The Common Sense of Political Economy

In agriculture it has long been recognised that though land, labour, instruments, and so forth, are all necessary to produce a crop, and no one of these can be substituted for any of the others in its totality, yet they can be substituted for each other at their margins. It will be possible to produce the same crop off the same piece of land, with slightly inferior implements or less effective manuring, if the requisite amount of extra labour is judiciously applied, or with less labour if better appliances are provided. Or the same crop may be produced on a smaller area of land, by the employment of more labour upon it; or the same amount of labour may produce a better result on a larger than on a smaller piece of ground.
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Nor is it in agriculture alone that labour and skill can be marginally substituted for land, and
vice versa. Any London tradesman or manufacturer may meet, in an acute form, the problem of balancing the marginal significance of increased area against that of increased height in his premises. Shall he build a relatively low structure on a relatively wide area or a relatively high structure on a relatively narrow area? Each will give him, say, the same cubical capacity, but the tall building will cost more to erect and will involve more labour and expense when erected. A given increment of land will enable him to dispense with a given amount of labour both in constructing and in working his premises. More land and less labour, or less land and more labour, therefore, may produce the same result, and the balance will be struck according to the condition of the markets. Will the extra amount I must pay for the land be covered by the saving on wages?

We need not work out any more details. It is already obvious that the main groups of factors of production, and within each main group every distinguishable sub-variety of effort, tools, skill, material, and so forth, may find a substitute, at the margin, in some other. All must be balanced against each other at their margins, and the market price of each factor will determine to what point it will be well for any individual to supply himself with that factor in preference to relying on some other as a substitute.

It will be well at this point to note how very unsatisfactory, from the theoretic point of view, is the popular division or classification of the factors of production as land, labour, and capital. The distinction between land and capital is obviously arbitrary. What we mean by land in practical life is something which admittedly consists very largely of the accumulated result of human effort, and accordingly it is usually regarded in books of Political Economy as capital, the term land being reserved for the “original and inalienable” properties of the soil. And these it has been found practically impossible to define or separate. Just where we have an area of the earth’s surface which, physically speaking, owes little or none of its value to anything that has been done to it or on it,—for instance a bare site in the centre of a great city,—we find that its value depends more than ever upon capital, that is to say, upon the results of accumulated effort. Only it is the capital that has been expended not upon the site itself but upon the surrounding areas. Land, therefore, even as economically defined, cannot be considered in isolation from capital. And since, as we have seen, the principle on which things balance each other in the market is independent of whether they have been accumulated or not,
*38 the distinction between land and capital, which it seems difficult or impossible to draw, would be theoretically worthless if drawn.

Moreover, the conception of capital as a third factor, distinct from land and labour, is in flagrant and irreconcilable contradiction with the usages of language. In estimating the capital of a company, for example, we include its land, at a proper valuation. Under an industrial system of slavery we should also include its live stock of men as well as of animals; and in countries such as our own we should include not only money that is to be spent on labour devoted to the production of tools or apparatus, such as the sinking of a shaft in mining operations, but the wages to be paid to men engaged in preparing the product for the market before that product is ripe for marketing. So that alike in slave and free countries the capital of a concern includes land, tools, raw material, products in every stage up to the finished goods waiting to be marketed, and command of the efforts of the workers, whether or not secured by legal possession of their persons. It is impossible that any precision of conception or any clearness of speculation should be based on a classification and terminology so outrageously at war with the usage of language.

Moreover, even if we were able satisfactorily to define three or more distinct and exhaustive groups of the factors of production, we should get no greater advantage from it than we should if we were able scientifically and exhaustively to classify the different branches of personal expenditure, as material, intellectual, and artistic for example. The attempt would fail in itself, but even if it succeeded it would throw no light on the laws of the market, for all our different satisfactions balance on the strength of that vital significance wherein they have a common measure, and can be substituted for each other at the margins, not in virtue of the generically different services which they render us at the origins. As a matter of fact there seems to be no possible scientific division of the factors of industry into great groups, and still less any possibility of an exhaustive enumeration of them. A firm, for example, may devote its resources in any proportion that seems fit to the laying down of plant in order to produce things, to advertisement to inform people that the things are produced or to persuade them that they are good, or to the enforcing of practices or traditions which they believe will in the course of long years gain them a desired reputation for straight dealing and intelligence, which will fertilise or economic advertisement, and secure confidence which will itself be a revenue. A good name, then, or almost any kind of notoriety, may be a factor of production in the commercial sense just as much as tools, site, raw material, strength, intelligence, or conscientiousness. In proceeding, therefore, to a closer examination of the laws of distribution and the function of the undertaker we shall entirely ignore all attempts to enumerate and classify the factors of production. We know already that the same principle determines the claims of them all so that the division, could we accomplish it, would have no theoretic importance.

What, then, is the problem of the undertaker? By hypothesis he is dealing with limited resources, and in applying these resources he must draw commodities, services, and privileges out of the circle of exchange, and so combine and direct them as to produce a result, that can itself be returned into the circle of exchange with a value higher than that of the factors or ingredients that were drawn out. He desires to maximise this result, just as the housewife or any other administrator desires to maximise the result of her expenditure. And as the housewife’s attention is fixed upon marginal considerations, while she takes the initial increments for granted,
*39 so the undertaker takes for granted the early increments, near the origin, of all the factors of production, land, labour, tools, and so forth; for some supply of all of them is necessary for any production at all; but at the margins, where each performs a service no longer distinctive and irreplaceable, but capable of being rendered equally well by some substitute, he carefully balances them, and the smallest change in their market prices may induce him to substitute a little of one for a little of another. Here, therefore, a common measure can be found; and just as the price the housewife is willing to pay for any article of consumption is determined, not by the fact that some of it is very important, perhaps essential to life, but by the relative importance of a little more or a little less of it, as against a little more or a little less of something else, so here the prices that the undertaker will pay for the different factors are determined not by the peculiar service that each renders near the origin, but by the extent to which the units of each can respectively perform at the margin the common service they can all render alike. In a former example we determined the equivalence of so much bread to so much water not by considering the nature of the specific functions of bread and of water in supporting the human frame, but by comparing them on the common ground of their satisfying a human craving.
*40 On this ground the value of each can be expressed in terms of the value of the other. It is not because they are unlike, but because they are like, that they come into comparison with each other. So if land and labour are to be compared and equated, and are to settle their respective claims on the common product, it must be because they are reduced to a common measure so that the significance of each can be expressed in terms of the significance of the other. And this must be accomplished by finding the aspect under which their significance is identical, not that in which it is specific to each. Lastly, here as in all markets, what each man is
willing to pay for a thing is determined by its relative place on his own scale, what he actually
has to pay (or go without it) by its relative place on the scales of others. There is equilibrium when these places coincide.

It is obvious that if we dispense with the undertaker altogether and think of different groups of persons, controlling different agents or factors of production, as freely combining and bargaining with each other, exactly the same principles will hold. We may suppose that some possess land, some tools or buildings, some material, some manual skill, some knowledge of the markets on which the product must be placed; and that all are willing to wait for their share till the product is made or sold, and so to take their share in the speculative risk of the undertaking. Some may contribute several factors, but all wait and all speculate. This supposition is necessary for our hypothesis, for if any one demands instant payment the value of his contribution is discounted and bought on speculation by the rest, and they are collectively taking the place of the undertaker with respect to him. Where there is no undertaker the co-operators must themselves determine how they are to share the proceeds, and it is at the margins, where the things that they respectively control can be substituted for each other, that they must find their common measure and come to terms. A marginal addition or subtraction of any one of the factors, the others remaining constant, may be expected to have such and such an effect on the product, and it is thus, and thus only, that they can make comparisons. The withdrawal of the whole supply of labour or the whole supply of land would annihilate the industry. The withdrawal of any one class of tools, or any one kind of intelligence or experience, would severely cripple it; but the withdrawal of a defined small amount of one factor, at the margin, would produce a definite result. How much of any other factor must be withdrawn to produce the same result? When we have answered that question we have determined the relative marginal efficiency of a unit of each of the two factors, and have arrived at the principle on which they must share in the proceeds; for we can now express the contributions made to the result by all the different factors in one and the same unit, and if we divide the proceeds by the sum of these units we shall determine the share to be claimed on account of each.

Now if any number of groups (whether spontaneously organised or brought together by an undertaker) are in a state of equilibrium with regard to each other, the relative marginal significances of all the factors will be identical in all of them. If not, then say that in one group the addition or withdrawal of a unit of land would affect the result twice as much as the addition or withdrawal of a given measure of some other factor, say of labour or of apparatus or intelligence, whereas in another group that same unit of land would produce an effect only equal to that of this given quantity of the other factor. Clearly a regrouping would be advantageous on both sides. The second group should cede a certain amount of land to the first, and the first should cede some of the other factor to the second. Each would be able to offer advantageous terms of exchange to the other, till equilibrium was reached. In the two groups the units of the two factors would then occupy the same relative positions. Thus the proportions in which the various factors that combine in any one group are to share in the product is determined by their relative significance at the margins in increasing or diminishing it. And the same proportions will tend, in the open market, to establish themselves in different independent groups. This will be the case whether the two groups are engaged in the same industry or in different industries that make use of certain common factors of production.

And again, if the total to be shared is proportionately larger in one industry than in another, though the factors employed in them are essentially the same, then clearly the group that reaps the lowest remuneration will divert the whole or a part of its energies to the more remunerative industry, thereby raising the marginal significance of the deserted and lowering that of the invaded industry, by respectively contracting and expanding the stream of their products put upon the market. Or if the different factors in any one group can severally distribute themselves among other groups, or form fresh combinations where their proportional claim in the product, determined by their relative marginal efficiency, represents a larger sum than they are now entitled to, the group will break up, and its constituents will distribute themselves amongst other groups, till equilibrium is reached. This gives us a complete theoretical solution of the problem of distribution with the undertaker eliminated.

Returning to the more familiar case of the undertaker, and stretching the term to include all the functions of promoter, director, and manager, we find him making bargains with those who control the several factors of production. Some of them will receive fixed payments or promises, and will have no further claims on the concern. On this method he may secure raw material, labour, machinery, and land, and may pay some part of the necessary premium on waiting (debentures). Others will take or share the risk, and will give their co-operation on an expectation as to the result, their respective claims on which are suitably defined. These others may be a distinct and separate class of persons with possessions for the direct enjoyment of which they are willing to wait (shareholders). Or the undertaker may himself take some, or all, of this risk, for he may be his own capitalist. Or he may be employed, at a fixed salary, by those who take the risk. In any case, on his own account, or on the account of his employers, he will make whatever initial bargains have to be made; and will then direct and combine the several factors, and determine their respective amounts. These functions may be separated or subdivided. A syndicate may be formed in the first instance to raise the capital, that is to say, to make speculative bargains with possessors who will wait, and then all other bargaining and directing may be handed over to a manager. Or the original syndicate may retain some control of the business, that is to say, may themselves exercise a part of the functions of the manager. But, in any case, whatever resources the undertaker commands, he must so balance their application that the marginal significance of a pound is identical whether expended in wages, rent, interest, or however else. He will, therefore, fix the proportions in which the different factors are to be combined on the principles we have already examined. He will have to make definite payments or promises in some cases, and he will raise more or less elastic expectations in others; and in every case he will have to pay, or to promise, or cause to be expected, as much as the open market offers, in order to command the factors of production he requires. To succeed, then, he must be able so to arrange the proportions of his factors, and so to combine them, as to make them all worth as much at the margin in his own concern as other people expect them to be in theirs. For he will have to give as much as other people offer for them, and he will get as much as they turn out to be worth to him. If he succeeds, the product will recoup him for all his payments, will enable him to meet all his promises, and adequately satisfy all the expectations he has raised, and will leave a balance which he considers a satisfactory remuneration for the exercise of his own sagacity; that is to say, not less than he supposes he could have obtained by some other application of it. This is on the supposition that he has no fixed salary, but has made his own bargains with all the others concerned and is the residuary claimant. If he has a salary that will be included amongst the payments and the syndicate, or whoever takes the ultimate risk, must include that salary amongst their speculative payments or promises.

If the result transcends or falls short of this mark, it may be due to the undertaker’s skill or want of skill, or it may be due to the conditions of the trade. In the former case the marginal significance of the undertaker’s services has been under- or over-estimated by himself or by his employers; and the price of these services will tend to rise or fall as the case may be; for the undertaker too is a factor of production, and his remuneration, whether it consists in a definite payment or in an expectation, was determined on an estimate of the marginal significance of his services. He too has his market, though the special conditions may make it a very imperfect one.

If the result is due to the general conditions of the trade, the undertaker’s anticipations are falsified, but it becomes clear that no other undertaker will be able to do what he has failed to do; so that the blame attaching to him will be that of having made the promises and payments in question, not of having failed to justify them. An adjustment will now take place between the collapsing or languishing industries which either cannot keep the promises or cannot fulfil the expectations they have raised, and the flourishing industries which can keep their promises and can fulfil the expectations they raise. And so the contracting and broadening streams of supply will restore equality of result. But in no case will the amount of the payments and promises that have been made, and the expectations that have been raised, determine the value of the product in the circle of exchange. In all cases it is the anticipated value of the product to be secured that determines the estimated marginal values on which payments, premiums, promises, and expectations were based. These estimated relative marginal significances of the properly grouped and distributed factors determine the proportions of their respective claims for remuneration, and the sum of the unit claims, expressed in the common measure, when divided into the total anticipated value of the product, determines the actual rate at which the concern believed it could afford to remunerate them. To have acted on that belief does not secure a result in accordance with it. If the result falsifies it, the belief will be corrected. But action—in this case costs incurred, promises made, and expectations raised—will always be determined by anticipated results, and will never itself determine what the actual results are. And thus we are insensibly brought to the consideration of our second problem, that of the relation of cost of production to value in exchange.
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To solve this problem also, we have only to array the facts already examined, and to draw the principles which we have been illustrating throughout the course of our investigations into explicit reference to the matter now in hand. At the risk of perhaps wearisome repetition, I will therefore throw this last section partly into the form of an epitome of the whole argument. The guiding principle of all administration, as we have often seen, is so to select between open alternatives as to direct our resources towards the fulfilment of that purpose which, given the terms on which it is open to us, takes the highest place on our scale of preferences. And seeing that the securing of that alternative perpetually lowers its marginal significance, and the neglect of other alternatives raises theirs, we shall always be able to bring our marginal increments of satisfaction into balance with the respective terms on which they are open to us. The purposes that the same resources will fulfil will then stand at the same height on our scales; and so long as we can keep them there, there will be equilibrium and a maximising of desired results. But if we have made an error of judgment, and have made a choice which we cannot now reverse, which puts us in possession of that which turns out to be of less value to us than something else we might have had in its place, the error so far as it goes is irreparable. We may, indeed, learn by experience. To-morrow, or months or years hence, the choice may present itself again, and we may then correct for the future the mistake of judgment which has already produced its full effect upon the past. And within that area of our lives which is irrevocably affected by the waste involved in our misdirection of efforts and resources, better and worse alternatives still remain, though the best of all has been shut out. A contracted range of alternatives may still be open to us, and we must still make the best of them by trying to bring them into equilibrium at the margins, so as to involve no further waste. To revert to our old illustration, even if she has taken in too much or too little milk, the housewife has a wide range of applications open to her. By carelessness in selecting between them, she may add many more mistakes and much more waste to what has already been perpetrated, and by care she may make the very best of the contracted opportunities which her initial mistake has still left her.

Now this principle of administration of resources is applicable as much to our getting as to our spending. Our getting, indeed, is very largely of the nature of spending. It is the spending of time, of energy, of thought, of resources of every kind. And even where it does not naturally come under the conception of spending, or administering resources, it comes under the wider conception of choosing between alternatives, which, as we have seen, follows the same law. If I encounter irksomeness, weariness, or positive pain, it may perhaps be straining language to call this an expenditure or administration of vital resources or powers of endurance, but in any case I am choosing between alternatives, on the principle of a balance of marginal significances. Practically speaking, then, the problem of getting is either identical with the problem of spending to the greatest advantage or strictly analogous to it. If I am devoting my efforts to the direct accomplishment of the things I desire, I shall be guided in my distribution of them by the several marginal significances to me of the experiences they will beget when turned down this channel or that. But if I am pursuing my purposes indirectly, doing things in which my interest is not direct, because that is the most effective way of securing what I want, then I shall be guided not by the place which the results of the various services I can render occupy on my own scale of preferences, but by that which they occupy on the collective scale, as indicated by the money price which they will command. If I am in control of a stock of timber (however I come to be so) which I desire to transmute into the maximum of literature or art or missionary activity, or political propaganda, or knowledge of mathematics, or silk and satin garments, or anything else that cannot be made of wood, I shall sell it at the highest price I can get; that is to say, I shall direct it to the supply of that want which, by the price offered for its satisfaction, proclaims itself to be objectively highest on the collective scale. In other words I shall go to market with my timber, and by the process of always selling to the best customer I can find, I shall be continuously producing or maintaining an equality between all customers, from which there will only be slight departures. The moment one customer becomes better than another, he will command supplies until the marginal value of the article has no higher place on his relative scale than on that of his neighbour. The market will perpetually tend to an equilibrium of prices. In the same way if I have any services to render, I shall render them in such a way as to maintain an equilibrium between all the different purposes which they can further, as expressed in their places on the communal scale.

If I am thinking of my son’s future life, I make a forecast of what I suppose will be, some years hence, the relative place on the collective scale of such services as can be rendered by an electrical engineer, a mechanical engineer, a mining engineer, a barrister, a doctor, and so forth. I try to estimate the likelihood of his achieving eminence or respectability in any of these occupations. I think, if I am wise, of his tastes as well as his talents, and consider which line of activity would be most desirable as an occupation apart from the command it would give him over the services and commodities of others. And I consider the resources I should have to devote to preparing him for each one of these careers and the alternative applications of them which I might make in furtherance of any of my purposes in life other than his establishment. Now all of these considerations will weigh with me, and amongst them my forecast as to the strength of his future economic position, that is to say, the place on the collective scale occupied by the services he will be able to render in one or the other of these professions. Not, as we have seen, that individual tastes and other considerations will go for nothing, but that they will not go for everything, even where they are pronounced; and there will be many cases in which they are not pronounced. Thus, there are persons whose selection of their own career, or of that of others whom they partly or completely control, will be influenced by the anticipated place which these or those services will take on the collective scale. And there will be a tendency to bring them into equilibrium.
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Thus, if in the general estimate, or the estimate of a sufficiently large number of persons to whom the alternative is open, the positions of a mining, a mechanical, and an electrical engineer are in themselves equally desirable, and if the expense of the education in each case is approximately the same, and if the progress of science has opened immense possibilities to electrical engineers, so that at present their services are marginally more effective, and therefore stand higher on the collective scale, than those of mechanical or mining engineers, then those who anticipate that this state of things will last for some time, will have a reason for training themselves or their sons to electrical rather than mechanical or mining engineering. Those who have already qualified as mechanical engineers may think that they have made a mistake. They have acquired one skill instead of another, which other they might have attained at the same effort and sacrifice, and would have found more valuable. But this does not in any way affect the market price of their services. It is affected solely by the number of persons in the market possessing this particular skill, and the place of the wants it ministers to on the collective scale. Slowly, however, this state of things will correct itself. As those to whom the two careers are in themselves indifferent are drafted into the electrical branch, the stream of supply of electrical engineers is constantly broadening and that of mechanical engineers narrowing until the balance is effected. Now it is likely enough that the general estimate may have exaggerated the extent of the initial departure from equilibrium, or underestimated the rapidity with which equilibrium will be restored. Just at the moment when I become convinced that there is a better career for electrical than for mechanical engineers, a vast number of other
patresfamilias may have been visited by the same inspiration, and a considerable though smaller number were visited by it several years earlier. As my son enters upon his long and laborious training, other people’s sons are issuing from theirs, in a broader stream than before; and the stream perpetually broadens till, when my son comes out of his training, it is of very different dimensions from what I anticipated. So that by this time the position of the mechanical engineer may even be better than that of his brother the electrician. Here, again, I have made a mistake, and as far as it goes it is irreparable. The fact that, if my sagacity had been greater, my son might have been performing the service of a mechanical engineer does not make his worth as an electrical engineer any higher. The value of his services is dominated by the law of the market. But though my mistake has been made, and its consequences must be accepted, I and others need not make it again. We shall not put the sons that are now entering upon their training into the same profession. Thus the result, though it does not influence the past, influences the future. The stream of supply will be checked, and a tendency in the counter direction will set in.

Now, the whole work of the world is done, and all the wants of the world are supplied, by the direction of human faculties to the accomplishment of human purposes. And every step in personal training or in manipulating the materials of the planet modifies human power or the materials on which it works in some specific direction, and therefore constitutes a specialising of resources and a relinquishing of one set of alternatives by the embracing of another. Nor has the alternative that has been relinquished any influence on the value or significance of the alternative that has been embraced; for I can no longer equilibrate the two against each other. But if the specialising has not been carried to the last point, if alternative applications are still open, then the anticipated significance of each of them tells upon my mind and influences my action as I equilibrate one against another. I shall not devote my powers or my possessions to the realisation of any purpose as long as they will serve another that seems to me preferable. So the resources, personal and material, of all men are perpetually being directed towards certain goals, alternatives are being perpetually accepted to the exclusion of other alternatives that are rejected, and each such selection narrows the possibilities still open, and at last closes them altogether, the ultimate result having been realised. At every step the alternatives relinquished may cause regret, but at no step do they affect the value of the alternatives realised. So far, then, as my selection between alternatives is dictated not by the value to me of the things that they directly secure, but by the command of generalised services and resources in the circle of exchange which they will indirectly give me, that is to say, so far as I am influenced by economic considerations, my determination is guided at every stage by anticipations of the place which services and things take, or will take, on the collective scale; and my success is measured not by the significance of the alternatives I have relinquished, but by the significance of the alternative I have embraced.

If a number of men have already made chairs the price they realise will not be affected by the knowledge that if they had made tables they would have been in a better position; but their conduct in future will be affected by that knowledge. They will redistribute the undifferentiated resources, which are still capable of being turned to the production of either tables or chairs indifferently; they will broaden the stream of supply of tables, and contract that of chairs, until the falling price of tables and the rising price of chairs bring the prices into conformity with the output of energy and resources respectively required to produce them. Just in the same way the housewife who finds that she has been buying vegetables and fruit in such quantities that, when they are consumed, a halfpennyworth of vegetables meets a less urgent want than a halfpennyworth of fruit, will henceforward contract the purchase of vegetables and increase that of fruit, till the rising significance of vegetables and the declining significance of fruit bring them into balance with the prices. Both alike, craftsman and housewife, have made a mistake in accepting a less eligible alternative than was open. The mistake of neither is itself removed by after-recognition. But both may learn wisdom; and when the alternatives are again open may choose the more eligible one.

But if a man, in full conviction that he could most profitably devote his resources to the production of chairs, had laid down special machinery which was only capable of producing chairs, the production of tables with it would not be an open alternative, and he would consider not whether it would be better to make it produce tables than chairs, but whether, having made a mistake by laying down that class of machinery, it is better for him to scrap it or to go on producing chairs. The question depends for its answer on the range of alternatives still open to him. His machinery will enable him to make chairs, but will not enable him to do anything else. So far there is no alternative. But his stock of wood, if he has any, may be employed in making chairs or tables or in many other ways; and his own thought and effort may likewise be turned into many channels, though he cannot go back to the time when he learned his trade and choose to have learned some other instead. His money may be turned to buying anything that is in the circle of exchange. It need not be spent on wood or wages for the kind of skill that deals with wood, if he can find anything that serves his turn better. Thus he has a certain acquired skill, a certain kind of stock, and a certain general command of commodities and services. Can he without the help of his machinery so combine these as to produce something that stands higher on the collective scale than the chairs which he could produce by applying the same resources to making chairs with the help of his machinery? If not, he will go on producing chairs however bitterly he may regret not having adopted a better alternative when it was open to him.

Cost of production, then, in the sense of the historical and irrevocable fact that resources have been devoted to this or that special purpose, has no influence on the value of the thing produced, and therefore does not affect its price. Cost of production, in the sense of alternatives still open which must now be relinquished in order to produce this specific article, influences the craftsman in determining whether he will produce it or not. Thus, the price of the chairs when produced will be determined by their marginal place on the collective scale; but the maker’s anticipation of what that place will be, compared with the place of anything else which it is still open to him to make instead of the chairs, will decide whether he will make them or not. These two propositions need no qualification, but the significance of the phrase, “anything else which it is still open to him to make instead of the chairs,” is subject to continuous change and narrowing as the process of specialising proceeds and the concrete result is approached. Money and untrained talent may be turned into any channel, but every decision as to the channel into which to turn them shuts out certain possibilities and limits the range of the things that it is still “open to the man to make instead of chairs,” until the chairs at last are actually made, and it is no longer possible to him to make anything else at all instead of them. At every stage the cost incurred in making a thing is the relinquished possibility of making other things, and its extent or amount is determined by the value, or marginal significance on the collective scale, which those other things would have had. So the “cost of production” of any one thing is only another name for the marginal significance of certain other things, which have been forgone for its sake. The marginal significance of things that can no longer be produced instead of it has no effect on its present price; the marginal significance of things that can still be produced instead of it will determine the lower limit of the price at which it will be made to order, and the extent to which manufacturers will continue to make it at all.

These reflections will explain the great ambiguity of the term “cost price.” Even members of the same trade, meeting for conference on their common affairs, and speaking with perfect freedom and sincerity, will use the word in different senses. One will declare that he is “making no profits at all,” but is “selling at a loss,” and another will say that “things are bad enough with him, but not quite so bad as that,” when they both mean to indicate exactly the same state of affairs. Men will declare in good faith that they are “selling below cost price,” and yet will never think of suspending operations. Or again, we may hear that a business goes into liquidation although it is really “perfectly sound in itself,” and we may see that it actually does go on without apparent disturbance. All these phenomena are easily explained. The one man says that he is “selling below cost price” because he takes as his measure of “cost” the estimated value of the things he might have produced when all his original opportunities were still open. Allowing a reasonable percentage on the money that he might have put into another business, though he did not, and a reasonable remuneration for the talents which he might have directed into other channels, though he did not, and adding to this his out-of-pocket expenses for wages, raw material, and so forth, that he need not have incurred, though he did, he finds that altogether they amount to more than the price which he can realise for the articles he has put upon the market; so that he gets less for the thing than it has cost him to make it. But the other man uses the phrase “cost price” in the sense of the sacrifice not of alternatives that once were, but of alternatives that still are open to him. He contemplates only the possibilities of turning his resources, as he now has them, to some other purpose, and he finds that there is nothing else he can now produce or do which would yield a more satisfactory result than what he is actually doing. He is indeed disappointed and dissatisfied at the range of alternatives still open to him, but, since his business still offers him the best of the yet remaining alternatives, now that it is once established, the marginal significance of what he relinquishes to keep it going is lower than that of what he gets by it; and his product, therefore, realises more than its actual “cost of production” as measured in the open alternatives that he relinquishes for it. He would be worse off if he declined orders and closed his works.

In the case of a firm that is “over capitalised” the state of things is this. Expectations were entertained and promises made on the supposition that certain results would be realised. They have not been realised, and to keep all the promises that have been made would be impossible, unless the persons who keep them are able and willing to pay more than they receive. If they do this, after a time they probably will be unable to pay at all. But if the persons to whom the promises were made can be induced, or forced, to face the facts in time, and to consent to take a share in the loss caused by the misdirection of resources, or bate something of the excessive hopes which the original misrepresentations or mistaken estimates caused, the continuance of the business may be a better alternative for all concerned than any other that is now open. If the fulfilment of all the promises is acknowledged as part of the “cost price,” it is above the value of the product. If the alternatives that are open now, or even those that were in real truth open at the beginning, are taken as the “cost price,” it is below that of the product.

We can now see how “cost of production,” which is simply and solely “the marginal significance of something else,” directly affects the quantity of anything produced, and thereby indirectly affects its price, so that there is a constant tendency for prices to conform to cost of production; that is to say, for the price of the thing I make and the price of the thing I might have made instead of it to coincide; for, obviously, I shall always embrace that one of the alternatives still open that offers the best result, and I shall thus increase the supply and lower the marginal significance of the best, and reduce the supply and raise the marginal significance of the others, till they balance. And if I have cut myself off from better alternatives than are now open to me by specialising my resources in a particular machine, it is true that I cannot immediately recover from the false step, but if I am a large manufacturer, and my machines are perpetually being replaced, I shall be able rapidly to recover from small errors of judgment. As my machinery for making chairs wears out, instead of completely replacing it, I may increase my stock of the machinery for making tables. As long as I have the machinery I shall be ready to make chairs for anything above the out-of-pocket expenses, but as I should not have made the machinery had I foreseen the state of things, so I shall not replace it now that I see it.

Resources flow down from their undifferentiated condition through a series of differentiations to the ultimate realisation of concrete purposes, and when I am about to lay down a new machine, I am considering alternatives higher up the stream than any that were open to me when I was considering how to use the machine I had already made. I may direct them now to a point which was inaccessible to me then. And exactly the same reasoning applies to the acquiring and training of special skill; that is to say, to the turning of human energy and faculty into channels from which it cannot be recalled, or can only be recalled partially and with loss. The misdirection of energy which makes me regret that I devoted myself to the study of Greek and took my University diploma in Arts, instead of in Brewing, is irreparable so far as I am concerned; but others may take warning by my fate, and may give the more remunerative direction to their energies when still
in statu nascendi, and thus the abundance of the better remunerated skill and the paucity of the other may bring their rewards more nearly into balance, and if equilibrium were actually reached there would be no professors of Greek in the world who wished that they had turned their talents into more remunerative if less pleasant channels.

Thus from first to last, so far as economic forces direct the application of energies and resources, they will aim at the highest place on the collective scale accessible to them. The results of alternative applications of the same resources will be brought rapidly into equilibrium if they remain open almost up to the end, slowly, and through many reactions, if the resources which bear upon them respectively were differentiated with reference to them at a point high up the stream. But a principle is always at work, corresponding to that of the mechanical “governors” of an engine. It should hardly be necessary to explain what these “governors” are. They are the twin balls that even the most casual observer must have noticed spinning round an upright rod. When the engine is going at a high speed the balls fly out, and in so doing raise a throttle that shuts off steam and so reduces the speed of the engine. The slower movement of the engine communicates itself to the rotation of the “governors,” and as they drop inwards they open the valve and let out more steam. Thus when they are duly regulated, the very fact of the engine working at a higher than the desired speed sets forces at work that reduce the speed, and the very fact of its working at a lower than the desired speed sets forces at work that raise it. Thus every departure from the normal speed constantly tends to correct itself. In like manner, the mere fact of any one price being lower than any other which the same application of energies and resources might have secured, will tend, at a point low down or high up on the stream, as the case may be, to divert the flow and effect a redistribution. The fact of low prices will tend to check off the supply that makes them low, and of higher prices to broaden the stream, the narrowness of which it is that makes them high. But at any given moment the economic forces will never in themselves have any direct tendency to make a man refuse the best price he can get because he would not have made the article unless he had expected a better price, or to accept a lower price than he can command because that lower price would have been a sufficient inducement to him to make the article even if he had anticipated nothing better. In no case will considerations of past sacrifices bring any economic force to bear which will prevent a man from embracing the best alternative still open to him, or that will induce him to accept anything short of the best.

There is probably no difference of opinion amongst serious thinkers as to the facts I have been insisting upon, and indeed they are so obvious that it is impossible for any one who begins to think at all to fail to recognise them when they are clearly put before him. But the words “value,” “price,” “cost price,” and “cost of production” are so ambiguous and are used in so many senses that a statement which is perfectly true in the sense in which it is made may be wholly or partially false in the sense in which it is understood. And these ambiguities react upon our thought and cause confusion. Nay, it is perfectly possible for one and the same man to make a statement to himself in one sense, and the next moment to understand and act upon it in another sense—and that sense one in which he would never have made it in the first instance. The history of Political Economy abounds in instances of the careful definition of such words as “land” and “capital,” the construction of elaborate arguments based on the defined meanings of the words, and the insensible transference of the conclusions to what are ordinarily and currently understood by the terms; this last step being sometimes taken by the original framers of the definitions and arguments, and sometimes by their disciples. This danger is acute in the matter we are now considering, and it will therefore be well to take detailed and even minute precautions.

By the true exchange value of a commodity at any moment I mean simply the place, relative to other things in the circle of exchange, which its marginal unit would take on the collective scale if it were so distributed as to secure present equilibrium. And this true exchange value determines what I have called the equilibrating, or sometimes the “ideal” price at the moment. By cost of production, or cost price, when the phrase is used without qualification, I mean the estimated value, measured in gold, of all the alternatives that have been sacrificed in order to place a unit of the commodity in question upon the market. And in this sense it is clear that cost of production can have no influence upon exchange value, and therefore none upon the “ideal” or equilibrating price. But we have seen that the ultimate facts which determine this exchange value can never be completely known. Ideal exchange value depends upon the composition of the collective scale and the amount of the commodity, and in most cases neither of these can be the subject of complete knowledge, but only of more or less intelligent conjecture. Hence the dealers or possessors name a price based upon their estimates of the ultimate facts as they are or will be. And human estimates may be influenced by irrelevant considerations. We have seen
*43 that in private life we are often unwilling to recognise the folly of our expenditure, and try to make out that we value a thing which is really no better than rubbish to us because we paid a high price for it. There is a natural unwillingness in the human mind to face unpleasant facts, and having committed an error of judgment we often shrink from recognising the fact, even though we thereby aggravate its results. In the same way, a commercial man who has made an error of judgment and has produced things which he cannot sell at cost price (that is to say, which he cannot sell at a price which would have justified him in producing them, at the moment when he determined to do so) will be unwilling to recognise his error, and will make a struggle to secure a price high enough to justify his action. Thus he may hold back from selling a thing at less than cost price, even when he has no sufficient prospect of getting a better price by waiting. That is to say, a price is offered him which is really as good as he is likely to get, and which nothing justifies him in refusing. Had it covered the cost price he would have accepted it without demur, but a certain shrinking from facing the facts induces him to hold on. If such motives really influence a man he is not obeying an economic force, but is making a sacrifice of things in the circle of exchange in order to gratify his desire to postpone as long as possible the recognition of his own error of judgment; for his hesitation to sell at a given price is either justified by the chance of his getting a better price by waiting and bargaining, in which case the economic forces would urge him to do so whether the price be above or below cost price, or else there is no such justification, and in that case by refusing to sell at what he can now get he is subjecting himself to the expenses of storage, as well as the continuous output of energy, and the vexatious wear, of striving unsuccessfully to mend a bad bargain, for all which there is no economic justification.

In such a case the man who fixes his price with reference to the cost of production is either allowing an irrelevant consideration to affect his judgment or else is deliberately taking a commercial risk to gratify a personal feeling. And it may be noticed that such personal feelings seldom influence men’s conduct in businesses in which mistaken estimates as to the value of the thing to be produced are of normal or frequent occurrence. In such a business a man will not hesitate to sell at what he can get, or if he should judge that this may have a deleterious influence on other branches of his business he will actually destroy the stock which it was a commercial error to have created. If a publisher, for instance, has brought out a work wholly or chiefly at his own risk he may find that there is no chance of its selling at cost price or anything like it; and then (after a suitable interval, determined amongst other things by a consideration of indirect effects upon the minds of purchasers of other books in the future) he may sell his stock as a “remainder” for what it will fetch, or, if he thinks it will be better in the long-run to do so, he may destroy the stock. But in any case he is entirely uninfluenced in his present conduct by considerations of what his costs have been in the past. He thinks only of what he can best do with his stock in the present and future.

Even in a necessarily speculative business, however, it is easy to conceive cases in which the judgment may be warped by the personal feelings engaged. It is notorious, for example, that persons who habitually deal in stocks will sometimes hold on to stock contrary to their better judgment. They “backed their judgment” some time ago when they bought for a rise, and though they would now never think of touching the stock if the whole transaction could be reopened, they will not sell, because to do so would be the formal admission to themselves that they had made a mistake in buying; though had they bought at such a price that they could now sell at a profit, they would be eager to do so. But this clearly is not business; and the man who is least subject to such impulses will be, so far, the best business man. Temper is expensive. And again, if it is not business to refuse the best price you can get because it is not good enough to cover cost price, neither is it business to accept something less than the best price that can be obtained, simply because this something-less-than-the-best already more than covers the cost of production, and is so far good. The best, though bad, is better than the second best; and the second best, though good, is worse than the best.

Nevertheless, an important relation exists between price and cost of production which is frequently illustrated in the history of industry, and of which our theory gives a perfectly satisfactory account. It is true that, if the cost of production of any article exceeds its value in exchange, the cost cannot raise the value to its own level; but by a curious reaction, the exchange value often lowers the cost of production. The idea that the business man is actuated by a uniform desire to make money, never sated and never varying, is, as we have seen,
*44 in flat contradiction with human nature. No man will fight as hard for an extra £1 if he possesses £1,000,000 as he will if he wants to keep himself and his family supplied with food. He may conceivably fight as hard for “money,” but if so it must be more money that calls forth the same effort. A man, then, will fight to avoid ruin harder and in closer detail than he will fight to make a large fortune larger. As long as he is fairly prosperous, he may be content to let things go on as they are, and to put forth no very great efforts in order to make himself a little more prosperous yet. But if his wares permanently command less than cost price in the market, ruin stares him in the face, and the whole resilience and energy of his nature will come into action in order to avert it. He will look into every detail, he will take nothing for granted, he will search for improved methods and improved machinery. He is driven back upon his base line, and must make his last and most desperate stand. History presents noteworthy examples of industries thus threatened, so husbanding their resources and so stimulating inventiveness and energy, that cost of production has been reduced and a new era of prosperity initiated; for many a man “looking for silver has found gold,” and in searching for small economies has hit on great ones. And then, again, since selling below cost price, except incidentally, means failure, and normally selling above cost price means success, it is natural that the level of cost price should make a powerful appeal to the imagination, and should even affect the judgment when it is not economically relevant; so that a man may largely take cost price as marking the level of solvency and be content when he is above it without seeking to secure any further gain. Moreover, a trustworthy and independent judgment is one of the very things of which a man may know that he has an inadequate supply, and which he may rightly desire to economise; and there may be some branches of trade in which he finds it an economy of thought and trouble to take the price that he has given for an article as the basis of the price that he will ask for it. Thus there are some second-hand booksellers who habitually sell the same book at different prices, and will even have two copies of the same book, in equally good condition, marked at different prices, in their shop-windows at the same time. Such dealers will of course be careful never to give a price for a book unless they think they will be able to sell it at a profit; but apparently it saves them trouble to have a mechanical system by which they fix their selling prices. Possibly they think that the occasional appearance of exceptionally cheap books may stimulate their trade. If so it is a naïve and half-unconscious form of “salting,” which preserves the dealer’s dignity, for it obviates the necessity of his recognising exactly what he is doing, and at the same time it avoids the shock that it would give his feelings to sell one copy at a lower price than that at which he bought it in the hope of making some one buy another copy at more. But it is obvious that the effect is the same as if he habitually fixed his price at the highest point which he thought he could realise, and now and again deliberately sold a book for less than it was worth in order to give his shop a reputation for “bargains.” From the business point of view it is an anomaly to have the same article in your shop avowedly at two prices.

But these phenomena are far from constituting the main source of confusion as to the connection between the cost of production and exchange value. In all the examples we have hitherto discussed, “cost of production,” or “cost price,” has been used in the sense of the expenses already incurred; and the price we have discussed has been the price of something already possessed or already in existence. But whenever in serious discussions cost of production is said to exercise any direct control on price, the cost of production intended is cost that has not yet been incurred, and the price meant is not the price at which an existing commodity is offered, but the price at which a promise is made to produce it. Now in this sense of course it is perfectly true that price, or rather the lower limit of price, is strictly determined by cost of production. That is to say, no man will, in the way of business, promise to procure or produce a commodity at a certain price when he deliberately believes that it will cost him more. But there are a hundred different ways of estimating this cost. When a man sits down to calculate the cost of production of an article, he may only consider the out-of-pocket expenses which he would incur in executing that particular order; or he may make an allowance for a suitable proportion of the whole expense of keeping the concern going; or to these he may add a suitable charge for interest on the capital originally invested; and he may or may not add something to represent his own remuneration. And on whatever basis he makes his estimate he may then make any addition which he thinks the state of the market will bear; or if he has made his estimate on any basis except that of the actual out-of-pocket expenses which the execution of the individual order will involve, he may be obliged to deduct something from the estimated cost price because the state of the market requires it. And he may be willing to do so sooner than lose the order, for perhaps it is only so far as these out-of-pocket expenses for the specific order are concerned that any alternatives are still open.

Thus the calculation of the cost of production, in any sense except this narrowest one, will be no more than an attempt to reach a basis which may offer some guide and support to the judgment. A man may know fairly well, from the general conditions of his business, how it is doing on the whole. That is to say, he may know roughly what relation the best values that he can now produce bear to the alternatives successively relinquished when he specialised free resources in more or less permanent forms of building or machinery, got together his staff and made engagements with them, and generally organised his business; and on making a detailed estimate of the proportions of these relinquished opportunities that should be debited to the production of any particular article, he forms a conception of the fraction of the total output which it represents; and this gives him a basis for considering its relations to the other things which he might produce instead of it. If the trade is in a normal condition he knows that the proceeds of this particular industry are neither so great as to induce a rush into it, nor so small as to scare people from it. That is to say, he knows that the value of the product and the cost of production about balance, so that his rivals will not allow him to get much more, nor will the state of the market compel him to accept much less, than the full cost of production. But if the business is especially prosperous or depressed, his calculation of the full cost of production will merely give him an idea of the proportion that the execution of this particular order will bear to his general output, and he will raise his tender far above or sink it far below the full cost price according to the state of the market.

To sum up, then:—In no case can the cost of production have any direct influence upon the price of a commodity, if the commodity has been produced and the cost has been incurred; but in every case in which the cost of production has not yet been incurred, the manufacturer makes an estimate of the alternatives still open to him before determining whether, and in what quantities, the commodity shall be produced; and the stream of supply thus determined on fixes the marginal value and the price. The only sense, then, in which cost of production can affect the value of one thing is the sense in which it is itself the value of another thing. Thus what has been variously termed utility, ophelemity, or desiredness, is the sole and ultimate determinant of all exchange values.