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Three Fundamental Concepts Of Economics

( Originally Published Early 1900's )



1. Human wants.—Two characteristics of human wants possess great importance in their bearing upon the production and consumption of wealth.

First, there seems to be no limit to the number of wants of which a human being is capable. This is one reason why most people find saving so difcult; any growth of income is speedily outdistanced by the growth of wants. This characteristic also ex-plains why a general overproduction of wealth is impossible; there may be too much of one thing but not too much of all things. It also accounts for the al-most infinite variety of goods found in the markets of any modern city.

Second, the continued gratification of any single want finally leads to satiety and may become even tedious and irksome. It is a well-known fact of everyday life that any pleasure loses its zest if indulged in too long.

2. Law of diminishing utility.—The fact that we get less and less satisfaction out of the continued gratification of any single want is so important that it is laid down as a fundamental proposition and is known as the law of diminishing utility. It may be stated as follows: The intensity of any utility, or of a man's desire for any good, tends to decline as he consumes successive units of it.

This law doubtless has both a physiological and a psychological basis. Sports weary certain muscles and finally cease to give pleasure. The hungry man gets great satisfaction out of the first few minutes of his dinner, but his enjoyment of the meal soon begins to decline. A man who is already the owner of a silk hat, is not profusely grateful if a friend sends him a second silk hat as a Christmas gift, and if he gets a third on his next birthday he will probably look at it gloomily and wonder if he has some friend or relative whose head it will fit, for to him it is only a nuisance.

This principle of diminishing utility applies with varying force in the case of different articles and different men. In the case of the silk hat, the utility declines very rapidly as the supply is increased. In the case of shirts the decline will be much less rapid. To the man who has only one shirt it will possess very great utility; he will prize it much more than he would any one shirt if he had twelve in his bureau drawer. It may be said that up to a certain point there is possible an increase in the supply of any commodity in our possession without any appreciable decline in its utility. We want a certain number of suits of clothes and a house with a certain number of rooms. Additional clothing and additional space in our house would be only a burden, something to be cared for but not wanted.

Bread, potatoes and beans are nourishing. Potatoes and beans in ordinary times are cheap. If the human race would be satisfied with such food, the population of the earth might be doubled and yet all be well fed; but we demand variety in food and would protest vigorously if the same rations were placed before us day after day.

3. The law of demand and supply.—Every business man knows that the value or price of any article depends upon the demand for and supply of it. The law of demand and supply may be briefly stated as follows: The price or value of any article tends to vary directly with the demand and inversely with the supply; increasing or declining as the demand increases or declines, but tending to rise as the sup-ply declines and to fall as the supply increases.

The reader must not think of this law as a complete explanation of value. It is not in any sense a theory of value. It merely states in general terms a truth well known to all men familiar with the operations of trade and industry.

If we analyze this law we run up against some difficult questions. What is meant by demand? Why does the value rise when the demand increases? Why does the value tend to fall when the supply increases? We find also that there is a curious interaction between value on the one hand and demand and supply on the other. If the price of an article is lowered, we discover that the demand for it tends to increase and that at the same time the supply tends to decrease. We will not undertake to discuss all these problems in this chapter, but will be satisfied with an examination of the terms demand and supply.

4. Analysis of demand.—The desire for a commodity is not in itself an economic demand for it. No matter how much a man may want an automobile, his desire can have no effect upon the prices or value of automobiles unless be has the necessary means of payment. Desire must be accompanied by the necessary purchasing power before it can become economic or effective demand, or have any influence in the market.

The second point to notice in connection with demand is that it varies with the price. For example, if the price of automobiles and. the cost of operation could be cut one-half, there would undoubtedly be a great increase in the demand for automobiles and many more cars would, be made and sold. On the other hand, if any conditions cause the prices of automobiles and gasolene to be advanced, the tendency will be toward a weaker demand and smaller sales. Hence when we speak of the demand for any article, manifestly we must always have in mind a certain price, for the demand varies with the price.

There is only one way of measuring the demand for an article at any given price, and that is by the quantity of it which is sold at that price. That shows how many people are willing to buy at such a price.

Hence it is possible for us to define demand as being the amount of goods which people are willing to take at a given price.

5. Analysis of supply.—The word supply as commonly used includes the entire stock of goods within reach of the market, but economists use it in a stricter sense, meaning by it only that portion of the entire stock which is actually offered for sale at a given price. The entire stock of wheat, for example, in a country might be 500,000 bushels and the price $2. If only 100,000 bushels were offered for sale, that would be the economic or effective supply at that price, and if 100,000 bushels were sold at that price, that would constitute also the economic demand.

Thus in our analysis of demand and supply, we find that at any particular time and price they are measured by the same quantity of goods.

This conclusion is not remarkable, for a man's purchasing power depends upon the goods he possesses, plus his credit or borrowing power which in turn depends on his power to produce in the future. How he shall use it is determined by his wants. A farmer going to market with 10 bushels of potatoes, intending to sell them and purchase groceries with the proceeds, is increasing the supply of potatoes in the market and the demand for certain groceries. To the buyers of potatoes his load constitutes an addition to the sup-ply, but to the grocer it represents a demand for certain groceries. Money is merely the medium by which the exchanges are effected; the economic demand for goods is the goods that are in the buyer's possession. In modern business the buyer always goes to market equipped with money or credit, and this he has obtained either by the production of goods or by the performance of valuable services.

6. Potential demand and supply.—That part of the stock of an article which is not offered for sale at a given price is sometimes called the potential sup-ply. When would-be buyers of an article are not quite satisfied with the present price and hold back for a lower price, this is referred to as the potential demand. Dealers in any article when determining what price they may hope for naturally take into account,, so far as possible, the intensity of the potential demand and the amount of the potential supply.

The great enlargement of cold storage and ware-housing facilities in recent years has made the potential supply of many commodities exceedingly important. The thrifty farmer is no longer compelled to market all his eggs. in the spring and summer, nor all his potatoes and grain crops in the fall. In normal times this withholding of foodstuffs from the market, so that they are not part of the effective supply, tends, first toward the steadying of prices and, second toward the lowering of prices, for the farmer, his profits being larger and more secure, is stimulated to an increase of production.

In this book we shall use,the words demand and supply in the sense given them ordinarily by business men, meaning by supply the goods in the market seeking a purchaser, and by demand the quantity of goods which people will buy at or near any given price.

7. The value equation.—Any business man knows that the price or value of an article tends to rise when-ever the demand for it at the existing price is in excess of the supply offered for sale at that price; and conversely that the price of an article is likely to decline whenever the supply offered at the existing price is greater than the demand. It is conditions of this sort which account for the zigzagging of prices in the speculative markets. In the world's great exchanges, where the prices of certain basic commodities are fixed, the traders give consideration to all possible circumstances that may affect the present or future demand or supply of the article in which they are trading. A drought in Argentina may fore-shadow a lessened supply of wheat and cause traders to bid a higher price for it, or storms in Kansas and Nebraska may threaten the corn crop and bring on a rise in the price both of corn and of pork.

At any given time there are in any market a number of men more or less anxious to buy a certain commodity and others who wish to sell. If the sellers are asking too high a price, certain buyers hold off and all the stock cannot be sold. On the other hand, if they should offer their goods at too low a price, the demand would exceed the supply, certain buyers would get all they wanted and others would be disappointed.

Assuming that the buyers and sellers are all keenly competing with one another, each anxious to get all possible advantage out of the market, it is evident that the sellers, even tho they enter into no agreement with one another, will endeavor to put the price at the highest possible figure at which all their supply can be sold. So we may say in general that value or price is such a ratio of exchange as tends to establish an equation between demand and sup-ply. The reader will not understand this definition unless he gives careful consideration to the fact that changes in the. price or value of a commodity tend to cause changes in the demand and supply. In the chapter on Value we shall discuss this subject from other points of view.

8. Agricultural law of diminishing returns.—One of the most important laws in economics was borrowed from the science of agriculture and is known as the law of diminishing returns. Most .economists have treated it mainly with reference to its bearing upon the profits of agriculture, but it applies also to other industries.

The law as it applies to land may be stated as follows: In the cultivation of a piece of land, after a certain point is reached the application of additional labor and capital fails to cause a proportionate in-crease in the yield.

This law states a truth that the experience of every farmer confirms. On a given field a fanner knows how many loads of fertilizer and how many men can be employed to the greatest advantage. He knows that if he puts on additional loads of fertilizer or em-ploys an additional man in the cultivation of the field, altho the total yield may be increased, the re-turn per unit of capital and labor will be less. Sup-pose that the land when cultivated by two men and enriched by ten loads of fertilizer yields 1,000 bushels of wheat. The next season let him increase the use of capital and labor by 50 per cent, that is, apply 15 loads of fertilizer and keep three men at work in the field. If he obtains less than 1,500 bushels of wheat it is manifest that the point of diminishing re-turns has been reached and that his wheat costs him more per bushel the second year than in the first.

This law is important because of its bearing upon the cost of production. As population increases farmers must do one of two things: (1) They must bring poorer or more distant lands into cultivation; (2) the land already tilled must be cultivated more intensively, by which is meant that more labor and capital must be applied. The result in either case is the same, namely, higher costs of production and hence higher prices of foodstuffs in the markets.

The law is manifestly applicable not only to agriculture, but to all extractive industries, such as mining and lumbering. As the demand for ores and lumber increases, mines must be worked to greater depths and lumber must be brought from forests more re-mote, all of which means higher costs of production and a tendency toward higher prices.

9. General law of diminishing returns.—The law is applicable to all forms of industry and may be stated as follows: In the development of any industry there is a point at which the returns upon capital and labor invested are at a maximum; after this point is reached, the application of further labor and capital does not cause a proportionate increase in the value of the return.

Note the difference between the agricultural law and this more general law. In agriculture there is a decline of product per unit of capital and labor; in industry in general there is a decline, not necessarily of product, but in the value of the product. This difference is due to the fact that the supply of land is limited, whereas in industry the number of factories may be indefinitely increased.

If we consider the producing power of a single factory, the law applies to it exactly as to a piece of land. In a given building only a certain number of machines and men can be employed to the greatest advantage. If more are introduced, the output per man and ma-chine declines, altho the total product may be in-creased. Hence it follows that in industry in general, after a certain point of development has been reached, more men and capital cannot be employed without a. certain decline in the output per capital and per man unless additional space for their employment has been provided. Since additional space for manufacturing industries can easily be found, an increasing demand for manufactured articles does not always lead to higher costs of production and higher prices. On the contrary, it often lowers costs because of the economies made possible by large-scale production.

But in any industry, if the demand for its product remain unchanged, then after a certain period in its development has been reached the employment of additional men and machines will not yield a proportionate increase in the value of the product, for the supply of the product on the market would be in-creased and the value would tend downward as a result. At any given time in any country only a definite number of men and a definite amount of capital can be employed to the greatest advantage in any industry.

Take shoes, for instance. The manufacturer must take into account the cost of leather and other materials, the wages of labor, the cost of machinery and its depreciation, and finally the market demand at prices which will yield him profit. These are things which he cannot control, yet upon them depend his costs of production and the price of his product. He has control solely of the amount of his own output; he knows the amount that he can produce with his present plant and he has pretty carefully estimated the probable output of his competitors, and he may decide that any increase of output by him or by any other manufacturer would tend to demoralize the market and compel sales at lower prices, even tho the cost of making a pair of shoes had not declined.

In all industries, therefore, there is constant effort on the part of managers to keep their output at the point which shall yield them maximum profit. In an industry where there is absolute freedom of competition this is one of the manager's hardest problems.

10. Counteracting forces.—Wherever the law of diminishing returns applies, each increase in product is obtained at an increased cost. While this is true for a given time and a given procedure in industry, it does not follow that only thru increased cost per unit can there be an increase of product. Increase in the efficiency of capital and labor may effect a corresponding increase in production. The progress of civilization, as shown in inventions, better methods of transportation, the lessening of taxation, improvements in education, tends to lessen the cost of production, and it is therefore bound to bring about greater returns from the application to nature of capital and labor. As John Stuart Mill says: "There is scarcely any possible amelioration of human affairs which would not, among its other benefits, have a favorable operation, direct and indirect, upon the productiveness of industry."

It was the improvement in agricultural machinery and the extension and cheapening of transportation facilities that brought the western lands of the United States and Canada into the wheat-producing area and made them profitable because of a lessened producing cost. The rise in the price of an ore will bring a mine into the market with its product, while a lowering of the price will exclude it. This is frequently illustrated in the case of bituminous coal.

Improvements in production have the same effect. The immense depths of the copper mines in northern Michigan are accounted for by the rise in the price of copper, and the marked improvements in pumps, engines and drills as well as in mining technic. Yet without question the increase in the temperature at the lower depths of the mines, the large amount of water to be pumped out, and the gradual lessening of the supply will in time bring about an increased cost of producing the supply. Unless there is a corresponding rise in the price of copper such mines will be forced into the margin of production, where their owners will be confronted by the question whether to continue at a loss in the hope of better prices, or to abandon operations. Furthermore, the history of mining records many instances where a rise in the price of the product has led to the re-working of properties once abandoned.

The law of diminishing returns, while it is true and does apply in an industry at a given time, is not to be extended in its application from one season to an-other, or from one period to another, without taking into consideration the introduction of machinery or new methods of production which may change the ratio of return.

What is the law of diminishing utility? Give an illustration of it.

What are the essential things to be noted in demand? How is it measured?

Show by an illustration how the economist uses supply in a different sense from that ordinarily given to it. How are demand and supply measured?

Define potential demand and supply.

What is the agricultural law of diminishing returns? How

does the general law of diminishing returns differ from it? Does increase of product always imply an increased unit cost of production? Illustrate.

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