before output plans come to fruition, the current supply may give little indication of the volume of supply which is on the way. For all these reasons, the individual farmer, assuming that there is no deliberate co-ordination of plans, may find it very difficult to take an informed investment decision: as a result, there may therefore be little chance of an efficient adjustment of supply to demand. Agricultural output does in fact show considerable instability, although all of it cannot be attributed to the fact that producers have to act more or less in the dark. The unpredictability of the weather is itself a potent cause of fluctuation and the effects of excess supply may be made more serious by the impracticability of storing imperishable commodities and by the fact that a reduction in price will frequently not persuade consumers greatly to increase their purchases. But even in the absence of these other factors, the inability of producers to estimate the volume of competitive investment would itself set up instability. Much of what has been said of agricultural also applies to the production of some raw materials. It is relevant also to a trade such as building, which can be entered easily by entrepreneurs with no very special skill and only very, limited capital. In this trade, as in many others, the fact that the level of ultimate consumers' demand may itself be difficult to forecast is sufficient in itself to prejudice efficient adjustment; the point made here is that the organization peculiar to the industry (the particular 'market structure' as it is sometimes called) will independently have the same effect. Let us now turn to consider the ways in which firms may impose conscious co-ordination upon their investment decisions. Our immediate concern is exclusively with the ways in which such coordination can cause the informational requirement for adjustment to be met; we are interested, that is to say, in how an agreement between firms, by supplying each with information about the plans of the others, may provide more secure market opportunities. It will be necessary to ask, at a later stage, whether the existence of agreements is compatible with competitive control. Let us recall that, in order that some firms should be prepared to invest in response to a profit opportunity, others have to be restrained from doing so. Firms might be held back, we concluded through having failed to appreciate the opportunity soon enough,

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through lack of supply potential, or through lack of established contacts with buyers. All these restraints might be called natural, in that they are not created deliberately for the purpose. When firms collectively co-ordinate their investment decisions, they in effect create artificial restraints on their freedom of action, in the hope that, by doing so, profitable markets can be secured for all. Thus each firm may be allotted a quota representing the maximum amount which it is permitted to produce, or given a geographical region within which it must confine its sales. Arrangements of this kind will not free firms from uncertainty as to the trend in the total consumers' demand for the product, but will at least relieve them of the uncertainty about the future volume of competitive supply. Firms can normally make such agreements, however, only with competitors already in the business; it is hardly likely that firms which do not already produce the commodity, but which could do so, will voluntarily bind themselves not to enter the market. Usually, therefore, collusive arrangements will achieve their purpose only where there are barriers to the entry of new firms into the industry. Such barriers may be set up by the advantages which established producers may have over new-comers simply by virtue of their experience and reputation with buyers. But entry may also be impeded by barriers deliberately erected by those inside the industry. I shall mention later some of the ways in which this can be done. The possible harm that these measures may cause is a matter to which we shall also soon turn; all we note now is that, to the extent that entry can thus be blockaded, concerted arrangements between existing firms are likely to be more effective in providing each of them with a predictable share of the total market for a good. Agreements of the kind which we have been discussing represent a partial abandonment of the decentralized decision-taking which was the hallmark of the private enterprise system. Amalgamation between firms represent a somewhat larger step in the same direction. If it is carried to the point at which there is only one firm left in the industry, then the problem of obtaining information about competitive investment is effectively disposed of, and the remaining uncertainty in estimates of profitable market opportunities will arise from uncertainty about ultimate consumer demand itself.

6 Competitive control I n my preliminary account of the working of the private enterprise system, competition was allotted a key role; it caused control over

144 ECONOMIC T H E O R Y resources to pass to those most able to employ them profitably and, by virtue of its influence on the formation of prices, it promoted efficient allocation. Let us recall the nature of the discipline which competition imposed. First, by obliging each firm to pay as much for productive factors as do its rivals, competition ensured that the prices of these factors were uniform and such as to bring the demand for each factor into equality with its supply. Secondly, the presence of actual or potential competitors prevented firms, in the long-run, from char'ging prices in excess of the cost of the marginal inputs (taken to include a normal rate of profit) required to produce their goods. We shall be able more fully to appreciate the need for competition if we examine how a firm would act in its absence. Let us therefore begin by considering a firm which has to purchase inputs at given prices, competitively determined, but which, being the sole producer of its own particular kind of output, is free to set its selling price. Let us set aside the questions of the adequacy of the information available to this monopolist by assuming that he can predict accurately how much of the product will be bought at different prices. What volume of output will he plan to produce? And at what price will he sell it? These decisions, let us first observe, will not be taken independently. There will be a maximum price at which any particular volume of output will be freely bought by consumers; and, for any given price, there will be a maximum amount that can be sold. Let us assume that the monopolist wishes to obtain maximum profits, so that he will choose that volume of output for which MR is equal to MC. In fig. vii is drawn the demand curve for the good in question; for a monopolist it also represents the relationship between sales and price charged. In order to increase the volume of sales, it will be necessary to set a lower price. Thus MR, for any volume of output, will be less than price, for against the amount of money, equal to the new price, obtained from the sale of the additional unit of output, will have to be set the loss resulting from the fact that all units are now being sold at a lower price than previously.1 Thus the curve of MR lies below the demand curve. The cost curve of a monopolist, on the assumption that he has no I. I am assuming that all units of output have to be sold to customers at the same price. A more thorough analysis would allow for the fact that it is sometimespossible for a monopolist to sell his output at more than one price.

I

0

Quantity Fig. vii

control over the prices of productive factors, will be the same as that of a competitive producer. In fig. viii demand and cost curves are combined, it being assumed that the most profitable output, at

A Fig. viii

Output

which MR equals MC, lies within the range of constant UC, where scale economies are exhausted and financial and managerial check! not yet in operation. The most profitable output is OA, where unit costs are AB, price AP and the excess of price over unit costs BP. It is easy to see that the particular output which maximizes the I45

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profits of a monopolist is therefore less than the socially desirable output. As we have assumed that factor prices are beyond the monopolist's control, MC will equal CMI. As price exceeds MR, which equals MC, it must therefore exceed CMI, so that the optimum condition is violated. Were we to assume that price did not diverge significantly from CMI in other markets, then it follows that the assortment of production contains too little of the monopolized good. We have taken the case of a firm with a monopoly in the sale of its output, but faced with input prices beyond its control. The absence of competition in the buying of inputs can itself be an additional and independent cause of misallocation. It is possible for one firm to be the principal purchaser of one particular resource, such as skilled labour, within a locality. Were this so, then the wage rate offered by the firm would have to increase with the number which it wished to employ; reluctant workers, or those living at some distance from the factory, would demand specially high wages, and these high wages would have to be given to all the other workers already doing the same job. Under these circumstances, MC would, at least over some ranges of output, exceed CMI; it would consist both of the wages paid to attract the additional workers and the increased wages which the entrepreneur would have to pay to those already employed. If, therefore, in maximizing profits, MC were made equal to MR, CMI would fall short of MR. Even if MR equalled price, CMI would be less than price, thus indicating an output less than optimal. If also, in the absence of competition in selling, MR was less than price, there would be two causes of divergence between CMI and price. What we have therefore shown is that, so long as the prices that an entrepreneur has to pay for inputs, or can obtain from his outputs, depend upon the amounts that he buys or sells, then he will be led, in the pursuit of profit, to choose a level of production less than that socially desirable. If such deliberate restriction is to be made unprofitable, then competition will have to be strong enough to establish ruling market prices, independent of any one producer's purchases or sales, and thus ensure that there is no difference between price and MR, or between MC and CMI. We have to remind ourselves that this is not a sufficient condition for attaining an optimal adjustment; it is not enough for entrepreneurs to lack the incentive to restrict output below its socially desirable level; they must also have markets sufficiently predictable to ensure that misallocation does not result simply through errors of foresight.

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Having accepted the need for competition, what can we say about the circumstances likely to promote or inhibit it? Competition will clearly be inadequate where only one firm is in a position to produce any particular product; misallocation will result, the extent depending on the degree of substitutability between this product and the alternatives to it. But the fact that more than one firm sell a product does not in itself ensure competitive behaviour. If the existing producers of a good act in concert, and if new rivals find it impossible to enter their market, then they may behave as a monopolist. They will realize that, with a less than perfectly elastic demand for the good they produce, their combined profits will be maximized at a total volume of supply less than that which would bring price down to the level of CMI. They thus have an incentive to agree to divide the market between them, maintaining the price of their product at the most profitable level. An arrangement of this kind will endure, however, only so long as the parties to it can agree as to the distribution of the monopoly profits which it provides. If one particular entrepreneur feels that he has been allotted less than his fair share of the market, or believes that he has a marked advantage over his competitors, either by having lower costs or a more attractive product, then he may decide to break loose from the agreement and to endeavour, by a small reduction in price, to increase his turnover and profits at the expense of his erstwhile associates. If all were to adopt this policy, aggregate output of the commodity would rise, its price fall, and the group as a whole would no longer earn abnormally high profits. This consideration might deter any firm from breaking the ranks, but it is perfectly possible that one entrepreneur might prefer to seek his fortune in independence, trusting that others would be too timid to follow suit. In order to restrict their combined output, firms may enter into one of several forms of agreement. At one extreme, they may subscribe formally to a strict, detailed and unambiguous set of rules designed to prescribe for each firm the quantity of the commodity which may be produced and the price at which it may be sold. Fines may be made payable by those who exceed their allotted sales quotas, and punitive measures may be taken against those who break away from the association. At the other extreme, the members of an industry may be bound by no more than a loose convention, according to which, for example, they may not alter price without consulting, or at least informing, their associatzs. It is also possible, however, for firms to adopt policies which will maintain price above cost, even when there is neither agreement nor convention between

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them. Where they are few in number, and the actions of each are closely observed by the others, a strong sense of the interdependence between their individual decisions is likely to develop. Any producer who contemplates obtaining an increase in sales by slightly reducing his price will not fail to realize that the others will not stand passively aside while their markets are encroached upon. It will be apparent to him that his lower price would be matched by his competitors and that the profits of the group, in the new situation, would be less than they were before. It is impossible to say a priori, in these circumstances, whether entrepreneurs' sense of common interest will be strong enough to ensure that the profits of the group as a whole are-at least approximately-maximized, so that capacity is below the socially optimal level, or whether the spirit of rivalry between firms will move them to compete for larger shares of the market, so that capacity is expanded to the point at which price equals cost. Something can be said about the particular circumstances, or market structure, which, in the absence of a formal agreement, will promote or inhibit competition between f3ms. The fewer the number of firms in the industry, the more likely are they to abjure price competition; each will maintain his price at a level yielding monopoly profits in the hope and expectation that the others will do likewise. Where the business is divided among many firms, however, only a formal agreement is likely to produce this result. Each firm, when competitors are many, is under temptation to reduce its prices, so as to enlarge its share of the market, in the hope that the effect on others will be too small to induce retaliation. And even if some firms would have been prepared to stand firm, they will not wish to be forestalled by others whom they fear will not do so. The sense of mutual solidarity, of common interest, will be too weak to preserve a monopoly price. The most important precondition for the successful restriction of capacity, in the hope of securing a monopoly profit, is that firms not already in the industry should somehow be prevented from entering it. If this cannot be done, then a policy designed to restrict capacity and raise price, whether pursued by one firm or by concert between several, would merely invite newcomers to exhaust the remaining profit opportunities. Under what circumstances, in practice, would entry into an industry be blocked? Let us begin by recognizing that the notion of ease of entry requires interpretation. What concerns us is the extent of the advantages which established producers of a commodity have over newcomers to the trade, whether these be either new firms or

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existing firms previously c o n k e d to different spheres; the difficulty of entering a market is therefore a matter of degree; the greater the difficulty, the greater will be the level of profits, which, by restricting output, established producers are able to exact. Outsiders may be at a disadvantage for several different reasons. First, it may take them longer, through lack of knowledge, experience and a nucleus of trained staff, to set up capacity. Secondly, their production costs, once capacity has been installed, may be higher--either for a time or permanently-than those of established firms. Thirdly, their selling costs may also be higher, because of the need to inform or persuade consumers of the merits of their hitherto unfamiliar goods. The first of these circumstances-the fact that outsiders may take longer off the mark, in response to an increase in the demand for a commodity, than do firms already producing it-scarcely constitutes a real barrier to entry. It makes it more likely that new firms will find it impossible to get a foothold in the market, but only so long as it can be assumed that the established producers will themselves install aggregate capacity sufficient to leave no unexploited profit opportunity. As to the second circumstance, there are a variety of reasons why outsiders may have higher unit costs of production than the established firms. Most obviously, they will be at a disadvantage in terms of experience; as we have already had occasion to note, many branches of manufacturing will have their peculiar tricks of the trade which can be learned only through practice. Whether this factor will constitute a significant barrier to entry will depend chiefly upon the length of time it takes for the personnel of a firm to acquire the necessary knowledge and experience; this will differ from one industry to another, but one is inclined to doubt that it will frequently be so long as to prevent outsiders from responding to a large profit opportunity. The possession by the established firm, or group of firms, of exclusive knowledge of an important manufacturing process, which they have succeeded in keeping secret, or for which they have obtained a patent: constitutes a more serious barrier to I. The possession of a patent for an article, or for a particular process of manufacture, confers the exclusive right to sell the article or make use of the process. Rights of this kind are granted by most governments in order to compensate private persons or firms for the trouble and expense to which the discovery or invention has put them. Patents can normally be sold or leased, by their original owners, and they are valid only for a limited period of years.

150 E C O N O M I C THEORY entry, behind which established firms may continue to enjoy abnormally high profits for a considerable time. A new entrant may also have specially high costs for the reason that an important input, or channel of distribution, has, through the actions of the established firms, been denied to it. Thus, for example, an aluminium producer might endeavour to control all the good available sources of bauxite in order to preserve for themselves a monopoly position in their field. By measures of this kind, the costs of outsiders can be raised so substantially as to enable the established firms to earn very high profits without entry taking place. The costs of potential entrants may also be high because they are unable to attain the scale of production required to minimize unit costs. In consequence of the policy of the established firms, the industry's total capacity may be such as to leave price in excess of the cost of the marginal inputs; at the same time, however, the installation of a further plant sufficiently large to gain full-scale economies might produce such an increase in output as would depress prices below cost. This possibility would be of importance in practice where the smallest unit of capacity capable of minimizing unit costs represented a fairly significant proportion of the total sales of the good. The third barrier to entry resulted from the fact that, even where new entrants could produce an article as cheaply as establishedlirms, they may have to spend more money, initially, in order to sell it. Reasons have already been given for the favour which purchasers are likely to show to firms with which they have grown accustomed to deal or to firms which have already built up a wide reputation. If the degree of this discrimination is marked, then newcomers may be deterred from attempting to break into the industry even although the profits of the insiders have been consistently high. The height of this barrier will, in practice, vary greatly from one trade to another. Much will depend on whether the buyers are able themselves to form a proper appreciation of the merits of alternative products. Firms are likely to be better informed as buyers than are ordinary consumers, especially when the article being bought is technically complex. If the cost of an article is small, and if its qualities and defects are soon detected in use, then there is less risk incurred by trying out the products of a new firm. But life is too short to permit much experimentation of this kind in the purchase of, say, a car or a steam turbine. Conservatism, therefore, may have a rational basis, but it is also possible that the consumer

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may remain faithful to a particular brand simply through having its name brought continuously to his mind by advertising. This in itself has a particular relevance to the difficulty of entry. Frequently, more massive advertisement may be needed to acquire customers than to retain them. Advertising itself, moreover, since the development of national broadcasting and national newspapers, may show important scale economies, and will therefore have to be invested in very substantially or not at all. A substantial investment in advertisement, however, will be justified only by massive investment in production itself. A potential entrant may therefore be faced with this dilemma: unit costs can be minimized only by entry on a large scale, but entry on this scale would depress prices below a remunerative level. The notion of 'ease of entry' into an industry is no more precise than is the notion of an industry itself. An industry, for the purposes of this present analysis, must refer to a group of firms with products that are closely competing, and it is easy to find different product groups, such as television sets and fountain pens, within which there is competition and between which there is not. But we have to observe, first, that competition between the different products within such a group will be of varying intensity, and secondly, that competition can take place also between firms which are in product groups which, technologically at least, are wholly distinct. Thus cellophane competes with paper, and nylon with wool. These considerations can either mitigate or strengthen the force of competition. One particular producer may be lucky enough to find a secure niche in making a product specially suited to a limited group of consumers; others may be able to copy the product and invade his market, but may be deterred by the fact that it is not large enough to support two firms of optimal scale. Thus the differentiation of products may result in some prices remaining above costs. More important, however, is probably the fact that the power of producers to raise price above cost-through some collusive action-will be limited not only by the threat of entry into their trade but also by competition from products which are economically effective substitutes even although technically distinct. The reader will have been struck by the fact that the conditions which now feature as unfavourable to competitive control are precisely those which appear most likely to afford entrepreneurs with predictable markets. Are we therefore to conclude that, in practice, market structures will never meet both the requirements for efficient allocation?

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This conclusion would be much too sweeping. Ideally, a producer should have a market for his goods sufficiently assured for him to be able to be prepared to invest, but not so protected as to permit him either to exact a monopoly revenue or to escape encroachment by more efficient rivals. Such conditions may in fact obtain. Firms already established in a market may have certain advantages, such as experience or customers' goodwill, which naturally afford them a 'first option' of meeting any increase in demand but which are not strong enough to enable them, for long, to charge a price much above the costs of a producer of normal efficiency. These established firms may predict their sales by assuming that their share of the total market will remain roughly the same provided that they can remain as efficient as their competitors. Given circumstances of this kind, firms may be able to take informed investment decisions, and promote orderly adjustment, without being free from the pressures of competitive control. It would be wrong to imagine, however, that, in any actual private enterprise economy, every market is likely to be so suitably organized. It may be that the total sales of a good are in the hands of a single firm, which has succeeded in blocking the entry of others. To ensure that output is not deliberately restricted in order to obtain monopoly profits and that production is managed efficiently, the government might then decide either to nationalize the firm or to subject it to government control. It may also be that a group of firms operates restrictive agreements which are not necessary to provide them with reasonably predictable markets; the public interest may then require that these agreements be made illegal. It is also possible that, in other markets, chronic maladjustment is to be avoided only by the planned co-ordination of investment decisions at the sacrifice of free competition. If this is the case, it will be necessary to find some other means of promoting the ends which competition normally serves. Our analysis cannot therefore tell us whether, in general, restrictions on competition are good or bad, or whether central coordination of investment plans is or is not desirable. All it can do is provide us with the means of answering these questions within the context of a particular industry at a particular time.

The short-run adjustment of supply to demand 1 The rate of output

Our discussion of the process of adjustment in the private enterprise economy has been concerned, up to now, with the relationship between capacity and demand. We must now ask ourselves whether entrepreneurs, in the pursuit of profit, will act so as to ensure that given capacity is employed to produce the flow of output which is appropriate at any particular time. Our criterion for appropriateness remains equality between the market price of a good and its CMI, but both price and CMI required to be defined carefully. In the context of long-run adjustment, the relevant price is that which a good will fetch, on average, over the life of the equipment used to produce it, and the CMI relates to the cost of all the marginal inputs required both to construct and employ this equipment. Once capacity is taken as given, the cost of constructing it having already been incurred, we are concerned with the price that a good will fetch at a point of time and the cost of the variable marginal inputs used, in conjunction with the given fixed capacity, to produce it.l As in the case of long-run adjustment, we shall begin our analysis by considering the two determinants of investment decisions; first, the supply potential of an individual firm,and secondly its market opportunities. In the short-run, by definition, an addition to the output of a good can come only from those fkms which already possess the appropriate fixed equipment and employ the appropriately skilled staff. It is therefore with the potential supply of these firms only that we are concerned. Each one has a plant which, I.

Vide p. 93. I53

154 ECONOMIC THEORY although designed to produce a certain volume of output, can normally be worked at varying degrees of intensity. Reasons have already been given (pp. 95-6) for expecting unit costs, under such conditions of short-ruu adjustment, first to fall as output rises, and then, as the limits of the existing capacity are approached, to rise. These then are the circumstances affecting a firm's ability to vary its output; to what extent will it be able to predict the market for its goods? The reader will already be familiar, from the discussion in the previous chapter, with the factors upon which the answer to this question will depend. The availability of information will be at a maximum for a monopolist controlling the total supply of a particular good; he will have to estimate the demand of consumers but not the production plans of competitors. The difficulty in predicting sales will be greatest, on the other hand, when many fams are fitted out with the appropriate capacity and are all equally ready and able to respond to an increase in demand. Given such a market structure, entrepreneurs, acting independently, will find it impossible to estimate the volume of supply being projected by their rivals, and, by implication, the rate of output which it will be profitable for them themselves to produce. Uncertainty about competitors' plans can be eliminated if the firms concerned divide the market between themselves in some agreed way, each of them being allotted a particular output quota. The threat of competition from newcomers does not exist in the short-run, which, by definition, precludes the setting up of new capacity in the industry. An arrangement by which firms agree to sell their goods at a common price, even if they do not formally divide up the market, will also make it easier for entrepreneurs to predict their likely sales. We have already remarked that, in many industries, each seller has a body of customers which prefers his goods to those of his competitors; whether the grounds for this preference are the distinctive character of each seller's goods, gratitude for good service in the past or merely inertia, they will serve to induce purchasers to buy from one seller rather than another, provided that there is no great difference in the prices which they charge. It follows, therefore, that if all sellers maintain a common price, each of them will be able to estimate, on the basis of past experience, the share of the total market which they can expect. Given that consumers' preferences change, it might be hazardous for a firm to assume that its share of the market would continue for very long to be the same in the future as in the recent past; but, for the short period with which we are concerned, the assumption may be well warranted.

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155

Relative shares in a market may frequently remain constant, in fact, even in the absence of a price agreement between manufacturers. Firms very frequently keep prices stable in the face of shortrun demand fluctuations, altering them only to take account of changes in wage and material costs. If, as is likely, these changes affect competing manufacturers in equal degree, then the relationship between the prices of their goods will vary little in the short period. There are several reasons why producers adopt the policies they do. Frequent price changes are a nuisance to the firm itself, to its distributors and its customers. One manufacturer will know that, if, in time of weak demand, he reduces his price, his competitors will probably feel obliged to follow him--especially if there are only a few firms in the industry, each of which keeps a close eye on the activities of the others. Should this happen, the firm which first cuts price may find itself worse off than before; it will not have succeeded in attracting custom from other firms but merely maintained its share of the total sales. These total sales, it is true, may now have increased, as the general reduction in prices may stimulate demand, but each firm may find that the increase in the number of units which it sells fails to compensate for the reduced margin of price over unit costs. Such an unfavourable result is more likely in the short than in the long-run, as customers' response to a change in price may be substantial only after they have been given time to make adjustments in their pattern of consumption, or, if they are themselves firms, after they have modified the processes of production which determine their input requirements. Price reductions will therefore be infrequent. So also will price increases, for producers will fear that a price increase, in times of specially high demand, and especially if rivals do not raise their prices, may cost them the goodwill of their customers. In many markets, therefore, one may expect to find that firms maintain prices stable in response to short-term demand changes, endeavouring neither to increase their share of the market, by a price cut, when demand is wealc, nor charging what the market will bear when demand is buoyant. Whether this policy is the result of express agreement, or convention, of a sense of fairness, or of enlightened self-interest, it is likely to increase each firm's ability to foretell its likely share of the market in which it sells its goods. In that it facilitates foresight, short-run price rigidity, like monopoly and market sharing, is advantageous. Nor is it likely to protect h s from the incursions of rivals, which, by virtue of their superior efficiency, can afford to charge, permanently, a lower price.

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On the other hand, it will inevitably result in frequent divergences between the price of a good and its CMI. If, when demand is in temporary decline, output is reduced but price is not, then price will normally exceed the cost of the additional variable factors needed to produce a marginal increase in output from the existing plant; this implies that output will be below the optimum level, purchasers being willing to pay, for extra units of the good, a price greater than what it would cost to produce them. In practice, however, such misallocation may be of slight importance. If the demand for a product is inelastic in the short-run, then a reduction in its price would make little difference to its sales; this being so, the actual output, at the maintained price, will not fall far short of the optimum output at which price would equal CMI. This misallocation may be a small price to pay for the advantage, afforded by short-run price stability, of predictable market shares.1 2 The rate of sales We now come to the third of the principal allocative decisions which those in control of an industry, whether under private or public ownership, will have to take. The first had to do with the optimum rate of capacity formation, and the second with the optimum rate of output which given capacity should be used to produce. The third decision concerns the optimum rate of sales (and, therefore, the optimum rate of investment in stocks) during any period. All these decisions rest upon estimates of future demand, but the relevant time horizons are different in each case. In considering the installation of fixed equipment, management will endeavour to predict demand over a period of years. Rates of output, from given equipment, will be based on forecasts of what demand will be some weeks or months ahead, when the goods are produced. The decision to augment or diminish stocks relates to demand in the present and the near future. I . Mention should be made of a further advantage afforded by shortrun price stability. On the reasonable assumption that the demand for their commodities is rather inelastic in the short-run, producers will suffer a greater fluctuation in their receipts (resulting from short-runfluctuations in demand) when prices are flexible than they do when prices are fixed. Such fluctuation, especially when unpredictable, makes it difficult to plan expenditure and is likely to deter investment in the business activity concerned. A mitigation of the fluctuation in receipts, other things being equal, is a social gain.

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Let us begin by observing how the second and third types of allocative decision are related. The optimum rate of output, we decided, was that which equated the price of a product to its shortrun CMI. When applied in practice this rule will have to be based on estimates of the price the output will fetch and of its CMI. By the time the output is produced and ready for sale, management's time horizon will have altered and it should be able to make a fresh, and improved, estimate of the demand then actually current. It may then appear that the original estimate of demand was erroneous, so that the current level of output is greater or less than that which is appropriate. But, by the time it is perceived, this fact is irrelevant; the earlier decision cannot be reversed, the output is available and it remains only to decide upon its disposal. What should be the current rate of sales? And, by implication, to what extent should present stocks of the commodity, in the hands of producers and distributors, be augmented or run down? The formal criterion already employed to identify the optimum level of output continues to be relevant, if properly interpreted, to these allocative decisions. Ideally the price which a good is to fetch in any future period should equal the cost of the inputs necessary to make a marginal unit of it available; if in fact it is to be made available by carrying forward a stock then the appropriate CMI is the price of the good in the current period together with the costs, at the margin, of interest and storage. This criterion, however, is much less widely applicable than might at first appear. The prices of manufactured goods, we have already noitced, are usually kept unchangedinresponse to short-run demand fluctuations, stocks being varied to meet any difference between current sales and current production but not in order to take advantage of inter-temporal differences in price. In the case of many foodstuffs and raw materials, however, prices do fluctuate, and traders, in the hope of a profit, carry stocks forward when they expect prices to rise. If price changes could conceivably be foreseen with accuracy, such 'speculation', as it is called, might fulfil our condition for efficiency in allocating goods between different time periods. Competition would be essential, as in the forms of adjustment considered previously, in order that prices, both current and future, should be independent of the purchases and sales of any one individual speculator. Under these circumstances, however, perfect foreknowledge of prices would scarcely be possible. Each speculator would have to estimate both the strength of demand in future periods as well as the supply which will then be forthcoming both from production and from other

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speculators who have carried goods forward over time. Given the great uncertainty introduced by the interdependence of all these decisions, foresight is likely to be highly imperfect-so much so, in fact, that speculation may sometimes aggravate, rather than correct, a misallocation of resources. In practice, therefore, a regime of price flexibility may be less likely to promote allocative efficiency than the practice of maintaining prices stable in the face of short-run fluctuations in demand.

3 The search for an ideal market structure Let us now, at the cost of some repetition, take stock of the position which our argument has reached. Our aim was to investigate the prospects of attaining successful supply adjustment as a result of the investment decisions of individual firms free from any superimposed central direction. We began by identifying two requirements for successful adaptation-that of adequate information and that of competitive control-and then sought to find out the type of market structure most likely to fulfil them. That there may be some conflict between the requirements became apparent; if entrepreneurs were to be able to foresee a profitable market for their goods, they required at least temporary protection against excessive investment by competitors, but, if they were to be obliged to produce efficiently and to charge no more than costs including normal profits, then their markets had to be vulnerable to the encroachments of others. Thus the market structures which appeared to provide the most competitive control seemed least likely to meet the informational requirement, while those which seemed most likely to permit entrepreneurs to predict profitable markets were those in which the pressures of competition were weak. Let us recall the reason for this conflict. No producer will be assured of a market for his goods, I argued, unless there is some limit to the supply which his competitors can bring forward. Thus there have to be restraints, either natural or artificial, on firms' supply potential. The ability to respond to a profit opportunity can be limited, naturally, by shortage of funds or of managerial talent, or by the fact that some firms are less qualified than others to produce particular goods or to sell in particular markets. (Factors of this kind can equally well be regarded as the restraints which bind some or the advantages which favour others.) Alternatively, firms may artificially limit their own scope for action by agreements or conventions regarding prices and markets.

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159

On the face of it, all these restraints would appear to sap the force of competitive control. Sometimes, however, their harmful influence will be very slight. Some firms may have advantages over others (such as being already established in the market or having the appropriate technical experience) sufficient to give them the 'first option' of seizing a profit opportunity, but neither strong nor permanent enough to provide any enduring shelter for abnormally high profits, or abnormally high costs. Differential advantages of this kind may facilitate orderly adjustment without preventing capacity from ultimately being expanded to the point at which price comes to equal the cost of marginal inputs. The fact that the build-up of capacity may be gradual, it is true, will enable those first to invest to sell at a price greater than cost. The excess profits they thus earn are a sign of imperfect adjustment, but we have to bear in mind that it is through their creation that the economy's selective mechanism must work; this is the way in which those entrepreneurs who can best foresee consumers' requirements in advance, as well as those who produce at lower cost than the majority, are given the means to expand more rapidly than their rivals. Misallocation becomes a serious threat when the firms already producing a commodity have a marked and permanent advantage over potential entrants into their industry. If this is so, then the established producers are given the opportunity to co-operate in the restriction of output knowing that the excess profits they can thus earn will be enjoyed with impunity. Even in such cases, of course, there will be a limit to the extent to which prices can be raised above costs, or to which actual costs may, through inefficiency, exceed what they might be; this limit will be determined by the alternative products to which buyers can turn, and, if these are very imperfect substitutes, may be wide enough to permit serious misallocation. Only governmental regulation can then prevent a monopolist or an association of producers from exploiting their position to the public disadvantage. Thus it appears that there will be an optimum strength for the restraints which ensure that a profit opportunity, by not being open to all, can actually be exploited by some. Misallocation may result either from lack of information, where very many E m s are all equally free and able to respond to an opportunity, or from monopolistic restriction, where the market for a commodity has become a highly protected preserve for an associated group of producers. Adjustment may sometimes take place as a result of an orderly sequence of independent investment decisions, but may

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sometimes require the abandonment of pure decentralization in favour of concerted planning. Sometimes competition or the threat of entry by new producers may keep established firms from raising price above costs, but they cannot be relied upon to do so always. In the absence of any effective competitive check, private profit maximization is no longer to the public benefit and pure private enterprise may have to be replaced by government control or government ownership. We have no alternative save to keep an open mind about the suitability of different arrangements to different circumstances. The reader may be disappointed that our analysis has produced such hesitant and untidy conclusions. Economic policy decisions would indeed be facilitated if we could set up an ideal market structure against which actual structures could be set for judgement by comparison. Some economists do in fact claim to have found such a blue-print or standard in the system known as 'perfect competition' to which I have already referred. This model system, indeed, forms a cornerstone of most elementary textbooks on economics; the analysis of this chapter, and of that which preceeded it, puts us in a position to assess its usefulness. No one has claimed that the system of perfect competition is realistic, in the sense that the conditions which define it are those generally found in private enterprise economies: everyone recognizes that simplification and abstraction are inherent in any attempt to construct a model of real situations and processes. What has been maintained is that perfect competition has two important uses: first, that it can often help us to explain the working of an actual private enterprise economy, and to predict the values which prices and outputs will assume, and, secondly, that it serves as a standard or criterion against which actual economic organizations can be appraised. Perfect competition earned its reputation as an ideal market structure because of the belief that, to the extent that the conditions defining it were realized, resources would be allocated so as to exhaust all profit opportunities. No one, in my view, ever provided a fully satisfactory explanation of how this was to come about; all that was demonstrated was that, under perfect competition, important impediments to the attainment of such an allocation would be absent. Thus it was appreciated, for example, that misallocatio~l might result where a producer, by deliberately restricting his supply, could raise price; the ideal structure therefore appeared as one in which there were so many firms that no single one of them made any significant contribution to total supply. As agreements between firms could also result in the deliberate restriction of output, all forms of

collusion were expressly banished from the model. Finally, as a profit opportunity would obviously fail to be exploited if no one was aware of its existence, 'perfect knowledge' (however this is to be interpreted) was frequently represented as a further attribute of the ideal system. It was illegitimate to conclude, however, that in the absence of these impediments to efficient allocation, efficient allocation would necessarily result. What I have referred to as the informational requirement for successful adjustment was throughout ignored; it did not appear to be realized that where, as under perfect competition, profit opportunities are equally open to all producers, no single producer would have a market prospect secure enough to induce him to invest. But once the informational requirement-and not only the need for competitive control-is given its due, it becomes clear that the conditions favourable to successful adjustment are not those laid down in the perfectly competitive model. This conclusion has important implications for policy. So long as perfect competition is the standard, market structures in the real world are judged according to the extent to which they conform to it. Thus the concentration of production in the hands of a few iirms, or the existence of agreements between firms, have invariably to be condemned as undesirable imperfections which it should be the aim of policy to mitigate or remove. If this view were correct, governments might find it easier than they do to frame laws against monopolies and restrictive practices; in fact, however, it is the product of an analysis which, though recognizing the need for competitive control, completely ignores the need for adequate information. As such, in the opinion of the author, it is useful neither in explaining the working of actual competitive systems nor in appraising their efficiency.

The general level of employment, output and prices 1 Introductory

From now on we shall shift the focus of our attention from the factors which, under private enterprise, regulate the supply of particular goods to those which determine the aggregate volume of output as a whole. Whereas previously we were concerned with whether individual goods would be produced in appropriate quantity, in accordance with the conditions for optimum assortment, we shall now ask, in this chapter, whether the aggregate output of all goods will be sufficient to ensure the full employment of all the available scarce resources. In the following chapter we shall analyse the factors which determine the general level of money prices ruling at any particular time. The aggregate volume of output, and therefore the employment given to factors of production, was determined, in a regime of state ownership, by a decision of the central government. Output targets were set deliberately to ensure that all scarce material resources were fully taken up and that everyone who wished to work, at the current wage rate, could do so. In a system of unregulated private enterprise, on the other hand, the level of aggregate output and employment is determined, not by any single policy decision, but by the many independent and unco-ordinated production plans of individual entrepreneurs. These plans depend, in turn, upon the amount of goods which entrepreneurs expect to sell. Future demand will itself depend, very substantially, on the incomes which consumers will receive, and therefore on the production plans, and implied factor requirements, of entrepreneurs. Here therefore we have a circular relationship. All firms taken together, that is to say, by virtue of the I 62

money they pay workers and the owners of material resources, create the demand for which they also cater. In this respect, the production programmes of different firms are complementary, in that each of them generates incomes which feed the demand upon which others depend for their profitability. The dependence of the demand for any one firm's products upon its own production programme or on that of any other single firm will be very slight, for the incomes paid out in fulfilment of the programme will be spent on a great variety of goods. But the demand for a firm's output will be decisively affected by the expenditure-on wages, interest and rent-of all other entrepreneurs taken as a whole. We have already studied that form of inter-dependencewhich owes its existence to the fact that firms may compete for the same market or may purchase each other's output; here now is an additional and much more pervasive form of inter-dependence, deriving from the fact that production creates income. In practice, of course, producers cannot hope to have any precise information about the aggregate incomes that consumers will earn or about how they will distribute this income between different goods. Their estimates of the future demand for a product will often be grounded on the simple assumption that the future will not differ much from the past or that present trends can safely be projected. Inevitably such predictions will bear the mark of the mood, either of optimism or pessimism, in which most business men find themselves. If many entrepreneurs are apprehensive about their future prospects, then this fact alone can cause this apprehension to be justified in the event, for if these entrepreneurs cut back their production programmes, then employment, incomes and therefore also demand and sales will be depressed. Widespread optimism, on the other hand, if it leads to an expansion of production, can bring the increase in demand-via an increase in incomes-for which firms were confidently hoping. These considerations do not lead one to suppose that, in a system of unregulated private enterprise, the demand for productive factors will necessarily be enough, and no more than enough, to take up all the supplies available at current prices. It might at first appear, in the case of a deficiency of demand for factors, that the prices of factors would fall-given sufficient competition-until their supply was fully absorbed. If demand were merely maldistributed-too much being required of some factors and too little of others-then full employment might in fact be secured in this way; a rise in the prices of the scarce factors, and a fall in the prices of those in

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abundance, would promote the necessary substitution. But any general deficiency in the demand for men and materials is unlikely to be eliminated by this means; a general fall in factor prices, although it would reduce production costs, would also reduce the earnings of factors and therefore lead entrepreneurs to expect a decline in spending. Under these circumstances, firms would have no incentive to set themselves higher output targets and employ more factors. A general fall in the prices of productive resources, one therefore concludes, in unlikely to augment the demand for them. Quite apart from this, the price of the most important productive factor-labour-may well not be reduced by a deficient demand. At least in advanced economies, the market for labour is not fully competitive; if a man is unemployed he does not normally seek to get a job by offering to work for less than the rate being paid currently to others. Wages are generally fixed by negotiations between the officials of a union-to which most, if not all, of the workers belong-and the representatives of the firm or industry concerned. As a general rule, unions will resist wage reductions even when there is unemployment, and employers-rather than face a strike-rarely endeavour to enforce them. If, therefore, the aggregate demand for labour falls short of the number of men willing to work at the going wage rate, unemployment will be the result. It may also happen, if business expectations are buoyant, that the production plans of entrepreneurs, in the aggregate, imply a demand for men and materials greater than the supplies available. In this case, the plans evidently cannot be carried out. Entrepreneurs will find their intentions frustrated by shortages and, in the endeavour to overcome them, they will compete with each other by offering higher prices for the inputs in excess demand. The costs of production will therefore rise, but so also will the earnings of productive factors and therefore the level of demand. The consequence of the original excess of the demand for inputs over their supply will therefore be a sustained upwards movement in the general price level. Unregulated private enterprise will therefore produce, the above argument suggests, a chronic instability of employment and prices. Of the two diseases, unemployment and inflation, the former is the more obviously undesirable. It entails a loss of output, and the men who wish to find work, and fail to do so, will suffer a reduction both in their material welfare and in their self-respect. Given a changing pattern of production, it is inevitable that some workers will lack

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jobs for some of the time; even if deficient demand in some industries is balanced by excess demand in others, it will take time for men to change the nature and the place of their occupation. But persistent and widespread unemployment, caused by a general deficiency in the demand for labour, represents an avoidable cause of misery and waste. Inflation, although less obviously harmful than unemployment, can have indirect consequences both socially and economically pernicious. In an economy which relies on exchange through the mediation of money, some stability of prices and incomes is an essential condition of long-run planning. If money has an unpredictable value in terms of goods, its usefulness as a store of purchasing power, and as the unit of account for deferred payments, is impaired. General inflation, moreover, does not imply that all prices and incomes will rise at the same rate. Some people receive incomes which, for a variety of reasons, are fixed over long periods, so that they stand to lose relative to those with more flexible incomes, when the prices of goods rise. Those living on pensions, or the yield of fixed interest securities, or those with salaries not subject to frequent revision, share this experience. Thus inflation produces an arbitrary redistribution of income within the society, without regard to legitimate expectation or to need. Although the advantages of private enterprise are very substantial, a chronic tendency towards unemployment and inflation would be a high price to pay for them. Fortunately we are not obliged to presume that the choice lies simply between unregulated private enterprise, on the one hand, and detailed central planning on the other. What we have to seek is a compromise system, combining a high degree of decentralized decision-taking with the assurance of full employment and stable prices. First, however, let us endeavour to analyse more closely the factors which, through their influence upon business demand for resources, determine the actual level of employment which an unregulated system would experience.

2 A model of income determination We shall begin by studying a simplified, or model, economy in which all the income received by labour or the owners of material resources is paid out by private firms. There will, in the first instance, be n o government, and there will be no foreign trade. What I wish first to demonstrate is that, if suitable accounting principles are adopted, the total output of the economy measured in money terms-the National Output-will be equal to the sum of all the incomes earned-the

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National Income. The explanation of this equality can be most readily understood by thinking first in terms of an economy in which there is only one firm. During the period for which output and income are to be computed-say a year-raw materials will have been worked upon by labour, with the assistance of fixed equipment, to form finished and semi-finishedconsumer goods; some goods will have been taken out of stock and others added to stock; existing capital equipment will have suffered depreciation through use and new equipment will have been installed. We may therefore define the Gross National Output of the year as equal to the value of all the things produced by the firm during this period, whether sold to consumers or added to the firm's physical capital. The addition to physical capital will consist of fixed equipment plus any increase (or less any decrease) in the value of the firm's stock of finished or semifinished goods; it is called Gross Investment if calculated without any allowance for the value of the depreciation suffered by the fixed equipment in the course of providing its services, and Net Investment if such allowance is made. Net Investment is therefore equal to Gross investment less depreciation. Thus we may say Gross National Output = Consumption f Gross Investment Net National Output = Consumption Net Investment

+

Both National Output and its components are always measured in terms of money. Goods that are sold are valued at the prices obtained for them; goods added to stock are valued at cost of production, and depreciation is valued by estimating, in some rough and ready fashion, the extent to which items of fixed equipment have suffered, during the year's use, a reduction in efficiency or working life. Let us now turn to the incomes side of the account. The country's Gross National Income is defined as the sum of all the incomes earned, during the year, in the form of wages, interest, rent and gross profits. The total of wages, interest and rent are equal, under our simplifying assumption, to the expenditure of the firm. The gross profits of a firm, by definition, are equal to the value of its gross output less its expenditure. In our case, therefore, gross profits equal the Gross National Output less payments on wages, interest and rent. Thus the Gross National Output is equal to the sum of wages, interest, rent and gross profits, which is the Gross National Income. We define the Net National Income as the sum of wages, interest and rent plus net profits, where net profits equal the value of the firm's net output less its expenditure. It follows, therefore, that Net National Income is equal to Net National Output.

LEVEL O F E M P L O Y M E N T , O U T P U T A N D P R I C E S

167 Let us now abandon our assumption that the economy comprises only one firm.The Gross National Output must now be defined as the value of all the things produced during the year by all firms taken together. In calculating it, however, we cannot simply aggregate the outputs of all firms; care has to be taken to exclude that part of each firm's output which is sold to other firms as raw materials or components for further production. Were this deduction not made, then the value of output sold by one firm to another would appear twice in the National Output, once as part of output of the firm that sells it and again as entering into the output of the firm that buys it. Gross National Income continues to be defined as the sum of all the incomes earned, during the year, in the form of wages, interest, rent and gross profits. In calculating it, however, we cannot simply aggregate the expenditures, and the gross profits, of all the firms in the economy. We have to take note that part of each firm's expenditure does not represent direct payments to factors of production in the form of wages, interest and rent, but corresponds to purchases made from other firms. If we are to calculate the total value of factor earnings by aggregating the expenditures and gross profits of all firms, we must remember to deduct the total value of these inter-firm purchases. The gross output of any one firm equals the value of its expenditure plus its gross profits. The aggregate of all outputs, therefore, is equal to the aggregate of all firms' expenditures and gross profits. The Gross National Output is equal to the former aggregate less inter-firm sales and the Gross National Income is equal to the latter aggregate less inter-firm purchases. As, however, inter-firm sales equal inter-firm purchases, the Gross National Output is equal to the Gross National Income. Net National Output is similarly still equal to Net National Income. One further important equality deserves attention. Looking at the output side of the account, we observed that Gross National Output equals the value of consumer goods sold plus Gross Investment. Gross Investment, that is to say, equals the Gross National Output less consumer goods sold. It must therefore equal Gross National Income less consumer goods bought, which we may call Gross Saving. Thus, during any period of time, Gross Investment must equal Gross Saving. If we define Net Saving as Net National Income less consumer goods bought, then Net Investment is likewise equal to Net Saving. The validity of all these various relationships, as the reader will have noted, is the logical outcome of the way in which we have chosen to define our terms.

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Let us now turn from the way in which income and output are computed to the circumstances which, at any particular time and place, will determine their level. I wish to assume, in the first instance, that firms' production plans can always be carried out, there being no shortage of the required resources. Similarly, I shall assume that consumers' plans to buy goods are always fulfilled, it being possible to draw goods out of stock whenever current output is deficient. The aggregate production programmes of business, and therefore the aggregate income generated, will depend upon entrepreneurial expectations regarding the future demand for goods. The time period to which these expectations relate, and the way in which they are formed, will differ according to whether the expectations are associated with decisions to add to fixed capital or decisions to vary the rate of output being obtained from existing equipment. The former-investment decisions-have to be based upon a view of the likely demand for a product for some considerable time ahead; the period to which this view relates will vary with the time taken to construct the equipment and with the normal length of its working life, but it will generaly be measured in years rather than months. The formation of long-range expectations cannot follow any simple valid rule, but will depend upon judgements concerning the underlying factors-both economic and political-which control the longrun trends in the volume and composition of consumers' demand. I propose therefore not to subject these judgements to any analysis; the level of business investment will feature, in the following discussion, as a given element in the situation, as a cause rather than an effect. An entrepreneur's decisions as to the volume of output to produce from existing equipment depends, as do his investment decisions, upon estimates of future demand; but the demand which is relevant, in this case, is that expected to develop at the end of the period of time-measurable in weeks or months-sufficient to carry the output plans to fruition. Such short-range estimates of demand will be based on many considerations, but it is reasonable to presume that they will be dominated by the level of demand which firms are currently experiencing. For the sake of simplicity, I shall in fact assume that entrepreneurs plan to produce for any one period a volume of goods equal to that they in fact sold in the previous period. Such a policy would, in practice, never be followed strictly; planned production will relate not only to expected demand but also to the need, if it exists, to increase or to decrease the quantity of goods held in stock, and, more fundamentally, it is implausible to

argue that business men always expect the status quo to be preserved when very frequently it is not. Nevertheless our assumption acknowledges that, in a world in which foresight is imperfect and change rarely sudden, expectations will be heavily influenced by recent experience. Short-run output plans, we have assumed, depend upon current sales. The level of these sales, throughout the economy as a whole, will vary with the incomes which consumers are receiving. The amount a man is prepared to spend will be affected by the magnitude both of the income he has just earned and of the income he expects to earn in the future. We shall assume that these two magnitudes are equal, consumers' income expectations, like the sales expectations of entrepreneurs, being based on what they have just experienced. And, in order to simplify still further, we shall begin by assuming that consumers' total spending is always a constant proportion of their total expected incomes. This proportion, c, we may call the community's propensity to consume. I wish now to show that, under the circumstances which have been postulated, the national income at any particular time will move towards a level determined by two things-aggregate investment plans and the propensity to consume-which we have taken as given. Entrepreneurs decide how much to produce on the basis of the sales that they expect to make; they will maintain their rate of output if their expectations are fulfilled and will alter it if their expectations are disappointed. Similarly, consumers will either maintain the same rate of spending, or will change it, according to whether their expectations as to their future incomes are fulfilled or disappointed. Consumers' expectations will be met only if their incomes are constant over time, for only then will the incomes of any one period equal the incomes of the period preceding. Producers' expectations will be met only if there is established a level of aggregate income such as will induce consumers to spend an amount equal to the value of the goods being offered for sale. Let us assume that the value of the national income, and therefore of the national output, is currently Y. The value of the consumer goods that business men hope to sell must therefore equal Y - I,, where I, is the value of the investment, in equipment and stocks, that they plan to carry out. If consumers' purchases do in fact equal Y - I,,, entrepreneurs' expectations will be fulfilled and they will not seek to change their plans. If consumers' purchases are more or less than this, stocks of goods will be run down or will pile up unexpectedly so that the level of investment actually realized will differ from that

170

ECONOMIC THEORY

which was planned; business men will then revise their production programmes. Consumers' actual spending, however, will be c.Ye, where c is the propensity to consume and Ye is the total expected income. If consumers' income expectations are to be fulfilled, Ye must be equal to Y. If, in addition, producers' expectations are to be fulfilled, in that the value of goods offered for sale equals consumers' spending, then we must have so that Y =

* I-c

Clearly, therefore, only this one level of income, equal to

I " will I-c

permit all expectations to be fifilled; let us call it the equilibrium level of income and denote it by Y. The term 1 - c is equal to what we may call the community's propensity to save, s, this being the proportion of thesational income which people plan to save. Thus we may say that Y = I,/s, i.e. the equilibrium level of the national income equals planned investment divided by the propensity to save. If the equilibrium national income were established, neither producers nor consumers would have any reason to alter, respectively, their rates of production and spending. National income would therefore stay at the same level. It remains to show that, if the actual level of income differs from the equilibrium level determined by the given current values of I, and c, then producers and consumers will be led to act in such a way as to bring the actual level closer to the equilibrium level. Let us first suppose that the actual national income, Y, is greater than the equilibrium level, y.

-

IP then as Y = I -c

This is to say that the planned sales of consumer goods, which equals national income less planned investment, exceeds the demand

for them, c.Y.1 Firms will therefore not sell as much as they had hoped and will reduce their rates of output to the level of demand actually experienced. Consumers will then find their incomes unexpectedly reduced and they will plan to spend less. Firms will again fail to sell as much as they produced, so that production programmes, and therefore incomes, will be further reduced. The national income will therefore fall to its equilibrium level and only when this level is reached will producers and consumers, finding their expectations justified, act so as to maintain the status quo. In practice, of course, this process would have time to work itself out fully only if the level of planned investment and the propensity to consume-the two determinants of equilibrium-remained cQnstant throughout. This is unlikely to be the case, so that the equilibrium concept is useful as an indication not so much of the level of income which will come to be established as the direction in which changes will take place. Similar reasoning shows that, if the actual income paid out by firms falls short of equilibrium income, the demand for consumer goods will exceed the supply, output programmes will be stepped up, consumers-finding themselves better off-will spend more, and, as a result, the national income will rise towards its equilibrium level. Equilibrium required the demand for consumer goods to equal the amount which firms plan to sell. This condition can be put somewhat differently by saying that planned investment must equal planned saving. Planned investment equals total output less planned sales, and planned saving equals expected income less planned purchases. In equilibrium, expected income will equal actual income, which equals actual output, and planned sales will equal planned purchases; planned investment will therefore equal planned savings.# An excess of planned investment over planned savings will imply I . I am here assuming that actual incomes, Y, are those expected by consumers. If consumers had expected higher incomes, then it would have been possible for their expenditure to equal the output of consumer goods, Y -1;. But, in this case,~consumers'incomes wo;ld have fallen short of their expectations, so that they would expect to earn less, and would plan to spend less, in the future. Producers would therefore soon find themselves unable to sell all they had produced and would cut back production. 2. Let expected income be Ye and actual or realized income (and therefore output) be Y. Let planned savings and planned investment be Sp and 1, respectively. Then planned purchases of consumer goods are Ye - S,, and planned sales by firms are Y - I,. If these are to be equal, to secure equilibrium, then Ye - S, =Y - I,. As, in equilibrium Y = Y, it follows that Sp = Ip.

172

ECONOMIC THEORY

that the demand for consumable output exceeds its supply, with the result that production and incomes will be stimulated. Any excess of planned savings over planned investment will have the opposite effect. The fact that there will be equality betweenplanned investment and planned saving at an equilibrium level of income is not to be confused with the quite different fact that realized values of investment and saving will necessarily be equal whatever the period chosen. Our accounting conventions ensure that national output equals national income; as realized investment is output less consumer goods sold and realized saving is income less consumer goods bought, the realized magnitudes of investment and saving cannot differ. Planned investment, however, need not equal planned saving, and if it does not, then both sets of plans evidently cannot be realized. The difference between tllanned investment and realized investment h e . unplanned investmint or disinvestment) will take the form o f an unexpected change in stock-holding. The difference between planned saving and realized saving (i.e. unplanned saving or dis-saving) will be equal to the amount by which realized income exceeded, or fell short of, expected income. Thus, when an equilibrium level of income is established, and only then, both unplanned investment and unplanned saving will be zero. We have established that the equilibrium level of incomes depends upon planned investment and the propensity to consume: let us now consider what the effects of changes in either of these two factors will be. It is convenient to introduce, at this point, a different, or rather more realistic, assumption about consumers' spending habits. If consumption were a fixed proportion of income, as hitherto assumed, this would imply that people would continue to save however poor they became. This is an unreasonable assumption, and we can avoid making it by representing spending as equal to a fixed proportion of income plus some constant. Thus, instead of the equality C = c.Ye we shall have C = c,. Ye

+K

where C is consumption expenditure, Ye is expected income, c, is the marginal propensity to consume and K a constant. Given this relationship, it is evident that changes in consumption will be a constant proportion of changes in income, the proportion being given by the value of the so-called marginal propensity to c0nsume.l I. This relationship implies that consumption will be positive even if income is zero, it being presumed that consumers can finance expenditure from capital or by borrowing.

LEVEL OF E M P L O Y M E N T , OUTPUT AND P R I C E S

173

Thus, if we denote a change in expected income by AY,, and the consequential change in consumption by LC, then AC = I&,. A Ye. The proportion of any increase in income which is not spent, the marginal propensity to save s,, will equal 1 - c,. I shall continue to assume that consumers expect to receive, in the immediate future, an income equal to that which they have just obtained. We can now begin to consider the effect on national income of a change in the level of planned investment. Let us assume that the equilibrium income appropriate to the old level of investment is already established and that then planned investment rises by an AI,. The aggregate income of amount AI, from I, to I, consumers will rise correspondingly and they will spend more. As an immediate consequence, stocks of consumer goods will be run down. This unplanned disinvestment will then lead producers to produce more consumer goods and, as a result, a further addition to incomes will be generated. A cumulative expansion will develop and come to an end only when the conditions for the establishment of an equilibrium income are fulfilled. Before the change in investment, planned savings (S,) had, for equilibrium, to equal planned investment (I,). After the change, planned savings have to equal I, AI, for equilibrium to be attained. Equilibrium therefore requires an increase in planning savings AS,, equal to AI,, and this will be forthcoming once income has risen by an amount AY, such that sm.AY = AI,. This increase in income which must

+

+

take place in order to restore equilibrium is therefore 1

-.sm

The

fraction -5 is commonly called the multiplier, as it is the coefficient Sm

by which a change in planned investment has to be multiplied in order to equal the change in income which will ultimately result from it. If, for example, the community were to save one quarter of any increase in its income, then the multiplier would be 4: any increase (or decrease) in investment would raise (or lower) incomes by an amount four times its own magnitude. Changes in the national income can be produced also by changes in the community's spending (or saving) habits. If consumers were to decide to save a higher proportion of their incomes, then, assuming planned investment remained the same, the national income would fall; a new equilibrium would be attained only when incomes were low enough to bring planned savings down to the level of planned investment. Increased thriftiness, therefore, so long as it is

174 ECONOMIC THEORY not matched by an increase in planned investment, will impoverish the community. On the face of it, this may appear to run counter to our everyday experience, for we know that a man can generally enrich himself by saving. But we have to beware of arguing by analogy from the individual to the community as a whole. The wealth of nations is created through the productive employment of their resources in the manufacture of investment or consumption goods. If the production of the latter is reduced, as a result of a fall in consumers' spending, while production of the former is not increased, then, inevitably, fewer resources will be employed, and a cumulative process of income reduction will be set in train. Increased saving, and the corresponding reduction in the demand for resources to make consumer goods, will benefit the community only if the resources released are taken up to produce an addition to the national stock of capital. Given the assumptions of our model economy, an equilibrium level of national income once reached will be maintained (though not necessarily at the level corresponding to full employment) provided the rate of investment and the propensity to consume remain the same; changes in either of these determinants would set up magnified fluctuations in income and employment. It is probably to changes in firms' investment plans that fluctuations can more usually be traced. Decisions to add to fixed equipment are grounded on assessments of long-run trends in demand, which, because of the lack of adequate information, may be irrationally unstable. The profitability of investment, moreover, depends considerably on the flow of new inventions which need not be steady. Nevertheless, fluctuations are not attributable exclusively to changing investment plans; consumers' saving habits, in practice, are a good deal less rigidly tied to the level of income that is being presumed in our model. Our analysis of the process of income generation has proceeded, up to this point, on the assumption that the aggregate demand for productive resources was never to exceed the supply of them. In fact, of course, this need not be so; it may be that the two determinants-planned investment and the propensity to consume-have values which imply a demand for resources greater than that which can be met. In this case, producers' plans to add to their capital stock, and consumers' plans to buy goods, will not be fulfilled; scarcities will develop and the prices both of products and of factors will be driven up. The consequent rise in the incomes of workers and the owners of material resources will generate a further increase in

the demand for goods, thus setting in motion a cumulative rise in the whole price level. Unless investment plans are cut back, or consumers become willing to save a larger proportion of their income, inflation will continue.

3 The role of government We are now in a position to turn from the causes of unemployment and inflation to an examination of the available remedies. One solution would be to abandon the very full decentralization of decisions characteristic of private enterprise. The possibility of unemployment and inflation arises from the fact that production decisions, upon which the demand for resources depends, are taken by many individual entrepreneurs acting independently and free from any centrally imposed co-ordination. If each entrepreneur were given instructions by the government as to how much to produce, and obliged to carry them out, then it would be possibleat least in principle-to ensure that the aggregate demand for men and materials was just equal to the supplies available. A solution of this kind would require much administrative machinery; it would make it difficult to preserve the stimulus provided by competitive profit seeking, and it would enhance the authority of the state at the expense of the liberties of the citizen. We have an interest, therefore, in finding a less drastic remedy. Any actual private enterprise economy, unlike that of our model, will have a government, which, by raising taxes and spending money on the provision of public services, cannot fail to exert some influence upon the aggregate demand for resources. By appropriate regulation of its own economic activities, therefore, the government can hope to bring this aggregate demand into conformity with the available supplies. Let us therefore amend our model so as to accommodate this factor. National output will now consist of consumer goods sold, plus investment, plus the goods and services provided by the government. If this last item is valued at the cost of the factors employed to produce it, then national output continues to be equal to national income. If we denote the realized values of national income, consumption, investment and government expenditure as Y, C, I, and G respectively then Y = C I + G. The national income must either be spent on consumer goods, or saved, or paid in taxes. If then we denote realized saving and realized tax payments as S and T, Y = C S T. It follows, therefore, that C I $ G

+

+ +

+

176

+ +

ECONOMIC THEORY

+

+

C S T so that I G = S T. Here then we have the first difference from the previous, simpler model: the realized values of investment and saving are no longer necessarily equal, but realized investment plus realized government expenditure necessarily equal realized saving plus realized tax payments. Let us now turn from the relations between realized values to the conditions which must hold for an equilibrium income to be established. It will be convenient to begin by first assuming that sufficient resources are available for both consumers and the government to succeed in implementing their plans, so that the same letters C and G can be used to denote consumption and government spending whether planned or realized. I shall assume that all government revenue is derived from a tax on individual persons, which is proportional to the incomes they receive. Thus, if the taxes which people plan to pay equal Tp, if the incomes they expect are Ye, and the fraction of income to be paid in tax is t, Tp = t.Y,. I further assume that the tax rate, t, is published in advance so that, if people predict their incomes correctly, then they likewise succeed in predicting their tax payments. I assume that consumers continue to expect to receive incomes equal to those they have in fact just received. It is reasonable to presume that savings plans are now related, not to expected income, but to expected income less tax. If we begin by regarding planned savings (S,) as a constant proportion, s, of expected income after tax, then =

Once again I shall assume that the investment plans of business are a given element in the situation. The level of government expenditure will also be taken as given and independent of variations both in the national income and in tax receipts. An equilibrium income is one which, once established, permits the plans of consumers and firms to be fulfilled, so that neither group has any cause to depart from their current spending and production plans. Thus equilibrium requires that consumers obtain the incomes they expect and that they buy just that amount of goods that firms produce for sale. Planned sales of consumer goods will equal realized national output less planned investment and government G. expenditure, i.e. Y - I, Planned purchases will equal expected income less planned savings and less planned tax payments (i.e. Ye S, Tp). For

-

- -

LEVEL O F E M P L O Y M E N T , O U T P U T A N D P R I C E S

177

equilibrium, incomes must turn out as expected, so that Ye = Y. In addition, planned sales must equal planned purchases, so that

Here then we have the condition which must hold for an equilibrium income. The sum of planned investment and government expenditure must equal the sum of planned saving and tax payments. At only one level of income can this condition be fulfilled. We know that Sp = s(1 - t)Ye and T, = t.Ye Sp Tp = ~ ( l t)Ye t.Ye = Y,(s(l - t) t) Tp = I, f G, and Ye = Y For equilibrium, therefore, when S,

.'.

+

+

+ +

In our model economy, therefore, an equilibrium level of income is determined by four factors: planned investment, government expenditure, the propensity to save (or consume) and the tax rate. Reasoning similar to that set out previously shows that if the aggregate income being received exceeds the equilibrium level appropriate to these determinants, then fxms will find that they cannot sell all the goods they are producing, so that incomes fall. If the actual national income is less than the equilibrium level, production and incomes will rise. The values of the four key determinants-I,, G, s and t-may determine an equilibrium level of income which ensures full employment, but there are no grounds for assuming that they will do so automatically without the government having deliberately sought this end. It is quite possible for the equilibrium to be compatible with the existence of unemployed resources. It is also possible for the plans of industry and the government, given consumers' spending habits, to imply a demand for resources greater than the available supply. In such a case, production and spending plans will not all be capable of fulfilment, as assumed hitherto; scarcities will develop and prices will rise. If both unemployment and inflation are to be avoided, the government will have to manipulate the two key factors which are in its control; by choosing appropriate levels for its own expenditure, and for the tax rate, it will be possible to control the G

178 ECONOMIC THEORY level of national income towards which the economy will move. An increase in G, the other determinants remaining the same, will raise the equilibrium income; an increase in t will lower it. There is no presumption that, at full employment equilibrium, the government's expenditure will equal its tax receipts. All we can say is G = S, T,. If, at full employment, planned investment that I, exceeds planned saving, then, for equilibrium, the government's revenue will have to exceed its expenditure; a 'budget surplus', in other words, will be required. If, on the other hand, business wishes to invest less than the community wish to save, a 'budget deficit' is required. The above analysis helps us to predict the effect on equilibrium income of changes in government expenditure. Being concerned specifically with changes, we shall have to deal with a marginal propensity to save and a marginal tax rate. The marginal propensity to save has already been defined. The marginal tax rate (tm) represents the proportion of any addition to aggregate incomes that will be paid in taxes. Let us suppose that the national income is originally in equilibrium, so that I, G = S, T,, and that the government then increases its expenditure by AG, I, and t remaining the same. If a new equilibrium is to be established, then the increase in government expenditure will have to equal the combined changes in planned savings and planned tax payments.

+

+

+

+

i.e. for equilibrium ASp f ATp = AG But ASp = sm(1 - tm) A y e and AT, = tm. Aye. therefore, for equilibrium, sm(l - tm) Aye tm. A Ye = AG i.e. AYe(sm(l - tm) tm) = AG

++

and, as in equilibrium, AY,

where k, the multiplier, is equal to

=

AY,

I

+

-

sm(l - tm) tm. It appears therefore, from this relationship, that any given change in government expenditure, other things remaining the same, will result in a change in the equilibrium level of the national income

which is in the same direction as, and never less than, the change in expenditure. If, for example, the marginal tax rate wereF50%,andconsumers planned to save 10% of additional income after tax, then the 1 value of the multiplier would be which is equal,

- 4)+4

approximately, to 1.8. Only if the marginal propensity to save, or the marginal tax rate, were unity, would the multiplier be unity and the change in equilibrium income no greater than the change in government spending that provoked it. The full increase in income given by our formula would not of course take place immediately. The first effect of an increase in government spending would be for those benefiting from it to find themselves with augmented incomes; part of these would be saved or paid in taxes and the remainder spent on consumer goods. As a result, there would be unplanned disinvestment in stocks, which would give the signal to entrepreneurs to increase their output, thereby generating more income, part of which would again be spent on consumer goods. This would then lead, in our model economy, to a gradual movement of the national income towards its equilibrium level. If, however, the new level of government expenditure, together with the other determinants of aggregate demand, implied an equilibrium level of income greater than that which the available resources made physically possible, then plans would be frustrated and prices would steadily rise. The reader will do well to remember some of the simplifying assumptions upon which our model of the process of income determination was based. Many of these are clearly unrealistic. It is not the case, for example, that all consumers estimate their future incomes, and entrepreneurs their sales, by a simple projection of the conditions they have just experienced. Nor will savings, for the economy as a whole, be related in any very regular and straightforward way to the size of the national income. Different people, for one thing, have different habits, and aggregate savings will therefore be affected by any variation in the distribution of the national income between them. Individual persons, moreover, are not the only savers; firms also save, to the extent that they keep profits in reserve rather than distribute them, as dividends, to shareholders. The realism of our analysis was also impaired by confining the discussion to the effect of changes in one of the determinants of national income, all the others remaining the same. In practice, planned investment, for example, is not likely to remain

180

E C O N O M I C THEORY

wholly unaffected by changes in spending habits or budgetary policy. This is particularly true as regards planned investment in stocks which will tend to vary in such a way as to offset unexpected changes in the volume of stocks being held. By setting aside all these manifold complications, I have represented the theory of income determination, and the recommendations for government policy which can be derived from it, as much more clear-cut and straightforward than they in fact are. In an introductory volume of this kind, such drastic simplification is not difficult to justify. Nevertheless, two important limitations of our theory deserve special mention. We have learned to regard the levels of employment and prices as depending upon the relationship between the aggregate supply of resources and the aggregate demand for them. This approach is exceedingly fruitful, but, if we do not appreciate the limits to its application, it may seriously mislead us. What we must now recognize is that inflation may not always be attributable to an excess of aggregate demand, and that a deficiency of demand is not the only cause of unemployment.

4 Cost inflation The foregoing analysis rested upon a particular assumption about changes in wage rates. I assumed, first, that wages would not fall when the demand for labour was deficient, and, secondly, that they would rise only when the demand for labour exceeded its supply. There is no need to revise the first assumption, which appears to be valid for most countries in which workers have formed strong trade unions. Nor is there any reason to doubt that sustained excess demand for labour is a sufJicient condition for wage increases to take place. Whether it is a necessary condition, however, is by no means certain. Let us begin by considering a situation in which the demand for labour is enough, but no more than enough, to secure full employment. Let us suppose that, for reasons which need not now concern us, a trade union demands higher wages for its members. On the face of it, employers have the strongest incentives to resist this claim. A higher wage bill will increase production costs, and if firms endeavour to compensate themselves by raising prices to the consumer, the volume of sales may fall to such an extent as to leave them with smaller receipts than before. Under these circumstances, wage increases will mean lower profits, or even losses for the firms that grant them. This being the case, one might expect employers to stand firm.

A little reflection, however, obliges us to reconsider this conclusion. Whether a firm can raise its prices without a reduction in the volume of its sales will depend upon the actions of its competitors. If only one firm among those making a particular product were to grant a wage demand, and to raise its prices correspondingly,then it would lose heavily to its rivals. But if all the firms concerned were simultaneously to raise their prices, then the reduction in demand suffered by each of them would be much less; its extent would depend upon the availability of substitutes for the product, at unchanged prices, to which the consumer could turn. Now, in practice, in Great Britain, trade unions commonly do negotiate wages, not with individual firms, but with an industry as a whole. Any wage demand, therefore, will generally be granted-if at allby all the firms concerned, each of which can then raise its price with reasonable confidence that others will do the same. If the demand for the industry's output, as a whole, is relatively inelastic, no very great fall in sales will be experienced, even although prices throughout the rest of the economy remain unchanged. In fact, however, other prices may not be unchanged, as pressure for higher wages may not be confined to any single industry. The granting of wage increases by industry generally will change the situation radically, for it will cause an increase in spending from which all firms are likely to benefit. Thus, if the firms in any one industry were assured that all other industries would give way to pressure for higher wages, it would be more prepared to give way itself, as it would then expect, given the increase in incomes and therefore in demand, to be able itself to raise its prices. Here again is an example of the circular interdependence with which we have already had occasion to become very familiar. Any one group of firms faced with wage demands will be unlikely ever to know for certain whether others are on the point of conceding to similar pressures, with the result that general atmosphere and recent experience will influence their decisions. If unions have been in the habit of making wage demands, and employers in the habit of granting them, all concerned will come to expect a general rise in wages and prices. This very fact alone will lead workers, eager to protect their living standards, to press for higher wages, and will make employers willing to pay them. The expectation of rising prices thus confirming itself, inflation will gather momentum as it proceeds. Nothing has been said, as yet, about the part which might be played, in these circumstances, by the government. By varying either its expenditure or its revenue, the government is able to

I 82

ECONOMIC THEORY

bring the aggregate demand for final output into line with the monetary value of the supply available. If it chose, therefore, it could so restrict aggregate demand as to disappoint the entrepreneurs' expectation that they would be able to pass on wage increases, in the form of higher prices, to consumers. Thus the process of inflation which we have been describing appears to depend, for its operation, on a government's willingness to maintain a level of aggregate demand never less than sufficient to ensure that the whole of final output can be sold, irrespective of its average price level. In fact there are reasons why governments may incline towards compliance in this matter. Let us suppose that a government, determined to arrest inflation, did adopt a budgetary policy designed to maintain a level of total demand no more than sufficient to ensure the sale of total final output at an unchanging average price level. And let us further suppose that firms followed what had become their habitual practice of granting wage increases and endeavouring to pass them on to consumers at higher prices. Under these conditions firms would find themselves unable to sell all their output and would cut back production. Such a reduction of output and employment, though in itself obviously wasteful, might be acceptable, temporarily, if the experience produced a desirable change in atmosphere and attitudes. The result could be that employers, ceasing to believe that higher wage costs could always be met by an increase in prices, would become much more reluctant to meet trade union demands. Observing this stiffer attitude among employers, and chastened also by the unemployment now developing in their own ranks, the unions might themselves become less demanding. If these changes in outlook could be produced rapidly by the government's restriction in total demand, and if they proved desirable, then a short-lived reduction in employment and output would be a small price to pay for conditions more favourable to price stability. But although things might work out in this way, there is no guarantee that they would; all would depend on the strength and the prevalence of particular habits and attitudes of mind. If union members had come to expect annual wage increases, then their representatives might feel themselves forced to continue to demand them, even if they knew that employers were likely to resist firmly. If neither side were prepared to compromise, the outcome might be widespread strikes, having as their result a further reduction in output and an impairment of industrial relations. Faced with such a situation, a government might well be inclined to allow aggregate

demand to rise sufficiently to restore employment and output even at the cost of a resumed inflation. Where then does all this lead us? We originally began by noting that, in a private enterprise economy, the levels of employment, prices and output would depend upon the production decisions of individual firms. It seemed perfectly possible for these decisions, being unco-ordinated, to imply an aggregate demand for resources either greater or less than the monetary value of the supplies available at current prices, so that inflation or unemployment would result. Government activity was then brought into our model, in order to show how the level of aggregate demand could be influenced by budgetary policy. It first seemed that, by adjusting aggregate demand to the level just sufficient to induce employers to take up all the labour available at current wage rates, both unemployment and inflation could be avoided. More realistic assumptions about the working of the labour market, however, obliged us to conclude that, given continuous pressure for higher wages, budgetary policy would be unlikely to succeed in realizing both its objectives; full employment might be obtainable only at the cost of persistent inflation, and price stability only at the cost of unemployment and loss of output. If the institutions and attitudes characteristic of wage bargaining were such as to confront the government with these unpalatable alternatives, then it might decide to intervene directly in the process of wage fixing. Political, even more than economic, considerations will affect the choice of a means to this end. The wage rates for different kinds of work could simply be decreed directly by the government, as in a centrally planned economy; this policy would cause a very substantial diminution in the freedom of private individuals and organizations; it would be complex administratively, and it might be difficult to enforce. Alternatively, an attempt could be made to persuade the unions and the employers to see to it that wage increases, in the aggregate, amounted to no more than could be offset, in their effect on production costs, by increased productive efficiency. The practicability of such an approach will depend upon the willingness of the unions to accept a limitation upon aggregate wage increases and upon their ability to agree amongst each other as to the proper distribution of these increases among different types of worker. It will seem to many, moreover, on grounds of fairness, or for reasons of political expediency, that restriction, if applied to wage increases, ought to extend also to increases in salaries, profits, interest and rent. But the further governments travel in this direction,

184 ECONOMIC T H E O R Y the nearer will they come to abandoning private enterprise in favour of centralized planning. If factor payments are set so as to reflect demand and supply conditions, then the price mechanism can still be operated; but if they are decreed simply according to the prevailing notions of equity (or the power of different pressure groups) then efficient resource allocation will be secured, if at all, only by intervention, both direct and detailed, by the state.

5 The problem of surplus labour Unemployment has featured, in our model, as the consequence of a deficiency in the demand for goods and services. General unemployment, we may say, arises when demand in the aggregate is deficient. By concentrating on aggregate values, our analysis has dealt exclusively with unemployment of this kind, but it could readily be extended to cover structural unemployment attributable to a disharmony between the distribution of demand, both between areas and types of manufacture, and the distribution of productive resources. The absence of any deficiency in the monetary value of demand as a whole is perfectly consistent with lack of demand in some sectors, provided that demand is excessive, to at least an equal extent, in others. The fact that fixed equipment cannot usually be transferred from one use to another, and the fact that workers may not be able readily to change their location or their particular skills, make structural unemployment a problem for both private enterprise and collectivist economies. Its solution must be found, not in manipulating the aggregate value of demand, but by the re-location of industries and the movement of men. So long as advanced economies are our chief concern, it is right to seek the cause of unemployment in the general level, or tlie distribution, of the demand for goods. In underdeveloped economies, however, it may not be possible to attribute all unemployment to these circumstances. Men may remain unemployed, not through lack of spending on goods, but through lack of certain co-operating factors--either physical capital or men with technical and managerial training-with which they must work. This situation might at first appear easily to be remedied. The fact that some factors are underemployed, whereas others are in excess demand, would suggest the need for a change in their relative prices. By lowering, in this particular case, the wages of unskilled labour, employers could be induced, it might appear, to switch to processes and products requiring more of it. But in fact, this might not prove a solution. The existing

technology, in the fist place, may not offer a continuous range of processes, each one requiring a little more of one factor and a little less of others: also equiproduct curves, in technical language, may not be continuous over their whole length, there being some minimum quantity of 'management' or 'skills' or capital indispensible to the production of particular goods. To some extent labour supplies can still be absorbed by changing the commodity composition of output, by concentrating, that is to say, on the provision of goods or services which happen to make least use of the scarce factors. But such a policy may fail to bring the total working force into employment. As the supply of these goods is increased, their prices will have to be reduced in order to provide a market, and, if their manufacture is to remain profitable, costs will have to fall likewise. If the prices of inputs other than labour remain the same, then wages will have to fall more than prices, in order that costs fall as much as receipts. But there will be some minimum wage which workers have to be paid if they are to be able to purchase the food, clothing and shelter necessary to ensure their efficiency, health and ultimate survival. Employers will be able to pay less than this, in the long run, only if their workers benefit from public subvention or private charity. And if the wage does not fall below the subsistence level, some men may remain ynemployed. Thus in the poorest societies, in which workers have no more than their earnings to ensure their own or their children's survival, the supply of labour will adjust itself, slowly and painfully, to the demand for it. One may refer to this problem as one of surplus labour, to distinguish it from unemployment, whether general or structural, associated with the level or distribution of the demand for goods. If one has regard not merely to advanced economies but to the world as a whole, both in the past and at the present time, there is no doubt that labour surplus is the more widespread and grievous affliction. The fundamental problem is that of poverty and the solution has to be found in education and training, in the accumulation of capital and in measures designed to keep the growth of population within the limits set by the growth of wealth.

9

The role of money 1 The demand for money No economy, whether based on public or private ownership, could work efficiently without a medium of exchange. At the most primitive level, goods and services may be exchanged for each other directly, but, unless each party to a transaction happened to wish to acquire precisely those articles that the other has to offer, the disadvantages of such a procedure are overwhelming. In any complex pattern of trading, money, defined as an acceptable medium of exchange, is indispensable. If money is to be an acceptable medium of exchange it must also be an effective store of purchasing power. As no one is likely to receive payments at precisely the same times, and of precisely the same amounts, as he has to make them, money will have to be carried over from one time to another; this people will be prepared to do, however, only if money has a reasonably stable value in terms of goods. The essence of money consists in its function and not in its form. Cattle have been used as money, and so have sea-shells. Gold served for many centuries within countries and still does in international transactions. But in modern advanced economies, money features chiefly as bank deposits, and, to a much lesser extent, as bank notes and coin. Payments are made by transferring deposits, usually by writing out a cheque, or by handing over note and coin. Despite their intrinsic lack of worth, anyone will accept these assets, partly because he knows that others will accept them from him, and partly because he is legally bound to accept notes (into which deposits can be cashed on demand) in settlement of a debt. The total quantity of money within present-day economies, whether private enterprise or collectivist, is under the ultimate control of their governments. The machinery of this control, and the I 86

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whole process of evolution by which money assumed its present form, although interesting and important, will be left out of our discussion. How much money ought a government to create? What is the relationship between the supply of money and the price we have to pay to borrow it, i.e. the rate of interest? Does the supply of money affect its value in terms of goods? These are the questions which will concern us in this chapter. As a first step to their solution, let us examine the circumstances which will determine the amount of money which persons and companies will wish to hold. Few workers will spend all their wages immediately on receiving them. Neither will a firm find that the time pattern of its receipts precisely coincides with the time pattern of its expenditures. Most people will therefore find themselves holding a stock of money which fluctuates according to the current balance between their incomes and outgoings. The average size of this stock will vary inversely with the degree of synchronization between incomes and outgoings and directly with their monetary value. The first of these two factors will depend upon structural elements in the economysuch as the intervals at which wages, or salaries or dividends, are normally paid-which probably change little from one year to another. The second factor-the monetary value of transactionswill depend on the level of the country's national income. Thus we should expect to find a relationship between the national income (in money terms) and the stock of money which the community wishes to hold. This relationship, however, is much looser than might at first be supposed. The size of a man's holding of money is not beyond his own control and he need not passively permit it to vary automatically with his getting and spending. There are three other ways in which he can react to a temporary imbalance between these two flows. A temporary surplus may be used to buy goods, to buy financial assets (i.e. securities) or to reduce indebtedness. Correspondingly, a temporary deficit may be met by selling goods, by selling financial assets, or by borrowing. The first of these alternative ways of dealing with the natural ebb and flow of payments is very unlikely to be adopted as a deliberate policy. No capable household or business will rely on the sale of furniture, machinery or materials to finance a temporary excess of expenditures. Physical assets are acquired for the direct services which they perform and which their owner will not normally wish to dispense with. They are a highly unsatisfactory store of readily

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available purchasing power, not only because they are cumbersome, but also because they are normally unlikely to sell for as much as was paid for them. Goods with this latter property we may call relatively unmarketable. Some goods are less marketable than others, chiefly because the number of people wishing to buy them at any particular time is limited; they can, it is true, normally be sold to dealers, but dealers will offer a price lower than they hope themselves to obtain on re-sale, in order to be compensated for the cost and trouble of storing the goods until a suitable buyer appears. Loans, or securities, can be a much more satisfactory store of readily available spending power than physical assets. Some loans, such as those made privately to a friend, without security, may be very unmarketable, as there may be no potential purchasers sharing the lender's confidence of being repaid. Securities issued by the government, on the other hand, or by known firms, can be sold very readily, on the stock exchange, merely by telephoning the appropriate instruction to a broker. Such securities therefore, being rapidly convertible into money, act as a substitute for money itself. In addition, they offer an interest yield, which bank deposits generally do not. As compared with money, however, they have two disadvantages. First, securities are not directly acceptable as a means of exchange but have &st to be sold for money; although this is easily done, the seller will have to pay the dealer, or broker, a small commission for his services. Secondly, the amount of ready cash for which securities can, at any time, be realized is not predictable, with precision, in advance. The prices of securities fluctuate, from day to day, under the influence of demand and supply. A man might buy, for £100, a security yielding £3 per annum in perpetuity. Some years later, conditions might be such that borrowers were offering 6% on money lent in perpetuity. If this were the case, the security bought previously would now fetch only £50, as this is the sum which, in current circumstances, could provide a lender with £3 per annum. Thus a rise in interest rates currently offered causes a fall in the price of old securities, and a fall in interest rates causes security prices to rise. As future interest rates are uncertain, security prices are uncertain also, and securities represent an uncertain amount of readily available spending power. The third alternative to a cash reserve, as a way of meeting an excess of expenditure over receipts, consisted of borrowing. Unused credit facilities, like securities, represent an uncertain source of ready money. A man cannot normally be sure of being able to borrow whatever sum he may require at the time he requires it and

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at a predictable cost. In addition, he may find it difficult to raise funds precisely when he most needs them, for this may be a time in which he is in difficulties which he, but not potential lenders, believes to be merely temporary. Enough has been said to show that, for anyone who wishes to take the trouble of assessing the risks and costs involved, the average amount of money held is a matter of deliberate choice. Money requirements will be neither absolute nor perfectly predictable. The larger a firm's bank deposits, the less often will it have to incur the costs, and the risk of capital loss, associated with the sale of financial assets. The price paid for this advantage will be the additional interest income which could have been obtained from holding more securities. Most people, therefore, will strike a balance. Their firstline reserve will consist of bank deposits, or of guaranteed bank overdraft rights, which are effectively equivalent. All short-term gaps between receipts and payments will be met from these sources. Securities will be held (or credit facilities relied upon) to cope with contingences which are either more remote or less likely. Although their realization may involve a loss, their owner will expect to have the benefit of an income from them over a sufficient period to offset this. The total demand for money to hold, not being absolute, will therefore depend, to some extent, upon the rate of interest which securities offer. The higher this rate, the greater will be the incentive to economize in cash reserves, even although, for most people, and for normal changes in rates, this consideration will carry little weight. We must now take account of the fact that money may be held, not as a means of payment, but as a store of value. On the face of it, securities may appear superior to money for this purpose, in that they offer a yield. But, as we have already observed, security prices may fluctuate. If a man expects that they are more likely to fall than to rise, then he will have a motive for preferring money to securities in the meantime. The stronger his belief that security prices will fall, the fewer securities will he wish to hold; if he is sure that their prices will fall, and by an amount sufficient to wipe out any interest yield in the meantime, he will hold no securities at all. Correspondingly, belief in the likelihood of a fall in interest rates, and therefore of a rise in security prices, will induce a wealth-owner to hold less money and more securities. One cannot say, without reference to the circumstances of the time, whether people will come to expect a rise or a fall in interest rates; opinion on the matter will, in general, be both divided and uncertain. But it is probably safe to say that,

190 ECONOMIC THEORY when rates are already low, judged by the levels normally experienced, most people will think them more likely to rise than to fall and will therefore be reluctant to hold securities. In any case, when rates are low, the threat of capital loss will loom much larger than the current yield. Irredeemable securities offering currently a yield of 2+% stand to be halved in value if rates were to rise to 5%. Only if an investor were very confident of not making such a capital loss would he be prepared to accept such a low yield. Money may therefore be held, it now appears, for two distinct reasons. It may be held specifically as a means of payment to be

E

1

T h e demand for money

8 1 I-

0 Quantity of money demanded Fig. i

used to bridge any gaps between receipts and expenditures. This may be called the transactions demand for money. It will vary, in the short-run, directly with the level of the national income and, to some extent, inversely with the current rate of return on financial securities. Alternatively, money may be held in the expectation that security prices may fall; the strength of this speculative demand for money will depend upon the relationship of current rates of interest to the rates which people expect. For any given national income therefore, combined with given expectations regarding future interest rates, the total demand for money will depend upon the level of current interest rates in the manner shown in fig. i. The higher the current level of interest rates, the smaller, for two reasons, will be the demand for money. The higher the current return from securities, the stronger will be the incentive to economize on money held for transactions purposes. Assuming given expectations regarding the

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future level of rates, high current rates will also be associated with a low speculative demand for money. Those expecting rates to rise will then be fewer, and the extent of the rise expected by them will be smaller. At low current rates, on the other hand, people expecting a rise in rates (and therefore a fall in security prices) will be numerous; the shape of the curve in fig. i is drawn to indicate that, once current rates have fallen to a particularly low level, everyone will come to prefer money to securities. 2 The determination of interest rates Whatever the amount of money that firms and householders wish to hold, the amount which they do hold must equal the particular supply that the government has created. No one, however, will hold money or securities unwillingly. If, at any level of interest rates, the amount of money in a man's possession is smaller than the amount he wishes to hold, then he will sell securities in order to acquire more money. Any general endeavour to augment money stocks in this way, however, must fail, so long as the government does not augment the supply; the volume of securities offered for sale will exceed the volume for which there are willing purchasers, security prices will fall and interest rates rise. This rise will continue up to the point at which the attractiveness of securities is so enhanced that the community's desire to hold money comes into balance with the actual money supply. In a similar way, if the demand for money, at given rates of interest, falls short of the actual supply, then rates will decline until the demand has adjusted itself. If the fixed supply of money is represented by the vertical line M in fig, ii then the current level of rates will be given by the intersection of this line with the curve LL representing the demand for money. If the quantity of money is increased, then, in order that the larger supply should be willingly held, interest rates will have to fall. If the quantity is reduced, rates will have to rise. We can more readily see how this will come about by considering how changes in the money supply can be effected. A government wishing to increase the supply will normally do so by purchasing securities from the public in exchange for newly created bank deposits. It will generally be able to do this only by offering a price for securities higher than that previously obtaining, in order to induce wealth-owners to part with some. Thus, as a result of creating more money, interest rates will be driven down. Before the change, the public consider the advantages of having a further marginal addition to their money stock to be offset

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by the interest return which would be lost by having to sell some securities. A fall in rates is required to raise the relative advantages of money over securities at the margin. Similar reasoning indicates that, were the government to reduce the quantity of money, interest rates would rise. To withdraw money from the economy, the government would sell new securities to the public, who would give up part of their bank deposits in exchange. While this was being done, security prices would be driven down and interest rates driven up to a new equilibrium level. It would therefore appear, given the simplifying assumptions upon

Fig. ii

which our analysis still rests, that it is in the government's power, by either buying or selling securities for money, to determine the general level of interest rates. But the nature of the demand for money is such as to impose a limitation upon this power. If current rates of interest are low, relative to the given expectations regarding future rates, there will be a widespread belief that security prices are much more likely to fall than to rise. If then the government decides to increase the money supply, it will find that there is no need to bid up the price of securities any further in order to persuade the public to exchange them for bank deposits; the rate of interest, therefore, will not fall. There will be, in effect, some minimum return necessary to persuade anyone to hold securities; the stronger the belief that the rate of interest will rise, the stronger will be the speculative motive for holding money, and the higher, therefore, this minimum return. If the public has become accustomed to high rates of interest, the

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government may be unable to persuade it that rates will not be high in the future, and unable, therefore, to engineer low rates in the present. This is an inevitable implication of the fact that, for any asset as marketable and storable as securities, the price in the present cannot fall much below the price which is generally expected in the future. The time has now come to abandon the special assumptions on which our analysis has been based. Both the level of the national income, it will be recalled, and opinion regarding the future course of interest rates, were assumed to be fixed and given. By implication, therefore, both of these were presumed to be independent of current interest rates and of the quantity of money. This simplification permitted us to think in terms of a straight, one-way causal sequence; incomes and interest expectations, together with the quantity of money, determined the current level of rates. In fact, however, the situation is that of circular inter-relationship, with current rates reacting back upon the factors by which we regarded them as determined. Our decision to neglect the effect of current interest rates upon expectations regarding future rates is the more easy to justify. The great importance of interest expectations, through their effect on the demand for money, is not in question. Nor would one doubt that expectations, in this matter as in others, will be influenced by present circumstances. But it seems reasonable to believe that expectations will be shaped, not so much by the level of rates yesterday or today, as by the whole course of rates during some considerable past period. Current movements will weigh heavily in the formation of expectations only if wealth-owners are convinced that, for some special reason, they are a good indication of future trends; governments, wishing to influence expectations,may endeavour to persuade the public that this is so-but they do not always succeed. Our second assumption-that the level of the national income could be regarded as given and independent of interest rates--can be justified only as an expository device enabling us to avoid dealing with too many things at the same time. It must now be abandoned. Aggregate incomes and employment, according to the argument of the last chapter, depend upon four things: the community's propensity to consume (or save), the level of business investment, the level of government expenditure and the tax rate. If interest rates are to react back on incomes, they must do so through their influence on these determinants. Neither government expenditure nor rates of taxation will react in any automatic way to changes in interest rates;

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they can be regarded simply as given. We are therefore left to consider the influence of rates of interest on the propensity to save and on the level of private investment. General reasoning scarcely enables us to identify any simple and universally valid relation between interest changes and savings plans. An increase in rates raises the reward for postponing consumption; at the same time, however, it reduces the amount that has to be set aside in order to obtain a particular sum, or flow of income, in the future. Thus the direction of this effect is uncertain, and its strength, compared with that exercised by changes in income, is small. There is, however, a less direct way in which interest rates may influence decisions to spend and save. These decisions have been so far related exclusively to that part of a man's financial position which we call his income. But it is difficult to believe that they will not also depend, to some extent, upon the total monetary value of his assets, or, in other words, upon his wealth. Part of this wealth may be held in the form of securities, the market value of which will vary inversely with current interest rates. A fall in rates by increasing the value of security holdings will encourage spending; a rise will produce the contrary result. Although the magnitude of this effect is difficult to judge, its direction is clear. We must also bear in mind that spending, particularly on durable fixed assets, such as houses, domestic equipment and cars, is frequently financed by borrowing, typically through the medium of a hire-purchase contract. The higher are interest rates, the greater will be the cost of the credit granted, and the greater, therefore, the size or the duration of instalment payments. Here again, therefore, spending plans may be expected to react inversely to the level of interest rates, but the actual degree to which they will do so may be reduced by the fact that some people, being imperfectly aware of the cost of the credit they are receiving, are insensitive to its alteration. Let us now turn from the influence of interest rates on plans to spend and to save and consider their influence on plans to invest. In the collectivist economy, the reader will recall, it was this influence which gave to the rate of interest its raison d'ztre. Managers were allotted output targets by the central government, but were left free to choose the particular methods of production which they thought would minimize costs. The fact that they had to pay interest on their debts with the central bank influenced their choice between processes which required different original capital outlays, so that, by varying the rate of interest, the government could cause a switch in demand between inputs available immediately and inputs to be available at

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future dates. In a private enterprise economy, producers have still to decide between more or less capitalistic techniques; they will have to choose, on occasions, between a process requiring much labour, for which wages will have to be paid throughout the period during which goods are being produced, and an equivalent process making use of a machine which will have to be paid for before production is started. In principle the rate of interest will affect the relative costs of these different techniques. If capital expenditure is financed by the issue of shares or by borrowing, a return will have to be offered which is in line with the current rate of interest; if financed from funds previously accumulated, then the rate of interest will represent the return which could have been obtained had the funds been lent out rather than used by the firm itself. In practice, however, this particular influence of the rate of interest may often be very slight. The entrepreneur is not likely to be confronted with a continuous range of alternative processes, each one of which is slightly more capitalistic than the one before it. The choice may be between a limited number of techniques, the difference between the costs of any two of which may be too substantial to be significantly affected by any normal changes in interest rates. We have to remember, however, that firms under private enterprise, unlike those in our model of a collectivist economy, will have to set their own production targets, and that they will do this by comparing expected receipts with costs. If they are to undertake an additional investment in any direction, they will require assurance that the expected profit rate is not less than the rate of interest at which they could raise funds or the rate which they could obtain from lending them. In fact, of course, the expected rate of profit from investment in production will have to exceed the general level of interest rates by some margin, in order to compensate for the fact that physical assets are a form of wealth less marketable than securities and offering, in general, a less predictable yield. Nevertheless, it is clear, at any rate in principle, that the number of investment projects judged eligible will depend upon the rate of interest ruling at the time; the lower this rate, the larger the number of projects which will show a return, net of interest costs, sufficient to induce entrepreneurs to undertake them. Planned investment, therefore, for the economy as a whole, will be related inversely to the general level of interest rates as shown. Once again, however, it is very difficult to judge the magnitude of the effect which changes in interest rates will have on the volume of investment plans. In manufacturing business, firms will often hope

196 ECONOMIC THEORY to make an investment pay for itself in a few years, so that interest charges will form only a small part of total production costs. A change of 1 or 2% in interest rates will represent an even smaller change in these costs. If, as is likely, entrepreneurs' estimates of the likely return from the investment are far from precise, then small changes of this kind are likely to influence the decisions only of those who are already very hesitant. The longer the period which must elapse before an investment pays for itself, the greater will be the proportion which interest charges will form of total costs, and the more powerful will be the effect of interest rate variation on investment plans. Thus a sharp rise in rates may persuade a local authority to delay the construction of a swimming pool or a firm from building a more luxurious office block. Capital consists not only of fixed equipment but of stocks of materials, of finished goods, and of half-finished goods. We have to consider the possible effect of interest rates, therefore, on the volume of stocks which firms will wish to hold. If producers, wholesalers and retailers decide to increase their holdings of stocks, production will be stimulated and incomes raised; a reduction of stocks will have the opposite effect. Now the holding of stocks represents a cost; the money that is spent on their purchase or manufacture could have been lent at interest or used to pay off debt. Thus the higher the interest rate, the greater the cost of holding stocks and the greater the incentive to economize by their reduction. But although the direction of this effect is clear, its magnitude once again is difficult to judge. There will usually be some minimum volume of stocks which a manufacturer, or a retailer, will regard as indispensable to the smooth conduct of his business, and even sharp changes in interest rates will not induce him to do with less. By holding stocks in excess of this indispensable minimum, a manufacturer will generally be able to enhance the flexibility of his operations; large raw-material stocks will permit him more rapidly to expand production, and stocks of finished goods will permit him to meet an unexpected upsurge of demand. As some balance will have to be struck between this gain of flexibility and the cost of providing it, one might expect stock-holdings to be sensitive to changes in interest rates. In fact, however, various empirical enquiries conducted in Britain and the United States have not produced much evidence of any marked effect of this kind; its importance is still a matter of dispute among economists, but the majority of them are inclined to regard it as slight. We are now in a position to pick up, once again, the main threads

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of our argument. We originally set out to investigate the relationship between the amount of money in the economy, on the one hand, and the levels of interest rates, and of incomes and prices, on the other. It proved convenient first to take as given both expectations regarding future rates and the current level of incomes and prices; these two factors could then be regarded as determining the demand for money balances as a function of interest rates. By confronting this demand curve for money with the given supply of money, we were enabled to identify the particular level of rates at which people would be content with the size of their money holdings. This represented the

Fig. iii

equilibrium level of rates, in that, if the actual level diverged from it, net selling or buying of securities would take place so as to close the gap between the two. What we have now come to recognize is that such an equilibrium would be short lived, as the actual level of interest rates would react back, via plans to save or invest, on the level of the national income and thereby on the demand for money. It appeared probable, if not altogether certain, that planned saving would vary positively with the level of interest rates in the manner shown by the curve SS in fig. iii. Investment plans, on the other hand, were inversely related to interest rates, as shown by the curve 11. Taking both curves together, it is evident that there is only one level of rates at which planned savings and planned investment will be equal. If the actual level is above this, planned saving will exceed planned investment, thus depressing the level of incomes; if

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the actual level is below that consistent with harmony between savings and investment decisions, then incomes will rise. The great complexity of the inter-acting relationship between money, interest rates, incomes and prices now becomes apparent. If the government increases the quantity of money by buying securities from the public, interest rates will be driven down; as a result, saving will be discouraged and investment stimulated, so that the general level of incomes will rise. The higher the national income, however, the greater will be the volume of business transactions and the larger the money balances that the community will wish to hold. This enhanced demand for money will then push up interest rates, which, by acting on plans to save and to invest, will check the rise in incomes. Bearing in mind this chain of action and reaction, how is the effect of changes in the money supply to be predicted? Any useful answer to this question will have to distinguish between effects in the shortrun and in the long-run. So long as we are concerned with the more immediate effects on interest rates of a change in the money supply, the level of incomes can safely be regarded as fixed and given. In order to increase the money supply, for example, the government will have to buy securities, thus bidding up their prices and depressing rates, and this effect will be apparent before the lower rates have had time, through their effect on saving and investment, to change the level of incomes. Only as incomes gradually rise will the community begin to desire larger money balances, and only then will interest rates start to move up again. This whole process will work itself out fully only when rates of interest have settled down to a level compatible with the fulfilment of two distinct conditionsfirst, with day-to-day balance between the demand for money and the supply of it, and, secondly, with equality between planned savings and planned investment. If both these conditions come ultimately to be realized, then both the level of interest rates and the level of the national income could be said to be in full equilibrium, there being no built-in reason for either to change. Our real world, however, is in constant flux. Long before the tendencies in any given set of circumstances have had time to work themselves out fully, the circumstances will have changed. The notion of long-run equilibrium values for interest rates and national income therefore is useful in explaining the direction of movement, rather than the currently realized values, of these two magnitudes. Thus, in the example with which we have been dealing, an increase in the money supply, other things being equal, will cause an

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immediate fall in interest rates, provided that these are not already at the minimum level sufficient to persuade the public-given their expectations about future rates-to hold securities. This fall in rates, by raising the level of incomes through its effect on savings and investment, will in time set up forces which can reverse the fall; but before this process is fully carried through, the supply of money, savings habits, expectations about future rates or opinion as to the profitability of investment, may themselves have changed. It now remains to assess the relevance of this theoretical analysis for public policy. In deciding whether to increase or decrease the quantity of money, the government's overriding aim must be maintenance of high employment and reasonable price stability. More immediately, therefore, it must attend to the level of aggregate demand, upon which the money supply, in the ways just discussed, will exert an influence. The aims of monetary policy are therefore the same as those attributed to fiscal policy, as exercised through the levels of taxation and government expenditure, and it is with their joint effect that a government should be concerned. As a weapon of control, fiscal measures are likely to be preferred, as they are probably more dependable than monetary measures, and are capable of greater discrimination. That they are more dependable was implied by the many doubts and qualificationswith which the above discussion of the effects of changes in the money supply was sown. Neither the effect of the quantity of money on interest rates nor the effect of interest rates on spending is at all easy to predict. Current rates, we had occasion to observe, are much influenced by general opinion about the rates that will rule in the future, and to this extent may be unresponsive to changes in money supply. And even if the government succeeds in establishing a level of interest rates of its own choosing, the consequent effect on private consumption and on the level of business investment will be difficult to predict, both as to its magnitude and to the time taken for it to be felt. Although fiscal measures also suffer from these defects, they do so to a lesser degree. If the government is concerned to control, not only the aggregate level of demand, but the demand of particular groups of people and the demand for particular things, the advantages of variations in tax rates, as contrasted with variations in the money stock, are evident. An income tax, the rate of which rises more than in proportion to income, enables the government to discriminate between rich and poor; by adjusting the weight of tax between persons and firms it is possible to discriminate, to some extent,

200

E C O N O M I C THEORY

between consumption and investment demand, and by imposing purchase taxes upon specific goods a special burden can be placed upon those who consume them. By instructing the banks to lend to some people, or for some purposes rather than others, some discrimination can be exerted by monetary policy, but it is likely to be much more difficult to operate. For these reasons the government is more likely to rely on taxrate changes, rather than changes in the quantity of money, to maintain continuous control over the level of aggregate demand. This does not mean that the quantity of money will never be varied or that it will be regarded as a matter of indifference. The very operation of fiscal policy will, in general, affect the quantity of money in circulation. If the government decides that, in order to maintain an adequate level of demand, it must spend more than it receives in revenue from taxes, then the deficit must be met either by the creation of more money or by borrowing. Should it decide to borrow, by selling securities to the public, the immediate effect may be a fall in security prices, and therefore a rise in interest rates, which will affect private spending in such a way as to offset the purposes of the government deficit. Given this inter-relationship between fiscal and monetary policies, it is evident that the government ought to plan them in conjuction. Frequently, it will be undesirable to rely exclusively on tax changes to affect the level of aggregate demand. If private demand threatens to be much in excess of the resources which can be devoted to meet it, exclusive reliance on fiscal restraint may require very sharp increases in tax rates; such increases may reduce the incentive to work, they will certainly increase the incentive to tax evasion and they are likely to be unpopular. It will probably be wise, therefore, to let a reduction in the money supply do some of the work of containing demand.

I0

Conclusion I have set myself, in this book, to acquaint the reader with some of the mental apparatus designed to help us in elucidating economic affairs. In order to do so, it proved convenient to discuss two alternative forms of economic organization, of which the first was central planning, the second competitive private enterprise. It is natural that our argument should be rounded off by some reference to the strengths, and the weaknesses, of these alternative systems. Inevitably, this must lead us to cross the boundaries of formal theorizing, but a good economist has to acquire a sense of where these boundaries lie and of what lies beyond them. Neither central planning nor free enterprise is likely to exist in pure form. The former system, in practice, will admit much decentralization of decisions and the latter much government intervention. Despite this, however, a radical distinction between the two methods of economic organization can still be drawn. Under collectivism, industrial managers take decisions by virtue of authority expressly delegated to them by the state, and the scope of these decisions is determined by the scope of this authority. In a system based on private property, private individuals or companies are free to make whatever use they choose of the resources they command, subject to the condition that they do not do so in such ways and in such fields as the state expressly forbids. Thus the former system is based on subordination, tempered by the delegation of authority, whereas the latter is based on freedom, subject to restraints. We have already had occasion to note that the very number and variety of the decisions necessary to promote efficient allocation would oblige any government, under collectivism, to delegate much of its responsibility. In fact, however, administrative complexity is not the only, nor even perhaps the most important, ground for 201

202

ECONOMIC THEORY

dispersing the power to take decisions. Economic progress must depend, in the long run, on the quality of human thought and action, on personal responsibility, on resourcefulness and energy. To the extent that a man's activity is confined to the mere execution of orders, originating from a central bureau, his capacity for fresh and enterprising decisions will atrophy through disuse. Without some widespread freedom of action, and the responsibility associated therewith, the mainsprings of economic and social progress will gradually fail. Thus, even under collectivism, the dispersion of authority, and the enlarged freedom that must accompany it, is more than a mere administrative convenience, such as we have been content to regard it hitherto; it is, in its own right, a powerful engine of progress. Even this admission, however, does less than justice to the case for individual freedom. The variety and freshness of decision which freedom promotes can indeed further economic progress; but human welfare comprises more than an ever increasing supply of goods and services. Intellectual and artistic achievement, together with personal development in the widest sense, thrive on individual freedom and are hampered by its restriction. Freedom, indeed, may be regarded as a good in its own right and not simply as a means of promoting other goods, material or immaterial. Enough has been said to show that, if human welfare is to be advanced, collectivism must somehow reconcile central direction with a substantial measure of freedom, in action as well as opinion, for individuals and associations within the community. This will be possible only if the government forbears from striving to fit the whole range of economic activity into a fully articulated and centrally imposed master plan. A system based on private ownership is likewise obliged, no less than collectivism, to make its compromises. The effective co-ordination of economic activity can never be wholly automatic or spontaneous. The analysis presented in the previous chapters can leave no doubt that a system of prices, although of indispensable assistance in furthering allocative efficiency, cannot be left to do all the work by itself. The role of prices is twofold. First, they should constitute a signalling mechanism, such as will provide those concerned with information about the relative scarcity of different factors of production and the relative strengths of demand for different goods. And, secondly, they should create a system of incentives that can induce socially desirable investment in response to the prospect of

CONCLUSION

203

private profits. Neither of these functions, however, is within the power of a free price system perfectly, and in all circumstances, to fulfil. It may come about therefore, under unregulated private enterprise, both that the community's resources are employed inefficiently and that they are not employed to the full. An inefficient use of resources may be attributed to the fact that the information with which prices supply producers relates more to the past and the present than to the future. An entrepreneur cannot safely deduce, merely from current price movements, either what consumers will want in the future or what other entrepreneurs are planning to do. Thus it became apparent, in chapters 6 and 7, that firms operating in competitive conditions may lack the informational basis on which to take rational output decisions. As a result, too much may be produced of one thing and too little of another. It is true that the uncertainty with which producers have to contend can be reduced, without government action, by measures that they themselves can take-by amalgamation, by concerted investment planning, by price agreements and the like. These arrangements, however, although they help producers to overcome the difficulties created by ignorance of the plans of others, weaken the forces of competition; they may give suppliers an incentive to raise prices, to the public disadvantage, and they can serve to protect the inefficient against encroachment by abler rivals. One solution to this problem consists in transferring those spheres, within which the price mechanism is markedly defective, to public ownership. By thus making related investment decisions the ultimate responsibility of the government, nationalization can facilitate (though it does not automatically secure) their conscious co-ordination. The nationalization of road, rail and air transport, or of coal, gas and electricity, has, for example, been advocated on these grounds. A less radical means of co-ordinating decisions may be provided by a nationally organized system of consultation both between industries and the government and between one industry and another. Given these arrangements, all the industries concerned will become acquainted with each other's provisional production plans; as a result, it is hoped that these plans will be revised in such a way that they come to conform, more or less voluntarily, to a central plan, the output targets contained in which are the outcome of the process of consultation. Flexible planning of this kind, based largely on consent, has been practised for some years in France, and tentative steps have recently been taken in the same direction in

204 ECONOMIC THEORY the United Kingdom. What remains to be seen is the extent to which these measures, designed to achieve conformity with a central plan, are compatible with the freedom of individual enterprises and with the stimulus to efficiency provided by a genuine competitive struggle. It was maintained in chapter 8 that the price system could not be depended upon, if left unregulated, to lead entrepreneurs to plan just that volume of production capable of ensuring an aggregate demand for resources neither greater nor less than the supplies available. But it at first appeared that full employment and price stability could generally be attained without the need to impose upon private enterprise any fully articulate central plan; it seemed sufficient to adjust aggregate money demand to the required level by general fiscal or monetary measures. Thus although government intervention was necessary, it seemed that it could take such forms as would leave the functioning of a competitive economy more or less intact. Recent experience, however, and a closer examination of the problems involved, has cast some doubt on the ability of fiscal or monetary policy to attain all the ends desired. We noted that, given full employment of labour, trade unions are likely to demand, and employers to grant, wage increases large enough to cause persistent inflation. Recourse to fiscal or monetary action could, in these circumstances, reduce the aggregate spending on goods, and, ultimately, if applied with force, stiffen the resistance of employers to wage demands. But the cost of such measures, in terms of unemployment and loss of output, could be heavy. Free competitive bargaining may therefore make it impossible to enjoy both full employment and stability in the value of money, and, if it does, governments will be inclined to seek to replace it by some more centralized system of wage-fixing. If the foregoing considerations are given full weight, then we cannot resist the conclusion that economic organization will of necessity, be a patchwork affair. There is no means of prescribing, irrespective of circumstances, time and place, the proper sphere of public and private action. But one can be certain that an effective economic organization will have to preserve a balance between the claims of economic order on the one hand, and, on the other, the need to sustain freshness and diversity of individual decision. By concentrating on the conditions for rational resource allocation, this book has emphasized the first of these requirements; but it should not be thought that the second, by being less amenable to formal analysis, is thereby less important.

Index AGREEMENTS made between firms,

147-8, 152, 155, 158, 161 Agriculture, 141-2 deposits, 186, 189 Barter, 11 Building, 142

BANK

CAPITAL, accumulation, 59-71 circulating, 49 def. deepening, 71 fixed, 49 def. marginal net productivity of, 63 def., 64, 65 widening, 71 Closed economy, 16 Competition, perfect, 7, 130-7, 139, 160 Competitive control, 123-4, 138, 143-52, 161 Complementarity, 65, 76, 163 Constant returns to scale, 31 def. Cost of marginal inputs (CMI), go def. long-run CMI, 93 def., 122 short-run CMI, 93 def., 122

Depreciation, I 66 Diminishing marginal substitutability, 27 def. Discounted values. 10I def. Distributive efficiency, 20, 3441,469 73, 84-8, 101-3, 119 justice, 35 def., 85 Durable-use producers goods, 48 def. of scale, 52, 58, 68, 93-49 135, 151 Educational capital, 50-1, 58, 69, 75, 108-9 Elasticity of demand, 130 def. Entrepreneurs, I 15 def. Entry, barriers to, 143, 148-51 Equicost curves, 82 def. Equiproduct curves, 22 def. Equity capital, I 13

ECONOMIES

FINANCE,

GOODWILL,

curve, 129

I52

Sir Roy, 8 Hicks, Professor Sir J. R., 49 205 HARROD,

DEMAND

availability of, 125-6

206

INDEX

curves, 35 def., 86 NATIONAL income, I 65-7 National output, 165-7 Inflation, 164-5, 175, 180-4 Information, availability of, 137- Normative economics, 12 def., I3 43 Informational requirement, 123, 136, 161 Interest rates, 97-106, Ch. g OPTIMUM assortment, 20, 41-4, passim 46, 73, 88-92, 103-7, 120 Investment, 49 def., 166-80, 198 effect of interest rates on, PATENTS, 149 Positive economics, 12 def. 194-6 Prescriptive economics, I 2 def., I3 Price rigidity, 155-6 LONG-RUN, opportunities, 53 def. Private property, I I 1-17 production frontier, 55 Production frontier, 30 def., 84 efficiency, 92-7 cost curve, 95-6, 125, 127-8, Productive efficiency, 20 def., 21-34946,729 80-4,97-IOI, I34 119 Productivity, 70 Profits, normal, I 19 def., 135 MANAGERIAL capacity, 127 Propensity to consume, 169 def., Marginal costs (MC), 133 def. 174, I93 Marginal opportunity cost marginal, 172 def., 177 (MOC), 31 def. Propensity to save, 170 def., 177, Marginal receipts (MR), 133 def. I93 Marginal relative utility (MRU), marginal, 173 def. 37 def. Public goods, 106-7 Marginal substitutability (MS), 24 def. diminishing, 27 def. Marginal utility, 38 def. Market opportunities, 123 def. Market shares, 155-6 Marshall, A., 16-17 RESEARCH, 75-6 Risk, 126 Minimum economic scale, 53 Monetary policy, 199-200 Money, Ch. g passim Monopolist, policy of, 144-6, SAVING, 102-6, 166-80, 198 effect of interest rates on, 194 154, 159, 161 Multiplier, 173 def., 178 Selective mechanism, I I 6, I 59 INDIFFERENCE

INDEX

Short-run opportunities, 53 def., 54-9 production frontier, 55 efficiency, 92-5 Single-use producers' goods, 48 def. Speculative demand for money, 190-2 Speculators, I I 6 Stocks, 121, 123 footnote, 1567, 169, 196 Supply potential, 123 def., 124, 140 Surplus labour, 184-5 TAXES, 175, I93 Technical progress, 74-8,107-10 Theory, function of, 16 Trade unions, 164, 180,181,182

207

Transactions demand for money, 190 countries, 184-5 Unemployment, 57-8, 164-5, 175, 180, 184-5 Unit costs (UC), 93 def. UNDERDEVELOPED

WAGES, 82, 89, 90-1, 104, 164, I 80-2 Welfare, economic, I 5 def. Welfare frontier, particular, 40 def. general, 42 def. Work, optimum supply of, 44-6 Working capital, 49 def. Wright, J. F., 8