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ELEMENTARY PRINCIPLES OF ECONOMICS

• Ine

THE MACMILLAN COMPANY
new York - Boston - CHICAGO
Dallas - san Francisco

MACMILLAN & CO., LIMITED
London -

Bombay - calcutta
Melbourne

THE MACMILLAN CO. OF CANADA, LTD.
Toronto

ELEMENTARY PRINCIPLES
OF

ECONOMICS :

IRVING FISHER
PROFESSOR OF POLITICAL ECONOMY
YALE UNIVERSITY

Meto gork
THE MACMILLAN COMPANY
1913
*

Set up and electrotyped.
January, 1913.

Published July, 1912. Reprinted

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Nortgcob 33regg
J. S. Cushing Co. — Berwick & Smith Co.
Norwood, Mass., U.S.A.

(Co
THE MEMORY OF MY FRIEND
AND

COLLEAGUE

PROFESSOR LESTER W. ZARTMAN

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~~~~ º）

PREFACE
FOR TEACHERS

THE words “Elementary Principles” in the title of this
book indicate the limits of its scope; the book is intended
to be elementary, not advanced, and concerns itself with
economic principles, not their applications.
First, being elementary, it does not attempt to unravel
the most difficult tangles of economic theory or to intro
duce controversial matter.

For such studies it should be

succeeded by more extensive treatises (e.g., my own: Nature
of Capital and Income, Mathematical Investigations in the
Theory of Value and Prices, Purchasing Power of Money,
and Rate of Interest, which follow out the same general
system of thought and exposition as adopted in this book).
Secondly, being devoted to principles, the book is con
fined to that part or aspect of economics which is now
coming to be recognized as capable of scientific treatment
in the sense, for instance, in which that term may be ap
plied to physics or biology. The fundamental distinction
of a scientific principle is that it is always conditional ; its
form of statement is : If A is true, then B is true. A prin
ciple differs in this respect from a fact which asserts
unconditionally that B is true. Science is primarily con
cerned with the formulation of principles. The aim of this
book is to formulate some of the fundamental principles
relating to economics.

The method and order of treatment are not altogether
traditional. The time-honored order of topics — produc
tion, exchange, distribution, consumption – has been found
vii

viii

impracticable.

PREFACE

Such an order was probably originally in

tended to parallel the natural course of events from the

production of an article to its consumption ; but to-day
these four topics scarcely retain any traces of such a
parallelism. “Distribution,” for instance, has, in theo
retical discussions, long ceased to be a description of the
processes by which food, clothing, and other goods are
distributed after being produced and prior to being con
sumed, and has become simply a study of the determi
nation of rent, interest, and other market magnitudes.
It is not, therefore, surprising that many other textbooks
on economics have also broken away from this unfortunate
order of topics.
Of the many possible methods of writing economic text
books, there are three which follow well-defined, though
widely different, orders of topics. These are the “his
torical,” the “logical,” and the “pedagogical.” The his
torical method follows the order provided by economic
history; the logical begins with a classification of economics
in relation to other studies, explains its methodology,
and then proceeds by means of abstract examples from the
simplest imaginary case of “Robinson Crusoe economics”
to the more complex conditions of real life; the pedagog
ical begins with the student's existing experience, theories,
and prejudices as to economic topics, and proceeds to mold
them into a correct and self-consistent whole.

The order

of the first method, therefore, is from ancient to modern ;
that of the second, from simple to complex ; and that of

the third, from familiar to unfamiliar. The third order is
the one here adopted. That the proper method of study
ing geography is to begin with the locality where the pupil
lives is now well recognized. Without such a beginning
the effect on the student’s mind may be like that betrayed
by the schoolgirl, who, after a year's study of geography,
was surprised to learn that her own playground was a part
of the surface of the earth.

In like manner we cannot

PREFACE

expect to teach economics successfully unless we begin
with the material already existing in the student's mind.
Those textbooks which open with a discussion of the rela
tions of economics to anthropology, Sociology, jurispru
dence, natural science, and biology, overlook the fact that
the beginner in economics is totally unprepared even to
understand the meaning of these great subjects, much less
their relations to one another.

The same sort of error is

made by those textbooks which begin with a comparative
study of the logical machinery by which truth is ground
out in economics and in other sciences.

The student's

logical faculty must be exercised before it can profitably
be analyzed.
This book, therefore, aims to take due account of those

ideas with which the student’s mind is already furnished,
and to build on and transform these ideas in a manner

adapted to the mind containing them. This is especially
needful where the ideas are apt to be fallacious. The eco
nomic ideas most familiar to those first approaching the
study of economics concern money, -personal pocket
money and bank accounts, household expenses and in
come, the fortunes of the rich.

Moreover, these ideas are

largely fallacious. Therefore, the subject of money is
introduced early in the book and recurred to continually
as each new branch of the study is unfolded. For the
same reason considerable attention is given to cash ac
counting, and to those fundamental but neglected princi
ples of economics which underlie accounting in general.
Every student at first is a natural “mercantilist,” and
every teacher has to cope eventually with the prejudices
and misconceptions which result from this fact. Yet no
textbook has apparently attempted to meet these difficul
ties at the point where they are first encountered, which is
at the beginning.
It may be worth while to distinguish the pedagogical
procedure here proposed from that recently advocated

PREFACE

under the somewhat infelicitous title of the “Inductive

Method.” I refer to the method by which the student is
at first to be taught economic facts without any formula
tion of principles. This proposal seems to assume that the
student’s mind is quite a blank to start with, and that it
is possible on this tabula rasa to inscribe facts without at
the same time intimating how they are related. The truth
is, however, that the student's mind is already familiar
with a great mass of economic facts acquired at home,
on the street, and from the newspapers. He knows some
thing, not only of money and accounts, but of banks, rail
ways, retail trade, labor unions, trusts, the stock market,
speculation, the tariff, poverty, wealth, and innumerable
other topics. It is equally true that his head is full of
theories as to the relations of these facts, – the working
of supply and demand, the nature of money, the operation
of a protective tariff, etc. The difficulty is that most of
his theories and many of his supposed facts are false; and
before we add to his ill-assorted collection of mental furni

ture we must arrange in orderly fashion that which he
already possesses. Moreover, it is almost impossible to
impart successfully any considerable mass of disconnected
facts.

If the teacher does not indicate the true connec

tions, the student will almost inevitably supply false ones;
º

or else the facts without connections will be also without
interest.

These objections to the so-called “inductive method”
are not, however, intended as militating against the object
which its advocates strive to attain, viz., to make the stu

iº
t

dent think for himself, nor against the chief means by
which they actually attain this object, viz., the use of
original problems. Every teacher can and should illus
trate, emphasize, and elaborate every step in the study of

principles by propounding problems. Sumner's collection
of problems, or the more recent collections of Taylor or of

the University of Chicago, may profitably be used to sup

l,
t

PREFACE

plement those which every good teacher will readily invent
for himself from the suggestions of the text, of current
newspapers, or of students’ questions. These should vary
from year to year according to current events and the
exigencies of the case as understood by the teacher.
A pamphlet of suggestions as to problems to be used in
connection with this book has been prepared for teachers
and may be obtained of the publishers. It is submitted
that the present treatment of the subject lends itself pecul
iarly to the use of definite soluble problems in place of the
vague “problems” which are usually employed in economics
and which call for little more than an expression of opinion.
Incidentally, the teacher will find that these definite
arithmetical problems are not only much more useful to
the student, but are much less trouble for the instructor

to correct and grade.
Problems should, I believe, supplement and not supplant
a textbook. The effort to substitute problems for textbooks
has always failed even in those subjects which, like algebra
and geometry, may be said to consist naturally of a series
of problems. A preliminary framework of general prin
ciples is needed in order to formulate special problems of
real value. Problems which are really soluble by the
beginner can be little more than applications of general
principles to special cases.
What has been said will help explain why greater atten
tion than usual is here paid to certain themes, such as
money, bank deposits, accounting, the rate of interest, and
the personal distribution of wealth ; as well as why less
attention than usual is paid to certain other themes, such
as methodology and those obsolete theories like the “wage
fund” theory which (unlike some other obsolete theories)
has probably never formed any part of the student's
mental stock in trade.

To some critics the abundant use of curves may seem
too advanced for an elementary work. But their use is

xii

PREFACE

now so common in the advanced treatises to which the

student is, if possible, to be led, that their introduction
here is but a necessary part of his preparation. The very
fact that there is at present no elementary book in which
the nature and use of the graphic method has been made
clear for the elementary student is a strong argument for
its adoption. Moreover, I am persuaded that the “diffi
culties” in the elementary use of curves are largely imagi
nary. Every beginner in economics may be assumed to be
familiar with latitude and longitude on a map, and perhaps
also with the temperature charts in the daily paper. It is
a very easy step from these to curves of supply and de
mand, provided they be used with sufficient frequency and

with sufficient system to take lodgment in the student's
memory. The student who sees but one diagram in a book
will find the initial effort of understanding that diagram
scarcely worth while, – not much more worth while than
to be taught the use of logarithms without applying them
to more than one or two practical examples. As a matter
of fact, there are few things which so facilitate the under
standing of economic relations at every stage of economic
study as the use of diagrams; and it is believed that, with
them, the elementary student can proceed both faster and
further in economic analysis than without them.
Some friends are inclined to criticize the book as being
too cold an analysis. They point out that the student's
main interest in the subject is a “human interest” and
concerned primarily with the practical and immediate
solution of great public problems. No one acquainted
with my interest in some of these problems can accuse me
of lack of appreciation of the “human” element in them all.
But the more one studies these problems and the attempts
at their solution, the more evident it becomes that most
students approach them with an insufficient grounding in
fundamental principles. In social as in medical therapeu

tics a lack of knowledge of anatomy and physiology results in

PREFACE

xiii

quackery — in remedies worse than the disease which it
is proposed to treat. I believe that one of the greatest
needs to-day in the teaching of elementary economics is
to curb this popular tendency to run after remedies before

formulating principles. Un the present book, therefore,
while most of the great practical problems of economics are
outlined in connection with the principles which must be
employed in their solution, the solutions themselves are

not discussed. Full discussion of all these problems is
impossible in any textbook, and I earnestly deprecate a
general ex cathedra pronouncement of personal opinion by
an author on moot questions, especially in a book for imma

ture students. The only proper course, in my opinion,
is for the student first to master the fundamental economic

principles on which all or most competent economists can
agree, and then, as suggested on the closing page of this
book, to take up some one moot question — some burning
issue of the day — and, so far as possible, master that also.
In the meantime he should, so far as possible, keep an open
mind on other problems until, in course of time, they may
also be taken up intensively, one by one. A textbook
which attempts to supply the student with ready-made
opinions on all practical problems “while he waits,” may
be supplying a real demand, but is not performing a high
service.

Possibly the slight emphasis here put on historical, de
scriptive, and practical economics may decide some teachers
against the use of this book and lead them to choose a
book in which “the whole subject of economics” is treated.
I submit, however, that no such “complete” book exists,
since no author exists capable of writing it, and that all
which aim to be complete lack at least half of the subject
matter here presented and which is taken for granted as if
fully known by the student. In many books the terms
“assets,” “liabilities,” “income,” “cost,” and “rapidity
of circulation” are used without discussion or even definition.

xiv.

PREFACE

It would be out of place here to criticize other textbooks, but
it has been my hope that the present book may be found a
useful introduction to other books, even those which

attempt to cover the subject “completely.” I would
also point out that, by omitting the more “therapeutical”
parts of the subject, I have escaped most of its controversies,
for the controversies to-day are more as to the solution of
practical problems than as to the validity of such elementary
principles as are contained in this book. Freedom is thus
allowed to each teacher who uses this textbook to follow

it up by whichever among others contains the therapeutical
treatment which he personally regards as correct. I have
been struck by the fact that my critics seldom question the
correctness of the propositions here laid down. If this
book may afford a common starting point for economic
instruction of different schools of thought and different
attitudes toward public problems, it will have served one
important purpose.
Especial care has been taken in formulating definitions
so that the concepts described by these definitions may
become firmly fixed in the students' minds. These defini
tions and concepts have been chosen in reference to their
usefulness in economic analysis as well as their conformity
to practical usage. I am one of those who believe that
when the usage of academic economics conflicts with the
ordinary usage of business, the latter is generally the better
guide. This is not only because business usage has a
thousand times the currency of academic usage, but also
because in general it comes closer to the needs of economic
analysis. Here is not the place to argue why this is true,
or even to prove that it is true. I will, however, mention
one consideration which appeals increasingly to practical
teachers: An academic tradition which is unconvincing to
the student is sure later, when he himself becomes a business

man and perceives how badly academic traditions are out
of tune with modern business usage, to breed a deep distrust,

PREFACE

if not contempt, for all academic economics. Thus, expedi
ency, as well as sound theory, should urge teachers to
respect the usage of business men.
I have taken so much space to justify those features of
this book which will seem new, because several teachers to

whom the experimental editions were submitted have
condemned it at sight as unteachable. I am glad to re
port, however, that the teachers who have actually tested
the book in classroom have usually become extremely
enthusiastic over its “teachableness,” although many of
them had begun its use with grave misgivings.
The experimental editions, of which there were two,
were made possible by special arrangement with the pub
lishers. This gave opportunity for thorough trial for two
years in classrooms at Yale, under nearly a dozen different
instructors. As a result of this trial and the many valuable
suggestions and criticisms which were obtained from

teachers, students, and friends, the book has been virtually
written three times. The present — the third and final —
edition is the first to be offered to the general public.
I am under obligations to President Hadley of Yale for
the fundamental idea employed in the discussion of those
supply curves which illustrate the willingness to produce
“a given amount or more” instead of, as ordinarily assumed,
“a given amount or less”; also for helpful criticism on the
presentation of that most difficult subject, the rate of
interest. I am also indebted for helpful criticism to my
colleagues, Professor Clive Day, Assistant Professors F. R.
Fairchild, H. P. Fairchild, W. H. Price, and A. L. Bishop,
Dr. H. G. Brown, Dr. E. J. Clapp, now in New York Univer
sity, and Dr. J. L. Leonard; also to Professor Charles W.
Mixter of the University of Vermont, Professor Harvey A.
Wooster of De Pauw University, Professor Louis N. Robin
son of Swarthmore College, Dean David Kinley of the
University of Illinois, Professor E. W. Kemmerer of Cornell

University, Professor H. J. Davenport of the University

xvi

PREFACE

of Missouri, Professors E. R. A. Seligman, H. R. Seager,
and H. R. Mussey of Columbia University, R. T. Ely and
W. A. Scott of Wisconsin University, and W. M. Adriance
of Princeton University, Mr. W. F. Hickernell, now with
the Brookmire Economic Chart Company of St. Louis,
Mr. Morrell W. Gaines of the Statistical Department of
Brown Brothers and Company of New York, Mr. Julius H.
Parmelee, statistician of the Bureau of Railway Economics,
Washington, D.C., Professor E. B. Wilson of the Massa

chusetts Institute of Technology, Dr. Leonard Bacon of
New Haven, and to Mr. J. M. Shortliffe of the Graduate
Department of Yale University.

I endeavored to obtain a clear idea of the undergraduates'
viewpoint by offering prizes for the best criticisms from
students using the book as a textbook, the prizes being
awarded by a committee of instructors other than myself.
In the college year 1910–1911, the students who won the
prizes were R. H. Gabriel, 1913, E. J. Webster, 1913, and
G. G. Chandler, 1912, and in the year 1911–1912, Edward
Glick, 1914, W. Van B. Hart, 1914, and M. W. Brush, 1913.

The criticisms of others besides the prize winners were
found helpful. To H. Briar Scott, 1913, I am also indebted
for suggesting the insertion of Figure 2. My greatest
obligations for criticism, especially as to the mode of pres
entation, are due to my brother, Herbert W. Fisher, who has
kindly read and criticized all of the original manuscript and
both preliminary editions.
-

MAY, 1912.

IRWING FISHER.

SUMMARY
FouxDATION STONES
Introduction

Capital

Income

Capital and Income

Chapters I–II
Chapter III
Chapters IV-V
Chapters VI–VII

DETERMINATION OF PRICES
.

Particular Prices.

Rate of Interest .

Ownership of Income .

General Prices

Chapters VIII-XIV
Chapters XV-XVIII
Chapters XIX-XXII

PRINCIPLES OF DISTRIBUTION

Sources of Income

Chapters XXIII-XXIV
Chapters XXV-XXVI

CONTENTS BY CHAPTERS
charrºr

I.
II.

pace

WEALTH

PROPERTY

•

III.

CAPITAL

•

IV.

INCOME

COMBINING INCOME ACCOUNTS

•

CAPITALIZING INCOME.

...

I O2

VII.

VARIATIONs of INCOME IN RELATION to CAPITAL .

127

L-VIII.

PRINCIPLES GOVERNING THE PURCHASING Power OF

V.
VI.

MONEY
IX.
X.

INFLUENCE OF DEPOSIT CURRENCY

XII.
XIII.
L-XIV.
XV.
XVI.
XVII.
XVIII.
XIX.

XX.
XXI.

•

I44

165

CAUSES AND EFFECTS OF PURCHASING POWER DUR
ING TRANSITION PERIODS

XI.

REMOTE INFLUENCES ON PRICES

REMOTE INFLUENCES (Continued)

184

I 92

204

OPERATION OF MONETARY SYSTEMS .

22 I

24O

CONCLUSIONS ON MONEY

•

SUPPLY AND DEMAND

. 258

THE INFLUENCES BEHIND DEMAND

THE INFLUENCES BEHIND SUPPLY

303

MUTUALLY RELATED PRICES

•

333

INTEREST AND MONEY

•

354

IMPATIENCE For INCOME THE BASIs of INTEREST

365

INFLUENCES ON IMPATIENCE FOR INCOME .

•

375

XXII. THE DETERMINATION of THE RATE of INTEREST

278

389

INCOME FROM CAPITAL

4 IO

XXIV.

INCOME FROM LABOR .

•

433

XXV.

WEALTH AND POWERTY

•

464

XXVI.

WEALTH AND WELFARE

•

494

XXIII.

CONTENTS BY SECTIONS
CHAPTER I
WEALTH
section

race

Definition of Economics and of Wealth

Distinction between Money and Wealth

Classification of Wealth

Measurement of Wealth
Price
.
Value

5
9

•

I3
17

•
.

Limit of Accuracy in Economic Measurements

•

•
•

23
25

CHAPTER II
PROPERTY
. The Benefits of Wealth .
The Costs of Wealth
.

Property, the Right to Benefits
.
The Relation between Wealth and Property .
Table of Typical Property Rights .
Practical Problems of Property
.
-

•

•
•

33
34

CHAPTER III
CAPITAL

1.
2.
3.
4.
5.

Capital and Income
Capital-goods, Capital-value, Capital-balance .
Book and Market Values
Case of decreasing Capital-balance.
Insolvency .
-

6. Real and Fictitious Persons

•

7. Two Methods of Combining Capital Accounts
8. Ultimate Result of Method of Couples .
9- Confusions to be Avoided
.
-

xxi

•

xxii

CONTENTS

SECTIONS

CHAPTER IV
INCOME
seCTION

PAGE

Concepts of Income and Outgo

Income Accounts.

Devices for Making Net Income Regular

How to Credit and Debit

Omissions and Errors in Practice.

75
77

CHAPTER V
COMBINING INCOME ACCOUNTS

1. Methods of “Balances” and “Couples.” “Interactions”

Production: Interactions which change the Form of Wealth
Transportation: Interactions which change the Position of
Wealth
4.

Wealth

Accounts Illustrative of Interactions in Production

Preliminary Results of Combining these Income Accounts
Analogies with Capital Accounting
.
Double Entry in Accounts of Fictitious Persons .
Double Entry in Accounts of Real Persons .

Exchange: Interactions which change the Ownership of

Ultimate Costs and Income .

CHAPTER VI
CAPITALIZING INCOME

The Link between Capital and Income

Capital as Discounted Income

The Discount Curve

Io2

Application to Valuing Instruments and Property
Effect of Changing the Rate of Interest
-

IoW
Io8
II 2

125

CHAPTER VII
VARIATIONS OF INCOME IN RELATION TO CAPITAL
Interest Accrued and Income Taken Out

Illustrations .

127
-

I29

CONTENTS

xxiii

BY SECTIONS

sECTION

PAGE

3. Confusions to be Avoided
4.

Standardizing Income .

5 The Risk Element.
6. Review .
-

I 32

136
138

I40

CHAPTER VIII
PRINCIPLES Governing THE PURCHASING Power OF MONEY

Introductory .
The Nature of Money
The Equation of Exchange Arithmetically Expressed
The Equation of Exchange Mechanically Expressed
The Equation of Exchange Algebraically Expressed
The “Quantity Theory of Money”

I44
I47

15I

I 56
I 59

16o

CHAPTER IX
INFLUENCE OF DEPOSIT CURRENCY

The Mystery of Circulating Credit.
The Basis of Circulating Credit
.
Banking Limitations
.
The Total Currency and its Circulation .
Deposit Currency Normally Proportional to Money
-

;

165

171
I74

178

Summary

18O

183

CHAPTER X
CAUSES AND EFFECTS OF PURCHASING POWER DURING
TRANSITION PERIODS
Transition Periods

184

How a Rise of Prices Generates a Further Rise
How a Rise of Prices Culminates in a Crisis .

187

Completion of the Credit Cycle

189

I86

CHAPTER XI
REMOTE INFLUENCES ON PRICES

1. Influences which Conditions of Production and Consumption
Exert on Trade, and therefore on Prices .

192

xxiv.

CONTENTS BY SECTIONS

SECTION

PAGE

2. Influences which Conditions Connecting Producers and Con
sumers Exert on Trade, and therefore on Prices

I94

3. Influence of Individual Habits on Velocities of Circulation, and
therefore on Prices

- *

196

4. Influence of Systems of Payments on Velocities of Circulation,
and therefore on Prices

I99

5. Influence of General Causes on Velocities of Circulation, and
therefore on Prices

2O I

6. Influences on the Volume of Deposit Currency, and therefore
on Prices .

2O2

CHAPTER XII

REMOTE INFLUENCES (Continued)
1. Influence of “The Balance of Trade” on the Quantity of
Money, and therefore on Prices
2. Influence of Melting and Minting on the Quantity of Money,
and therefore on Prices

3. Influence of the Production and Consumption of Money Metals
on the Quantity of Money, and therefore on Prices
4. Mechanical Illustration of these Influences
.
-

CHAPTER XIII

2O4

209
2II

215

22 I

OPERATION OF MONETARY SYSTEMS
I. Gresham's Law

2. Bimetallism

3.
4.
5.
6.

When Bimetallism Fails
When Bimetallism Succeeds .
Changes in Production and Consumption
The “Limping” Standard .
-

223
226

230
233
235

* --

CHAPTER XIV
CONCLUSIONS ON MONEY

1.
2.
3.
4.

Can “Other Things Remain Equal?” .
An Increase of Money does not Decrease its Velocity
An Index Number of Prices .
The History of Price Levels .
-

24o
242

247
253

CONTENTS

SECTIONS

CHAPTER XV
SUPPLY AND DEMAND
SECTIox

1.
2.
3.
4.
5.

PAGE

Individual Prices Presuppose a Price Level
A Market and Competition .
Demand and Supply Schedules
.
Demand and Supply Curves .
Shifting of Demand or Supply
-

•

258
26o

261

263
268

CHAPTER XVI
THE INFLUENCES BEHIND DEMAND
1. Individual Demand Schedules and Curves

2.
3.
4.
5.
6.
7.
8.

Desirability .
Illustration .
Some Remarks on Desirability
.
Individual Demands Derived from Marginal Desirabilities
Relation of Market Price to Desirability.
Importance of the Marginal Desirability of Money.
Desires or Wants, the Foundation of Demand
-

278
28 I

283
286

287
294

298
3oo

CHAPTER XVII
THE INFLUENCES BEHIND SUPPLY
I

Analogies between Supply and Demand
Principle of Marginal Cost .
Upward Supply Curves which Turn Back
Downward Supply Curves
.
Resulting Cutthroat Competition
Resulting Tendency toward Monopoly .
Fixed and Running Costs
.
General and Particular Running Costs .
-

Monopoly Price

303

307

312
3I4

317

32 I

323

326

329

338

CHAPTER XVIII
MUTUALLY RELATED PRICES

Arbitrage

Speculation

333

XXVI

CONTENTS BY SECTIONS

section

PAGE

3. Prices of Goods which Compete on the Demand Side .
• 344
4. Prices of Goods which are Complementary on the Demand Side 347
5. Similar Relations on the Supply Side .
- 348
6. Prices of Goods in Series

•

350

•

35 I

354

7. Efforts and Satisfactions the Ultimate Factors
CHAPTER XIX
INTEREST AND MONEY

1.
2.
3.
4.

The Importance of Interest .
A Common Money Fallacy .
Effect during Appreciation or Depreciation
Effect of Unequal Foresight .
-

•

. 356

•

359

362

CHAPTER XX
IMPATIENCE FOR INCOME THE BASIS OF INTEREST

1. The Productivity Theory
2. The Socialist Theory .
3. Impatience the Source of Interest .
-

365

369

•

37 I

CHAPTER XXI
INFLUENCES ON IMPATIENCE FOR INCOME

1. Differences in Impatience Due to Differences in Human Nature 375
2. Differences in Impatience Due to Differences in Income.
. 378

3. Influence of the Distribution in Time of the Income-stream . 379
4. Influence of the Size of the Income-stream

5. Influence of Uncertainties of Income
6. Summary
.
-

.
.
.

381
383
386

CHAPTER XXII
THE DETERMINATION OF THE RATE OF INTEREST

1. Equalizing Marginal Rates of Impatience by Borrowing and
Lending .
389
2. Equalizing Marginal Rates of Impatience by Spending and
Investing .
• 394
-

CONTENTS

xxvii

SECTIONS

section

PAGE

3. Futility of Prohibiting Interest
.
4. Clearing the Loan Market
.
5. The Conditions Determining the Rate of Interest .
-

Historical Illustrations

7. Interest and Prices

396

398

8. Classification of Price Influences

4OO

4O4

. .

406
408

CHAPTER XXIII
INCOME FROM CAPITAL

Distribution according to Agents of Production and according
to Owners

4 Io

2. The Rent of Land .

413

3. Rent and Interest .

4. Four Forms of Income: Interest, Rent, Dividends, and Profits

5. Avoidance of Risk.

422

423
427

CHAPTER XXIV
INCOME FROM LABOR

1.
2.
3.
4.
5.
6.
7.

Similarity of Rent and Wages
Peculiarities of Labor Supply.
The Demand for Labor .
The Efficiency of Labor.
The “Make-work” Fallacy .
Wages and Enterprisers' Profits .
Profits and Distribution Generally.
-

433

436

45 I
454

458

469

472

CHAPTER XXV
WEALTH AND POVERTY

. The Problems of Wealth and Poverty
National Wealth or Poverty .

. Per Capita Wealth or Poverty
. Population in Relation to Wealth .
-

. Distribution of Wealth .

6. Fauality of Distribution an Unstable Condition
7. The Limits of Enrichment and Impoverishment

464
467

476
478
483

xxviii

CONTENTS BY SECTIONS

section

PAGE

8. The Cycle of Wealth .
9. The Actual State of Distribution .
Io. The Inheritance of Property
-

487
489

49 I

CHAPTER XXVI
WEALTH AND WELFARE
True and Market Worth

Evils Connected with the Quantity of Wealth
Forms of Wealth Injurious to the Owner
Forms of Wealth Injurious to Society .
-

Forms of Wealth used for Social Rivalr

The Cost of Vanity
.
Remedies for the Evils of Vanity.
Recapitulation
.
-

494
495

498
499
500

508

5II

ELEMENTARY PRINCIPLES OF ECONOMICS

CHAPTER I
WEALTH

§ 1. Definition of Economics and of Wealth

ECONOMICs may be most simply defined as the Science of
Wealth.

It is also known under several other titles, of

which the most common is “Political Economy.” The P
purpose of economics is to treat the nature of wealth; the
human wants served by wealth; the satisfaction of those
wants and the efforts required to satisfy them; the forms
of the ownership of wealth; the modes of its accumulation
and dissipation; the reasons that some people have so
much of it and others so little; and the principles that regu
late its exchange and the prices which result from exchange. ,
In a word, everything which concerns wealth in its general
sense comes within the scope of economics. It is worth
emphasizing at the outset, that the chief purpose of eco
nomics is to set forth the relations of wealth to human life

and welfare. It is not, however, within the province of
economics to study all aspects of human life and welfare,
but only such as are connected in some rather direct manner
with wealth.

To most persons the chief interest in the subject lies in its
practical applications to public problems, such as those
connected with the tariff, taxation, currency, trusts, trade
unions, strikes, or socialism. These problems suggest that
something is wrong in the present economic order of society
and that there is a way to remedy it. But before we can
treat of economic diseases, we must first understand the
b

. . . . ; ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

çconomic principles which these public questions involve.
(hat
is, the study of economic principles must precede the
application of those principles to problems of public policy.

ſ Tn the end the student will reach more satisfactory con
clusions, if at the beginning he will put aside all thought

of such applications, and cease to count himself a free trader
or a protectionist, an individualist or a socialist, or, indeed,
any other kind of partisan.

We must, then, in the first place, distinguish economic
principles from their applications to public problems; in
the second place, we must distinguish those principles from
their applications to private problems. Economics does
not concern itself with teaching men how to become rich;
nor does a practical skill in the art of becoming rich imply,
necessarily, a sound knowledge of economics. Economics, it
is true, represents the theory of business; and business, the
practice of economics. But, though they are not in the least
conflicting — indeed, to some extent they are mutually

helpful – economics and business are nevertheless totally
different. The primary requisite of a good business man
is to master the detailed facts which concern his own indi

vidual operations; the primary requisite of a good economist

G to master the general principles based on business facts.
S ome of

the wildest economic theories have originated among

uccessful financiers.

Men who have been trained in Wall

Street are often the most sadly lacking in elementary in
struction in economics. This is so because the very matters
with which people have longest been familiar are frequently
the ones which they have been least disposed to analyze.
In business theory, no less than in the theory of public
problems, men take too much for granted.
Our first rule, then, in approaching the study of economics
is to take nothing for granted. It is quite as important to
be careful in defining familiar terms, such as “prices"
and “wages,” as in explaining unfamiliar ones, such as
“index numbers ” and “marginal utility.”

Sec. 1]

WEALTH

…”
_*
º
º

The chief purpose of this book is to define clearly the
fundamental concepts of economics and to state and prove
the fundamental principles of the science. These concepts
and principles will then serve as a basis for further study.
In other books the student will find these concepts and prin
ciples applied to problems of public policy, or of business
management, or of the economic history of nations. We
are not concerned in this book either with practical prob
lems or economic history except as they are used occa
sionally to illustrate the principles under consideration.
Wealth having been designated as the subject matter of
economics, the question at once arises: What is wealth?
By wealth in its broader sense is meant material objects

owned by human beings. This meaning, however, is broader
than the ordinary meaning of the term; for it includes
human beings themselves. Every human being is a “ma
terial object” and is “owned ” either by another human
being, as in the case of slavery, or by himself, if he is a
freeman. But in ordinary usage men except themselves
from the category of “wealth '' just as, with equal incon
sistency, they except themselves from the category of “ani
mals.” Properly speaking man is wealth, just as, properly
speaking, man is an animal. But we so seldom need in
practice to take account of man as wealth that the ordinary
meaning of wealth includes only material objects owned by
human beings and external to the owner." In this book we
* Every writer may define a term as he pleases, except that he should
justify his definition in one or both of two ways: (1) by showing that it
accords with common practice; and (2) by showing that it leads to useful
results. The above definition of wealth meets both of these requirements.
It agrees substantially with the usual understanding of business men, and it
is useful in the development of the science of economics.
Some economists add to the definition that an object, to be wealth, must
be useful. But utility is really implied in ownership. Unless a thing
is thought to be useful, no one would care to own it. Nothing is owned
which is not useful in the sense that its owner hopes to receive benefits from
it, and it is only in this sense that utility is to be employed as a technical
term in economics. Therefore, as utility is already implied in ownership, it

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

shall follow ordinary usage by employing this narrower
meaning except occasionally when it will be found conven

ient to refer to the broader meaning. Any particular
article of wealth may be called an “instrument.” Thus a
locomotive is an article of wealth or an instrument.

Other

examples are an automobile, a horse, a house, a lot, a
chair, a book, a hat, a loaf of bread, a coin.

In common parlance “wealth '' is often opposed to
“poverty,’” the contrast being between a large amount of
wealth and a small amount; precisely as in common par

lance “heat" is opposed to “cold,” the contrast being
between a large degree of heat and a small degree. But
just as in physics ice is regarded as having some degree of
heat, so in economics a poor man is regarded as having some
degree of wealth.

f Wealth, then, includes all those parts of the material
| universe that have been appropriated to the uses of man
kind." It includes the food we eat, the clothing we wear, the
dwellings we inhabit, the merchandise we buy and sell, the
tools, machinery, factories, ships, and railways, by which
other wealth is manufactured and transported, the land on
which we live and work, and the gold by which we buy and

sell other wealth. It does not include the sun, moon, or
stars, for no man owns them. It is confined to this little
need not be mentioned separately in our definition. Other writers, while
including in their definition the idea of utility, omit the idea of ownership
and simply define wealth as “useful material objects.” But this definition
includes too many “objects.” Rain, wind, clouds, the Gulf Stream, the

heavenly bodies, especially the sun, from which we derive light, heat, and
energy, are all useful and material, but are not appropriated, and so are not
wealth as commonly understood. Even more objectionable are those defi
nitions of wealth which omit the qualification that it must be material; they
do this in order to include stocks, bonds, and other property rights, as well
as human and other services. While it is true that property and services
are inseparable from wealth, and wealth from them, yet they are not them
selves wealth. To include wealth, property, and services all under “wealth,”
involves a species of triple counting. A railway, a railway share, and a
railway trip are not three separate items of wealth; they are respectively
wealth, a title to that wealth, and a service of that wealth.

SEc. 2)

WEALTH

planet of ours, and only to certain parts of that; namely,
the appropriated sections of its surface and the appropriated
objects upon that surface.
§ 2. Distinction between Money and Wealth

One of the first warnings needed by the beginner is to
avoid the common confusion of wealth with money. Few
persons, to be sure, are so naïve as to imagine that a million

aire is one who has a million dollars of actual money stored
away; but, because money is that particular kind of wealth in
terms of which the value of all other kinds of wealth is meas
ured, it is sometimes forgotten that not all wealth is money.
We are not yet ready for an extended study of money, nor
even for a definition of money, but as a warning we shall here
enumerate a few of the most common fallacies which beset

the subject. The nature of these fallacies the student will
understand at a later stage.

They are introduced here not

with any idea that the student will at once see where the
error lies, but chiefly for the purpose of ridding his mind of
the ordinary unwarranted assumptions about money.
First among these fallacies, is the assertion that if one
man “makes money,” some one else must “lose ’’ it, since
there is only a fixed stock of money in the world, and it
seems clear that “whatever money the money-maker gets
must come out of some one else's pocket.” The flaw in
this reasoning is the assumption that gains in trade are
simply gains in actual money, so that in every business
transaction only one party can be the gainer. If this were
true, we might as well substitute gambling for business and
for manufacturing; for in gambling the number of dollars
won is equal to the number of dollars lost. As a matter
of fact, however, it is not in order to obtain money that
people engage in trade, but in order to obtain what money

will buy, and that is precisely what both parties to a normal
transaction eventually do obtain.

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

Again, some persons have tried to prove that the people of
the earth can never pay off their debts because these debts
amount to more than the existing supply of money. “If
we owe money,” it is argued, “we can't pay more money
than there is.”

This assertion sounds plausible, but a

moment's thought will show that the same money can be,
and in fact is, paid over and over again in discharge of
several different debts; not to mention that some debts are

paid without the use of money at all.
A few years ago at a meeting of the American Economic
Association a Western banker expressed the opinion that
the total amount of money in the world ought to be equiva
lent to the total wealth of the world; else, he suggested,
people would never be able to pay their debts. He explained
that in the United States there were twenty dollars of wealth
for every dollar of money; and he inferred that therefore
there was but one chance in twenty of a debtor's paying his
debts. “I will give five dollars,” he said, “to any one who
can disprove that statement.” When no one accepted the
challenge, a wag suggested that it was because there was

but one chance in twenty of getting the promised five
dollars |

The attempt to equalize money and wealth by increasing
money twenty fold would, as we shall see later, prove abso
lutely futile. The moment we increased the amount of
money, the money value of all other forms of wealth would

rise, and there would, therefore, still be a discrepancy be
tween the amount of money and the amount of wealth.
A very persistent money fallacy is the notion that some
times there is not enough money to do the world's business,
and that unless at such times the quantity of money is
increased, the wheels of business will either stop or slacken
their pace. The fact is, however, that any quantity of
money, whether large or small, will do the world's business
as soon as the level of prices is properly adjusted to that
quantity. In a recent article on this subject, an editor of a

Sec. 2)

WEALTH

popular magazine put this fallacy into the very title: “There
is not enough money in the world to do the world's work.”
He says, “The money is not coming out of the ground fast
enough to meet the new conditions of life.” In reality,
money is coming out of the ground faster than the “new
conditions' require, with the consequent result of raising
prices.

A more subtle form of money fallacy is one which admits
that money is not identical with wealth, but contends that
money is an indispensable means of getting wealth. At a
recent meeting of the American Economic Association a very
intelligent gentleman asserted that the railways of this
country could never have been built in the early fifties had
it not been for the lucky discovery of gold in California in
1849, which provided the “means by which we could pay
for the construction of the railways.” He overlooked the
fact that the world does not get its wealth by buying it.
One person may buy from another; but the world as a
whole does not buy wealth, for the simple reason that there
would be no one to buy it from. The world gets its railways,
not by buying them, but by building them. What provides
our railways is not the gold mines, but the iron mines. Even
though there were not a single cent of money in the world,
it would still be possible to have railways. The gold of
California enriched those who discovered it, because it en

abled them to buy wealth of others; but it did not provide
the world with railways any more than Robinson Crusoe’s
discovery of money in the ship provided him with food. If
money could make the world rich, we should not need to

wait for gold discoveries. We could make paper money.
* This, in fact, has often been tried. The French people once
thought they were going to get rich by having the govern

ment print unlimited quantities of paper money. Austria,
Italy, Argentina, Japan, as well as many other countries,
including the American colonies, and the United States,

have tried the same experiment with the same results — no
*

ELEMENTARY

PRINCIPLES OF

ECONOMICS

[CHAP. I

real increase in wealth, but simply an increase in the amount
money to be exchanged for wealth.
The idea that money is the essence of wealth was one of

the ideas which gave rise to a set of doctrines and practices,
called Colbertism or Mercantilism, the earliest so-called

“school’ of political economy.

Colbert was a distinguished

minister under Louis XIV of France in the seventeenth

century, and a firm believer in the theory that, in order to
be wealthy, a nation must have an abundance of money.
His theory became known as Mercantilism because it re

garded trade between nations in the same light in which
merchants look upon their business — each measuring his
prosperity by the difference between the amount of money
he expends and the amount he takes in. To keep money
within the country, Colbert and the Mercantilists advo

cated the policy now known as “protection.”
To-day it is generally understood that, in trade between
nations, as in that between individuals, both parties may
gain in an exchange transaction; but the mercantilistic fal–
lacy that a nation may get rich by selling more than it pur
chases, and collecting the “favorable balance of trade ’’ in
money, still forms one of the popular bases of protectionism
in the United States. The more intelligent protectionists
give quite different reasons for a protective tariff, but the
old fallacious reason still appeals to the multitude. They
continue to think that by putting up a high tariff so that
people are prevented from spending money abroad and are
compelled to keep it at home, the country will in some way
be made richer. One reason for the persistence of this
fallacy is the continued use of the misleading phrase “favor
able balance of trade '' to indicate an excess of exports over
imports and “unfavorable balance of trade '' to indicate
the opposite condition.
Money fallacies of the kinds we have described must be
carefully avoided by the student. He should realize that

no technical term, such as “money,” can be used as a basis

•.

SEC. 3]

WEALTH

of reasoning without a carefully formulated definition. All
catch phrases should be avoided. Especially should the
student be on his guard against every proposition concerning
money. “Making money,” for instance, is a catch phrase
used without any definition. Properly speaking, nobody
can “make ’’ money except the man in the mint. The rest
of us may gain wealth, but, unless we are counterfeiters, we
cannot literally “make ’’ money.
We live in a complicated civilization in which we talk in
terms of money. Money has come to be a sort of veil which
hides the other and more important wealth of the world.
Our first task is to take off the veil and see the wealth under

neath. We shall then see clearly that wealth can be accu
mulated only as it is actually produced and saved.
§ 3. Classification of Wealth

Various kinds of wealth may be distinguished. That
kind of wealth which consists of portions of the earth's sur
face is called land. ) Among examples of land are to be in
cluded not o
farms, city lots and streets, but mines,
quarries, oyster beds, fisheries, waterways, etc. All waters
which are owned are in economics called land, being a part
of the surface of the earth. Fixed structures upon land are
called land improvements. The chief examples of land im
provements are houses and other buildings, fences, drains,
railways, tramways, macadamized streets, etc.

Land and

land improvements taken together are called real estate, the
word “real" signifying immovable. All wealth which is
movable may conveniently be called commodities, although
the usage for this term is not altogether certain. Among
examples of commodities are wheat, pig iron, food, fuel, fur
niture, jewelry, clothing, books, chairs, machinery, etc.
The term “commodities" also includes slaves, so far as this

particular species of wealth exists.
It will be remembered, however, that the definition of

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

wealth which has been adopted excludes free human beings.
It was in order to exclude free human beings from the cate
gory of wealth that the phrase “external to the owner’’ was
inserted in the definition. Slaves are wealth, for they are
external to their owner; but freemen are not wealth in its

narrower or ordinary meaning."
There are, of course, many admissible ways of classifying
wealth. That which follows is intended to exhibit the prin
cipal groups into which wealth most naturally falls. It is
advisable that the student construct other classifications for
himself.

Land
Real Estate

Land improve-

Agricultural land
Building land
Ways of transit
Buildings
Improvements

on highways

mentS

WEALTH

Miscellaneous
-

Raw materials

Commodities

Mineral

Agricultural
Manufactured

Finish

inished products

{{.

Consumable

* In the broader meaning of the term “wealth” all men, even freemen,
are, as has been said, wealth. But they are wealth of a peculiar kind be
cause they are not, like ordinary wealth, bought and sold and because the
wealth owned and its owner are in this case, identical. It is difficult, how
ever, to draw a strict line of distinction between slaves (human beings
owned by other human beings) and freemen (human beings owned by them
selves); for in some cases human beings are owned partly by others and
partly by themselves; as, for instance, vassals, serfs, indentured servants,

long-time apprentices, and men held in peonage. A man bound out to ser
vice for thirty years is almost indistinguishable from a slave, and if his
term of service be long enough, the distinction fades away completely. On
the other hand, the shorter the term of service the nearer does his condition
approach freedom. As a matter of fact, almost all workers in modern

society are bound by contract to some extent and for some period of time,
even though it be no more than an hour; and to that extent they are not
free. In short, there are many degrees of freedom and many degrees of
slavery, with no fixed line of demarcation. This is one reason why the
broader meaning of “wealth” is often more useful than the narrower.

SEc. 4)

WEALTH

It scarcely needs to be stated that these groups are not
always absolutely distinct. Like all classes of concrete
things, they merge imperceptibly into one another. For
this reason the classification is of importance only as it
gives a bird’s-eye view of the subject matter of economics.
§ 4. Measurement of Wealth

Having seen what wealth is and what it is not, and having
classified it roughly, we shall next examine separately its
two essential attributes, materiality and ownership, devoting
the remainder of this chapter to the first of these.
The materiality of wealth provides a basis for a physical
measurement of the various articles of wealth.

Wealth is

of many kinds, and each kind has its own appropriate
unit of measurement.

Some kinds of wealth are measured

by weight. This is true, for instance, of coal, iron, beef,
and in fact of most “commodities.” Of units of weight,
a great diversity has been handed down to us, such as the
pound avoirdupois, the kilogram, etc. In England, besides
the avoirdupois pound, and the Troy pound, there is the
pound sterling, used for measuring gold coin. This is much
smaller than any other pound, owing partly to the frequent
debasements of coinage that have occurred, and partly to
changes in the past from silver to gold money. In the

United States a dollar of “standard gold" (gold which is
Tº fine) is a unit of weight employed for measuring gold
coin. It is equivalent to 25.8 grains, or to #5% of a pound
avoirdupois, since there are 7ooo grains in a pound avoirdu
pois. We can scarcely put too much emphasis on the fact

that the pound sterling and the dollar are units of weight..
They should be understood as such before any attempt is
made to understand them as units of “value.”

For many articles it is not so convenient to measure by

units of weight as by units of space, whether of volume, of
area, or of length. Thus we have, for volume, milk meas

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

ured by the quart, wheat by the bushel, wood by the cord,
and gas by the cubic foot. For areas, we have lumber
measured by the square foot, and land by the acre. For
length, we have rope, wire, ribbons, and cloth measured in
feet and yards.
Many articles are already in the form of more or less
convenient units.

In these cases the measure of their

quantity is the number of such units. For instance, eggs
or oranges are usually measured by their number, expressed
in dozens. Similarly, sheets of writing paper are reckoned
by the “quire,” pencils and screws by the “gross.” In
such cases the article is said to be measured “by number.”
But “number" is by no means peculiar to such cases. All
measurement whatever implies an abstract number, as well
as a concrete unit. The only peculiarity of so-called measure
ment “by number * is that the unit, instead of being one
which is applied from the outside, as by the yardstick, is
one into which the things measured happen to be already
conveniently divided.
In measuring the quantity of any particular kind of
wealth it is assumed that the wealth measured is homogene
ous, or so nearly so as to admit of measurement by a given
unit. If different qualities or grades have to be distin
guished, the amount of each quality or grade requires sepa
rate measurement. A continuous gradation in quality,
such as is usually found in real estate, makes it necessary to
distinguish a great number of different qualities. A tract of
land of Ioo acres may consist of a dozen different qualities of
land, variously adapted to pasture, crops, or other uses.
To describe all this land as simply so many “acres" is
misleading. It is necessary to specify separately the num
ber of acres of “pasture-land,” “wheat-land,” etc.
The unit of measure of any kind of wealth, therefore,
when fully expressed, implies a description, not only (1) of
size, but also (2) of quality; as, for instance, a “pound of
granulated sugar.” It is necessary to enumerate the attri

SEC. 5]

WEALTH

butes of the particular wealth under consideration, or
enough of these attributes to distinguish that species of
wealth from others with which it might be confused.

Thus it is often necessary to specify what “grade ’’ or
“brand ” is meant, as “grade A,” “Eagle brand,” etc.
Sometimes the special variety is denoted by a “trademark''
or “hall-mark.”

Some writers have erroneously supposed that the attri

butes of wealth constitute separate and independent “im
material" sorts of wealth.

But “

rtilityx

for instance,

is not wealth, though “fertile land" is wealth. “Sweet
ness” is not wealth, though “ sweet

sº is

wealth;

“Abeauty” is not wealth, although a “beautiful gem" or
other object of art is wealth; “strength” and “power”
are not wealth, although “powerful horses,” automobiles, or
waterfalls are wealth."

§ 5. Price

We have considered articles of wealth as measured sepa
rately. Each kind has its own special unit, as the pound,
gallon, or yard. But it is convenient also to measure
the combined value of aggregations of wealth. The term
“value" introduces the subject of exchange. So much
mystery has surrounded the term “value" that we cannot
be too careful to obtain a correct and clear idea of it at the

outset. In the explanation which follows, the concept of
value is made to depend on that of price; that of price, in
turn, on that of exchange; and finally, that of exchange on
that of transfer. In this section we shall treat of price;
* Some people speak of human qualities — strength, beauty, skill, honesty,
intelligence, etc. — as though they were wealth. But these bear the same
relation to human beings as similar qualities of articles of wealth bear to
those articles; and the only way we can logically make them even attri
butes of wealth is, as already stated, to call human beings wealth. Then
their attributes become attributes of wealth in the broader meaning of that
term.
-

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

and, to observe the order of sequence, we must begin with
transfer.

Wealth is said to be transferred when it changes owners.
A transfer is a change of ownership. Such a change does not
necessarily imply a change of place. Ordinarily, of course,
the transfer of an article is accompanied by a change in its
position, the purchase of tea or sugar being accompanied by
the physical delivery of these articles across the counter
from dealer to customer; but in many cases such a change of
position does not occur, and in the case of real estate it is
even impossible.
Transfers may be voluntary or involuntary. Examples of
involuntary transfers of wealth are: (1) through force and
fraud of individuals, as in the case of robbery, burglary, or
embezzlement; (2) through force of government, as in the
case of taxes, court fines, and “eminent domain.”

But

at present we have to do only with voluntary transfers.
These are of two kinds: (1) one-sided transfers, i.e., gifts
and bequests; and (2) reciprocal transfers, or exchanges,
which are of most importance for economics. An exchange
of wealth, then, is a pair of mutual and voluntary transfers of
wealth between two owners, each transfer being in considera

tion of the other.
When a certain quantity of wealth of one kind is ex
changed for a certain quantity of wealth of another kind,
we may divide either of the two quantities by the other and
obtain what is called the price of the latter. That is, the
price of wealth of any given kind is the amount of any other
kind of wealth supposed to be exchanged for one unit of the
given kind of wealth. Thus if Ioo bushels of wheat are ex
changed for 75 dollars of gold, the price of the wheat in
terms of gold is 75 + Ioo, or three-fourths of a dollar of
gold per bushel of wheat. Contrariwise, the price of gold
in terms of wheat is Ioo + 7.5, or one and one-third bushels
of wheat per dollar of gold. Thus there are always two
prices in any exchange. Practically, however, we usually
_-T

c
*

- Sec. Sl

WEALTH

.
º

speak only of one, viz., the price in terms of money, obtained

F by dividing the number of units of money by the number of
* units of the article exchanged for that money. It follows

that, practically, the price in money of any particular sort of

wealth is the amount of money for which a unit of that wealth
is exchanged. The fact that wealth is exchangeable and in
the civilized world is constantly changing ownership is of
great importance for our study. Articles of wealth which

3 are seldom exchanged, such as public parks, are not com
~
monly thought of as wealth at all, although logically they
.s
* must be included in that category.
*

While it is true that any two kinds of wealth may be

exchanged, some kinds of wealth are more acceptable in ex

change than others. Money primarily means wealth which
is generally acceptable in exchange. Here for the first time
y
we reach a preliminary definition of money. This definition
is based on the most important characteristic of money —
*
its exchangeability. An exchange in which money does not
:
figure is called barter. An exchange in which money does
figure is called a purchase and sale – a purchase for the
* man who parts with the money (or its representative, a
check), a sale for the man who receives it. Originally, all
, exchange was barter, but to-day most exchange is, as we
*

all know, purchase and sale.
S- In order that there may be a price, it is not necessary that
the exchange in question shall actually take place. It
may be only a contemplated exchange. A real estate agent
often has an “asking price ’’; that is, a price at which he
tries to sell. This is usually above the price of any actual
sale which may occur later. In the same way there is often
a “bidding price,” which is usually below the price of actual
sale. Hence, the price of actual sale usually lies between
the price first bid and the price first asked. But it sometimes
happens that the bidder refuses to raise his bidding price,
and the seller refuses to lower his asking price enough to

bring the two together. In such a case no sale takes place,

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

and the only prices are those bid and asked. For many
commodities the trade journals report, preferably, prices of
actual sales; but, where there have been no sales, they
simply report the prices bid or asked, or both.
When there is no sale, especially when there is no price bid
or asked, it is not so easy to answer the question: What is
the price? Recourse is then had to an “appraisal,” which
is simply a more or less skillful guess as to what price the
article would or should bring. Appraising or guessing at
prices is often very difficult. It frequently has to be em
ployed, however, by the government, for the purpose of
assessing taxes and customs duties and condemning land;
by insurance companies for settling claims and adjusting
losses; by merchants for making up inventories and similar
statements; and by statisticians for numerous purposes.
In fact, some people make a living by appraising wealth
on which, for one purpose or another, a price of some sort
must be set. The purpose evidently makes a great differ
ence in the appraisal. Sometimes we want to know the
price for which an article could be sold in an immediate
forced sale; sometimes, the price it might be expected to
bring if a reasonable time were allowed; sometimes, the
price the owner would probably take; sometimes, the price
a purchaser would probably give. These prices may all be
different. A family portrait may be worth a big price to
the owner, and yet bring next to nothing if sold to strangers.
The owner would naturally appraise it at a high figure if he
wished to insure it against fire, but if he should try to bor
row money on it from a pawnbroker, the appraisal would
undoubtedly be low.

Consequently, in applying an appraisal, we encounter
many difficulties because the parties involved usually have
some interest to serve.

When a farmer has land for sale,

he will hold it at a high price to prospective purchasers,

but will enter it, if the truth must be told, at a low price on
the tax list. When a fire loss is adjusted, the two conflict

Sec. 6]

WEALTH

ing interests, viz., the “insured ” and the “company,” are
usually represented by two experts, who in case of disagree
ment call in a third.

§ 6. Value

Having succeeded in defining the price of any kind of
wealth, we may next proceed to define the value of any given
quantity of that wealth. The value of a given quantity of
wealth is that quantity multiplied by the price." Arithmetic

ally expressed, if the price of wheat is # of a dollar per bushel,
then a lot consisting of 3ooo bushels would have a value of

3ooo times # of a dollar, or 2000 dollars. Algebraically ex
pressed, if the price of any good is p and its quantity is Q,
its value is expressed as p0. In other words, the value of a
certain quantity of one kind of wealth at a given price is the
quantity of some other kind for which it would be exchanged,
if the whole quantity were exchanged at the price set.
The distinctions between quantity, price, and value of
wealth may be illustrated by an inventory such as the fol
lowing: —
QUANTITY

Shoes . . . .
Beef . . . . .
Dwelling house .
Wheat

PRICE IN TERMS OF WHEAT

. . Iooo pairs |4} bu. *per pair
. 3oo lb.
# bu. per pound
.
1 house | Io,000 bu. per house
. . Ioo bu.
I bu. per bushel

VALUE IN TERMs
of we eat

42.5o bu.
6o bu.

Io,0oo bu.
Ioo bu.

* This definition of value departs from the usage of some textbooks, but
follows closely that of business men and practical statisticians. Economists
have sometimes confined “price” to what is in this book called money price
and applied the term “value” to what is here called price. Other econo
mists have used the term “price” in the sense of market price — what an
article actually sells for — and “value” in the sense of appraised price or
reasonable price—what it ought to sell for. Still others have used the term
“price” in the sense employed in this book, but “value” in the sense of the
degree of esteem in which an article is held — what in this book will later be
called “marginal utility” or “marginal desirability.”
* “Bushels” refers to bushels of wheat throughout this table.
C

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

The three columns must be carefully distinguished.
Only in special cases can any two of the three magnitudes,
quantity, price, and value, be identical. The table illus
trates these special cases.

Thus in the last line we find

quantity and value identical because, in this special case,
the value of the good is reckoned in terms of itself, wheat in wheat. In the line above, price and value are
identical because, in this special case, the quantity valued is
only one unit. The value of one house is the price per
house.

The measurement of various items of wealth in respect
of “value,” expressed in terms of a single commodity, such
as wheat or money, has one great advantage over its meas
urement in respect of “quantity.” This advantage is that
it enables us to translate many kinds of wealth into
one kind and thus to add them all together. To add

up the “quantity” column would be ridiculous, because
pairs of shoes, pounds of beef, houses, and bushels of
wheat are unlike quantities. But the items in the last
column (representing values), being expressed in a single
common unit (the bushel), may be added together de
spite the diversity of the various articles thus valued in
bushels of wheat.

Since prices and values are usually expressed in terms of
money — the most exchangeable kind of wealth — money
may be said to bring uniformity of measurement out of
diversity. In other words, it is not only a medium of ex
change, but it can be used also as a measure of value.

serves as a means of comparing values of different things by
expressing them both in a common denominator. It would
be far more trouble to compare each article directly with
every other article, for there would be many more com
parisons.
Although this reduction to a common measure is a great
practical convenience, we must not imagine that it gives what
could in any fair sense be called “the only true measure"

Sec. 6]

WEALTH

of wealth. In fact, to measure the amount of wealth by
its value — i.e., its money value – is often misleading.
The money value of car wheels exported from the United
States in one month was $12,000 and in a later month,
$15,000, from which fact we might infer that the quantity
of these exports had increased. But the number of car
wheels exported in the first of those two months was 2200,
and in the second only 21oo, showing a decrease.

The

price had increased faster than the number had decreased.
Likewise, the figures for imports of coffee in these periods
show a decline in dollars, despite an increase in pounds.
Here the price had fallen faster than the number of pounds
had risen. It is conceivable that the quantity of every
article might decrease, and yet the price simultaneously
increase so much that there would be an apparent increase
of wealth when there really was nothing of the kind. This
is apt to be the case in times of inflation of the currency.
Even when we are confessedly trying to measure the value
of wealth and not its quantity, it is difficult or impossible
to find a right way. Imports into the United States from
Mexico in one year were worth twenty-eight millions of
American gold dollars, and ten years later their value was

forty millions — an increase in value of forty-two per cent;
but these very same imports measured in Mexican silver
dollars were forty-one millions in the first year and ninety
millions in the second – an increase in value of nearly one
hundred and twenty per cent. These two rates of increase,
although they represent exactly the same facts, do not agree
with each other; yet the American merchant reckons the

values one way, and the Mexican merchant, the other. In
a sense both are right; that is to say, both are true state
ments of the value of the articles imported, one of the
value in gold and the other of the value in silver. If the
value were to be measured in iron, copper, coal, cotton, or
any other article, we should have many other different
“values,” no two of which would necessarily agree. “The

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

value of wealth,” therefore, is an incomplete phrase; to be
definite we should say, “the value of wealth in terms of
gold,” or in terms of some other particular article. Hence
we cannot employ such values for comparing different
groups of wealth, except under certain conditions, and to a
limited degree. To compare the wealth values of distant
places or times — as America and China, Ancient Rome
and Modern Italy — will inevitably give conflicting and
unsatisfactory results.
§ 7. Limit of Accuracy in Economic Measurements

We have learned how the three magnitudes — quantity,
price, and value of wealth — are usually measured, and that
their measurement is practically a very inaccurate affair.
Yet in the minds of most persons, even of business men, the
degree of accuracy attainable is exaggerated. Even in the
measurement of the mere quantities of wealth there are two
sources of error; for every such measurement includes, as
we have seen, two elements: a unit and a number or ratio

(as the pound, and the number of pounds); and both the
unit and the number or ratio may be inaccurate.

modern times the first source of error — that of the unit —

is practically eliminated. Our units of weight and meas
ure are standardized by law, and a pound in California is,
for all practical purposes, equal to a pound in Connecticut.
There is, moreover, at Washington a national bureau and a
special building for preserving and testing standards of
measurement. Different towns have their sealers of weights
and measures, to prevent error through ignorance or fraud.
Fraud and error still exist, but are much rarer than in

former times. The Egyptians are said to have been un
able to test the accuracy of their units of length closer
than to 1 part in 350. The Roman weights were true only
to 1 part in 50. And when we go back to primitive units,
we find that they were very rough indeed. A yard was

SEc. 7]

WEALTH

probably at first the length around the waist, which naturally
was apt to vary considerably. So also the distance between
the elbow and the end of the finger was taken as a unit
and called the ell. Fraud was, therefore, as easy as it was
common. At Bergen, in Norway, among other relics of
the old Hanseatic League, are the scales used for buying
and selling fish, with two sorts of weights used, one con
siderably heavier than the other. The heavier were used for
buying and the lighter for selling ! Such tampering with
weights and measures is probably much less frequent to-day,
although instances of short weights, as in the “sugar trust
frauds,” are often brought to light.
To-day, therefore, the chief source of error lies not in the
unit, but in the ratio of the quantity of wealth to that unit.
In retail trade the inaccuracy from this source is very great.
If we get our apples or potatoes measured correctly within
five per cent, we are fortunate. Wholesale transactions
are more accurate. Probably the greatest degree of accu
racy ever attained in commercial measurements is on the
mint scales employed by the federal government in Phila
delphia and San Francisco. These scales weigh accurately
to within about one part in two million.
Besides the two sources of error in the measurement of

mere quantity, when we proceed from quantity to value,
we introduce still a third source of inaccuracy, viz., the price
factor by which we multiply the quantity in order to get
the value. This is especially true if the price be merely
an “appraised " price. The price in an actual sale is an
absolute fact and cannot be said to have any inaccuracy;
but the price at which we estimate that a thing would sell
under certain conditions is always uncertain. In the case of
“staple '' articles, i.e., articles regularly on the market, a
dealer can often appraise correctly within one per cent.

Real estate in certain parts of a city where sales are active
can sometimes be appraised correctly within five or ten per
cent, but in the “dead " or out-of-the-way parts of some

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. I

towns where sales are infrequent, the appraisement be
comes merely a rough guess. Again, in the country districts,
while farms in the settled parts of Iowa and Texas can be
appraised within ten or fifteen per cent, in the backward
parts even an expert's valuation is often proved wrong by
more than fifty per cent. And where a sale of the article
in question is scarcely conceivable, an appraisement is almost
out of the question. To estimate the value of Yellow
stone Park is impossible, unless we allow ourselves very
wide limits of error."
* Still wider limits must be allowed when we try to value human beings.
We can often give a lower limit, but seldom an upper one. The estimates
may vary enormously with the point of view. It is sometimes said, “If I
could buy Mr. So-and-so at my valuation and sell him at his, I'd get rich.”
Freemen are seldom appraised at all. When the slaves in the South
became freemen, they ceased to be appraised as wealth. The result has
been somewhat confusing to our census statistics. The “Manufacturers’
Record” of Baltimore recently issued figures showing a sharp drop in the
assessed valuations of wealth in the South after the war.

The inference

was drawn that the value of wealth had immensely decreased; but a large
part of this so-called decrease consisted merely in the change of ownership
of slaves from their old masters to themselves, and their consequent omis
sion as items of value. Any valuation of freemen, should exceed that of
slaves; but even on the basis of slave values the total value of the human
beings in any country is always greatly in excess of the total value of all
other wealth.

CHAPTER II

PROPERTY

§ 1. The Benefits of Wealth

THE definition of wealth which has been given restricts
it to concrete material objects owned by man. Accord

ingly, wealth has two essential attributes: materiality
and ownership.

Its materiality was the subject of the

preceding Chapter; its ownership will be the subject of
the present chapter.

To own wealth is to have a right to the benefits of wealth,
and before proceeding further with the discussion of owner
ship, we must consider these “benefits" of wealth. To

own a loaf of bread means nothing more nor less than to have
the right to benefit by it – i.e., to eat it, sell it, or otherwise

employ it to satisfy one's desires. To own a suit of clothes

is to have the right to wear it. To own a carriage is to
have the right to drive in it or otherwise utilize it as long
as it lasts. To own a plot of land means to have the right
to use it forever. The ultimate objects for which wealth
exists are the benefits which it confers. If some one should
give you a house on condition that you should never use it,
sell it, rent it, or give it away, you might be justified in refus
ing it as worthless.

Benefits may also be rendered by free human beings (who,

according to our broader definition, are included under
wealth). Such benefits are then usually called services ren
dered or work done. When rendered by things rather
than persons, benefits are commonly called uses. Some
23

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. II

times benefits consist of positive advantages and sometimes
of the prevention of disadvantages. Benefits, then, mean
desirable events obtained or undesirable events averted by means

of wealth or free human beings. For example, when a
loom changes yarn into cloth, the transformation is a de
sirable change due to the loom; it is a benefit conferred or
performed by the loom. The benefit from a plow is the
turning up of the soil. The benefits or services performed
by a bricklayer consist in the laying of bricks. The benefits
or uses conferred by a fence around a farm consist in pre
venting the cattle from roaming away. The dikes in Hol
land confer the benefit of keeping out the ocean. The
benefits conferred by a diamond necklace consist in its
pleasing glitter.
Many articles confer benefits on their owners by yielding
them money. The benefit to the landlord from the land or
building which he lets is the receipt by him of rent. The
benefit to the owners of a railway from the railway is the
receipt by them of their dividends. But not all benefits,
of course, are simply the receipt of money.
To be desirable to the owner, an article must confer bene
fits on the owner, but not necessarily on the community
at large. For instance, the noise of a factory whistle may
be a nuisance to the community, but as long as it is service
able to the owner of the factory, it is for him a benefit.
Benefits to the owner and benefits to society may be very
different or may be mutually incompatible. The benefits to
society are of the greater importance, but, under our present
system of ownership, the benefits to the owner control the
prices and values of wealth. In order, therefore, to under
stand prices and values as they are actually determined,
we must fix our attention for the present on the benefits to
the owner rather than on those to society.
Benefits may be measured just as wealth may be measured,
although the units of measurement are, of course, not the
same. We measure some benefits by number—as when we

Sec. 2)

PROPERTY

count the strokes of a printing press. We measure other
benefits by time — as when we reckon a laborer's work by
the number of hours or days during which he works. Some
benefits we measure by the quantity of wealth which is pro
duced or treated — as when the work of a coal miner is

measured by the amount of coal he mines, or when the use of
a loom is measured by the number of yards of cloth it
weaves, or when the services of a lawn-mowing outfit are
measured by the number of acres covered.

The measure

ment of services or benefits is usually rougher than that of
wealth, because it is more difficult to establish units of
measure.

The shelter of a house or the use or “wear” of a

suit of clothes is difficult to measure accurately. To save
trouble, benefits are usually measured by time, although, as
soon as it becomes profitable to do so, the tendency is to
establish a more satisfactory measure “by the piece.”
When we have measured the benefits of wealth or of free

human beings, we may apply to them the same concepts of
transfer, exchange, price, and value, which, in the last chap
ter, we applied to wealth. We have seen that wealth may
be exchanged. The same is true of benefits. In fact, every
exchange is an exchange of benefits; for to exchange wealth
is really to exchange the benefits of wealth, the only object
in getting wealth being to get its benefits.
-

§ 2. The Costs of Wealth

Opposed to the benefits of wealth are its costs. Costs
may be called negative benefits. The purpose of wealth is
to benefit its owner; that is, to cause to happen what he

desires to happen, and to prevent from happening what he
desires not to happen.

But often wealth can work no

benefit without entailing some cost, i.e., preventing what is
desirable or occasioning what is undesirable.

For instance,

one cannot enjoy the benefits of a dwelling without the costs
of taking care of it, either through the actual labor of clean

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. II

ing, heating, repairing, and keeping it in order, or the pay
ment of money to servants for such purposes; one cannot

get the benefit of flour without assuming the cost of knead
ing and baking it into bread; one cannot get the benefit of
a farm without the cost of tilling it. Whatever wealth brings
about to the pleasure of the owner is a benefit; whatever
it brings about to his displeasure is a cost. He assumes the
costs only as a means of securing the benefits. Costs are
thus the necessary evils which must be if we are to obtain
the good which wealth affords.
Like benefits, costs are not only occasioned by wealth,
but also by free human beings. An employer can
get benefits from a workman only at the cost of pay
ing him wages; an independent workman can get bene
fits from his own exertions only at the cost of his own
labor.

The costs of wealth or of free human beings may, of course,
be measured, just as benefits are measured — by number,
by time, or by other appropriate units; and costs when
thus measured may, by price and value, be translated into
terms of money precisely like the opposite items—benefits.

We must beware of assuming that cost is always in the
form of an expenditure of money.

Such money cost has

received exaggerated importance in the eyes of business
men and has tended to hide the more important and funda
mental kind of cost, namely, labor. Even labor appears to
the employer in the guise of a money cost – the expenditure
of wages. This expenditure, however, is not itself labor.
Those who feel a real labor cost are the laborers themselves.

It is by their physical and mental exertions that the work

of the world is chiefly done.
§ 3. Property, the Right to Benefits
We have said that to own wealth means to have the

right to its benefits.

We have seen what is meant by

SEC. 3]

PROPERTY

“benefits,” and shall next examine what is meant by
“rights.” "

A property right is the liberty or permit (under the sanc
tion and protection of custom and law) to enjoy benefits of
wealth (in its broader sense) while assuming the costs which
those benefits entail. The term “property" is merely an

abbreviation for “property right” or “property rights.”

Just as different kinds of wealth are more or less exchange
able, so different kinds of property rights differ greatly in
exchangeability. Those forms which are most easily and
commonly exchanged are of most importance for our study.
Those the exchange of which is infrequent, difficult, or for
bidden, are in fact seldom thought of as property rights at
all, although logically they must be included in that cate
gory. In the modern world the right of a parent over a
child or of a husband over a wife is not by ordinary usage
called property; for, except in certain remote corners of
the earth, their exchange is tabooed.

It will be observed that property rights, unlike wealth or
benefits, are not physical objects nor events, but are abstract
social relations. A property right is not a thing. It is that
relation of man to things, called ownership. It is in this
human relationship to wealth that we are most interested,
and not in the physical objects as such.
The benefits flowing from wealth require time for their
occurrence and are therefore either past or future. The past
and the future are separated by the present, which is a mere
point of time. The only benefits from wealth which can be
owned at this present point of time are future benefits.
Past benefits have vanished. When a man owns any form
of property, he owns a right to future benefits.

The idea of

“futurity” is, therefore, implied in our definition of property,
which may, therefore, be more explicitly expressed as follows:
* As we have seen that “benefits” may be occasioned not only by wealth
in its narrow sense, but by free human beings, we shall consider “rights”
to benefits from both of these sources.

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. II

Property is the right to future benefits of wealth (in its broader
sense). It is also to be observed that the future is always
uncertain; no man can ever tell in advance exactly how
much future benefit he can obtain; he can only take the
chances and risks involved. Consequently, the idea of un
certainty is also implied in our definition of property, which
may, therefore, be still more explicitly expressed as follows:
Property is the right to the more or less probable future benefits

of wealth (in its broader sense).
If a man has the right to all the benefits which may come
in the future from a particular article of wealth, he is said
to have its complete ownership, or its ownership without
encumbrance. If he has a right to only some of the bene
fits from a particular article of wealth, he is said to own that
wealth partially, or to “ have an interest" in it. When
two brothers own a farm equally in partnership, each is a
part owner; each has a half interest in the farm; that is,
each has a right to half of the benefits to be had from the
farm.

What is divided between the two brothers is not

the farm, but the benefits of the farm. To emphasize this
fact, the law describes each brother's share as an “undivided

half interest.” Partnership rights are usually employed only
when the number of coöwners is small.

When the number

is large, the ownership is usually subdivided into shares of
stock; but the principle is the same – each individual owns
a right to a certain fraction of the benefits which come to
the owners.

After the quantities of property of different kinds are
measured, we may apply the same concepts of transfer,
exchange, price, and value which have already been applied
to wealth and benefits, each particular kind being measured
in its own particular unit. Consider, for example, the prop
erty called stock in the Pennsylvania Railway Company.
This is measured by the “number of shares,” the share here
being the unit of measurement.
It is important that the student should become accus

SEc. 3]

PROPERTY

tomed to see the real basis underlying property rights. This
basis is either wealth or free persons, or both. Practically it
is usually wealth. A mortgage is based on land, and great
care is taken not to have the mortgage too large for the basis
on which it rests.

Railroad stocks and bonds are based on

the real railway. Personal notes are based partly on the
person issuing them and partly on his wealth. A street
railway franchise is a property right, the physical basis of
which consists in the streets. Sometimes the property
rights are removed several steps from the real basis. If a
number of factories are combined into a “trust,” the origi
nal stockholders surrender their stock certificates to trustees

and receive in their place trust certificates. Their rights are
then a claim against the trustees who hold the stock which

represents the factories. The ultimate basis for their rights
is still the factories, but their ownership is indirect.
The future benefits flowing from wealth may be compared
to a pennant attached to a flagstaff — a long streamer
stretching out into the future. Two of the possible ways
in which the present ownership of these benefits may be sub
divided are indicated in Fig. 1. Here are two “streamers ”
representing the streams of benefits which may come from
a dwelling house. These begin at the present and stretch
out indefinitely into the future. If two brothers own the
house in partnership, each has a right to half the shelter
of the house, i.e., to half of its benefits; the benefits are

therefore divided, so to speak, longitudinally in time.
But if the house is rented, the division of benefits between
the tenant and the landlord is transverse, as shown in the
lower “streamer" of the diagram. The tenant has all the

shelter of the house until the time when his lease is to expire,
while the right to all shelter beyond the time of the lease
rests in the landlord, either to use himself or to sell to

others by new leases.
These are not, of course, the only ways in which future
benefits may be parceled out among their several owners,

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. II

but they are the principal and usual modes of sub
division.

In common speech, the minor rights to wealth are not
ordinarily dignified as rights of ownership. Thus a tenant's
right in the dwelling
B's st-ARE of FUTURE BENEFITs. T he occupies is sharply
A's 5HARE of FUTURE BENEFITS,

}

distinguished from the

right of the owner.
Yet, strictly speaking,
every right to the
benefits of wealth or

to the services of free

TENANTs

LANDLORD's

human beings, how

uman beings,
ever insignificant that
right
may
g
y be, is a Dpart
ownership. When an

PRESENT

INSTANT

FIG. I

owner of land wishes

to give an unencum
bered title, he finds it necessary to extinguish all out
standing leases, or claims for future benefits, often at

considerable cost. It is the total ownership which he is
selling, and the total ownership always includes the owner
ship which the tenant enjoys. Thus the tenant of a
dwelling is, to a very slight extent, a part owner of that
dwelling. In the same way the employer is, to a very
slight extent, a part owner of the employee.
§ 4. The Relation between Wealth and Property

We have thus far considered three very important and

fundamental concepts: wealth, benefits, and property. A
convenient collective term for all of them is “goods.”
Wealth and property are only present representatives of
future benefits and future costs. Wealth (in its broader

sense) is the present means by which we secure future bene
fits; while property is the present right to these benefits,

SEc. 4)

PROPERTY

and so to the wealth (in its broader sense) which yields
them. It follows that wealth (in its broader sense) on
the one hand, and property rights on the other, may be

said to correspond to one another. The wealth (including

free human beings) consists in real tangible things, while
the property rights represent intangible, abstract relations
which persons, as owners, hold toward them (the wealth,
including free human beings). Wealth and persons are
the important things; property is the human right of
ownership of the wealth or of the services of free

human beings. In specific cases we can readily see the
correspondence between the wealth and its ownership.
In fact, in cases where wealth is owned unencumbered

or completely, the correspondence is altogether too ob
vious; so obvious that in ordinary parlance the two
terms, “wealth '' and “property,” become confused, as
when speaking of a piece of wealth, in the form, say, of
land, we call it a “piece of property.”
On the other hand, where the ownership is minutely
subdivided, the wealth and the property rights to that
wealth become so dissociated in our minds that we are apt

to fall into the opposite error, and entirely lose sight of
their connection.

For instance, when railway shares are

sold in Wall Street, the investor rarely thinks of those shares
as connected with any actual wealth. All that he sees are
the engraved certificates of his property rights; he has no
visual picture of the railway. Sometimes the rights are so
far separated from the thing to which the rights relate, that
people are unaware that there is anything behind the rights
at all, and delude themselves with the notion that there
need not be anything behind them. A government bond, for
instance, is often regarded as a kind of property behind which
there is no wealth.

But if we examine the case, we shall

find that the wealth of the entire community is behind
this property right; for it is by means of the taxing power
that the bonds are to be paid, and this taxing power can

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. II

only be effective by means of wealth (including freemen)
as sources of income. For cities, in fact, this is definitely
recognized; there is usually a legal debt limit expressed
in terms of the value of taxable wealth, to insure the
creditors that there shall always be sufficient real wealth
behind the city bonds to make their ultimate payment
SeCure.

Not only should the student clearly distinguish in his
mind between the three important concepts, wealth (in

cluding man), benefits and property, but he should avoid
confusing any of these with a fourth relatively unimpor
tant concept, namely, certificates of ownership. To avoid
misunderstanding, it is often necessary that property rights
should be evidenced by written documents. Examples of
such written evidence or certification of property rights are
deeds for real estate, receipted bills for goods bought and paid
for, engraved stock certificates, railway tickets, signed prom

issory notes, written contracts with laborers to “work out”
a sum of money advanced, etc. It is clear, however, that
such written evidence of property rights is very different
from the property rights themselves; and in many cases
such rights exist without any written evidence. Thus, the
farmer who rears his own cattle, or horses, or sheep, usually
has no written evidence of property rights in them. Or,
two brothers might own and operate a farm in partnership,
without any written evidence as to their partnership rights,
i.e., their respective rights in the products of the farm. Or,
again, one person might, without written evidence, lease
(say) a cottage for a season from a friend. In all these
cases, there are no documentary evidences of property
rights. Yet in all three cases property rights exist. In
the first case the right is complete; in the other two cases
partial, the benefits being subdivided, -in one case lon
gitudinally, in the other, transversely.

SEc. 5]

PROPERTY

§ 5. Table of Typical Property Rights
The following table indicates the most important types of
property, and shows in each case the wealth on which the

property right is based and the benefits accruing from that
wealth. The most important forms are: unencumbered,
stocks, bonds, notes, leases, and partnership rights.
TYPICAL CASES ILLUSTRATING THE EXISTENCE OF
WEALTH

BEHIND

PROPERTY

RIGHTS

WEALTH on which

CERTIFICATE

Naws or caseſ." Hº ;º. º.º.
Unencumbered

Yielding crops

Farm

Right to all use | Deed
of farm for
ever

Partnership

Yiclqing profits One

Dry goods

from sale

partner's Articles

“undivided ”
fractional in

agreement

terest

Joint Stock

Railway

Yielding

profits. The

shares
stock

Stock

certifi

cate

Street Franchisel Street

Use of same for Right to run Charter
passage, etc.
cars through

Lease or Hire | Dwelling

Use of same for Right of tenant Lease

Railway Ticket Railway

Transportation | Right to speci- Ticket

Railway Bond

Payment of “in- Right to same Bond

shelter, etc.

till fixed date

fied trip
Railway

terest"

and

“principal''

and

contin-

certifi

Cate

gent right to
foreclose

Personal Note All the posses- || Payments
sions of

the

and

signer

Work due from Workmen
Contract Labor

Right to same | Note

Work

fault thereof,
right to collat
eral security
Right of employ- Written
er to perform- tract
ance of same

con

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. II

§ 6. Practical Problems of Property
We have seen that wealth (including man), on the one
hand, and property rights, on the other, correspond to each
other.

When we treat of the welfare of a community, we

think rather of wealth (in its broader sense) than of prop
erty. When we treat of the welfare of an individual, we
think rather of property than of wealth. This fact of corre
spondence between property rights, on the one hand, and
wealth (including man), on the other, should be empha
sized, because it will save us from confusions which are all

too common, and it will save us also from many practical
blunders growing out of these confusions. If our State
legislators understood this, there would be less of the
iniquitous double taxation that is the bane of the present
systems of State and local taxation. Such unjust taxation
is illustrated by the case of the Massachusetts factory owner

who decided to transfer his property to a stock company of
which he himself should hold all the stock. Previously he
paid taxes only on the factory itself; but when the “com
pany” was formed (under a Maine charter), the tax collector
came along and informed him that henceforth not only
must the “company ” pay taxes on the factory, but that
he personally must pay taxes on the stock also, since stock
in a Maine company is taxable “personal property.”
Thus the owner was taxed both on the stock which repre
sented the factory and on the factory itself. Instances
of double taxation are quite common in the United States,
though they are not all so self-evident as this.

It is not

within the scope of this book to discuss taxation or other
practical problems of economics. The object of this
section is merely to point out what practical problems are
related to “property.”
Many of the most important problems of economic
policy are problems of the form of ownership of wealth.

SEc. 6]

PROPERTY

The great question of slavery, for instance, turned upon the
question whether one man should be owned by another.
A more modern problem of property is that of perpetual
franchises. Is it, for instance, good public policy to grant to
a street railway company in perpetuity the right to use a
city's streets? Or ought we to fix a time limit, say fifty
years, after which the right shall revert to the city? A
kindred question has been raised as to private property in
land. Is it wise public policy that the present form of land
ownership in fee simple should continue? Ought a man
to have the right to a piece of land forever, perhaps abus
ing that right, obstructing others, and neglecting the oppor
tunities which it affords; or should the government own
the land and lease it to individuals for limited periods?
This question is now being discussed with reference to our
mineral lands, and particularly our coal lands in Alaska.
Questions of land ownership have in all ages vexed men's
minds and been the source of social unrest.

Rome had

her agrarian troubles, not unlike those of modern England
and Ireland.

The right to bequeath property is also a prime source of
trouble. This right to dispose of property by will has not
always been recognized. It was developed by the Romans,
from whose system of law we borrowed it. Even now it

is a limited right, and its exercise differs with law and custom.
These differences are responsible for peasant proprietorship
in France and for primogeniture in England. The right has,
indeed, been limited so as to prevent the perpetual tying-up
of an estate by a testator. Its further limitation will prob
ably be one of the problems of the future.
An even broader question of the same sort is the question
of socialism. Shall we discontinue what is called private
property, except in the things that we wear and eat, and pos
sibly the houses in which we live? That is, shall we allow
our railways and our factories to be owned by private indi
viduals? Or shall they be owned by the community at

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. II

large so that we may all have shares in them, as we already
have in the post office and the government printing office?
These are some of the greatest problems in economics;
and they are problems concerning the ownership of wealth.

The answers to these questions do not come within the pur
pose of this book, which is concerned merely with principles.

* The problems are mentioned, however, as illustrating the
-**

application of principles here discussed.

CHAPTER III
CAPITAL

§ 1. Capital and Income
IN the foregoing chapters we have set forth several funda
mental concepts of economics – wealth, property, benefits,
price, and value. We have seen that wealth in its broader
sense includes human beings, and that property in its
broader sense includes all rights whatsoever; that benefits
are the desirable occurrences which happen through wealth
(in its broader sense); that prices are the ratios of exchange
between quantities of goods of various kinds (wealth,

property, or benefits); and that value is price multiplied
by quantity. These concepts are the chief tools needed in
economic study.
Little has yet been said about the relation of these
various magnitudes to time. When we speak of a certain
quantity of wealth, benefits, or property, we may refer either
(1) to a quantity existing at a particular instant of time, or
(2) to a quantity produced, exchanged, transported, or con
sumed during a particular period of time. The first is a
stock of “goods”; the second is a flow of “goods.” Ex
amples of stocks are the stock in trade of a merchant on

a certain date, the cargo of wheat on board a ship, the
amount of food in a pantry at a particular instant, the
number of shares of stock owned by a particular individual
in a particular corporation at a particular date. Examples
of flows are the sales of merchandise made in the course of

a given month by a given merchant, the amount of wheat
37

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

imported into a given country during a given year, the
quantity of food consumed by a family in a given week,
the sales of a given kind of stock on the New York Stock
Exchange during a given number of days, the transporta
tion accomplished by a railway in the course of a certain

year, the work done by a given man in a given time.
The most important purpose of the distinction between a
stock and a flowis to differentiate between capital and income.
Capital is a stock, and income a flow. This, however, is not
the only difference between capital and income. There is
another, equally important; namely, that capital consists
of wealth, while income consists of benefits. We have,
therefore, the following definitions: A stock of wealth existing
at a given instant of time is called capital; a flow of benefits
from wealth through a period of time is called income.
Many authors restrict the name capital to a particular
kind or species of wealth, or to wealth used for a particular
purpose, such as the production of new wealth; in short, to
some specific part of wealth instead of any or all of it.
Such a limitation, however, is not only difficult to make,
but cripples the usefulness of the concept in economic
analysis."
A dwelling house is capital; the shelter or the rent it
affords, during any given period of time, is income. The

railways of the country are capital; their benefits (in the
form of transportation or its equivalent in dividends) are
the income they yield.
The term capital is also applied to a stock or fund
of property existing at an instant of time. But such

“capital property” is not, of course, in addition to “cap
*Just as wealth may be considered in a broader sense as including
freemen, so capital may also be considered in this broader sense. Thus
an individual, because of his ability to work, may be considered as capital,
while the benefits resulting from his labor (services rendered employer or
self) should be considered as income. However, in the following dis

cussion of “capital,” we shall, except where the contrary is expressly
stated, use the term in its narrower sense.

SEc. 2]

CAPITAL

ital wealth,” but merely instead of it; for we have seen
that wealth and property are coextensive. The only
true capital of society as a whole is its capital-wealth, –
its lands, railways, factories, dwellings, and in its broader
sense its human inhabitants also; but since the owner

ship of many of these things is subdivided, the capital
of an individual can often be stated only in terms of
property—his stocks, bonds, mortgages, personal notes, etc.
§ 2. Capital-goods, Capital-value, Capital-balance
We have defined capital as a stock of wealth existing
at a given point of time. An instantaneous photograph of
wealth would reveal, not only a stock of durable wealth,
but also a stock of wealth more rapid in consumption.
It would disclose, not the annual procession of such wealth,
but the members of that procession that had not yet passed
off the stage of existence, however swiftly they might be
moving across it. It would show trainloads of meat, eggs,
and milk in transit, as well as the contents of private store
rooms, ice chests, and wine cellars. Even the supplies on
the table of a man bolting his dinner would find a place.
So the clothes in one's wardrobe, or on one's back, the

tobacco in a smoker's pouch or pipe, the oil in the can or
lamp, would all be elements in this flashlight picture.
We have seen in the last two chapters that wealth and
property may be measured either by quantities (such as so
many bushels or pounds or so many shares or bonds of a
particular description) or by value (such as so many dollars'
worth). When a given collection of capital is measured in
terms of the quantities of the various goods of which it is
composed, it is called capital-wealth or capital-property or,
to include either, capital-goods; when it is measured in
terms of its value, it is sometimes called capital-value.
One of the best methods of understanding the nature of
capital is to understand the method of keeping capital ac

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

counts. We shall, therefore, in the remainder of this chapter
indicate some of the principles of capital accounting. Such
a study is useful not only because it enables us to keep our
own capital accounts and to understand the accounts of
banks, railways, and other institutions as published, but,
what is more important for our present purpose, because
it shows how in the present complicated world of divided
ownership of capital, with its interrelated arrangement of
stocks, bonds, debts, and credits, the capitals of individuals
dovetail into one another, forming together the capital of
the community.

A capital account or balance sheet is a statement of the
quantity and value of the wealth of a specific owner at any
instant of time.

It consists of two columns — the assets and

the liabilities—the positive and negative items of his capital.
The liabilities of an owner are his debts and obligations to
others; that is, they are the property rights of others for
which this owner is responsible. The assets or resources of
the owner include all his capital, irrespective of his liabilities.
These assets include both the capital which makes good
the liabilities, and that, if any, in excess of the liabilities.
The owner may be either a physical human being or an
abstract entity called a “fictitious person’’ made up of a
collection of human beings and keeping a balance sheet
distinct from those of the individuals composing it. Ex
amples of fictitious persons are an association, a partner
ship, a joint stock company, a government. With respect
to a debt or liability, the person who owes it is the debtor,
and the person owed is the creditor. The difference in
value between the total assets and the total liabilities in

any capital account is called the net capital, or capital
balance of the person or company whose account it is.
A fictitious person is to be regarded as owning all the
capital nominally intrusted to it and as owing its individ
ual members for their respective shares; consequently,
there is no net capital-balance belonging to the fictitious

SEc. 2)

CAPITAL

person, although in most cases there is a liability item
called capital which represents what is owed to those
most responsible for the management of the business.
The most important example of a fictitious person is a
joint stock company. This may be roughly described as
an aggregation of individuals uniting for the purpose of
holding property jointly, and so organized that the in
dividual shares of ownership and management are repre
sented by “stock certificates.” Associated with the stock
holders are usually also bondholders without voting power,
but with the right to receive fixed payments stipulated

in the bonds which they hold. The “capital” item in
the capital account of a joint stock company is a liability
due to the stockholders.

It represents what is left after

the value of all other liabilities is deducted from the value
of the assets.

The items in a capital account are constantly changing,
as also their values; so that, after one statement of assets

and liabilities is drawn up, and another is constructed at a
later time, the balancing item, or net capital, may have
changed considerably. However, bookkeepers are accus

tomed to keep this recorded “capital” or “capital-balance”
item unchanged from the beginning of their account, and

to characterize any increase of it as “surplus” or “un
divided profits” rather than as capital. There are several
reasons for this bookkeeping policy. In the first place,
the less often the bookkeeper's entries are altered, the
simpler the bookkeeping. Again, by stating separately
the original capital and its later increase, the books show
at a glance what the history of the individual or company
has been as to the accumulations of net capital. Finally,
in the case of joint stock companies, the stockholders'
capital is represented by stock certificates, the engraved
“face value " of which cannot conveniently be altered
to keep pace with changes in real value. Consequently,
it is customary for bookkeepers to maintain the book

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

value of the recorded “capital,” or “capital-balance,”
equal to the face value of the certificates. But this book
keeping policy does not alter the fact that at a given instant
the stockholders' capital consists of the entire excess of as
sets over liabilities, including in that excess the accumulated
surplus and undivided profits. If the excess of assets over
liabilities be added to the liabilities, the two sides of the

account will exactly balance. A capital account so made out
is therefore called a “balance sheet.”

The following two balance sheets illustrate the accumula
tion in a year of that part of capital which bookkeepers sepa
rate from the “capital ’’ item and call “surplus.”
JANUARY 1, 1910
ASSETS

Plant .

LIABILITIES

. $200,000

$200,000

Debts
. . . .
$1oo,0oo
Capital (owed to the
stockholders) . .
Ioo,ooo
$200,ooo

JANUARY 1, 1911
ASSETS

LIABILITIES

Plant, etc. . . . . $246,324

$246,324

Debts
. . . . . $100,ooo
Capital . . . . .
Ioo,ooo
Surplus . . . . .
46,324
$246,324

Not only is the book item, “capital,” maintained intact
as long as possible, but often the surplus also is put in
round numbers and kept at the same figure for several succes

sive reports. This leads bookkeepers to distinguish a third
part of the capital, namely, the odd sum usually existing
in addition to the surplus. This third item is called “un

divided profits,” and is subject to constant fluctuation
from one date to another.

The distinction between sur

plus and undivided profits is thus merely one of degree.

SEc. 2)

CAPITAL

The three items — capital, surplus, and undivided profits —
together make up the total capital-balance due the stock
holders. Of this, “capital ’’ represents the original capi
tal, “surplus ” the earlier and larger accumulations, and
“undivided profits” the later and minor accumulations.
The undivided profits are more likely soon to disappear in
dividends, i.e., to become divided profits, although this may
also happen to the surplus, or even in certain cases to the
“capital " itself.
We see, then, that the capital of a company, firm, or
person, is to be understood in two senses: first, as the item en
tered in the balance sheet under that head—the original cap
ital; and secondly, this sum plus surplus and undivided profits
— the true net capital at the instant under consideration.
In the case of a joint stock company, since the stock
certificates were issued at the time of the formation of the

company, and cannot be perpetually changed, they ordi
narily correspond to the original capital instead of the present
capital. Recapitalization may be effected, however, by
recalling the stock certificates and issuing new ones. In this
way the nominal or book value may be either decreased or
increased. It is sometimes scaled down because of shrinking
assets, and sometimes increased because of new subscrip
tions or expanding assets. If, for instance, the original
capital was $1oo,0oo, and the present capital (including the
surplus and undivided profits) is $300,ooo, it would be pos
sible, in order that the total certificates outstanding might
become $300,ooo, and the surplus and undivided profits be
enrolled as capital, to issue additional stock certificates to
the amount of $200,000 free to the holders of the original
stock.

Such an issue of stock is called a stock dividend.

Ordinarily, however, the stock certificates remain as origi
nally, and merely increase in value. Thus, if the present
capital is $300,ooo, whereas the original capital or the out
standing certificates amounted to only $100,000, the
“market value " of the shares will be triple the “face

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

value "; for the stockholders own a total of $300,ooo,
represented by certificates the face value of which is
$100,000.
§ 3. Book and Market Values
If, however, we attempt to verify such a relation by refer
ence to the company's books, we shall find some discrepancies
in the results.

For instance, a certain bank of New York

recently reported a total capital, surplus, and undivided
profits of $1,295,952.59, of which the original capital was
only $300,ooo. We should expect, therefore, that the stock
certificates, the total face value of which was $300,ooo,
would be worth $1,295,952.59; or, in other words, that each
stock certificate with a face value of $1oo would be worth

$432. The actual selling price, however, was about $700.
The discrepancy between $432 and $700 is due to the fact that
there are two estimates of the value of capital — one that
of the bookkeeper, which is seldom revised and usually
conservative, and the other that of the market, which is

revised almost daily. The stockholders of this bank were
credited by the bookkeeper with owning $1,295,952.59,
whereas in reality, the total value of their property was more
nearly $2,100,000. The bookkeeper systematically under
valued the assets of the bank, and even omitted some valu

able assets altogether, such as “good will.” The object of a
conservative business man in keeping his books is not to
obtain mathematical accuracy, but to make so conservative a
valuation as to be well within the requirements of the law and
expediency. The law discountenances the valuation of assets
above their original cost; and sometimes there is an addi
tional motive to undervalue, – the wish to conceal a large
surplus, from fear either of competition or of taxation.
Of the two valuations of the capital of a company, the
bookkeeper's and the market's, the latter, being more fre
quently revised, is apt to be the truer of the two, al
though it must be remembered that each of them is merely

SEc. 4)

CAPITAL

an appraisement. The ordinary bookkeeper's figures,
which have so imposing an appearance of accuracy, are,
in reality, and often of necessity, very wide of the mark.
For instance, a certain bank recently reported its capital,
surplus, and undivided profits at $444,814.40, but at the
same time the president of the bank boasted that the bank
ing house was entered among the assets at $20,000, while
its real value was probably $50,000. Thus the figure giving
the capital, surplus, or undivided profits, instead of being
correct to the last cent or even the last dollar, was not
correct even to the last ten thousand dollars.

§ 4. Case of Decreasing Capital-balance
We have seen that the effect upon the balance sheet of an
increase in the value of the assets is to swell the surplus or
the undivided profits. Conversely, a shrinkage of value
tends to diminish those items. For instance, if the plant of
a company having a capital of $100,000 and a surplus of
$50,000 depreciates to the extent of $40,000, the effect
on the account will be as follows:–
ORIGINAL BALANCE SHEET
Assets
Plant

LIABILITIES

. . . . $200,ooo.oo

Miscellaneous .

IoI,256.42

Debts

. . . . . $150,000.oo

Capital . . . .
Surplus . . . .
Undivided profits .

$3ol,256.42

Ioo,ooo.oo
50,000.00

1,256.42

$3o1,256.42

PRESENT BALANCE SHEET

Assets

LIABILITIES

Plant . . . . . $160,000.oo

Debts

Miscellaneous .

Capital . . . .
Surplus . . . .
Undivided profits

IoI,256.42

$261,256.42

. . . . $150,000.oo
Ioo,ooo.oo
Io,ooo.oo

I,256.42
$261,256.42

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

Here the shrinkage in the value of the plant, as recorded on
the assets side, “comes out of the surplus,” as recorded on
the liabilities side.

In case the surplus and undivided profits have both been
wiped out, the capital itself becomes impaired. In this case
the bookkeeper may indicate the result by scaling down the
capitalization.

This sometimes occurs in banks and trust

companies, but not often in ordinary business. It is often
avoided by making up the deficiencies through assessment
of stockholders or postponement of dividends. Such meas
ures are sometimes required by law, as in the case of insur
ance companies.
Dishonest concerns, however, often conceal their true con
dition by the reverse process of exaggerating the value of the

assets. Sometimes this is done systematically, as in the case
of stock-jobbing concerns. The sums intrusted to unscrupu
lous promoters by confiding stockholders are often invested
in unwise or fraudulent ways. For instance, take an Oil
Well Company in California, of the illegitimate type called

“stock-producing wells.” Suppose it borrows $50,000 and
collects $50,000 more from the sale of stock (at par), and
with this $100,ooopurchases land at a fancy price from friends
who collusively agree that a part of the proceeds shall be

secretly returned to the promoter. In such a case the books
of the bubble concern will show the following figures: —
ASSETs

Land .

LIABILITIES

. . . . . $100,000

Debts .
Capital

$1oo,ooo

. . . . . $50,000
. . . . .
50,000
$1oo,0oo

But if the land is worth, say, only $60,000, these accounts
should have been quite different, viz.:
ASSETs

Land

. .

LIABILITIES

. $60,000
$60,000

Debts .

Capital

. . . . . . Io,0oo
$60,000

$50,000

SEC. 41

CAPITAL

In other words, the investor has only $10,000 worth of
property, instead of the $50,000 which he put in, or 20 cents

for every dollar invested. The rest has been diverted into

** the pockets of the promoter and of those in collusion with
him.
---This is stock jobbing. It is one example of what, in
commercial slang, is called “stock watering,” being an
issue of stock whose nominal or face value is greater than the
actual capital. Another and more usual use of the term
“stock watering” makes it mean not an issue of stock beyond
the original cost value of the capital as shown by the actual
money paid in, whether or not this be beyond the real

commercial capital-value. . Thus a “trust” may buy up
a number of factories and then capitalize them far beyond
that cost, because the combination of the factories gives
them a monopoly value beyond the sum of their values
when separate. By this kind of stock watering, conceal
ment is made of the fact that the trust is earning an enor
mous rate of dividends in proportion to the original invest
ment; for the dividends make a much smaller rate on the
inflated, or watered, capitalization than on the cost value.
Stock watering is usually employed to prevent a knowl

edge of the original value of the capital, for instance, to
avoid public displeasure, taxation, or legal regulation of
the rates charged. It is sometimes said that there is no
wrong in such stock watering, so long as it is fully known.
This is much like saying that to lie is not wrong, pro
vided everybody knows you are lying. Stock watering
of the kind described is the exaggeration of the “capital ’’
item entered on the liabilities side of the balance sheet;
and, since the two sides must balance, it involves the

exaggeration of the assets also. It usually represents an
intention to deceive, and through this deceit injury may
be done both to buyers of stock and buyers of bonds.
The buyers of stock are injured if they buy without knowl
edge of the proposed stock watering, and the bond buyer

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

is injured if the watering of the stock, having given him a
false idea of the actual capital, induces him to lend more
money than the capital can satisfactorily Secure.

$ 5. Insolvency
The original capital of a concern may be either increased
or decreased. It may even disappear altogether if the
assets shrink so much as no longer to exceed the liabilities
(other than the capital liability itself). Insolvency is the
condition in which the assets fall short of the liabilities

other than capital. The capital-balance is intended to
prevent this very calamity; it is for the express purpose
of guaranteeing the value of the other liabilities — those to
bondholders and other creditors.

These other liabilities, for the most part, are fixed blocks
of property, carved, as it were, out of assets, the value of
which property the merchant or company has agreed to keep
intact at all hazards. The fortunes of business will naturally
cause the whole volume of assets to vary in value, but all
the “slack ’’ ought properly to be taken up or given out by
the capital, the surplus, and the undivided profits. A man's
capital thus acts as a safety fund or buffer to keep the liabili
ties from overtaking the assets. It is the “margin'” he
puts up as a guarantee to others who intrust their capital to
him.

The amount of capital-balance necessary to make a busi

mess reasonably safe will differ with circumstances. A capi
tal-balance equal to five per cent of the liabilities may, in
one kind of business, such as the business of a mortgage
company, be perfectly adequate, whereas fifty per cent may

be required in another kind. Much depends on how likely
the assets are to shrink, and to what extent; and much,

likewise, depends on the character of the liabilities.
The risk of insolvency is the chance that the assets may
shrink below the liabilities — to others than stockholders.

Sec. 5)

CAPITAL

This risk is the greater, the more shrinkable the assets,
and the less the margin of capital-value between assets and
liabilities.

Insolvency must be distinguished from insufficiency of
cash. The assets may comfortably exceed the liabilities,
and yet the cash assets at a particular moment may be less
than the cash liabilities due at that moment.

This condi

tion is not true insolvency, but only insufficiency of cash.
In such a case, a little forbearance on the part of creditors
may be all that is necessary to prevent financial ship
wreck.

A wise merchant, however, will not only avoid insolvency,
but also insufficiency of cash. He will not only keep his as
sets in excess of his liabilities by a safe margin, but he will
also see that his assets are invested in such a manner that

he shall be able, by exchanging them for cash, to cancel
each claim at the time and in the manner agreed upon.
From this point of view there are three chief forms of
assets; namely, cash assets, quick assets, and slow assets. A
cash asset is in actual money, or what is acceptable in place
of money. A quick asset is one which may be exchanged for
cash in a relatively short time, as, for instance, gold or silver
bullion, wheat, short-time loans, and other marketable se

curities. A slow asset is one which may require a relatively
long time to be exchanged for cash. Such are real estate,
office fixtures, and manufacturers’ equipment.
If all property were as acceptable as money, there would
be no need of classifying assets into these three groups.
But since the creditor will not accept railwaystock or bonds,
when he has contracted for payment in money, the debtor
must maneuver so as to keep on hand a sufficient quantity
of cash assets to enable him to meet his immediate obli

gations and enough quick assets to enable him to exchange
them for cash in time to meet obligations soon to fall due.

A large part of the skill of a business man consists in marshal
ing his assets so that he always has enough cash and enough
E

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

quick assets to provide for impending debts, while maintain
ing at the same time enough slow assets to insure a satis
factory income from his business.
Originally, before business was separated from private life,
all of a debtor's assets, even including his own person, were
regarded as pledged to the payment of a debt. An insolvent
debtor could be imprisoned. To-day, however, laws exist
in most countries by which a bankrupt may, under certain
conditions, be discharged, free from further liability.
Since the liabilities of one man are also the assets of

another, when one man fails and is able to pay only fifty
cents on the dollar, the unlucky man who is his creditor –
who has the first man's notes as assets – suffers a shrinkage

in his own assets which may in turn mean embarrassment
or even bankruptcy to him. It is usually true in a panic that
the failures start with the collapse of some big firm, involv
ing a shrinkage in the assets of others. This indicates why
assets ought usually to be undervalued. A man who is in
debt has no right to exaggerate his means of payment. A
conservative and honest business man will always under
value rather than overvalue his assets, in order to be fair to
his creditors.

§ 6. Real and Fictitious Persons
It is well to note here the distinction between the account

ing of real persons and of fictitious persons. For a real per
son, the assets may be, and usually are, in excess of the
liabilities, and the difference is the capital-balance of that
person. This capital is not, in the case of real persons,
to be regarded as a liability, but as a balance or difference
between the liabilities and the assets.

For a fictitious

person (i.e., a corporation, partnership, association, etc.,
regarded as independent of the real persons comprising
it), on the other hand, the liabilities are always exactly
equal to the assets; for the balancing item called capital

Sec. 7]

CAPITAL

is as truly an obligation (from the fictitious person to the
real stockholders) as any of the other liabilities. For
instance, the items entered as “capital,” “surplus,” and
“undivided profits” in the accounts of a joint stock company
do not belong to the company, as such, but to the stock
holders. So far as the “company ” is concerned, they are
its liabilities; they represent what it owes to the stockholders,
just as truly as the other items of liabilities represent what
it owes to the bondholders, etc. A fictitious person, in fact,
is a mere imaginary being, holding certain assets and owing
all of them out again to real persons, including the stock
holders. A joint stock company may, it is true, be re

garded as consisting of real persons (stockholders, etc.).
But if we prefer, it may be regarded as a separate entity.
In this case, of course, the “company ” becomes a mere
bookkeeping dummy having no capital-balance of its own
and apart from what it owes the stockholders.
§ 7. Two Methods of Combining Capital Accounts
We have seen how the capital account of each person in a
community is formed. Our next task is to express the total
net capital of any community. This is the sum of the net
capitals of its members, i.e., all the innumerable assets of all
the persons less all the liabilities of those persons. This net
sum will be the same, of course, in whatever order the items
are added and subtracted. We might write each item on a

slip of paper, marking each asset item as positive and each
liability item as negative, and, shuffling them into any ran
dom order, add and subtract them one by one according as
they are positive or negative. But there are two ways in
particular which need to be emphasized.
The simplest is, first, to obtain the net capital-balance of
each person by subtracting the value of his liabilities from
that of his assets, and then to add together these net capitals
of different persons to get the capital of society. This

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. III

method of obtaining society's net capital may be called the
method of balances; for we balance the books of each indi

vidual. The other method is to cancel each liability against
an equal and opposite asset, which equal and opposite
asset, as we shall see, must exist somewhere in another

individual's account, and then add the remaining assets.
This method may be called the method of couples; for we
couple items in two different accounts. The method of
couples is based on the fact that every liability item in a
balance sheet implies the existence of an equal asset in
some other balance sheet. This is true because every
debit implies a credit. A debt may be owed to somebody,
a creditor, as well as from somebody, a debtor, and the
debt of the debtor is the credit of the creditor.

It follows

that every negative term in one balance sheet may be can
celed against a corresponding positive term in Some other.
Each of these two methods—of balances and of couples —
is important in its own way.
Let us illustrate each by the balance sheets of three real
persons, say X, Y, and Z.
PERSON X
ASSETS

LIABILITIES

Z's note . . . . $30,000 A
Residence . . . .
7o,ooo
Railroad shares . . 20,000
$120,000
Capital-balance
. $70,000

Mortgage held by Y.

$50,000 b

$50,000
-

PERSON Y
ASSETS

LIABILITIES

X's mortgage . . . $50,000 B
Personal effects
Railroad shares

.
.

Capital-balance

20,000
Io,000
$80,000
. $40,000

Debt to Z . . . . $40,000 c

.
.

$40,000

Sec. 7]

CAPITAL

PERSON Z
ASSETS

Y’s debt . .
Farm . . .
Railroad bonds
Capital-balance

LIABILITIES

.
.
.

$40,000 C
50,000
20,000
$1 Io,000
. $80,000

Debt to X

$30,000 a

$30,000

As the persons are real, not fictitious, the “capital” is
in this case not a true liability, but is the excess of the
total assets over the total liabilities.

The sum of these

capital-balances is the total net capital of X, Y, and Z, and
is thus obtained by the method of balances. To show the
method of couples in the table, each couple of corresponding
items—i.e., each item which appears twice, once as a liability
of one man and again as an asset of another — is indicated

in both places by the same letter. Thus, “A ’’ in X's
assets is matched by the equal and opposite item “a " in
Z's liabilities. The method of couples thus consists in
canceling, and, therefore, omitting from society's balance
sheet, these pairs of items, and entering and adding only
those which remain uncanceled. These, in the present
case, are all assets.

Adding these, we again obtain a sum

representing the total net capital of X, Y, and Z, this time
by the method of couples.

The results of summing up the capital accounts by the
two methods are shown in the following tables:–
METHOD OF BALANCES

X's capital
Y’s capital
Z's capital

. .
. .
. .

.
.
.

. $70,000
. 40,000
.
80,000

$190,000

METHOD OF COUPLES

Residence . .
Personal effects
Farm . . .
Railroad shares
Railroad bonds

. . . $70,000
. . . 20,000
. . .
50,000
. . . 30,000
. . .
20,000
$190,000

The totals are the same by both methods, but the method
of balances exhibits the share of this total capital which is

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. III

owned by each individual, while the method of couples ex
hibits the portion ascribable to each different capital-good.
§8. Ultimate Result of Method of Couples
Let us now introduce into our addition the capital ac
counts of the railroad whose stocks and bonds were included

among the assets of persons X, Y, and Z. For simplicity,
we shall suppose that these three persons are the only

persons interested in the road. The balance sheet of the
railroad company will accordingly appear as follows:–
RAILROAD COMPANY
ASSETS

Railway

LIABILITIES

. $50,000

Bonds (held by Z) . . $20,000
Capital stock

(held by X) $20,0oo
(held by Y) $10,000
$50,000
Capital-balance of the R.R. Co. itself $oo,ooo

3o,Ooo

$50,000

If now, by the method of balances, we combine this balance
sheet with those of X, Y, and Z, we shall see that its inclu

sion does not affect the results which were obtained by the
same method before the railroad was introduced into the
discussion. The totals will stand as follows: —

X's capital-balance.
Y’s capital-balance .
Z's capital-balance .

.
.
.

. . . . . .
. . . . . .
. . . . . .

$70,000
40,000
80,000

Railroad Co.'s capital-balance . . . . . ooooo
$190,000

When we apply the method of couples, we find, however,
that the inclusion in our consideration of the railway

company's capital account will affect the items, though not
the final sum.

The stocks and bonds, as assets of X, Y,

and Z, will then pair off or couple with the corresponding
liabilities of the railroad company, and their place will be
taken by the concrete railroad itself, as follows:–

Sec. 8]

CAPITAL

METHOD OF COUPLES

Residence . . . . . . . . . $70,000
Personal effects. . . . . . . .
20,000
Farm . . . . . . . . . . .
50,000

Railway . . . . . . . . . .

50,000
$190,000

The appearance of the capital inventory is thus changed.
Formerly, the items of property rights in it included such
part-rights as stocks and bonds; now they consist only of
complete property rights. But the complete right to any
article of wealth is best expressed in terms of the article of
wealth itself. Consequently, instead of the long phrase,
the “right to a residence,” we may merely use the term
“residence.” The property no longer veils the wealth be
neath it; and the inventory, which before was an inventory
of both capital wealth and capital properly becomes an in
ventory of only capital wealth.
Such a result is sure to follow when we combine capital
accounts, provided we combine enough of them to supply,
for every liability item, its counterpart asset, and for every

asset which has one, its counterpart liability. Those assets
which have no counterparts are what we have called the
complete rights to wealth; while those assets which do
have canceling counterparts are the partial rights to wealth.
The reason is that partial rights to wealth necessarily
have canceling counterparts in that whenever any partial
ownership of a given article of wealth is held by a partic
ular person, its whole ownership must be supposed to be
held by some fictitious person even if specially created for
the purpose.

Thus, if a farmer named Smith owns an un

divided half interest in a farm jointly owned by himself
and brother, we conceive of the whole farm as owned by
the fictitious person, the partnership, known as the “Smith
brothers.” The owner of the half interest, “John Smith,”
thus holds a claim against the partnership “Smith broth
ers.” This claim is an asset to Smith but a liability to the

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. III

partnership. It is clear that an individual cannot own a
part interest in any given, wealth without its being true
that the fictitious owner of it all is liable to him to that

extent. Therefore every partial right to wealth, while an
asset to the owner of that right, is a liability to the ficti
tious person owning the whole. Every article of concrete
wealth has to be regarded as owned by some one, even if
we have to set up a fictitious person or dummy for that
very purpose.

To follow out totals of capital thus requires the inclusion
of many fictitious persons, for it is often only the fictitious
persons who hold the complete rights. Locomotives and
railway stations, for instance, are owned by corporations,
not individuals. In fact, these fictitious persons — partner
ships, corporations, trusts, municipalities, associations, and
the like — are devices for the express purpose of holding
large aggregations of concrete wealth and parceling out its
ownership among a number of real persons.
If, then, we suppose balance sheets so constructed as to
include all the real and fictitious persons in the world, with
entries in them for every asset and liability, - even public
parks and streets, household furniture, and other possessions
not formally accounted for in ordinary practice,—it is evi
dent that we shall obtain, by the method of balances, a
complete account of the distribution of capital-value among
real persons; and, by the method of couples, a complete
list of the articles of actual wealth thus owned.

In this list

there will be no stocks, bonds, mortgages, notes, or other
part-rights, but only land, buildings, and other land improve
ments, and commodities. All debit and credit items being
two faced — positive and negative — cancel out in the total.
This self-effacement, however, does not mean that the total

would be just the same if there were no stocks, bonds,
mortgages, notes, or other two-faced items. On the con
trary, the existence of such property rights indirectly adds
a great deal to the effectiveness of wealth. They make

SEc. 9]

CAPITAL

possible the coöperative ownership of great aggregations
of capital which without such ownership could scarcely
exist, and thus result in increasing greatly the total bene
fits we enjoy from capital.

§ 9. Confusions to be Avoided
Among the forms of part-rights in real wealth is “credit.”
Credit is simply a debt looked at from the standpoint of the
creditor.

of credit.

There has been much discussion as to the nature

It has been sometimes regarded as an item of

wealth; and an increase or inflation of credit has been
looked on as a real addition to the wealth of the commu

nity.

But, of course, since every credit is also a debit, it

cannot be regarded as a simple addition to the wealth

of the community as a whole. The phenomenon of
credit means nothing more nor less than a specific form of
divided ownership of wealth. Credit merely enables one
man temporarily to control more wealth or property than he
owns – i.e., some part of the wealth or property of others.
It is, therefore, a cardinal error to regard credit as increas

ing the capital of the debtor.

Indirectly, of course, credit

may result in an increase of society's capital, by stimulating
trade and production, as well as by getting the management
of capital into the right hands and its ownership into the most
effective form. In these ways the earth is made to yield up
more wealth, or greater benefits from the same wealth — in

either case entailing an increase of capital; but the amount
of any such increase of capital thus indirectly produced bears
no necessary relation to the amount of the credit which
facilitated its production. Even when capital is increased
through credit, the credit does not constitute the increase.
A great deal of confusion in legislation and discussion could
be avoided if the two methods of combining capital accounts
were distinguished and their interrelations recognized. In
taxation, the two methods are often confused. An impor

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. III

tant problem of efficient taxation of property is how to avoid
unintentional double taxation and at the same time not to

allow some property unintentionally to escape any taxa
tion.

There are two solutions.

One is to tax the amount

owned by each real person as obtained by the method
of balances; this method seeks out the real owners or

part-owners of wealth. The other is to tax the actual
concrete wealth as obtained by the method of couples;
this method seeks out the real wealth owned. In short,
one method follows the person, the other the thing. At

present the two methods are much confused. Legislators
too often fail to perceive that under the first, or owner
method, corporations should not be taxed, for they are not
true owners; and that under the second, or wealth-method,

bonds, stocks, and other part-rights to wealth should not
be taxed, for these are already taxed when the actual rail
ways and other items of physical wealth underlying such
part-rights are taxed. It is not claimed, of course, that a
complete system of taxation can be worked out merely by
choosing one of the two methods just indicated. But the
distinction between the two should be borne in mind, when

ever any scheme of taxation is considered; for where one
system is applied, the other cannot also be applied without
double taxation.

The study of capital accounting, therefore, enables
us to avoid many common confusions. More important
still, it gives us a clear picture of the relations between the
capital of a community and the capital of the individuals
of which the community is composed, i.e., between the
stocks of actual wealth in a community and the stocks of
property representing the ownership of this wealth among
different individuals.

In short, it enables us to see both

individually and as a whole the items which make up private
and collective property, as stocks, bonds, mortgages, debts,
etc., on the one hand, and land, ships, dwellings, and other
concrete wealth, on the other.

SEc. 9]

CAPITAL

In the light of the foregoing principles we are in a position to take a bird's-eye view of the capital in any country. In
America, for instance, we find a stock of wealth of various
kinds with an estimated value of over $100,000,000,ooo.
More than half of this consists of real estate; about ten

per cent consists of railways and their equipment; manu
factured products make up about $8,000,000,ooo; furniture,
carriages, and kindred articles about $6,000,000,ooo; live
stock on farms about $4,000,000,ooo; tools, implements,
and machinery in factories about $3,000,000,ooo; clothing
and personal adornments about $2,500,000,ooo; street
railways about $2,000,ooo,ooo; agricultural products about
$2,000,000,ooo; gold and silver coin and bullion about
$2,000,000,ooo; and there are numerous other smaller items.

The ownership of this real wealth is divided up in various
ways. To a very large extent, especially in the case of farms,
the real estate is owned completely by the occupier. In other
cases it is mortgaged, the occupier then owning merely the

excess of value over the mortgage. Of the national capital
apart from real estate, on the other hand, probably by far
the greater part is owned by corporations, which means, of
course, simply that its ownership is parceled out among the
stockholders and bondholders of these corporations.

From

what has been said the student will not make the mistake

of adding the value of stocks and bonds to the value of
the tangible wealth which these represent. Stocks, bonds,

mortgages, and other items which are assets to some persons
are liabilities to others, and thus cancel themselves out for
the country as a whole. The student will also notice how

insignificant is the stock of gold and silver as compared with
the total capital, although the value of all is measured in
terms of gold.

CHAPTER IV
INCOME

§ 1. Concepts of Income and Outgo

THE income from any particular article of wealth has been

defined as the flow of benefits from that article. These bene
fits may sometimes consist of money payments; but it is
important to avoid the mistaken notion that they always
consist of money payments. (Income is the flow of whatever
benefits accrue from any article, whether these benefits
happen to be in the form of money payments or not) A self
supporting farmer, for instance, may not receive or expend
a single dollar from one year's end to the other. He has,
nevertheless, an income. He gets a “living ” — the very
essence of income — from the farm. A windmill pumps
water; the pumping is the benefit or income resulting from
the windmill.

A derrick hoists coal from a mine; the hoist

ing is the income from the derrick. A wife does housework;
her work is an item of the family's income, for, as was
stated in the last chapter, the services of a human being
are income. The warmth and shelter that a house provides
for its occupants constitute the income furnished by the
house. All the operations of industry and all the transac
tions of commerce are items of income.

When axes fell

trees and sawmills turn them into lumber, these changes
constitute items in the income flowing from the agencies

which produce them. When a manufacturing plant con
verts raw materials into food or into fabrics or into imple6o

SEc. 1]

INCOME

ments, these changes constitute income produced by the
plant. What we call agriculture, mining, commerce, and
domestic operations constitute large and important classes
of income.

Practically, of course, most of the examples given of bene
fits or services are not income to the owner of the instru

ments rendering those services; for, practically, those
services are not enjoyed by the owner, but are sold to some
one else, the owner receiving a money payment instead.
Thus, although a farmer may get his living directly from the
farm, it is more usual for him to sell some of the farm products
and to receive money payments instead. Likewise it may
be that the owner of the windmill pumps water for others
and receives money payments in return; and that the
owner of a house sells its use for a money rental. Simi
larly the owners of the derrick, axes, sawmill, manufacturing
plant, etc., do not get the direct benefit of the hoisting,
cutting, sawing, manufacturing, etc., but exchange these for
money payments. In such cases the owners get their in
come in the form of money payments by selling to others
the direct benefits of their capital. Thus their capital yields
them an indirect money income through the sale of the direct
income produced by the capital. So usual is it for the owner
of capital to sell his direct or natural income for a money
income that ordinarily we think of income as consisting only
of such money return. One of the early economists seri
ously maintained that the owner of a house could receive
no income from it except by renting it, forgetting that to
let a house is merely to sell the shelter income for money
income. A man who lives in his own house gets the shelter
income directly. A man who lets his house to another
secures a money income as the equivalent of the shelter in
come which he sells to the tenant.

Income, being a flow of benefits, implies a stock or fund
which produces the flow. This stock or fund may consist
partly of instruments of external wealth, which we have

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IV

designated as capital (in the narrow sense), and partly of
the population itself, which is also capital (in the broader
sense).
It has already been noted that income differs from capital
in two respects. In the first place, income is a flow relating
to a given period, whereas capital is a stock or fund relating
to a given instant.

In the second place, income consists of

(intangible) benefits, whereas capital consists of (tangible)
instruments; not farms, therefore, nor houses, nor food, nor

railroads, nor artesian wells, nor instruments of any sort can,
strictly speaking, ever constitute income. Income consists
rather in the yielding of crops by the farms; the warming
and sheltering of people by the houses; the nourishing of
people by the food; the transporting of passengers and
freight by the railroads; the raising of water by the wells;
and benefits of any sort rendered by instruments of wealth.
Although income consists partly of other benefits than

money receipts, all income, like all capital, may be translated
into terms of money. For, as was pointed out in chapter
II, § 1, to all items of income, i.e., benefits, may be applied
the concepts of price and value.
Income, as well as capital, is subject to accounting.
Thus far we have considered only such items as would
belong to the positive side of income accounts. But just
as in our capital account we found a negative side — com
prising the liabilities — so we shall find a negative side
to income. The negative of income is called outgo, and
the items which constitute outgo are called costs. A cost
occasioned by an article has already been defined as the
opposite of a benefit. It is an undesirable event occa
sioned by that article. Labor, trouble, expense, and sacri
fices of all sorts are entailed by wealth and are counted
among its costs. An instrument seldom confers benefits
without also involving costs. A dwelling, while it gives
shelter, compels its. owner to assume important costs in
keeping it in repair, painting it, cleaning it, caring for it,

SEc. 1]

INCOME

insuring it, and paying taxes upon it. A saddle horse yields
income to the owner when it gives him a pleasure ride, but
it requires feeding, stabling, and shoeing — the negative side
of the account, constituting the outgo or flow of costs oc
casioned by the horse. A farm produces benefits in yielding
crops; but it requires fertilizing, tilling, and seeding, all of
which are costs occasioned by the farm. A railroad pro
duces benefits called “transportation” – hauling passengers
and commodities; but it involves an expenditure of money,
it burns coal, it requires labor; and these are the outgo, or
the negative side of its account.

Costs, too, may be measured in money just as income may
be measured in money; and some costs, whether of dwel
lings, farms, railways, or other articles, consist in the actual
expenditure of money, just as some benefits consist in the

receipt of money. Strictly speaking, neither consists of actual
money. We must, therefore, distinguish carefully three
money items: (1) money on hand at an instant of time,
which is an example of capital; (2) the receipt of money
during a period of time, which is an example of income (from
whatever instrument occasions the receipt of the money);
and (3) the expenditure of money during a period of time,
which is an example of outgo (on the part of whatever instru
ment occasions the expense).
In general, the costs of a given item of capital are out
weighed by its benefits. For if it should occasion more
costs than benefits, it would be thrown away, thereupon
ceasing to be wealth according to our definition. Or if it
should still remain in any one's possession, it might be called
negative wealth, of which ashes, rubbish, garbage, etc., are
familiar examples.
Costs, then, are never voluntarily assumed except in the
hope of benefits which will make them worth while. The
total value of all the benefits flowing from a given instrument
in a given time is called gross income-value or simply
gross income, during that time. Similarly, the total value

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IV

of its costs is called outgo-value or simply outgo. The
total gross income during a given time minus the total
outgo (i.e., the value of its costs), constitutes net income.
Thus, just as net capital is found by subtracting the lia
bilities from the assets in a capital account, so net income
in an income account is found by subtracting the value
of the costs from the value of the benefits.

Both benefits

and costs, moreover, are attributable to a definite capital
source. In income-accounting the benefits or income-items
are credited to capital, and the outgo or cost-items are

debited to capital. In keeping income accounts, therefore,
it is important to know to what category of capital any item
of income should be credited, or any item of outgo debited.
§ 2. Income Accounts

We are now in a position to apply the foregoing definitions
to income accounts. Perhaps no other subject in economics
has been so fraught with confusion, misunderstanding, and
double counting, as income. It will help the student to
understand these accounts if he will bear in mind that they
show the income and outgo which any given capital (or free
human being) yields. We are apt to think of income and
outgo too much with reference to the owner of the income
instead of the source of the income. It will be easy later
to make up the owner's income account; but first we must
construct the income account for an isolated article of capital.
We may begin by imagining a certain “house-and-lot ”
as one composite instrument or article of wealth, and may
first consider its income and outgo during the calendar
year 1910. The instrument is capital, and the income which
this capital brings to its owner may be either a money rental
or the direct shelter and similar benefits of the house enjoyed
by himself and his family. In either case the income may
be measured in money, although in the case of occupancy
by the owner this measurement requires a special appraise

Sec. 2)

INCOME

ment. The house, let us suppose, was built many years
ago, and is now nearly worn out. It yields an income worth
$1ooo a year. Against its income there are offsets in the
form of repairs, taxes, etc. — costs which it occasions. We
have, then, the following “income account ’’: —
INCOME ACCOUNT FOR HOUSE AND LOT DURING THE
YEAR 1910

OUTGO

INCOME

Use of house and lot .

. $10oo

Repairs
Taxes

. . . .

. $200

180

Insurance . . . . . . . 20
Net income

$4oo

$1ooo
$600

Next year the house is found to have rotten timbers, is
condemned, and must be abandoned or torn down.

Its

benefits are ended, but the land is still good, and the owner
can build a new house. The period consumed by this opera
tion is the first six months of the year 1911, so that during
such period there is no income attributable to the house and
lot, but only outgo. During the second half of the year the
house is occupied, and its use is valued at $600. In the first
six months not only did the “house-and-lot ” fail to yield
any income, but it occasioned a cost. This cost was the
cost of production of the new house.
We have, then, the following account: —
INCOME ACCOUNT FOR HOUSE AND LOT DURING THE
YEAR 1911
INCOME

OUTGO

Use of house and lot (six
months). . . . . . $600

Expense
house

of building
. . . . . $10,000

Taxes and insurance .

$600

Net outgo.

Ioo

$1o, Ioo
$9,500

During this year, then, the house causes a net outgo of

$9500. As we know, all costs are “necessary evils’’; they
F

ELEMENTARY PRINCIPLES OF ECONOMICS

ICHAP. IV

lead to good, though not good themselves; and this cost of
constructing the house was incurred only for the sake of
expected future benefits. The adverse balance it creates is
only temporary, and should be more than made up in the
years which follow.
For the year 1912, for instance, we may have the follow
Ing: —
INCOME ACCOUNT FOR HOUSE AND LOT DURING THE
YEAR 1912
INCOME

Use

OUTGO

. .

. $1300

Net income .

Repairs . . . . .
Taxes and insurance .

$130.o
.

. $ 50
.
.25o
$300

$10oo

These figures remain about the same for forty-nine years
and give $49,000 net income during that time, offsetting the
1912

to 13

1914,

1915

is 16

is ir

1918

19te
tezo

INcome
shelter

ouTGO
repairs
etc.

excess in cost for 1911 ($9500) and leav
ing a large margin besides. Then the
house is worn out a second time and has

to be rebuilt. The same cycle is repeated,
one year of excess of cost being offset by
forty-nine years of excess of income. Figure 2 shows a
part of this cycle, picturing graphically the figures in the
above income-and-outgo accounts.
It will be observed that the cost of reconstructing the
house was entered in the accounts in exactly the same way
as the cost of repairing it or as any other costs. This may

SEC. 3]

INCOME

be puzzling at first, because most of the other costs are
fairly regular year by year, whereas the cost of reconstruc
tion occurs only once, or at any rate only once in a long while.
It may also seem puzzling because the cost of reconstruc
tion is so large in comparison with other costs. But the
irregularity or size of costs is, of itself, no reason for omitting
them from our accounts. The only way in which we can
escape recording such a cost– for instance, the cost of
constructing the house – is by substituting in its place an
equivalent series of smaller and more regular costs. What
is called a depreciation fund is sometimes created for this
very purpose. This fund is accumulated during the exist
ence of the house by setting aside annually small portions
of the income yielded by the house, sufficient in the aggre
gate to replace the house when it is worn out. The depreci
ation fund, combined with the “house-and-lot ” renders

the flow of costs uniform or regular. But even when a
depreciation fund is used, we can only say that the com
bination of the two things (the fund and the house) has a
regular cost. We cannot say that this is true of the house
by itself; and when no such device as a depreciation fund
at all is used, there can be no escape from charging the cost
of reconstruction in precisely the same way as we charge any
other cost. If this still seems puzzling, it is because we are
in the habit of seeing the cost of reconstruction entered as
the value of the house and, hearing it called, for that
reason, a “capital cost.” It is true that the value of the new

house must be entered on the capital-balance sheet; but
the cost of producing it belongs properly to the income ac
count. The value relates to an instant of time (which
may be any instant from the time the house is begun till
the time when it ceases to exist); the cost relates to a period
of time (which may be all or any part of the time during
which the labor and other sacrifices occasioned by the house
occur). The value of the house is quite distinct from the
series of costs by which it was built, although the confusion

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IV

between the two is natural in view of the bookkeeping
practice of entering capital at its “cost value.” The house
on which $10,000 was expended for construction may be
worth either more or less than $10,000.

In either case the

income account should contain $10,000 on the outgo side,
and the capital account a larger or smaller figure, as the
case may require.
§ 3. Devices for Making Net Income Regular
We have seen that the irregularities in the net annual

income or outgo flowing from the “house-and-lot” may be
combined with the opposite irregularities of the net an
nual outgo or income from a “depreciation fund,” so that
the net result from the two combined is a steady net in
come. . The same result may be secured in other ways.
For instance, if the owner of the house-and-lot happens to
own a large number of other houses-and-lots in different
degrees of repair, the irregularities in income from them in
dividually may tend to offset each other.

Thus, if a man

owns fifty houses, each lasting fifty years, and every year
one wears out and has to be rebuilt, it is then evident

that he will have an expense of $10,000 every year for the
rebuilding of a house, which will be a regular item; and
he will have a regular income balance as a consequence,
because he will get the benefit of forty-nine houses, which
will far outweigh the cost of building only one. The differ
ence will be his net income, which will be a fairly regular
amount year after year.
This example ought to set at rest any lingering doubts
as to the correctness of our including the cost of recon
structing a house as an item of outgo, to be entered as
such in a true and complete income account. The only
reason this may, at first, seem wrong is that the cost of
reconstruction is not usually a regular item. In the case
of the fifty houses it becomes a more or less regular item.

SEC. 4)

INCOME

But if it is correct to call it outgo when there are fifty
houses, it must be correct to call it outgo when there are
ten houses or when there is only one. Irregularity of in
come is an inconvenience and we usually seek to avoid it
by depreciation funds, by having a large number of articles
at different stages of repair, or otherwise. But so long as
irregularity of income exists it must be entered as such.
The effect of reducing irregularities by combining a large
assortment of articles is present wherever a sufficiently
large assortment exists. Professor Clark of Columbia Uni
versity suggests a helpful simile when he compares a stock
or fund of capital to a waterfall: the drops of water, or
component parts of the waterfall or fund, are constantly

changing; but the waterfall or fund remains substantially
the same.

§ 4. How to Credit and Debit

Before leaving the subject of income accounts, we shall
speak of one particular kind of capital, namely, a stock of
cash. This will furnish an opportunity to illustrate anew
some of the principles of accounting which we have just dis
cussed. What puzzles the novice in accounting is the manner
of debiting and crediting a stock of cash, or what is called
the “cash drawer.” At first sight the usage seems to be the
opposite of what it should be. To understand the practice
of accountants in this particular is to go a long way toward
understanding the main principles of accounting. It will
help us to understand it if we liken a cash drawer to a gold
mine. We credit a gold mine with all the gold extracted,
and we debit it with all the costs put into it. In the case of
the gold mine, what it costs to run it is outgo; all of the
yield of gold is gross income; and the difference is the net
income. Similarly, the gross income from the cash drawer
consists of what the cash drawer yields, or whatever comes
out of it. It benefits us whenever it pays our bills; it costs
us whenever we pay its bills, i.e., whenever we pay some

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IV

thing into it. All the payments which we have to make to
the drawer are a cost of that drawer to us, whereas all the

payments that we make by the drawer are the benefits which
it produces for us. As long as we pay money into the drawer,
we realize no income, but merely accumulate capital for
future use. If we should only pay money into the drawer and
never throughout our life take any out, the “drawer" would
benefit us nothing.

Its benefits would go to our descendants

whenever they should take the money out. Ordinarily,
however, the money is taken out soon after it is put in. What
met benefit, then, does the cash drawer yield in the long run?
Seldom anything at all. We pay out just as much as we
put in; and if we subtract one amount from the other, the
net annual income from the cash drawer will be about zero,

unless during a certain year we store up more than we take
out, or take out more than we put in.
The reason that these credits and debits of “cash ’’ seem

at first the reverse of what they should be is that we are ac
customed to think of money receipts and expenditures, not
in their relation to the stock of cash into or out of which they
are paid, but in their relation to some other item of wealth
on account of which the payments are made. If a lodging
house keeper receives $10 from a lodger and puts it into her
cash drawer, she finds it hard to debit $10 to “cash.” She

thinks of the $10 as income; and it is income with respect to
her lodging-house, for the latter has yielded it to her. Her
stock of cash, however, has not yielded the $10 to her. On
the contrary, it has taken that amount from her. Later on
it will yield back that amount or some portion of it, and
at that time may properly be credited with the sum it
yields up.
We are now ready to understand how to derive a man's
total income. It is simply the combined income from all
the capital he owns. We could obtain a full account of it by
keeping a separate income account for each item of capital
he owns, crediting and debiting each such item with its re

SEC. 4)

INCOME

spective benefits and costs. The difference of all the benefits
and costs of all his capital is his net income. In these
accounts we should include, therefore, all positive and nega
tive items of income pertaining to all positive and nega
tive items of capital. The negative items of capital are
the liabilities. Liabilities yield a net outgo instead of a
net income.

In order, then, to find out the net income of

any person during a certain day or month or year, the
proper method is to make a complete statement of all his
assets and all his liabilities; and for each asset as well

as each liability, credit all the benefits and debit all the
costs.

The net result will be the

net income of the

person.

A real person will have a net income, but a fictitious
person will not. We have seen, in the case of fictitious per
sons, that there is no net capital because the liabilities always
equal the assets; for what is often called the capital of a
“company” really means the capital of its stockholders. As
there is no net capital of the company, as such, the “com
pany ” owing it all to the stockholders, so there is no net
income of the company, as such, the “company ” paying
it all to the stockholders or others.

The following is an imaginary income account of a rail
road company: —
INCOME ACCOUNT OF A RAILROAD CORPORATION
INCOME

By passenger and
freight service .

OUTGO

$1,246,147

To operating expenses $8oo,ooo
To interest to bond
holders . . . .
Ioo,ooo
To dividends to stock
holders
. .
.

200,000

To surplus applied to
(1) purchase of land
(2) cash paid into
treasury .

$1,246,147

140,000
.

6,147

$1,246,147

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IV

The passenger and freight service has yielded $1,246,147.
That is the gross income of the road. All the benefits flowing
from that road are worth this amount of money. On the
other side of the railroad account we find the costs of the

road to the company; they exactly equal the benefits, for
the company is an abstraction – a mere holding concern —
not a real individual. The outgo consists principally of
operating expenses, $800,000; interest to bondholders,
$100,ooo; dividends to stockholders, $200,000.

The words

by and to are usual in income accounts. The receipts are
benefits; they come by virtue of the services designated.
The costs represent something which has to be given to
these several items in order to make the benefits possible.
These items leave a surplus, part of which is expended for
land ($140,000); this is a cost just as much as anything
else.

Then there is cash left in the treasury to the amount

of $6147. It must not be concluded that this cash is a net
income. The cash drawer swallows it up. The company
loses $6147, so to speak, in feeding its cash drawer. There
fore the two sides of the account balance, and there is no

net income at all to the “company.”
§ 5. Omissions and Errors in Practice

Practically, however, it is not convenient to enter in an
income or a capital account everything which theoretically
ought to be entered there.

Moreover, capital and income

accounts are not always treated consistently in practice.
For instance, in a capital account a man would not ordi
narily enter his own person, as a free human being is not
ordinarily counted as wealth; and yet in his income ac
count he will enter the money he earns or the work that
he does. That is, work and wages are entered in the income
accounts, but the corresponding items representing the
agencies which do this work or earn these wages are not

entered in the capital accounts. The correspondence be

SEC. 5)

INCOME

tween the two accountsis, therefore, obscured. On the other

hand, a man never, in practice, enters in his income account
the shelter of his own house as a benefit, and yet he may
include the house among his assets in his capital account.
In ideal accounting we should insist upon recording every
benefit of any kind, every cost, and every source of benefit
or cost. As we have already indicated, an early economist
fell into error when he said that a dwelling occupied by the
owner yields no income. He claimed that, on the contrary,
it is a source of expense. Evidently he had in mind only
those costs and benefits which come in the form of money
payments. One certainly gets no money benefits by living in
his own house, while he does suffer a money cost to run it.
So far as money receipts and expenditures are concerned,
therefore, the house costs more than it brings in.

But no

man would keep his house if it did not afford him benefits
greater than its costs. We should, therefore, appraise the
shelter of the house and enter this as its gross income.
If we do not, we reach the absurd conclusion that if I live

in my own house and you live in your own house, neither of
us receives any income; but if you rent your house to me
and I rent mine to you, then we shall each be receiving
income ! Obviously the income is really there, all the time,
in the form of shelter; and when one man rents another

man's house, he gets the shelter-income and gives the other
man a money-income in its place.
An account of money received and expended by a given
person can sometimes furnish a fairly complete picture of
his income; but only when two conditions exist; namely,
that all the income from his property is in the form of
money, and all the outgo is in the form of money spent
for personal satisfactions (i.e., goes directly to pay for
clothes, food, shelter, amusements, and the like, and is not
expended in investments, repairs, and the expenses of run
ning a business). Under these conditions the cash drawer
and the cash account constitute a kind of money meter of

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IV

income. These conditions are approximately fulfilled when
people live in a city and rent the houses or furniture of
others instead of owning them themselves. Such people
get practically all of their income in the form of money
receipts, as salaries, dividends, and interest. This money
is spent for benefits, as food, clothing, theater going, etc.
The cash drawer (or bank account) then intervenes be
tween the money-income on the one hand, and the final

income which this money-income buys, on the other hand;
much as a cogwheel intervenes to transmit motion from
one part of a machine to another. A man who receives
$5000 a year in money or checks and spends it all on
food, clothing, shelter, amusements, and other final or
enjoyable benefits, and gets no such benefits from any
other source, evidently receives a real income of $5000
a year. His money income correctly measures his real
income. But if he “saves” part of the $5000, i.e., ex
pends it for stocks, bonds, or a savings bank account or
any other capital, the benefits from which are greatly de
ferred, his real income may be less than $5000; while if
he derives shelter from his own house, or food from his

own garden, his real income may be greater than his
money income. Thus money income is an unsafe indica
tion of real income. The only method, then, of construct
ing income and outgo accounts which will be correct and
which can serve as a basis for economic analysis is the
method already indicated — the method by which are re

corded, for each article of capital (including human beings),
the values of all its benefits and all its costs.

These benefits

and costs are of many kinds. Sometimes they consist of
money payments — not in themselves enjoyable to anybody;
sometimes they consist of merely intermediate or produc
tive operations; and sometimes, of truly final or enjoyable
elements.

All these items should be entered in the accounts

on the same footing; but we shall see that all except the
“enjoyable ’ elements will cancel among themselves.

CHAPTER V

COMBINING INCOME ACCOUNTS

§ 1. Methods of “Balances” and “Couples”
“Interactions '

WE have now learned how to reckon the income of either

a real or a fictitious person. Of reckoning the income of all
society, on the other hand, there are many ways, including,

in particular, two that correspond to the two ways which we
discussed in Chapter III of reckoning society's capital.
These are the method of

balances and the method of

couples. The method of balances is very easy to apply. All
that is necessary is to make up an income account for any
given period for each instrument or article of wealth so as
to include all possible income or outgo in society and, de
riving from each such account the net balance, add these
net balances together. The result is the total income of
society. Its constituent parts are the net incomes from
the several articles of society's wealth.
The “method of couples’’ is somewhat more difficult to
follow. But it is also more important. Just as it often
happens that the same item in capital accounts is both asset
and liability, according to the point of view, and is therefore
self-canceling, so it often happens that the same item in
income accounts is both benefit and cost, and is, therefore,
likewise self-canceling. In fact, the reader may have felt
that, in many of the examples cited, what we called costs
were really benefits. He may have asked himself: Why
75

ELEMENTARY PRINCIPLES OF

ECONOMICS

[CHAP. V

should we call repairing a house a cost? When a carpenter
and his tools repair it, do we not credit him and them with
a service performed? Is not any production a benefit?
Have we not, then, placed repairs on the wrong side of the
ledger? It all depends upon which of two accounts we are
considering. When a carpenter with his plane, hammer, and
saw helps to rebuild a house, we have to consider two groups

of capital." One group, the carpenter and tools, is acting on
the other group, the house. The carpenter and tools cer
tainly perform a service or benefit, but the house does not.
Considered as occasioned by the house, the repairs are costs.
The house absorbs or soaks up these costs, promising to com
pensate for them by benefits to be yielded later on. The
renailing of loose shingles is certainly not what the house is

for; with respect to the house, it is a necessary evil; with
respect to the hammer, however, it is a service rendered.
Therefore the repairing of the house is at once a benefit and
a COSt.

Such double-faced events are so important as to require a
special name. We shall call them interactions. Each inter
action takes place between two instruments or groups of
instruments.

An interaction, then, is a double-faced event, at once a bene
fit or service of the acting instrument, and a cost or disserv
ice of the instrument acted on.

There can never arise the

slightest doubt as to when it is to be regarded as positive and
when negative. The definitions of benefit and cost settle
this question in each case. If it is desired by the owner of
a given instrument that this instrument should occasion a

given event, then the event is “desirable” or a benefit.
If it is desired that an instrument should not occasion a

given event, then the event is “undesirable” or a cost.
Thus, since the house owner desires that the house should
not occasion repairs, these repairs are costs of the house;
* In this instance and throughout the following discussion we shall
consider capital in its broader sense as including free human beings.

Sec. 2)

COMBINING INCOME ACCOUNTS

and since he desires that the tools should produce repairs,
such repairs are the benefits from those tools.
The example given is typical of the general relations be
tween interacting instruments.

The mental picture we

should construct is that of two distinct groups of capital.
Group A acts on, and, so to speak, benefits Group B. What
ever the nature of this interaction, A, the giver of the bene
fit, is credited with it and B, the recipient, is debited with
it as a cost. These two items of credit and debit are equal
and simultaneous because they are the selfsame event
looked at from opposite sides.
Interactions constitute the great majority of the elements
which enter into income and outgo accounts. The only
benefits which do not form merely the positive side of such
canceling interactions, and so do not cancel out, are satis

factions — desirable conscious experiences – often called

“consumption ” (these are credited to the things enjoyed
— for instance, a house); and the only costs which do
not form merely the negative side of such canceling inter
actions, and so do not cancel out, are “labor and trouble ’’

(these are debited to human beings).

But these two

final elements – “satisfactions,” on the one hand, and

“labor and trouble,” on the other — are only the outer
edges of the series of interactions. Between them lies a
connective chain of productive processes and commercial
transactions, every link of which has two sides, a positive
side of benefits or services and a negative side of costs,
always mutually canceling.
§ 2. Production: Interactions which Change the Form of
Wealth

The interactions between two articles or groups of articles
are of three chief kinds: changes in the form of wealth,
changes in the position of wealth, and changes in the owner
ship of wealth; in other words, transformation, transporta

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. V

tion, and transfer or exchange. All three may be called
“production,” although this term is sometimes confined to
the first two and sometimes even to the first alone.

These

we shall take up in order, and show how each is a two
faced event or an interaction.

First, what is here called “transformation ” of wealth is

practically identical with what is usually understood by
“production ” or “productive processes.” By this trans
formation or change in the form of wealth is meant the
change of relative position of its parts. Weaving, for
instance, is the transformation of yarn into cloth by a re

arrangement in the relative positions of the warp and woof.
Spinning, likewise, consists in moving, stretching, and twist
ing fibers into yarn; sewing, in changing the position of
thread so that it may hold cloth together; and so it is
with carding, wool sorting, shearing, and all the other
operations which constitute the manufacture of fabrics.
All these operations—which include all manufacture and all
agriculture — consist simply of a series of transformations
of wealth, each transformation being a two-faced operation.
With respect to the transformed instrument or instruments,
the transformation is a cost; with respect to the transform
ing instrument or instruments it is a benefit. So it is
when a loom produces cloth out of yarn, or when land
renders a service in producing wheat. So it is, not only
when a carpenter and his tools build or repair a house,
but also when the painter decorates it or the janitor
cleans it; or when a cobbler transforms leather into shoes,
or when a bootblack transforms dirty shoes into clean and
polished ones.
The principle is not altered when the interaction consists,
not in producing a change, but in preventing one. A ware
house renders its service as a means of storing bales of cotton,
i.e., protecting them from the elements; and this storage is,
on the part of the stock of cotton, an element of outgo, or ex
pense, as on the part of the warehouse it is an item of income.

Sec. 2)

COMBINING INCOME ACCOUNTS

Nor is the principle altered when there are, as indeed is
usually the case, more articles than one in either or both of

the two interacting capitals. Plowing, or the transformation
of land into a furrowed form, is performed by a plow, a
horse, and a man. The plowing is a cost debited to the land,
on the one hand, and at the same time a service credited to

the group consisting of the plow, horse, and man, on the
other.

Nor is the principle altered if one or more of the trans
forming agents perish in the transformation and another
comes for the first time into existence. Bread making is a
transformation debited to the bread and credited to the cook,
the range, the flour, and the fuel, of which the last two are con

sumed as soon as they perform their services. Agents which
disappear in the transformation, but reappear in whole or
in part in the product (as here the flour), are called “raw
materials.” The production of cloth from yarn is a trans
formation effected by means not only of the loom, but also of
a number of other agents, among them the yarn itself,
which thus vanishes as yarn and reappears as cloth. The
cost of weaving includes the consumption of raw material
— yarn; and this consumption of yarn is, on the part of
the yarn itself, not cost, but service. It is the use for
which the yarn existed. When cloth is turned into clothes,
this transformation is a service to be credited to the cloth,
and a cost to be debited to the clothes.

All raw materials

yield benefits as they are converted into finished products.
Their conversion is, however, on the part of these prod
ucts, always outgo and not income.
In general, production consists of a succession of stages,
and at each stage there is an interaction. The finished
product of one stage passes over as the raw material of the
next, and its passage from the earlier to the later stage is an
interaction between the capitals of the two. Each opera
tion is credited to the group of instruments earlier in the
series and debited to the group next later in the Series.

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. W.

§3. Transportation: Interactions which Change the Posi
tion of Wealth

The second class of interactions we have called “trans

portation.” It is a very slight distinction which separates
this class from the preceding class. Transforming or pro
ducing wealth consists in changing the position of its parts
as related to one another; transporting wealth consists
mechanically in changing the position of that wealth as a
whole. But “part ’’ and “whole ’ are themselves loose and
relative terms. Bookbinding is a transformation or pro
duction of wealth; it assembles the paper, leather, thread,
and paste into a whole book. Delivering the finished book
to a library is transportation. Yet the library is, in a sense,
a whole; and to assemble books into a classified and organized
library is to make a whole out of parts and may be regarded
as a transformation or production of wealth. The distinction
between transformation and transportation is thus merely
one of convenience. Many writers prefer to include them
both under “production.” We prefer to include them under
the less ambiguous and more inclusive head of “inter
actions,” and our object here is not to emphasize their
difference but their similarity. The principles already
discussed of coupling and canceling equal and opposite
items apply also to transportation. The following are
examples. When merchandise is transmitted from one
warehouse to another, the stock in the first warehouse is

credited with the change and that in the second, debited.
The stock which has rendered up the merchandise has done
a service; that which has received it is charged with a
cost. A banker who takes money from his vault and puts
it into his till will, if he keeps separate accounts for the two,
credit the vault and debit the till. When wheat is carried
from wheatfield to barn the wheatfield is credited and the

barn debited. When wheat is imported from Canada,
Canada is credited, and the United States debited.

SEc. 4)

COMBINING INCOME ACCOUNTS

§ 4. Exchange: Interactions which Change the Ownership
of Wealth

The third class of interactions is the change of ownership
of wealth or of property. This has been called “transfer.”
Every transfer is a species of interaction. If two dollars
are transferred from Smith's cash drawer to Jones's, Smith's
cash drawer is credited with the two dollars yielded up, and
Jones's is debited with receipt of the same. Transfers usually
occur in pairs, and involve two objects transferred in oppo
site directions between two owners. One transfer pertains
to each object. Such a double transfer we have called an
exchange. Since an exchange consists of two transfers, and
since a transfer is a species of interaction and as such is self

canceling, every exchange is self-canceling, and hence cannot
be counted as a part of the total income of society unless it
be counted out again (although it may lead to later items

which are not self-canceling). Whatever is credited on one
side is debited on the other. This is shown in the following
scheme which gives the credits and debits involved when
goods worth $2 are sold. The dealer credits his stock of

goods and debits his “cash,” while the buyer does the
Stocks of Goods | Stocks of CASH

Seller's .

Buyer's.

Cr. $2
Dr. $2

Dr. $2
Cr. $2

opposite. We see, then, that an exchange, whether of
goods against goods or of goods against money, occasions
an element of income to the seller equal to the corre
sponding element of outgo to the purchaser, and an element
of outgo to the seller equal to the corresponding element of
income to the purchaser, and therefore no immediate in
come at all to Society.
G

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. W.

The effect of canceling these items — the credit item of
the seller and the debit item of the purchaser — is to free
the income account for any article from all entanglements
with exchange, to wipe out all money-income, and to leave

exposed to view the direct or natural income from that
article. Thus books yield their natural income, not when
the book dealer sells them, but later when the reader

peruses them. The sale is a mere preparatory service, a
credit item to the book dealer, and a debit item to the

buyer. Only the book remains in the hands of the pur
chaser. Again, a forest of trees yields no natural income
until the trees are felled and pass into the next stage of logs.
The owner of the forest may, to be sure, “realize " on the
forest long before it is ready to be cut, by simply selling it to
another. To the seller the forest has then yielded income;
but, as the purchaser has suffered an equal outgo, the net
result of this interaction, as of every other, is zero.
Only the forest remains ready for future use. Similarly,
the money “rent" of a rented house is, for society, not
income at all. It is income to the landlord, but outgo
to the tenant – outgo which he is willing to suffer solely
because of the shelter he receives. As we may cancel the
landlord's money-income against the tenant's money-outgo,
it is clear that the shelter alone remains as the income from

the house. The shelter-income is the essential and abiding
item, and without it there could be no rent-income to the

andlord. Thus we see clearly the fallacy of the old view
that a dwelling yields income only when it is rented. In
like manner, a railway yields as its natural income solely
the transporting of goods and passengers. Its owners sell
this transportation service for money, and regard the rail
way simply as a money-maker; but to the shippers and pas
sengers this same money is an expense, and exactly offsets

the railway's money earnings. Of the three items —
money-income of the road, money-outgo of its patrons, and
transportation—the first two mutually cancel and leave only

SEC. 4]

COMBINING INCOME ACCOUNTS

the third, transportation, as the real contribution of the
railway to the sum total of income.
We do not mean, of course, that interactions are useless,
but simply that in the accounting of Society they are self
canceling. They are a necessary step toward achieving the
final income which remains uncanceled, but they themselves
** disappear under the method of couples. We see that

&*capital is not a money-making machine, but that its income
to Sºciety is simply its services of production, transporta
tion, and gratification. The income from the farm is the
yielding of its crops; from the mine, the giving up of
its ore; from the factory, its transformation of raw into
finished products; from commercial capital, the passage of
goods between producer and consumer; from articles in con
sumers’ hands, their enjoyment or so-called “consumption.”
Although these items are all measured in terms of money,
they do not consist of money receipts. Those items which
do consist of money receipts are money receipts for in
dividuals, never for the world as a whole; since each dollar
received by one person implies that some other person —
the one from whom it was received — expended it.
Similar principles apply to outgo, no part of which, for
society, occurs in money form. The great bulk of what
merchants call “cost of production,” expense, or outgo,
consists of money costs which, as concerns society, carry with
them their own cancellation, and so are not ultimate costs
at all. For manufacturers, merchants, and other business
men, almost every outgo is an expense, i.e., consists of a
money payment. But such money payments are for
wages, raw materials, rent, and interest charges, all of which
are incomes for other people. The wages are the earnings
of labor; the payment for raw material is received by some
other manufacturer, farmer, or miner; the rent is received
by the landlord; the interest charges, by the creditor.
Labor itself — human effort, not the payment for it—re
mains, however, uncanceled.

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. V

§ 5. Accounts Illustrative of Interactions in Production
Not only do money transactions completely cancel them
selves out in reckoning the total income of society, but the
great majority even of the natural benefits of capital do the
same. Even these natural benefits of capital consist for

the most part of “interactions”; they are transformations
or transportations of wealth. They are intermediate stages,
merely preparatory to the final enjoyable benefits of wealth,
and, after the interactions have been canceled out, do not

enter as items either on the income or the outgo side of the
social balance sheet.

In order to show the effect of cancel

ing out the equal and opposite items entering into every
interaction throughout all productive processes, let us ob
serve the various stages of production which begin with the
forest above referred to. The gross income produced by
the forest is the series of events called the turning out of
logs. This log production is a mere preparatory service, a
credit item to the forest and a debit item to the stock of

logs of the sawmill, to which the logs next pass. Next the
sawmill turns its logs into lumber, and is therefore cred
ited with its share in this transformation while the lumber

yard is debited with the production of lumber. Intermedi
ate categories may, of course, be created, and we may
follow, in like manner, the further transformation, transpor
tation, and exchange to the end of the stages of produc
tion — or rather, to the ends; for these stages split up and
form several streams flowing in different directions. To fol
low one only of these streams, let us suppose that the lumber
which goes out from the yard is used in repairing a certain

warehouse. The warehouse is used for storing cloth; the
cloth goes from the warehouse to the tailor; the tailor con
verts the cloth into suits for his customers; and his cus
tomers receive and wear those suits.

In this series of

productive services, all the intermediate services cancel
out in “couples’’ and leave as the only uncanceled ele

SEc. 5)

COMBINING INCOME ACCOUNTS

ment, or fringe of final services, the use of clothes in the
consumers' possession.
Should we stop our accounts, however, at earlier points in
the series, the uncanceled fringe at which we should find
ourselves would be some other item.

The uncanceled in

come item in a production series is always the positive side
of some intermediate service or interaction whose negative
side does not appear, as it belongs to a later stage in the
series. This will be clear if we put the matter in figures,
stage by stage. The following are the items for the logging
camp above mentioned, in the accounts of its owner.
INCOME ACCOUNT FOR LOGGING CAMP
INCOME

Yielding of logs to sawmill

OUTGO

$50,000

The income from the logging camp is here seen to consist
in the production of $50,000 worth of logs. Of course
there are usually large outgoes; but as these do not con

cern our present point, for simplicity we leave them out
of account. If we now combine the account of the logging
camp with that of the sawmill, we shall have accounts like
the following, in which, to avoid irrelevant complica
tions, no mention is made of any outgoes which do not
happen to be interactions between the groups of capital
considered:—
INCOME ACCOUNT FOR LOGGING CAMP

AND SAW

MILL
CAPITAL SOURCE

Logging camp .

INCOME

OUTGO

. . Yielding logs to saw
mill . . . $50,000

Sawmill . . . . . . Yielding lumber to
lumber yard $60,000

Receiving logs from
camp

. $50,000

g
9o,ooo Receiving
.
stock
500,ooo
stock
tailor's
from
suits

8Warehouse.
.
cloth
to
shelter
|Warehouse
70,000
yard
from
lumber
0,000
Receiving

warehouse
from
cloth
Receiving

|YSawmill
60,000
yard
to
lumber
$50,000
camp
logging
from
logs
.
ielding
Receiving
6YLumber
.
sawmill
from
Receiving
7o,ooo
warehouse
to
lumber
yard
ielding
0,000
SNPECIFIED
A
ACCOUNT
IINCOME
OF
SERIES
1910
FOR
STRUMENTS
OUTGO
INCOME
SOURCE
CAPITAL

Yielding
in
of
9Stock
tailor.
to
Scloth
8|
.
warehouse
from
helter
o,ooo
0,000

6oo,ooo
.
“wear”
Yielding
5oo,000
.
customers
to
suits
Yielding

$Logging
.
sawmill
to
logs
Yielding
camp.
50,000

customers
clothes
of
Stock
tailor.
cloth
of
Stock

SEc. 5]

COMBINING INCOME ACCOUNTS

In this case, canceling the two log items of $50,000 each,
we have left only the lumber item; that is, the net income
from the combined logging camp and sawmill consists only
of the production of lumber, their final product. The
transfer of logs from one department to the other no longer
appears. This transfer is like the taking of money from
one pocket and putting it into another – a fact which
would be particularly evident in case the logging camp and
sawmill were combined under the same management.

Extending the same principles to the entire series, we have
the accounts as given in the table on the preceding page.
In this table we may successively cancel each pair of
items constituting an interaction. An item on the left is
the positive side of an interaction of which the item on the
right in the line next below is the negative side. Thus, as
previously, the $50,000 in the first line on the left cancels the

$50,000 in the second line on the right. Similarly, the two
items of $60,000 cancel in the two lines next below, to the

right and left, respectively. If we stop after the first two
cancellations, thus restricting the account to the first three
horizontal lines of the table, we shall find that the net in
come from logging camp, sawmill, and lumber yard consists

only of the production of retail lumber, worth $70,000; it
includes neither the transfer of logs from the camp to the mill
nor the transfer of lumber from the mill to the yard.

like manner, if we proceed one stage further, i.e., if we stop
our cancellations at the end of the first three interactions,

the production of retail lumber no longer appears as an ele
ment of income; and so on, step by step to the end, when the
only surviving item will be the “wear ” of the suits.
It is, of course, true that in any actual accounts there will
be other items besides those which have been exhibited in

this simple, chainlike fashion. Were it worth while, we
might insert these additional entries of income and outgo
elements.

Most of them would likewise consist of the posi

tive or the negative side of interactions; and if we were to

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. V

introduce their respective mates, the opposite aspects of the
same interactions, it would be necessary to include the
accounts of still other instruments.

If we should follow

up all such leads, we should soon have, instead of the simple
chain represented in the table, an intricate network of re
lated accounts; but the same principle of the interaction as
a self-effacing element would continue to apply.
§ 6. Preliminary Results of Combining these Income
Accounts

The table given will throw light on the question: Of
what does income consist?

or, to be more definite: Of

what does the income from a particular group of capital
goods consist? Whether the yielding of logs by the logging
camp to the sawmill is income or not depends upon what
capital we are including. It is income with respect to the
first link of capital in our series (the logging camp); it is

not income with respect to the first two links (the logging
camp and the sawmill taken together), but merely a self
canceling interaction between the two. Likewise the use
of the warehouse is income with respect to the first four
links of capital, but is not income with respect to the first
five links.

We see, therefore, that in reckoning up the income from
any group of capital we may as well omit all interactions
taking place within it, and confine ourselves to the outer
fringe of services performed by the group as a whole. As
the group is enlarged, this particular outer fringe disappears
by being joined to the next part of the economic fabric, and
another fringe still more remote appears.

To answer the

question whether any particular item is or is not income—
as, for instance, the question, “Is sawing lumber income P”
— we must first ask, “Income from what?” Income is
always relative to its source.
Contrasting the method of couples with the method of

SEC. 6

COMBINING INCOME ACCOUNTS

balances, we may say that the method of couples is useful
in showing of what elements income consists in any given
case.

The method of balances, on the other hand, is useful

in exhibiting the amount of income contributed from each
capital source. The two methods, as applied to the example
just given, are as follows: —
(Summarized from Table on p. 86)
METHOD OF BALANCES

CAPITAL

INCOME

Logging camp . .
Sawmill . . . .
Lumber yard . .

.
.
.

. $ 50,000
. 60,000
. 7o,ooo

Warehouse .

OUTGO

NET INCOME

$ 50,000
$ 50,000

Io, Ooo

60,000

Io, Ooo

8o,ooo

7o,ooo

Io,000

Stock of cloth in warehouse 90,000
Stock of cloth of tailor . . 5oo,ooo
Stock of clothes of customers 6oo,ooo

8o,ooo

Io,000

90,000

4Io,ooo

5oo,ooo

Ioo,ooo

$600,ooo

METHOD OF COUPLES

INCOME

OUTGO

The two methods — balances and couples — show the

same final result ($600,000), but from different points of
view.

By means of the method of balances we are enabled

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. V.

to see that, of this $600,ooo, the part contributed by the
logging camp is $50,000, that contributed by the sawmill,
$10,000, and so on. By means of the method of couples,
we are enabled to see that, canceling by the oblique lines,
we have left but one item, $600,ooo, representing the
“wear” of the suits. Thus the entire $600,ooo consists of
the use or “wear” of the suits, although five-sixths of it is
contributed by other kinds of capital than the stock of
clothes of customers. Combining the results of both meth
ods, we may state that the total net income from the speci
fied group of instruments consists of $600,000 worth of
“wear” of suits, and that this is due partly to the stock of
clothes and partly to other capital. Of course our table
does not give all the capital to which the wear of the suits
is indebted. We have, as already noted, omitted, for the
sake of simplicity, all items of cost which do not belong
to our chosen series.

But the inclusion of other items,

while it complicates the accounts, does not change the
principle of cancellation. It merely introduces other chains
of interactions.

§ 7. Analogies with Capital Accounting
The two methods correspond in a general way to the two
methods for canceling liabilities and assets in capital ac
counts. Applied to capital, the method of balances gave,
it will be remembered, the amount of capital belonging to
each individual; the method of couples showed of what
elements the total capital consists. Similarly, applied to
income, the method of balances shows what share of the

resulting income is contributed by any articles or groups of
articles of capital; while the method of couples shows
wherein that resulting income consists.
Let us consider for a moment the method of couples as
applied to the two sorts of accounts. In capital accounts
the self-effacing items were debts; in income accounts the
self-effacing items were interactions. These concepts —

Sec. 7]

COMBINING INCOME ACCOUNTS

debts and interactions — supply the key for the mutual
cancellations between accounts. A debt is both positive
and negative and so is self-canceling. An interaction is
likewise both positive and negative and so self-canceling.
A realization of the two-faced nature of debts helps us to
avoid the confusions of double counting in capital accounts
and double taxation; a realization of the two-faced nature

of interactions saves the confusions of double counting in
income accounts.

It is important here to observe of income, as was pre

viously observed of capital (Chapter III, § 8), that the self
effacement of the self-effacing elements (interactions in
the case of income) does not mean that the total income

would be just the same if there were no interactions.

the contrary, the existence of interactions—the operations
of industry and commerce – are essential steps toward the
final goal of uncanceled income to which they lead.
Without them the final uncanceled income would be very
much less and often nonexistent.

Debts mean subdivided

ownership of capital and interactions mean subdivided
steps in income. They make capital and income respec
tively more abundant and effective.
We may illustrate what has been said by two simple
examples. If a man owns a piece of real estate worth
$1oooo and mortgages it for $6000, this debt must be
entered in his accounts as a liability of $6000 and in the
accounts of the mortgagee as an asset of $6000. Conse
quently, as between the two men the item cancels out.
But this does not mean that the mortgage is of no ac

count. It does not mean that the two men would be just
as well off if there were no mortgage. If we should force
them against their will to cancel the debt, it would be an
inconvenience to both.

The owner would find it difficult

to make the payment and the mortgagee would have the
inconvenience of finding another investment for the $6000

returned to him.

The inconvenience to the owner might

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. V

be so great that he would be forced to sell his land per
haps at a sacrifice below the $10,000 which is its real
worth, while if the mortgage is allowed to stand, he might
not be willing to sell even for a sum considerably above
the $10,000. The inconvenience to the mortgagee might
be less.

We find the same thing true of interactions.

A book

seller who sells $2000 worth of books in the course of a

year credits his business with this sum while his customers
debit their libraries with $2000 worth of books.

These

entries are evidently correct accounting, and the receipts
of the bookseller and the expenditures of his customers
exactly offset each other.

But this does not mean that

the transactions are of no account.

Without them the

bookseller would find a great accumulation of books which
would be entirely useless to him while his customers would

be deprived of the satisfaction of reading these books. If
we could force the reversal of the normal process and
make the customers resell their books to the dealer, there

would be an obvious loss to both parties. The dealer
would refuse to take them except at a price far below the
$2000, while their possessors would not be willing to sell
them unless for more than $2000.

§8. Double Entry in Accounts of Fictitious Persons
We have now followed the cancellations to which inter

actions lead, whether they be interactions of exchange or of
production. The case of exchange, however, needs further
consideration. Since every exchange consists of two trans
fers, and every transfer of two items, a credit and a debit,
the exchange evidently consists of four items in all, two of
which are credits and two of which are debits.

These four

may be paired off in two ways, only one of which has thus far
been mentioned.

They stand, as it were, at the four corners

of a square, as in~
the scheme given
in § 4.
--~
--

SEc. 8]

COMBINING INCOME ACCOUNTS

The two transfers into which any exchange may be re
solved are represented by the second and third columns of
that scheme. The second column indicates that a $2
article has been transferred from the stock of the seller to

that of the buyer, being, therefore, credited to the one and
debited to the other; the third column indicates that $2
of money has been transferred from the stock of cash of

the buyer to that of the seller and credited and debited
accordingly. But this same exchange may also be resolved
into two pairs of items represented by the two horizontal
lines of the scheme. The upper line indicates that the
seller has exchanged goods for cash crediting his goods
with the sale and debiting his cash; the lower line indi
cates the reverse conditions for the buyer.
Every exchange, then, consists of four items, and may be
resolved either into two transfers (one for each good ex
changed) or into two transactions (one for each person
exchanging those goods).
These latter items, namely, transactions represented by
the horizontal lines, we must now consider more fully.

Each of the previous income accounts is an account of in
come flowing from a specified good owned, not of the entire
income received by a given person as owner. But it is easy
now to form the income accounts of any given person, i.e.,
the income and outgo of all his assets and liabilities, simply
by combining in each case, by the method of balances, the
accounts of all his items of property (whether assets or lia
bilities). We must distinguish, however, the accounts of
real and of fictitious persons. We begin with the income
account of a fictitious person.
The following account represents the entries during a given
year for a dry goods company. In this account we observe
that every item on the income side is balanced by an equal
and opposite item on the outgo side. All items thus paid
are represented by the same letters, the capitals being
used for positive items and the small letters for negative.

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. V.

INCOME AND OUTGO OF A DRY GOODS COMPANY
FOR

CAPITAL SOURCE

INCOME

1910

OUTGO

Stock of goods | By goods sold $1o,ooo A. To goods bought $5,000 b
Cash .

. . By cash taken out
To cash received
for purchases $5,000 B | from sales . . $1o,ooo a
for profits
$2,000 C

Capital Stock .
(a liability)

To dividends

$2,000 c

The rule we have learned in Chapter IV for making com
plete income accounts is to start with the capital account,
taking each item of assets and each item of liabilities, and to
enter for each item of either kind all the items of income to

which they give rise, plus or minus, as the case may be.
For simplicity, it is here assumed that, instead of fifty or one
hundred different items of capital, there are only three items;
namely, the stock of goods, the stock of cash, and the “capi
tal stock,” which is “negative capital.” The stock of goods
yields $10,000 worth of sales. But, on the other hand, it
costs $5000 to replenish this stock of goods. Therefore it is
credited with a plus item of $10,000, and debited with a
minus item of $5000. The student will notice, moreover,
that each of these items is entered twice, once on each side.
The doubly entered items may be mutually canceled. A
cancels with a ; that is, though the stock of goods is credited

with bringing in $10,000 (A) in cash, the cash drawer must
be debited with the $10,000 (a) which it swallows up. Like
wise the stock of goods costs $5000 (b), which must therefore
be debited to it; but the cash drawer has to supply this
$5000, and is therefore credited with $5000 (B), so that items
B and b cancel. Finally, when the profits are paid, they
also come out of the cash drawer, and the cash drawer is

SEc. 9]

COMBINING INCOME ACCOUNTS

credited with exactly that amount, $2000 (C); while the
“capital stock” is debited with that amount as a cost (c).
So we see that all six items cancel one another in pairs.
The two sides of the account of such a fictitious person
necessarily balance. Even if the company accumulates its

profit instead of paying it in dividends to the shareholders,
the two sides of its account still balance; for, as has been

seen, all money received is not only credited to the capital
source which brought it in, but is also debited to the cash
account. Here, for instance, the $2000 item (doubly entered
as C and c) would merely be omitted. There would be no
$2000 dividends, but the cash drawer would be $2000
fuller.

$9. Double Entry in Accounts of Real Persons
In the case of real persons, however, the two sides do not
balance, for the accounts do not then consist solely of double
entries. To show this, let us consider the accounts of a

real person as given in the next table. In these accounts, as
in the previous ones, both of which are much simplified,
we have indicated the like items on opposite sides by like
letters, the positive items being represented by capitals and
the negative by small letters. We observe that, as in the
accounts of the previous company, many of the items will
“pair.” But, unlike the company's accounts, the present
accounts contain a residue of items which will not pair.
The letters representing these unpaired items are designated
on the next page by being inclosed in square brackets.
They show that [B] and [C] – the shelter of the house, and
the use of food — constitute a kind of income which does

not appear elsewhere as outgo.
When studying the accounts of goods owned, we found in
considering the chain of productive services of a lumber
camp, etc., that there always remains some outer fringe of
uncanceled income.

We have now reached this same kind

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. V

INCOME AND OUTGO OF A REAL PERSON FOR THE
YEAR 1910
CAPITAL SOURCE

INCOME

OUTGO

Stocks and bonds. By receipt of money from To money expended
stocks and bonds $200o A

for

stocks

and

bonds . $500 d

Lease right .

. . By shelter .

Food .

. . By use of food .

$10o [B]|To money rent
paid . . $10o e
. $150 [C]|To money cost of
food . . $150 f

“Cash” . . . . By cash taken out for

To receipt of money
stocks and bonds $500 D | from stocks and
bonds . $2000 a

By payment for rent $100 E |To
receipt
of
money for work
done . $20oog

By payment for food $150 F
Self

. . By receipt of money for work
done

. $ 2000 G

Uncanceled items: Shelter [B]

$10o

Use of food [C] . $150
Total uncanceled income

$250

of outer fringe in studying the accounts of owners, provided
they are real persons. This outer fringe consists of the
final benefits of their goods. All other items are merely
interactions preparatory to such final benefits, and pass
from one category of capital to another. Thus the in
come from investments, being paid into the cash drawer, is
outgo with respect to the drawer; the drawer yields income
by paying for stocks and bonds, food, etc., but in each case
the same item enters as outgo with respect to these or other

Sec. 9]

COMBINING INCOME ACCOUNTS

categories of capital. In all these cases the individual re
ceives no income which is not at the same time outgo. It
is only as he receives shelter from the house, consumes food,
wears clothes, or uses furniture, or some other article, that
he receives income. And these final benefits are, of course,
the end and goal of all the preceding economic processes and
activities.

We have thus reached what may be called the stage of
final or enjoyable income. This is the stage at which wealth
at last acts upon the person of the recipient. This final
income is that of which the economist is in search, and is

that which the ordinary statistics of workingmen's expen
ditures represent. It has been made clear that, in the
final net income which we derive from wealth, all interactions

between different articles of wealth drop out—all the trans
formations of production, such as the operations of mining,
agriculture, and industry, all the operations of transportation,
and all transfers and exchanges in business. For in all such
cases the debits and credits inevitably occur in pairs of equal
and opposite items. Each pair consists of the opposite facets
of the same interaction. The only items which survive are
the final personal uses of wealth. The chief classes of such
uses or benefits are those of nourishment, shelter, and
clothing.
Having reached the action of wealth on the human
body, we may, as students of economics, be content to
stop. But, theoretically, there is one step more before
the process of tracing a series of interactions has reached
its final goal. Indeed, no benefits outside ourselves
are of significance to us except as they lead to feelings

within our minds. And if we regard the human body in
the same light in which we have regarded articles of
wealth, we could extend our accounts bby conceiving wealth
as interacting with the human body. We would then
debit the human body with the nourishment, shelter, pro
tection from cold, etc., which it receives from food, dwellings,
H

ELEMENTARY

PRINCIPLES OF ECONOMICS

[CHAP. W.

clothing, etc., and credit it with the satisfactions experienced
through the brain, i.e., the feelings of enjoyment of food or
avoidance of pain, etc. As, however, we have in general,
in this textbook, limited the concept of wealth to its nar

rower definition, excluding free human beings, we shall not
attempt to follow these transformations of income after
they reach the person of the owner. Usually the mental
satisfactions follow so closely after the physical effects of
wealth on the human body that practically we scarcely
need to distinguish between those physical effects and the

resulting satisfactions. Hereafter we shall speak of satis
factions of food, shelter, clothing, etc., as if they flowed
directly from these external objects.
§ Io. Ultimate Costs and Income
We have now reached a convenient place at which to
emphasize a point of great importance, but one which is
seldom understood; namely, that most of what is called

“cost of production ” is, in the last analysis, not cost at all.
We have found, in using the method of couples, that every
item of money cost is also an item of income, and that in
the final total no such items survive cancellation.

It costs

the baker flour to produce bread; but the cost of flour to
the baker is a benefit to the miller. To society as a
whole, on the other hand, it is neither cost nor benefit,
but a mere interaction.

As has been said, in the last analysis, payments of
wages, interest, rent, or any other payments from one mem
ber of Society to another, are not costs to society as a whole.
This fact should now be clear; yet it is commonly over
looked. When people talk of the cost of producing coal or
wheat, they usually think of money payments. The items
called costs of production are mostly payments from per
son to person, or interactions, at various stages of produc
tion. We have seen that each such item is two-faced and,

Sec. Iol

COMBINING INCOME ACCOUNTS

in the final total, wipes itself off the slate. The only ulti
mate item of cost is labor cost or efforts; that is, all the
experiences of an undesirable nature which are undergon
in order that experiences of a desirable nature may be
secured.

We may conclude, therefore, that in the last

analysis income consists of satisfactions and outgo of efforts
to secure satisfactions.

Between efforts and satisfactions

may intervene innumerable interactions, but they all must
cancel out in the end. They are merely the machinery
connecting the efforts and satisfactions. At bottom, eco
nomics treats simply of efforts and satisfactions. This is
evident in the case of an isolated individual like Robinson

Crusoe, who handles no money; but it is equally true of
the most highly organized society, though obscured by the
fact that each member of such a society talks and thinks
in terms of money.
In the light of the foregoing principles we are now in a
position to take a bird's-eye view of the income of any coun
try.

Unfortunately, there are no available statistics for

income in the United States. We can only guess as to what
the amount of it may be. Possibly $20,000,000,000 worth
of final income is annually enjoyed in the United States,
of which about one third is in the form of nourishment or

food uses, about one sixth in the form of shelter, and

about one eighth in the form of clothing. These and
the other items of the direct uses of wealth constitute the

real income of society. In other words, our real income is
what is often called our “living.” Money-income, as we
have seen, is not real income, but is converted or spent for
real income in what we call our “bread and butter,”
which, more exactly expressed, means the use of our

“bread and butter” and of the other goods contributing
direct benefits to human beings.

These uses include the

necessaries, comforts, luxuries, and amusements of life.

These are what make up our “living.” The more money
wages it costs to acquire a given amount of real wages,

IOO

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP.W

the higher the “cost of living” of which we hear so much
to-day. The money which the workman is paid in wages
is not his real wages, but only his nominal wages. The
real wages are the workman's living for which that money
is spent. Money payments, as we have seen, cancel
themselves out when we take a view of the whole, for they
are not only receipts, but also payments. They there
fore disappear, just as in our view of capital the bonds
and stocks disappear, being not only assets, but also liabili
ties. And in exactly the same way the operations of pro
duction and transportation cancel themselves out in the
total production of the farms. The ten billions of dollars'
worth of farm products, for instance, which we are produc
ing are not a part of the income of the country to be added
to our consumption of food, etc., any more than they are
a part of the costs of the country. To the farmer they
represent income, but to those who buy of the farmer they
represent outgo, while to the country as a whole they rep
resent neither income nor outgo. By the method of couples
they vanish, and in their stead we have the consumption of
bread and the other finished products which originated with
the farm; and should we, as is sometimes erroneously
done, try to add together the value of these finished products
and the value of the farm products, we should be guilty of
double counting, as would be the case in capital accounting
if we should add the value of mortgages to the value of
real estate.

The method of couples thus provides us with a view of real
income, making clear what it consists of and what it does
not consist of. If, however, we wish to know the extent to
which various agencies have produced this income, we must
look at the matter from the standpoint of the method of
balances. From this standpoint, perhaps three quarters of
the total income enjoyed in the country is produced by
human beings, the workers of society, the remainder being
produced by capital in
its narrower sense. Of this capi
—-T

SEC. Iol

coMBINING INCOME Accounts. : :

- ; 15: ...”

tal that which produces the greater part of our income is
land, but some of our income must also be credited to

railways, ships, factories, shops, dwellings, etc. It does
not matter whether the capital is or is not itself the prod
uct of other capital, of human beings, or of nature.
There will usually be a net income to be credited opposite
each kind of capital, as shown in the table of the Method
of Balances in § 6.

CHAPTER VI
CAPITALIZING INCOME

§ 1. The Link between Capital and Income
WE have now learned what capital and income are, and
how each is measured. We have seen that the term “capi
tal” is not to be confined to any particular part or kind of
wealth, but that it applies to any or all wealth existing at a
given instant of time, or to property rights in that wealth,
or to the values of that wealth or of those property rights.
We have seen that income is not restricted to money
income, but that it consists of all kinds of benefits of wealth.

We have seen that, like capital, income may be measured
either by the mere quantity of the various benefits or by the
value of those benefits.

We have seen that in the addition

both of capital-value and of income-value there are two
methods available for canceling positive and negative items,
called respectively the “method of balances" and the
“method of couples.” By the method of balances the nega
tive items in any individual account are deducted from the
positive items in the same account, and the difference or
“balance ’’ gives the net capital (or income, as the case
may be) with which that account deals, whether this net
capital (or income) pertains to a particular instrument or
instruments, or to all the property of a particular owner.
The method of couples, on the other hand, cancels items in

pairs and is founded on the fact that, as to capital, every
liability relation has a credit as well as a debit side—
IO2

SEc. 1]

CAPITALIZING INCOME

IO3

namely, as related to creditor and debtor respectively; and
that, as to income, every interaction is at once a benefit and
a cost — a benefit occasioned by that good (or person) by
which the event originates; a cost occasioned by that good

(or person) for which it originates.
We observed that it is the method of couples alone which,
if fully carried out, reveals wherein capital and income
ultimately consist. This method, applied to capital, gradu
ally obliterates all partial rights, such as stocks and bonds,
and exposes to view the concrete capital-wealth of a com
munity.

The same method applied to income obliterates

the “interactions” such as money payments between
persons, and exposes to view an uncanceled outer fringe of
benefits and costs. It leaves simply the final benefits of the
wealth, poured, so to speak, into the human organism —
the satisfactions and the efforts of human life.

We have seen that capital and income are in many re
pects correlative; that all capital yields income and that
all income flows from capital including human beings.
In spite of this close association between them, capital
and income have thus far been considered separately. The
question now arises: How can we calculate the value of
capital from that of income or vice versa 2 The bridge or
link between them is the rate of interest. The rate of interest
is the ratio between income and capital, both the income and
the capital being expressed in money value. Business men,
therefore, sometimes call the rate of interest the “price of
capital’’ or the “price of ready money.” Suppose, for
instance, that a merchant wants a capital worth $10,000 and
is willing to pay a bank $400 per year for it perpetually;

then the price the merchant pays for the capital (or the ratio
between the annual payment to the bank and the capital
received from it) is $400 + $10,000 = {{m, or four per cent,
and the rate of interest is, therefore, said to be four per cent.

We may also define the rate of interest as the premium
on goods in hand at one date in terms of goods of the same

IO4

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

kind to be in hand one year later. Present and future goods
seldom exchange at par. One hundred dollars, if in hand
to-day, is worth more than if due one year hence. To-day's
ready money will always buy the right to more than its full
value of next year's money. If, then, $100 to-day will ex
change for $104 to be received one year hence, the premium

– or rate of interest — is four per cent.

That is, the price

of to-day's money in terms of next year's money is four per
cent above par; for $104 + $100 exceeds $1oo + $1oo by
1$o, which is four per cent.
We have, then, two definitions of the rate of interest,
viz., “the price of capital in terms of income " and “the
premium which present goods command over similar goods
due one year hence.”
But the two definitions are quite consistent, and either defi
nition may be converted into the other. The rates of interest

in the two senses are, in fact, normally equal. For instance,
if a man borrows $100 to-day and agrees to pay it back in
one year with interest at four per cent, we may conceive of
him as selling for $100 a perpetual income of $4 a year –
and at the same time agreeing to buy it back for $100 at the
end of one year. But these two stipulations — to sell and
to buy back — amount simply to an exchange of $100
to-day for $104 next year – i.e., an exchange of present for
future money at four per cent. Thus the rate of interest in
the price sense becomes equivalent to the same rate in the
premium sense. Or, beginning at the other end, conversely
if we suppose $100 to-day to be exchanged for $104 due
one year hence, so that the rate of interest in the premium
sense is four per cent, we may suppose that when the time
comes to receive the $104, only $4 of it is really kept, the
$1oo being again exchanged for $104 due the year follow
ing. If this process is repeated indefinitely, the man will
continue to receive simply $4 a year; and thus the rate of
interest in the premium sense becomes equivalent to the
same rate in the price sense.

Sec. 1]

CAPITALIZING INCOME

IOS

By means of the rate of interest we can evidently translate,
as it were, present money-value into its equivalent future

money-value, or future money-value into its equivalent
present money-value. To translate any present value into
next year's value, when interest is four per cent, we multiply
this year's value by the factor I.O4; to translate any next
year's value into this year's value, we divide next year's

value by the factor 1.04. Thus if the rate of interest is
four per cent, $25 to-day is the equivalent of $25 × 1.04 due

one year hence, i.e., $26.

Or, vice versa, $26 due one year

hence is worth in the present $26+ 1.04, or $25. Again,
$1 due one year hence is worth in the present $1 + 1.04,
or $o.962. In general we may obtain the present worth of
any sum due one year hence by dividing that sum by one
plus the rate of interest. This latter operation is what we
learned in our school arithmetics as “discounting,” by which
is meant finding the “present worth " of a given future sum.
The rate of interest is thus a link between values at any
two points of time – a link by means of which we may
compare values at any different dates.
The rate of interest, however defined, may be regarded as
a species of price; but it is a very different species from any
prices mentioned in previous chapters. We have seen that
the price of wheat enables us to translate any given number
of bushels of wheat into so many dollars' worth of wheat;
and the prices of other goods in like manner, to translate
their respective quantities into their money equivalents.
Any price thus serves as a bridge or link between the quan
tity of any good and its value in some other good, as money.
By means of prices we can convert a miscellaneous assort
ment of goods at any time into their money-value for that
same time, or convert a miscellaneous assortment of benefits

occurring through a period of time into their money-value
for that same period. By such prices we may only convert
quantities into simultaneous money-values. We cannot, by
them, pass from one time to another. By means, however,

Ioé

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

of that unique price called the rate of interest, we may
convert the money-values found for one time into their
equivalent at another time. The rate of interest is thus the
hitherto missing link necessary to make our reckoning of
money equivalents universal.
We are not yet ready to explain how the rate of interest
comes about. In fact, we are not yet ready to explain how
any prices come about. We must, for the present, take
the rate of interest ready-made, as it were, just as we have
taken other prices ready-made. In the preceding chapters
we have seen how to form capital accounts and income ac
counts by assuming the prices necessary in each case to turn
quantities into money-values. We are now ready, by as
suming a rate of interest, to show the relations between these
two sets of accounts – i.e., to turn income into capital. It
is worth while, however, at the outset to rid our minds of the

idea that money is the one and only source of interest, just
as we have already rid our minds of the idea that money is
the only kind of wealth. We may, as we have seen, express
a great many things in terms of money-value which are not
themselves money. This habit leads us unconsciously into
the fallacy of thinking of these things as though they were
actual money. If we question a man who says, “I have
$10,000 of money invested, and from it I get $500 of money
each year as interest,” implying a rate of interest of five per
cent, he will be forced to admit that he has not really got
$10,000 of money at all, and, perhaps, even that the $500 of
money interest which he says he gets each year is not at
first in money form. The true form of statement is simply
that he has a farm (or other capital-wealth) which yields
crops (or other products), and that both of these may be
measured in terms of money, the farm being worth $10,000
and the crops $500. Money need not enter at all except as
a matter of evaluating in bookkeeping. Hence, if we are
careful, we shall avoid thinking and speaking of a fund of
$10,000 producing an interest of $500, but will instead think

SEc. 2]

CAPITALIZING INCOME

IoW

and speak of actual capital, such as farms, factories, rail
ways, or ships, worth $10,000 and producing actual benefits
(such as yielding crops, manufacturing cloth, or transporting
goods) which are worth $500.
There is another confusion to be carefully avoided, viz.,
the confusion between interest and the rate of interest.

the interest from $10,000 worth of capital is $500 worth of
benefits, the rate of interest is five per cent. Interest and
the rate of interest are as distinct as value and price and in
the same way.

The rate of interest, then, is a sort of universal time price
representing the terms on which men consider this year's
values exchangeable in next year's or future years' values.
By assuming this rate, we are enabled to convert future values
into present, and present values into future.
§ 2. Capital as Discounted Income
But although the rate of interest may be used either for
computing from present to future values, or from future to

present values, the latter process is far the more important
of the two. Accountants, of course, are constantly comput
ing in both directions, for they have both sets of problems to
deal with ; but the problem of time valuation which nature
sets us is that of translating the future into the present;
that is, the problem of ascertaining the value of capital.
The value of capital must be computed from the value of its
expected future income. We cannot proceed in the opposite
direction and derive the value of future income from the

value of present capital.
This statement may at first puzzle the student, for he may
have thought of income as derived from capital, and, in a
sense, this is true. Income is derived from capital-goods.
But the value of the income is not derived from the value of

those capital-goods. On the contrary, the value of the
capital is derived from the value of the income. These re

Io8

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

lations are shown in the following scheme in which the
arrows represent the order of sequence – from capital
wealth to its future benefits, from its benefits to their

value; and from their value back to capital-value:—
Capital-wealth

–2-

Flow of benefits (income)

Capital-value

-6-

Income-value

Not until we know how much income an item of capital
will bring us can we set any valuation on that capital at
all. It is true that the wheat crop depends on the land
which yields it. But the value of the crop does not depend
on the value of the land. On the contrary, the value of
the land depends on the value of its crop.
The present worth of anything is what men are willing to
give for it. In order that each man may decide what he is
willing to give, he must have: (1) some idea of the value of
the future benefits his purchase will bring him, and (2) some
idea of the rate of interest by which these future values may
be translated into present values by discounting.
With these data he may derive the value of any capital
from the value of its income by means of the connecting
link between them called the rate of interest.

This deriva

tion of capital-value from income-value is called “capi

talizing” income or “discounting” income.
§ 3. The Discount Curve
Let us assume that, for any given article of wealth or
property, the expected income is foreknown with certainty,
and that the rate of interest is also known. With these pro
visos, it is very easy, by the use of the rate of interest, to
compute the capital-value of said wealth or property; and
this, whether the income accrues continuously or discon

tinuously; whether it is uniform or fluctuating; whether
the installments of it are few or infinite in number.

Sec. 3]

CAPITALIZING INCOME

Io9

We begin by considering the simplest case; namely, that
in which the future income consists of a single item becoming
due at some particular time.

If, for instance, one holds a

property right by virtue of which he will receive at the end
of one year a benefit worth $1.04, the present value of this
right, if the rate of interest is four per cent, will be $1. Or if
the future benefit one year hence is worth $1, its present
value (interest being at four per cent) is found, as we have
seen in § 1, by dividing the $1 by the factor 1.04. The
result is $1 + 1.04, or $o.962. If the value to which the
right entitles the owner is any other amount than $1, its
present value is simply that given amount divided by 1.04.
Thus the present value of $432 due in one year is
$432 + 1.04, which is $415.38.
Let us now take a period of two years instead of one. We
know by “compound interest” (at 4 per cent) that not only
will $1 amount to $1.04 next year, but that this $1.04 next
year will amount to $1.04 × 1.04 or $1.082 the year after, -

in short, that $1 to-day amounts in two years to $1 X (1.04)*
or $1.082. Conversely, of course, the sum of $1.082 due two

years hence is worth in present value $1.082 + (1.04)”, or $1.
Similarly, the present value of, let us say, $10oo due two
years hence is $10oo + (1.04)” or $924.21. We see then that,

if interest is 4 per cent, we can, by multiplying by (1.04)*,
translate any present sum into its equivalent two years

hence, and we can, by dividing by (1.04)*, translate any
sum due two years hence into its equivalent present value.
By the same reasoning it is easy to show that we must

multiply any sum in hand to-day by (1.04)” to obtain the
equivalent sum due three years hence, and must divide
any sum due three years hence by (1.04)” to obtain its

present value. If the period is four years, we must multi
ply or divide by (1.04)*; for five, by (1.04)", etc. For our
present purposes we shall need to apply the process of divi
sion by (1.04) or (1.04)” or (1.04)”, etc.; for our chief object
is to translate future sums into present, not the reverse.

ELEMENTARY PRINCIPLES OF ECONOMICS

IIO

[CHAP. VI

We may illustrate this process by a diagram, much in the
same way as geography is illustrated by a map. Curves
sometimes puzzle beginners, but they are very important
in economics, and render the subjects which they illustrate
so clear and simple that the student should not fail to make
himself master of their use at the outset.

In Figure 3 the vertical distances measure the money
and the horizontal distances measure the lapse of time.
The sum of $100 (represented as b|3) is supposed to be
due at the beginning of the year 1901. The problem is
to find its value at the point of time represented by a ;
that is, at the beginning of the year 1900, which we

shall consider the “present instant ’’ or simply the “pres
ent.”

This discounted value is a A.

If we draw the line

BA, its slope downward from right to left pictures the fact
that a future sum becomes smaller and smaller in present
value the longer the period of
time involved.

# a

This line BA is

called the discount curve.

It is

not a straight line, but a line such
that its height at any point rep
resents the discounted value of

bH for the particular instant cor
responding to that point. If the
$100 due in 1901 be discounted
in 1900 at four per cent, its value
in the latter date will be $96.15,

4O
4900

JSOI

the difference in value between

the two points of time being
$3.85, as indicated in the dia
gram, where a0 is equal to bb, and AC is the difference
between ac or bp, the amount due in 1901, and a A, the
discounted value of that amount in 1900.
We shall understand the nature of this curve better if,
instead of taking merely the interval of one year, we con
sider a longer interval such as ten years. This is represented
FIG. 3.

SEC. 3]

CAPITALIZING INCOME

III

in Figure 4. In this figure, as in the preceding figure, the
vertical distances (or “latitudes”) above the base line
represent sums of money and the horizontal distances (or
“longitudes") represent periods of time. The curve,
ABCDM is the discount curve.

The latitudes of these

points (or their vertical distances above the base line, abodm)
represent the values of the same capital-good at different
instants of time; and the longitudes or horizontal distances
between them represent the intervals of time between those
$
1.50

J.I.O

J
oo

190o on 'oz 'os 'o'; 'os 'o6 oz 'o6 'os 'io
FIG. 4.

instants. Thus, let the point a represent the present
instant, say the beginning of the year 1900, and let the
longitude interval, ab, represent a year, say from the be
ginning of 1900 to the beginning of 1901. Using equal
intervals for successive years, we have a A representing any
capital-value at the beginning of the year 1900, say $1, bb
representing its equivalent next year, say $1.04, c0, the
equivalent two years hence, and so on. We see that be is
what we have called the “amount,” $1.04, of a A put out
at interest for one year, and cc is the “amount” of the same

II 2

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

compounded for two years. Conversely a A represents the
present value in 1900, or discounted value, of any one lati
tude on the curve, such as b13, as well as of any other, such
as cC or d D. The latitude of any point on the curve may
thus be regarded as the “amount" of the sum represented
by any preceding latitude or as the “present value” of the
sum represented by any succeeding latitude. Thus, if the
total breadth of the diagram am represents ten years, we
may either say that mM is the amount, at the end of the

ten years, of the present sum a A, or that a A is the “present
value" of the future sum, mM, discounted for ten years.
The line AM not only ascends, but at an accelerating rate
– i.e., it does not ascend in a straight line, but gradually
bends upward, being continually steeper toward the right.
The slope of the curve is due to the rate of interest, and
the greater the interest in any given period of time, the
more steeply will the curve slope. This curve, if prolonged
to the left to show what the “present value" was prior to
the time a, will, of course, never reach the bottom line.

keeps becoming flatter and flatter, so that its distance
above the line can never become zero.

If there were no rate of interest or if the rate of interest

were zero, the curve would not slope at all, but would be
a horizontal line.

§ 4. Application to Waluing Instruments and Property

The principles which have been explained for obtaining
the present value of a single future sum apply to many com
mercial transactions, such as to the valuation of bank assets,

which exist largely in the form of “discount paper,” or short
time loans of other kinds.

The value of such a note is al

ways the discounted value of the future payment to which it
entitles the holder. Similarly, the value of any article of
wealth, reckoned when that wealth is in course of construc
tion, is the present value of what it will bring when com

Sec. 4)

II3

CAPITALIZING INCOME

pleted (less the present value of the cost of completion).
For instance, the maker of an automobile will, at any of its
stages in the course of construction, appraise it as worth the
discounted value of the price expected for it when finished

and sold, less the discounted value of the costs of construction
and selling which still remain. Thus, if an automobile is to
be sold for $5000 and requires a year before this sum will be
realized, while it will cost to complete a sale $2000, which
sum for simplicity, we also assume is payable at the end of
the year, the present value of the automobile will be the
present value of $5000 minus $2000, which, at four per
cent, will be ($5000 – $2000) + 1.04, or $2884.62. The
element of risk should not, of course, be overlooked; but

its consideration does not belong here.
Another application of these principles of capitalization
is to goods in transit. A cargo leaving Sydney for Liverpool
is worth the discounted value of what it will bring in Liver
pool, less the discounted value of the cost of carrying it
there. Another good example is a young forest, which is
worth the discounted value of the lumber it will ultimately
form.

Ordinarily, however, we have to deal, not with one future
sum, but with a series of future sums.

A man who buys a

bond or a share of stock is really buying the right to a series
of future items of income.

But we can treat a series of items

of income by discount curves in exactly the same way that
we can treat one such item.

For instance, let us consider a $10o “five per cent” ten
year bond. Such a bond is simply a promise to pay $5
each year for ten years and at the end of these ten years

to pay in addition the “principal’’ sum of $100.

The

problem is to discover the present value of the bond. This
is evidently the discounted value of the eleven sums which

the owner will receive from the bond; in other words, the
discounted value of the “principal,” due ten years hence,
together with the discounted values of the ten separate in
I

II4

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. VI

terest payments due respectively one year, two years, three
years, etc., up to and including ten years from date. As
we have just seen how to get the discounted value of any
one of these sums, it is simply a question of arithmetic to
calculate them all and then add them together. Before
we can perform the calculations, however, we must know
what rate of interest to use.

The mere fact that the bond

is called a “five per cent” bond does not mean that those
who buy the bond will calculate its present value to them
by discounting its benefits at five per cent. The five per
cent named in the bond is called the nominal rate of in

terest. It may or may not be the same as the rate of
interest used by investors in ascertaining the present value
of the bond.

This latter rate is called the rate “realized.”

If the rate realized happens to be the same as the nomi
nal rate of interest, i.e., that named in bond, the present
value of the bond will be par, or $100. This can be shown
in various ways, as by calculating separately all the eleven
different sums to which the bond entitles the owner; namely,
the ten interest payments of $5 each and the final principal
of $100. Such a calculation shows that the present value of
the first interest payment of $5 (namely, that due one year
hence) is $5 + 1.05, or $4.76; that the present value of the
second interest payment of $5 is $5+ (1.05)”, or $4.55;
that the present value of the third interest payment is
$5 + (1.05)”, or $4.32; that the present value of the fourth

interest payment is $5 + (1.05)*, or $4.11; and so on up
to the tenth, the present value of which would be $5 +
(1.05)" or $3.07. To this series must be added the present
value of the principal, which, being discounted for ten years,

is $100 + (1.05)", or $61.39. The sum of all these will be
$4.76 + $4.55 + $4.32 + $4.11 + $3.92 + $3.73 + $3.55 +
$3.38 + $3.22 + $3.07 -- $61.39 = $100, which is the present
value of the bond.

Another method of getting the same result is, beginning
our calculation at the time when the bond falls due in the

SEc. 4)

CAPITALIZING INCOME

II5

future, to proceed backwards, discounting year by year. It
is evident that just before the payment of the bond it will
be worth $105; for at that time there is immediately due
$5 of interest and $100 of principal. Any time earlier in
the ninth year, the value of the bond will evidently be
the discounted value of this $100 and this $5, the discount
being for whatever portion of the year may be involved.
Just after the ninth interest payment, and just one year be
fore the date when the $105 are due, the value of the bond
will evidently be found by discounting $105 for one year at
five per cent. This gives $105 + 1.05, or $100. In other
words, the value of the bond at the end of nine years, just
after the ninth interest payment, will be par, or $100. The
instant preceding, namely, just before the ninth interest
payment, the value of the bond will be more by the amount
of interest payment, $5. That is, the value of the bond will
be $105 just before the ninth interest payment and $10o just
after. This sudden drop of $5 is due to the abstraction of the

$5 of interest. For this reason, care is always taken by
brokers at or near the time of interest payments to specify
whether the bond is to be sold with the interest payment
or without it, the higher price being paid if the bond is
bought before the interest has been abstracted.

Thus, the instant before the ninth payment of interest
the bond is worth $105, just as was the case the instant before
the tenth and last payment. By the same reasoning, there
fore, its value one year earlier, just after the eighth interest
payment, will be $100 and just before, $105. In this manner
we may proceed year by year back to the present, finding
that the value of the bond will be $100 just after any interest
payment and $105 just before. Its value will therefore be
$1oo just after the first interest payment, which occurs one

year hence, and $105 just before that payment. The value
of this $105 at the present instant will therefore be $100.
Reviewing these figures in the reverse order, we see that
the value of the bond begins at $100, ascends to $105 one

ELEMENTARY PRINCIPLES OF ECONOMICS

II6

(CHAP. VI

year from date, then drops suddenly to $100, ascends during
the next year to $105, and then drops, and so on, ascending
and dropping, as it were, by a series of teeth until the whole
ten years have elapsed, when the value reaches its last
height of $105 and then disappears altogether. In these
oscillations, the gradual rise of $5 each year is evidently the

accrued, while the sudden fall of $5 at the end of each
\interest
year is the income taken out.
It is appropriate, here, to remind the student, that the
entire height from the base line to any point in this tooth

too

FIG. 5.

like curve— whether at highest or lowest or anywhere
between — represents the value of the capital at the cor
responding instant of time. This should be constantly
borne in mind.

The life history of such a bond can best be seen by the aid

SEc. 4)

CAPITALIZING INCOME

117

of Figure 5. The ten small, dark lines marked “5” stand
ing on the base line MA (or the equivalents of these above
the par line) and the long, dark line A B represent the eleven
sums to which the bondholder is entitled; in other words,

the small, dark lines representing the interest payments
in the ten successive years, and AB, the principal, $100,
due at the end of the ten years. The problem is: Given
these eleven sums to which the bondholder is entitled, to
show in the diagram the value of the bond at different dates.
Assuming as before that the rate of interest used in comput
ing is 5 per cent, we obtain the results seen in Figure 5.
We observe that the value of the bond, just before it be
comes due, is the sum of Aa (or BC, $5 of interest), and
A B (the $100 of principal). This sum is represented by
the vertical line AC. One year earlier, just after the ninth

interest payment A'a' (or B'C'), the value of the bond is A'B',
or $100, being the discounted value of AC obtained by draw

ing the discount curve CB'. The value just before the ninth
interest payment will be A'C', or $105. Continuing in this
manner backward, we obtain the series of “teeth,” as in

dicated in the diagram.
If the various discount curves in Figure 5 are all continued
to the left (as in Fig. 6), they will divide the line MN, rep
resenting the present value ($100) of the bond, into the
eleven parts of which it is composed, each part representing
the present value of one of the eleven payments to which
the bond entitles the owner. Thus the present value of
the principal is seen to be $61.39, this being the height
above M at which the lowest discount curve meets MN;

the present value of the last or tenth interest payment

is $3.07, this being the difference in height between the
two lowest discount curves; the present value of the
ninth interest payment is $3.22, as indicated in the next
space above. Similarly, the present value of each of the
other future payments is indicated in the diagram. The
parts into which MN is divided thus form a picture

II8

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

of the eleven present values calculated earlier in this
section.

As we pass from left to right in the diagram, we see that
the value of the bond at the beginning of each year is
$1oo, made up of the discounted values of all the remain
ing future receipts; and that the value increases each year
along a discount curve to $105 at the end of the year, im

FIG. 6.

mediately before the annual payment is made. The value
then drops again to $100, when this annual income is
received. It thus continues to oscillate (just as in Figure
5) between $100 and $105 each year to the end, when the
final income of $105 is received.
But often the bond is not sold at par because the rate of
interest used by the purchaser in calculating what he is

Sec. 4)

CAPITALIZING INCOME

II9

willing to pay for it may be more or less than the five per
cent named in the bond; in other words, the rate realized

by the purchaser may be more or less than the nominal
rate. When a bond is sold above par, this fact shows
that the rate of interest realized by the investor is less

than five per cent. In this case the bond is only nom
inally a “five per cent bond.” If the rate used in calcu
lating the value of the bond is four per cent, that value
IOB.17
Poir

vite}oo

FIG. 7.

will be found to be $108.17; so that if the bond is sold at
$108.17, the purchaser is said to “realize' four per cent.
It will be seen that the rate realized is that market rate

which is actually used for discounting eleven items, namely
the ten annual items of $5 each and the final item of $100.

I2O

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

The value of the bond, $108.17, is found in the way already
explained and is illustrated by the discount curves in Fig
ure 7. Expressed arithmetically the calculation consists in
adding together the following: the present value of the first
payment of $5 (namely that due one year hence) which is
$5 + 1.04, or $4.81, then that of the second which is
$5 + (1.04)” and so on up to and including the present
value of the principal which is $100 + (1.04)". The sum
is $108.17.
Here the five per cent bond is said to be sold on a four
per cent basis. Its capital-value ($108.17), at the begin

ning of the period represented (i.e., the value of a five per
cent bond, valued on a four per cent basis), is obtained
just as before, except that we now reckon by discounting
at four per cent instead of at five per cent. Thus, in Fig
ure 7, we see that the value of the bond, just before it be
comes due, is $105, or AC; that its value one year earlier,

just after the ninth interest payment, is A'B', or $105 +
1.04, or $100.96, and, just before the interest payment, is

A'C', or $100.96 + $5, or $105.96; and so on back to its
value at the beginning, MN, which is thus found to be
$108.17. This is greater by $8.17 than the value of the
bond as reckoned on the five per cent basis. The fact
that four per cent has been used in our calculations instead
of five per cent has made all of the discount curves less
steep.

We see, therefore, that nominally the rate of interest of
the bond is not necessarily the actual rate of interest used in
buying or selling that bond, and if the value of the bond is
calculated on the basis of a rate of interest below the nominal

rate of interest in the bond, the resulting value of the bond
* Of course, the same result could be obtained by discounting separately
at four per cent each of the eleven items to which the bondholder is en
titled and adding the results together. The elements of which MN is
composed may then be easily indicated just as, for the previous example,
in Figure 6.

SEc. 4)

CAPITALIZING INCOME

I2 I

will be above par. Nominally the rate of interest is that
named in the bond and, as previously noted, this is the
actual rate of interest if the bond is worth par, but not
otherwise. The actual rate is always that rate by which
the actual value of the bond is calculated from the pay
ments to which it entitles the holder. Tracing the history
of the capital-value of the ten-year-five-per-cent bond
reckoned at four per cent from the present toward the
future, we may say that the rise in value during each

... Parn...

yº.
92.61 Too

FIG. 8.

year is the interest accrued during the year on the capital
value at the beginning of the year. Thus, the rise in
value during the first year is four per cent of $108.17, or
$4.32, and in the last year is four per cent of $100.96, or
$4.038. It is also clear that the fall in the capital-value at

I22

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

the end of each year (except the last), when the payment
of the nominal interest is made, is exactly $5. That is, the
income taken out each year is greater than the interest
accruing during the year; hence the general decline in the
capital-value of the bond. In the last year the income
taken out is $105; although if the investor is wise, he will
put back at least $100 into Some other bond or equivalent
property.

The reverse is true if the present value of the bond is
calculated on a six per cent basis, or on any other higher
than the five per cent named in the bond.

Figure 8 repre

sents the case of a five per cent bond valued on a six per
cent basis. In this case the discount curves are steeper
than in Figure 5, and the value of the bond at present, ten

years before it becomes due, is $92.61. In Figure 8, as in
the preceding diagrams, we know that the rise of capital
value during any year is always the accruing interest on
the capital-value at the beginning of that year.

Thus, the

rise in the first year will be six per cent of $92.61, that is,
$5.55, and the rise during the last year will be six per cent
of $99.05, namely, $5.95. It is also clear that the drop in
capital-value at the end of each year is, as before, equal to
the income taken out, or $5; that is, the income taken out
each year is less than the interest accrued during the

year; hence the general increase in the capital-value of the
bond.

It will be seen (as shown in the three figures, 5, 7, and 8)
that the final value of the bond just before it becomes due
will be $105 in all three cases, but that the present value is
different in each case; namely, $100, $108.17, and $92.61.
In each case the value zigzags year by year, but approaches
in a general way $105 as its final value. If the “five per
cent ’’ bond is sold on an actual five per cent basis, the
value of the bond is maintained year by year, as seen
in Figure 5, where the curve indicating capital-value runs
in general horizontally; if it is sold on a four per cent basis,

SEC. 4]

CAPITALIZING

I23

INCOME

its value in general decreases, as shown by the descending
trend of the curve in Figure 7; while, if it is sold on a six

per cent basis, it tends to increase in value, as shown by
the general upward trend in Figure 8.
Elaborate tables have been constructed, called “bond

value books,” calculated on the foregoing principles. They
are used by brokers for indicating the true value of bonds on
different bases; that is, the prices a man ought to pay for
bonds, at different rates of interest and having different
times in which to mature, in order to realize on them the
market rate of interest.

These tables are also used for

solving the converse problem, viz., for finding the true rate
of interest “realized” when a bond is bought at a given price.
This rate realized will be the market rate, if the man has

paid the right price, but sometimes he pays a wrong price.
Given the market rate, we can deduce the right price to
pay. Given the actual price paid, we can deduce the
actual rate realized. The following table is an abridg
ment of these brokers’ tables, for a five per cent bond.
The prices of such a bond are in all cases the prices imme
diately after an installment of interest has been received.
In all cases the gradual increase in capital-value during
any time is equal to the interest accruing during that time,
while the sudden decrease at any time is equal to the value
RATES OF INTEREST
FIVE PER CENT BOND
YEARS to MATURITY
PRICE
r

IO2

3.O

IOI

4.O

4.6
4.8

4.9

IOO

5.o

6. I

5.2

5. I

7.I

5.5

5.3

4.8

I24

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

of the income taken out at that time. The only exceptions
to these statements are when capital-value varies up or down
because of changed opinion as to the chances of future in
come; but we are here assuming that there are no uncer
tainties to be reckoned with.

From this table we see that if the so-called five per cent
bond is sold at $102, and has one year to run, it will

“yield” the investor three per cent; that is, if three per
cent is used in calculating its value, this value will be
$102. Again, if the bond has five years to run and is sold
at $102, it will yield the investor 4.6 per cent; and if ten
years, 4.8 per cent. If the bond is sold at $98 and has
one year to run, it will yield the investor 7.1 per cent; if
ten years, 5.3 per cent. If it is sold at par, it will yield five
per cent, whatever may be the number of years it has to run.
The same principles as have just been applied to valuing
bonds apply also to valuing any other article of property or
wealth.

The student will find it a useful exercise to draw

diagrams for other cases. He may construct a series of
diagrams, the vertical lines representing the successive items
of income expected, and beginning at the last item proceed
backward year by year, by a series of teeth, to obtain the
present value of the capital. The value of the capital must
always befirst traced backward, but, after it has been obtained,
we may retrace our steps.

The zigzag curves which have been indicated for bonds
and which could be constructed for exhibiting the valua
tion of any other property right entitling the owner to
definite sums of money or benefits of definite value at
definite times are visual representations of the fact that

the present value of any future benefit or collection of
benefits gradually rises as the time grows near for their
realization and suddenly falls as the realization occurs.
The rate at which the value thus grows with time (between
benefits-realized) is the rate of interest employed in these
market valuations.

SEC. s]

I25

CAPITALIZING INCOME

§ 5. Effect of Changing the Rate of Interest
From what has been said, it is evident that the value of

any article of capital depends very greatly on the rate of
interest.

If there were no rate of interest, or if, in other

words, the rate of interest were zero, the value of the capital
would be simply the sum of the values of the anticipated
benefits. In the case of the five per cent bond, for instance,
running for ten years, if reckoned on a zero per cent basis, its
value would be simply the sum of the $100 and the ten in
terest payments, amounting to $50, or a total of $150. Since
the rate of interest is always higher than zero, the value
of the bond will always be lower than $150. To change
the rate of interest will always change the value of capital
in the opposite direction. For several generations the
rate of interest has been falling, and consequently the
value of bonds and of capital in general has tended to
rise. Of course, the change in value of capital will be
due also to many other circumstances than the change in
the rate of interest, and, moreover, the effect of the

change in rate of interest will not be the same on all
articles of capital. For instance, the capital, the income
from which is most remotely future, will be most affected.
The following table shows the effect of lowering the rate
|

carrº | Nºr is: º, year || 1: ‘àº'àº."
$1ooo per yr. forever | Infinite $20,000.oo
$1ooo per yr. for 5o
yrs.
$50,000.oo 18,300.oo
Horse
$1oo per yr. for 6 yrs.
6oo.oo
508.oo
Suit of
$20 1st yr.; $10 2d
clothes | yr. . . . . . .
3o.oo
28.oo
Loaf of
$36.5o per yr., for I
bread
day . . . . .
..IO
. IO

Land
House

$40,000.oo
28,400.oo
55I.OO
29.Oo
. IO

* The figures in this table are worked out by the principle of discount

ing previously explained.

I 26

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VI

of interest from 5 per cent to 2% per cent on five typical
articles, whose incomes have different degrees of remote
IneSS.

If the value of the benefits derivable from these various

articles continues in each case uniform, but the rate of in

terest is suddenly cut down from 5 per cent to 2% per cent,
there will result a general increase in the capital-values, but
a very different increase for different articles. The more
enduring ones will be affected the most. These effects are
seen in the last two columns of the table.

When the rate

of interest is halved, the value of the land will be doubled,
rising from $20,000 to $40,000, but the value of the house

will rise by only about sixty per cent, namely, from $18,300
to $28,400; the value of the horse will rise only ten per

cent, namely, from $508 to $551; the value of the suit will
rise only from $28 to $29; and, finally, the value of the
loaf of bread will not rise at all, but will remain at Io cents.

We see from the changes in the values of these five types of
articles that the sensitiveness of capital-value to a change
in the rate of interest is the greater, the more remote the
income. A high rate of interest requires a high premium
on income near at hand as compared with income remotely
future; or, expressed the other way about, a high rate of
interest diminishes the attractiveness of remotely future
income as compared with income close at hand.

CHAPTER VII
VARIATIONS OF INCOME IN RELATION TO CAPITAL

§ 1. Interest Accrued and Income Taken Out
WE have seen how the value of capital is derived from that
of income. We have also seen that the value of capital
rises in anticipation of income and falls after its realization.
The alternate rise and fall may or may not be equal. From
the principles explained it is evident that the rise of the capi
tal-value as it ascends on the discount curve is equal to the
interest accrued on that capital during that time, while the
fall in that capital value due to the taking out of income
is equal to the income taken out. If the income taken out
is just equal to the interest, the capital is thereby restored
to its original value. If more than this amount of income
be taken out, the capital-value will be impaired, that is, made
less than it was at the beginning of the period under considera
tion; if less, the capital-value will increase.
When a man is said to own a capital fund of $10oo, this
means simply that he owns capital-goods worth that much;
and these capital goods are worth that much simply be
cause, in terms of money, the discounted value of the
expected income from them is that much.

The income

which he expects may be a perpetual income flowing uni
formly or in recurring cycles; or it may be an income like
that from the bond, flowing recurrently for a limited time,
at the end of which a large lump sum, ordinarily called the

“principal,” is returned in addition; or it may be any one
of innumerable other forms.

Thus if we assume that five
127

I28

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VII

per cent is the rate of interest used in calculating the capital
value, then any one of the following investments will have
a present value of $10oo: a perpetual annuity of $50 per
year; or an annuity of $50 a year for ten years, together
with $10oo at the end of that period; or $100 a year for
fourteen years, after which nothing at all; or $25 a year
for ten years, followed by $167.50 a year for ten years, after
which nothing at all; or any one of innumerable other
forms. The student can easily prove that any one of these
series of incomes, when discounted at five per cent, will
make up a present value of $10oo.
In the first case the income taken out ($50 a year) is
exactly equal to the annual accrued interest, for $50 is the
interest for one year at five per cent on $10oo. The same
is true of the second instance mentioned, that of the five

per cent bond, except in the last year when the income
taken out ($1050) exceeds the interest for the year by
$1ooo, thereby reducing the value of the bond to zero.
In the third case the income taken out the first year

is $100, while the interest accrued in that year is only $50.
Thus the income taken out exceeds the accrued interest by
$50. This excess of $50 involves a reduction of $50 in the
capital-value of the property, which therefore becomes $950
instead of $10oo. Thus, at the end of the first year and
after the $100 of income has been taken out, $950 is the
discounted value of the remaining thirteen items of $100 a

year for each year. In the second year the interest (on
$950) is $47.50; whereas the income taken out is $100, the
difference being $52.50. Hence, at the end of the second
year, the capital-value of the remaining payments has been
reduced by $52.5o, becoming $897.50. Similarly, the capi
tal-value of the property decreases each year by the excess
of the income over the accrued interest until the last in

come item of $100 is received; after which, no more income

being anticipated, the capital-value is zero.
In the fourth case, the interest accruing during the first

SEc. 2)

VARLATIONS OF INCOME

I29

year is $50, whereas only $25 income is taken out at the
end of the year, the difference being $25. Hence, at the
beginning of the second year the capital-value of the bond
goes up to $1025. During the second year, the interest (on
$1025) is $51.25. After the receipt of the second income
item of $25, therefore, the capital-value of the bond is in
creased by the difference ($26.25) and becomes $1051.25.
Similarly, the value of the bond increases until after the
payment of the tenth income item of $25, when it becomes
$1314.43. The interest on this amount in the eleventh
year is $65.72; whereas the income taken out that year,
and each of the remaining nine years, is $167.50. Hence,
from the beginning of the eleventh year to the end of the
twentieth, the capital-value of the bond decreases, finally
reaching zero at the end of the period.
The principle here shown may be summarized as follows:
(1) When a property yields a specified foreknown income,
and is valued by discounting that income at a specified rate
of interest, if the income taken out is equal to the interest
accrued, the value of the capital will be restored each year
to the level of the year before. (2) If the income taken out
exceeds the interest accrued, the value of the capital will fall

below that of the year before, the amount of the fall being
equal to the amount of the excess. (3) If the amount of in
come taken out is less than the interest accrued, the value of

the capital will rise above that of the year before, the amount
the rise being equal to the amount of the deficiency.
Briefly, the general principle connecting income taken out
and interest accrued is that they differ by the net apprecia
tion or depreciation of capital.

It is thus possible to describe

interest accrued as income taken out less depreciation of cap
ital, or as income taken out plus appreciation of capital.
§ 2. Illustrations
In order that these important relations may be as clear
and vivid as possible, we shall illustrate them by concrete
K

I3o

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VII

examples, and by business accounting. The following table
gives the income supposed to be taken out for five selected

kinds of capital-wealth; the capital-value found by dis
counting that income at five per cent; the accrued interest .
for the first year; the resulting change or net appreciation
or depreciation of capital-value; and the ratio of the first

year's income to the original capital-value.
The student will readily understand how the figures in
the successive columns are calculated although the actual
calculation of the third column (capital-value) from the
second (income) is a tedious process involving in most
cases the discounting of a large number of separate items.

CAPITAL-

Income TAKEN out

WEALTH

PER YEAR

Cº(I

NT. At 5%)

INCREASE
INTEREST | (+) or DEAccRUED | CREASE (–)
For FIRST
of CAPITAL
YEAR
VALUE. In
FIRST YEAR
r

RATIo of
FIRST
r

tºo
ORIGINAL
CAPITAL
r

value

Forest land $1ooo a yr. for
I4 yrs. and

then $3000 a

yr. forever . $40,000.ool $2000.ool--$1ooo.o.o. 2.5
Farm land $1ooo per yr.
forever . . . 20,000.ool Iooo.oo
o.OO
5.o
House
$1ooo per yr.
for 50 yrs. . 18,300.ool 915.ool
-85.oo
5.4
Horse
$1oo per yr. for
6 yrs.
. .
508.oo
25.40
–74.60. 19.6
Suit of
$20 1st yr.; $10
clothes
2d yr. . .
28.oo
I.4O
– 18.60 71.4

1. The forest land yields $1ooo worth of income the first
year on a capital-value of $40,000, from which, on the five
per cent basis assumed, the interest accrued would be five
per cent of $40,000, or $2000. Consequently, the income
taken out ($1ooo) is less than the interest accrued ($2000)
by $10oo. Therefore the forest will appreciate in the year
by the excess, $2000 – $10oo, or $10oo, and will be worth
$41,000 at the end of the year. Similarly, it will continue

Sec. 2)

VARIATIONS OF INCOME

I31

to appreciate for fourteen years, when it will be worth
$60,000; after which the income that is annually taken out
($3000) will be equal to the annual accrued interest on
$60,000.

2. The farm land yielding $10oo a year in perpetuity
is, on the five per cent basis, worth $20,000, and continues to
be worth that amount each succeeding year. The income
taken out ($10oo) is always equal to the interest accrued
from $20,000.

3. The house yields an income of $10oo on a capital
value the first year of only $18,300. The interest accrued on
$18,300 would be five per cent of $18,300, or only $915. The
consequence is an excess of income taken out over interest
accrued of $10oo — $915, or $85, and a corresponding fall
of $85 in the value of the capital. That is, the house depreci
ates by $85 in the year, or from $18,300 to $18,215. It will
continue to depreciate each year until its value vanishes
entirely at the end of fifty years.
4. The horse also depreciates, and very fast. Its owner
realizes from the horse an income of $100 on a capital-value of
$508, from which the interest accrued would be only $25.40.
The difference between the income taken out and the interest

accrued is $100 – $25.40, or $74.60, and the horse will lose
that much in value during the year, and will continue to
depreciate in value for all of the six years during which it
yields income.
5. The suit of clothes yields an income the first year of
$20 on a capital of $28, from which the interest accrued
would be only $1.40. It therefore depreciates by the differ
ence, $20 — $1.4o, or $18.60.
In all cases the interest accrued is 5 per cent of the capital
value, while the income taken out is in some cases a higher,
and in some cases a lower, percentage. Expressed in per
centages, the actual rate of value-return (i.e., ratio of income
taken out to capital) on the forest land is 2.5 per cent;
on the farm land, 5 per cent; on the house, 5.4 per cent;

I32

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VII

on the horse, 19.6 per cent; and on the suit of clothes, 71.4
per cent. The more rapidly the income is taken out, the

greater the rate of value-return realized; but (if that rate ex
ceeds the rate of interest) the more rapidly will the capital
be exhausted. The house yields a rate but slightly higher
than the rate of interest, and lasts 50 years; the horse yields
a rate nearly 4 times the rate of interest, but it lasts only 6
years; and the clothes yield a rate over 14 times the rate of
interest, but last only 2 years. The farm land, which yields
a rate exactly equal to the rate of interest, lasts forever,
while the forest land, which yields a rate only half the rate
of interest, not only lasts forever, but also increases in
value for the first 14 years.

The various cases supposed may also be illustrated by the
dividends declared by a joint stock company. If a company
declares dividends of five per cent, when it earns five per
cent, these dividends will be the interest accrued on the
capital and will leave it intact. If the dividends are less than
five per cent, capital will be accumulated; that is, a “sur
plus” will be added to the original capital. If the dividends
are greater than five per cent, the capital or surplus pre
viously accumulated will be decreased. In the last-named
case the company is said to pay its dividends partly “out of
capital.” Such a practice is unusual, and when it occurs is
generally condemned because of an assumed intention to de
ceive as to the ability to pay dividends.
A case at the opposite extreme occurs when the dividends
are made unusually small in order that the capital may be
increased. There is in New York City a company which has
never declared any dividends, but has been rolling up a large
surplus for years, and whose stock is for this reason much
above par.
§3. Confusions to be Avoided
With all the preceding explanations and illustrations the
distinction between income taken out and interest accrued

SEC. 3]

VARLATIONS OF INCOME

I33

should be clear. Interest accrued is the income which,
if it were taken out, would maintain capital intact, neither
impaired nor increased, at the value it had at the beginning
of the period under consideration.
Of the two concepts, income taken out and interest ac

crued, the former is by far the more fundamental. Every
thing else depends upon income expected to be taken out.
We cannot, as would at first seem possible, begin with capital
value and derive the actual income from it; nor can we

begin with interest accrued, for interest accrued presupposes
some capital-value. That is, interest accrued depends on
capital-value, and capital-value depends on income to be taken
out. The order of dependence, then, is income taken out,
capital-value, interest accrued. It is not uncommon to con
fuse these three concepts. The illustrative table (§ 2) of
this chapter will help to keep us from confusing them. For
instance, from this table we see clearly one reason why
certain articles have been erroneously identified with income.

Clothes have nearly the same capital-value as income-value,
so that, if a person were not accustomed to fine distinctions,
he might think it unnecessary to discriminate between the
$30, which is the total value of the use of the clothes for two
years, which is, therefore, income, and the $28, which is the
value of the clothes themselves, and which is, therefore, capi
tal. There is almost as much danger of such confusion in
the case of the horse; for there is no very great difference
between the $600, the value of the use of the horse, and the
$508, which is the value of the horse. As we pass to the

more enduring articles, there emerges so wide a difference
between the value of the use of an article and the value of

the article itself, that there is no difficulty in distinguishing
between them. But if the distinction is valid in one case, and
all acknowledge that it is, it is valid in the others. We find no

difficulty in distinguishing between the shelter of a house,
which is income, and the house itself, which is capital; nor
between their values.

Thus the shelter is worth $10oo a

I34

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VII

year for 50 years (or $50,000 in all), whereas the house itself
is the discounted value of all this $50,000, or only $18,300.
We ought to find no greater difficulty in distinguishing be
tween the horse and the use of the horse, nor between the
clothes and the use of the clothes.

The more rapidly any capital yields up its benefits, that
is, the greater the rate at which its income is taken out, the
more the danger of confusing the capital with the income it
yields.
We have shown the tendency to confuse three concepts —
interest accrued, income taken out, and capital-value. We
have also dealt with a fourth concept, which must not be
confused with the other three, viz., appreciation or deprecia
tion. Appreciation is also sometimes called savings, for
savings in its broadest sense includes more than simply saved
money. It includes all the net increase in capital-value after
all income has been detached. It is the net appreciation,
or the difference between the interest accrued and the income

taken out. Savings are therefore still a part of capital.
They are the part of capital saved from being taken out
for income. They are not a part of income taken out.
The individual is always struggling between saving more
capital and taking out more income. He cannot do both —
have his cake and eat it too. A savings bank depositor is
sometimes thought to draw income from his deposit when
the interest merely “accumulates’’ in the bank. This is
an error. The bank renders income to the depositor when,
and only when, money is drawn out of it. It occasions
him outgo when, and only when, money is put into it. If
the depositor merely lets his deposit accumulate, he derives
no income and suffers no outgo. There is no effect on in
come. The only effect is upon capital, which is made to
increase. If we accept the fiction that the man who allows
his savings to accumulate virtually receives the interest, we
must, to be consistent, also accept the fiction that he re
deposits it and so cancels the receipt. If the teller hands

Sec. 3]

VARIATIONS OF INCOME

I35

over the interest across the counter, the depositor's account
or claim against the bank certainly yields up “income '’ to
him, but if the depositor hands it back, the account occasions
“outgo,” and the net result is simply a cancellation. To
allow a deposit to accumulate is evidently equivalent to this
double operation. We see, then, that net appreciation is not
income, but is an addition to capital. Likewise, net de
preciation is not outgo, but is a subtraction from capital.
Almost every article except land ultimately depreciates in
value, owing to the fact that the services which it still re
mains capable of rendering gradually diminish in number
and value. The approaching cessation of services may be
due to physical wear and tear, but not always. Sometimes
the expression “wear and tear” is a misnomer. There are
articles which suffer no physical change, but of which the
services, nevertheless, last only a limited period. On the
Atlantic coast the fishermen sometimes construct temporary
platforms which are pretty sure to disappear in the Septem
ber gales. It is evident that without any physical deteriora
tion during the summer the value of such property must,
nevertheless, decrease rapidly as the end of the fishing sea
son approaches. The “World's Fair” buildings at St.
Louis depreciated, during the brief period of the fair, from
$15,000,ooo, which was first paid for their construction, to
$386,ooo, for which they were sold after they had served
their main purpose during the few months of the Fair. The
buildings equipping a mine become worthless when the mine
is exhausted. “Wear and tear,” therefore, is a phrase
which we should use only in a metaphorical sense. Even
when there is actual physical deterioration, this deterioration
affects the value only in so far as it decreases or terminates
the flow of income, and not directly because of a physical
change in the capital which bears the income.
There are, then, four concepts which we must keep dis
tinct. Stated in the order of dependence on income taken
out, these concepts are:

136

ELEMENTARY PRINCIPLES OF ECONOMICs

(CHAP. VII

(1) Income (value) taken out.

(2) Capital-value (the discounted value of expected in
come to be taken out).
(3) Interest accrued (the interest on capital-value).
(4) Appreciation (the excess of interest accrued over

income taken out), and its opposite, depreciation (the excess
of income taken out over interest accrued).
This order of dependence together with the dependence
of the first element (income taken out) on antecedent ele
ments previously explained may be conveniently expressed
in a scheme as follows:–
Capital wealth—-Benefits (income)

4- Income (value) taken
Capital value > Interest accrued

*}-ſº
depreciation

§4. Standardizing Income
Various devices have been used to make income taken out

agree with interest accrued. The method of the depre
ciation fund has already been mentioned under income
accounts, and before the relation of income to capital was
explained. By means of a depreciation fund, an irregular net
income is converted into a regular net income; and we know
that the capital-value of a perpetually regular income will
remain constant. For instance, the possessor of $18,300
purchases a house and obtains at first an income worth
$1ooo a year. He knows, however, that by the end of
50 years the house will need to be rebuilt, and therefore
sets aside a depreciation fund into which he pays annually
a sum equal to the depreciation of his house. This, in the
first year, is $85, as we have seen. The depreciation fund
costs him this sum as outgo the first year. At the end of
50 years his depreciation fund, accumulated at interest,
is large enough to rebuild the house. Although the house
by itself does not yield him a uniform income of $915 for

Sec. 4)

WARLATIONS OF INCOME

I37

ever, but instead $1000 a year for 50 years, yet the house
and the depreciation fund taken together yield him the $915
in perpetuity, or as long as he keeps up the system.
In this way, any article of capital may be made to yield a
uniform perpetual income, not by itself, but conjointly with
a depreciation fund. The latter is often forgotten. Only
by actually paying into this fund can income taken out be
made to agree with interest accrued. Merely to reckon what
the depreciation is will not make the income taken out agree
with the interest accrued. Reckoning depreciation is as
poor a substitute for providing a fund to meet depreciation
as Beau Brummel's keeping a dinner hour was a substitute
for a dinner. Of course, depreciation payments only rectify
or change the distribution in time of one man's income at the
expense of some other man's income. That is, every addi
tion and subtraction caused in the one man's income implies
equal and opposite changes in some other man's. A banker
must be found who is willing to take the $85 and succeeding
payments into the depreciation fund and to pay back
$18,300 at the end of 50 years.
Another and simpler method of keeping income steady
is to take care that one's capital shall consist of a large
number of instruments at different stages of production or
consumption. If a weaving mill is equipped with twenty

looms of the same degree of wear, the value of this plant
will evidently diminish, and a depreciation fund may be
necessary. But if the twenty looms are evenly distributed
throughout the different stages of wear, and if we assume
that one loom wears out each year and is replaced at a
regular cost, no depreciation fund will be necessary. The
replacement of one loom annually is equivalent to such a
depreciation fund, and the capital is thereby maintained at a
uniform level. This method, which consists in properly
assorting and combining a large number of instruments,
is the chief reliance for steadying the income of society as
a whole, for to society as a whole purely shifting devices,
V

138

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VII

such as borrowing, are inapplicable, since society can find
no outside party on whom to shift the fluctuations.
In a new country just being opened up, such as the
early American colonies, little income can at first be ob
tained because almost all the stock of wealth, especially
the land, is, with respect to ability to yield income, in an
embryonic stage, so to speak. The first settlers must, there
fore, wait several years before they can get a comfortable
living. An older country, on the other hand, such as the
United States to-day, will have its capital better assorted.
Only part of its capital will be in the embryonic stage —
young forests, new mines, railways in process of construc
tion. Other capital will be in full operation, yielding a large
stream of benefits – older forests, mines, railways, factories,
farms, dwellings, etc.
§ 5. The Risk Element
There is one important feature in the relation between
capital-value and income-value which has not yet been
mentioned. This is the fact that at any point of time when
we take account of capital-value, the future income from
which it is obtained is only imperfectly foreknown. The
capital-value is the discounted value of the future expected
income, with all the chances of loss or gain included in pres
ent expectations.
Hitherto we have assumed that the entire future history
of the capital in question is definitely known in advance;
in other words, we have ignored chance. The articles of
capital which were taken for illustration were supposed to
yield definite future income which could be counted upon, pre
cisely as the interest payments on a bond may be counted on
by the bondholder. But as every enterprise offers chances
of both gain and loss, we cannot close our discussion of the
relation of income to capital without some account of how
-

these chances affect the matter.

SEc. 5]

VARIATIONS OF INCOME

I39

It has been explained that capital-value increases with
the approach of an anticipated installment of income, and
diminishes when that installment is taken out or received.

These changes in capital-value take place when the future in
come is regarded as certain. The introduction of the ele
ment of chance will bring other and even more important
changes in capital-value. If we take the history of the prices
of stocks and bonds, we shall find it to consist chiefly of a
record of changing estimates due to what is called chance,
rather than of a record of the foreknown approach and de
tachment of income. Few, if any, future events are entirely
free from uncertainty. In fact, property, by its very defi
nition, is simply the right to more or less probable future
benefits.

The owner of a mine takes his chances as to what

the mine will yield; the owner of an orange plantation in
Florida takes his risk of winter frosts; the owner of a farm
assumes risks as to the effect of sun and rain and other

meteorological conditions, as well as the risks of the ravages
of fire, insects, and pests generally. In buying an overcoat
a man takes some risk as to its effectiveness in excluding
cold, and as to the length of time it will continue to be ser
viceable. Even what are called “gilt-edged ” securities are
not entirely free from risk. Strictly speaking, therefore,
every owner of property is a risk bearer.
We may now take a bird's-eye view of the capital and
income of any country, such as the United States. We
have seen that the capital of the United States consists of
over a hundred billion dollars' worth of articles of various

kinds, mostly real estate, and that the income consists of
several billion dollars' worth of nourishment, clothing, shel
ter, and other satisfactions. We now see how the capital
is related to the income. All income comes from capital
(in its broader sense) whether, as is frequently the case,
the capital is a human being, or some other form of wealth.
The income produced by capital gives value to that capital;
for instance, the fruit borne by a tree gives value to the tree.

I4o

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VII

Business men seldom assign value to human beings by
capitalizing their earning power, although statisticians oc
casionally do this. But other forms of capital are com
monly valued by capitalizing the income which they yield,
that is, the one hundred and odd billions of dollars which

our national capital is worth represent merely the discounted
value of the nation's net future satisfaction which, it is

expected, that capital will ultimately produce. The value
of our capital is merely the present value of the future
“living ” of ourselves and our descendants. Most of the

capital does not directly produce that “living ”— does
not turn out bread and butter ready-made; but contributes
to it only indirectly — by growing the wheat which will be
made into bread or pasturing the cows from whose milk the
butter will be churned. But all of the capital has as the
goal toward which its services aim the production of bread
and butter and the other necessities, comforts, and amuse

ments of life the enjoyment of which constitutes our “liv
ing ” or real income; and each individual article of this
capital derives its value from the value of the services it
is expected to render in helping toward this goal. These
expectations may never be realized, and often are not real

ized, or the expectations may be surpassed by realization.
But in either case it is expectation and not realization which
gives the value to capital; and any change in expectations,
whether occasioned by a shock to business confidence, a
rumor of war, or any other cause, will tend to change the
value of our national capital.
§ 6. Review

The preceding chapters are intended to give a definite

picture of the mass of capital and its benefits to man. LIn
such a picture we see man standing in the midst of a
physical universe; the events of this universe affect his life

favorably or

unawnº, Over many of these events he

SEc. 6]

VARIATIONS OF INCOME

I4I

can exercise no control or selection; they constitute his
natural environment.

Over others he exercises selection

and control by assuming dominion over part of the physical
universe and fashioning it to suit his own needs.

The parts

of the material world which he thus appropriates consti
tute wealth, whether they remain in their natural state or
are “worked up” by him into products to render them more
suitable to his needs.

This mass of instruments will con

sist, first, of the appropriated parts of the surface of the
earth, the buildings and structures attached to the soil, and

the movable objects or “commodities” which man possesses
and stores up; and, secondly (if we take wealth in its
broader sense), of human beings.
This mass of instruments serves man's purpose in so far
as its possession enables him to modify the stream of occur
rences. By means of land and the modifications to which
he subjects it he is enabled to increase and improve the
growth of the vegetable and animal kingdoms in such a way
as to supply him with food and the materials for constructing
other instruments. By means of dwellings and other build
ings he is enabled to avert or minimize the unfavorable
effects of the elements upon his body and upon the articles

of wealth which he stores in those buildings. By means of
machinery, tools, and other instruments of production, he
is enabled to fashion new instruments, to add to his store of

goods or to supply the place of those destroyed or worn out.
By means of the final finished products which minister to his
more immediate enjoyments – such, for instance, as food,
clothing, books, ornaments – he is enabled to consummate
the purposes for which the entire mass of wealth is produced
and kept in existence; namely, the satisfaction of his

desires, whether these be for the necessities, the comforts,
the luxuries, or the amusements of life. In these and

other ways the stock of wealth will modify the course of
natural events in a manner more or less agreeable to the
owner. These desirable changes in the stream of events

I42

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VII

which occur by means of wealth constitute the benefits
of wealth.

But these benefits are obtained by dint of certain costs.
In the last analysis, costs are simply human efforts, and
benefits are simply human satisfactions; but the interval be
tween efforts and satisfactions is divided into so many stages,
and at each of these stages there are so many processes of
production or exchange, that these intermediate occurrences,
or interactions, are much more in evidence than either the
efforts which precede them or the satisfactions which follow.
Each interaction is accounted as a benefit with respect to
the producing article or agent, and a cost with respect to
that on account of which it occurs.
The whole economic structure therefore — all that is

represented in capital and income accounts — rests on two
ultimate elements, namely, efforts and satisfactions. These
enter our accounts, transformed simply by means of factors
called prices, including that important price called the rate
of interest. By means of such price factors, we reach
from these elements, first, the interactions which depend
on them, then the complete income and outgo accounts
(containing the values not only of interactions, but of ef
forts and satisfactions as well), and then the capital ac
counts (containing the discounted values of the items in the
income accounts).
To recapitulate in a few words the nature of capital and
income, we may now say that those parts of the material uni
verse which at any time are under the dominion of man,
constitute his capital-wealth; its ownership, his capital
property; its value, his capital-value. Capital-value im
plies anticipated income, which consists of a stream of bene
fits or its value.

When values are considered, the causal

relation is not from capital to income, but from income to
capital; not from present to future, but from future to pres
ent. In other words, the value of capital is the discounted

value of the expected income. The fluctuations of this

Nº.
N
Sec. 6]

S. I.45
VARIATIONS OF INCOME

capital-value will, barring chance, be equal and
the divergencies of “income taken out” from “interest ac
crued.” When the influence of chance is included, there
will be in addition to these fluctuations still others which

mirror the successive changes in the outlook for future
income.

CHAPTER VIII

PRINCIPLES GOVERNING THE PURCHASING POWER OF MONEY

§ 1. Introductory

WE have now finished the first great division of our sub
ject — a study of the foundation stones of Economics and
how they fit together. These foundation stones are wealth,
property, benefits, costs, capital, and income. Our study
has so far consisted in pointing out the nature and rela
tions between these various concepts, and particularly be
tween capital and income.
All of these relations find expression by means of prices.
By prices, as we have seen, a miscellaneous collection of
goods may be translated into a homogeneous mass of money
values. Only by such reduction to a common money basis
are capital and income accounts possible. Capital accounts
and income accounts are groups of heterogeneous elements re
duced to common terms by means of prices. But in all the
capital and income accounts to which reference has thus far
been made, and in all our previous discussions, we have
taken prices for granted. We have, in other words, started
out in our investigations upon the assumption that prices
were fixed and known. But inasmuch as prices themselves
are the outcome of economic forces, they must in turn be
made the subject of analysis, and we must consequently
now take up the second part of our task, which consists in
discovering the principles that determine prices.
If one were to ask how theI44price of wheat is determined,
w

Sec. 1]

PURCHASING POWER OF MONEY

I45

the immediate answer would probably be: By supply and
demand. This answer, though correct so far as it goes, is
superficial. It is well to be on one's guard against glib
phrases which are so often substituted for real analyses.
“Supply and demand ” is such a phrase. A long time ago,
when economics consisted rather of glib phrases than of real
analyses, a critic of the study said, “If you want to make
a first-class economist, catch a parrot and teach him to say
‘supply and demand’ in response to every question you
ask him. What determines wages? Supply and demand.
What determines the distribution of wealth? Supply and
demand.” In every instance the answer is right, but it
explains nothing. We must discover the forces which
determine supply and demand. In so doing we shall learn

that to determine the price even of one simple commodity,
like wheat, involves practically all the principles of economic
science.

We are now ready to undertake — not the full study of
the supply and demand'of any article — but one of the im
portant forces underlying the supply and demand of all
articles. That force is the purchasing power of money, a
force as subtle as it is omnipresent. As every price is ex
pressed in money, it is evident that the willingness to take
or give a certain amount of any article at a given price in
money depends on the willingness to give or take a certain
amount of money in exchange. This willingness to give or
take money depends on the purchasing power of money over
other things. Will a man pay ten cents for a pound of sugar?
That depends on whether or not he wants the sugar more
than something else purchasable with the ten cents. The
man, in other words, balances in his mind the sugar and the
money — the latter standing in his mind for any goods he
could spend it for. If the purchasing power of money is
high, he will conceive so high a regard for money as to be
reluctant to part with a given amount of it for a given quan
tity of sugar, i.e., he will be willing to pay only a low price
-

I46

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VIII

for sugar. The seller, on the other hand, is more eager to
take a unit of money when it has a high purchasing power,
i.e., he is more willing to take a low price for sugar. Hence,
if in a given year money has a high purchasing power, the
price of sugar will be low. We see then that the price of
any particular article will tend to be low if money has a high
purchasing power; that is, if the prices of articles in general
are low. It is therefore clear that the money price of every
particular commodity depends partly on the prices of other

commodities, i.e., on the general level of prices; just as the
actual height reached by a particular wave of the sea depends
partly on the general level of the tides, or as the actual
height of a spire depends on the elevation of the ground
on which it stands.

The phrases “the purchasing power of money ’’ and “the
general level of prices" are reciprocal. To say that the pur
chasing power of money is high or low is the same thing as to
say that the general level of prices is low or high, respec
tively. If the price level is doubled, the purchasing power
of money will be halved, and vice versa.
It is possible to study the general level of prices inde
pendently of particular prices, just as it is possible to study
the general tides of the ocean independently of its particular
waves. Moreover, it is not only more logical to study the
general price level first, but this order of study has also the
advantage of acquainting us as early as possible with the
nature of money. v. Therefore, before we attempt to explain
even the price of wheat in particular, we shall first take up
the study of prices in general.
In practice, money is a most convenient device, but in
theory it is always a stumbling-block to the student of
economics, who is exceedingly prone to misunderstand its
functions. At the beginning of this book we pointed out
some of the imagined functions of money that do not
belong to it. We are now in a position to ask: What are
the real functions of money?

SEc. 2)

PURCHASING

POWER OF MONEY

I47

§ 2. The Nature of Money
We define money as goods generally acceptable in exchange
for other goods. The facility with which it may thus be ex
changed, or its general acceptability, is the chief character
istic of money. The general acceptability may be reënforced
by law, the money thus becoming “legal tender” (i.e., money
which may be legally tendered or offered by a debtor to his
creditor as a means of discharging his obligations expressed
in terms of money units and which the creditor must

accept). But such reënforcement is not essential. All
that is necessary in order that any good may be money
is that general acceptability shall attach to it. On the
frontier, without any legal sanction, money is sometimes
gold dust or gold nuggets. In the colony of Virginia it
was tobacco. Among the Indians in New England it was
wampum.

How does it happen that any particular commodity
comes into use as money? Not originally because a
government so decreed, but because the commodity was
very salable for other uses than money and could be readily
resold.

Thus gold was readily sold and resold.

Many

wanted it for jewelry, and many others could easily be
induced to accept it in exchange, even if they had no
personal use for it themselves, for they knew they could
resell it at any time to some one who had such a use for

it. Gradually it became customary to accept it with no
thought of any other use than to resell it or pass it
on indefinitely. Gold has finally survived as the most im
portant form of money. It is easily transportable and is
durable.

There are various degrees of exchangeability which must
be transcended before we arrive at real money. Of all kinds
of goods, one of the least exchangeable is real estate.

It is

often difficult to find a person who wants to buy a particular
piece of real estate. A mortgage on real estate is one degree

I48

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VIII

more exchangeable. Yet even a mortgage is less exchange
able than a well-known and safe corporation security, or
a government bond. One degree more exchangeable than
a government bond is a time bill of exchange; one degree
more exchangeable than a time bill of exchange is a sight
draft; while a check is almost as exchangeable as money
itself. Yet no one of these is really money, for none of
them is “generally acceptable.”
If we confine our attention to present and normal condi
tions, and to those means of exchange which either are
money or most nearly approximate it, we shall find that
money itself belongs to a general class of goods which we may
call “currency” or “circulating media.” Currency may
be any kind of goods which, whether generally acceptable
or not, do actually, for their chief purpose and use, serve as
a means of exchange.

Currency consists of two chief classes: (1) money; (2)
bank deposits, which will be treated fully in the next chap
ter. By means of checks, bank deposits serve as a means of
payment in exchange for other goods. A check is the evi
dence of the transfer of bank deposits. It is acceptable to
the payee only by his consent. It would not be generally
accepted by strangers. Yet by checks, bank deposits, even
more than money, do actually serve as a medium of ex
change. In this country bank deposits subject to check, or,
as they are sometimes called, “deposit currency,” are by far
the most important kind of currency or circulating media.
But although a bank deposit transferable by check is
included in circulating media, it is not money. A bank note,
on the other hand, is both circulating medium and money.
Between these two lies the final line of distinction separat

ing what is money and what is not. The line is delicately
drawn, especially in the case of such checks as cashier's
checks or certified checks. For the latter are extremely
similar, in respect to acceptability, to bank notes. Each is
a demand liability on a bank, and each confers on the holder

SEc. 2)

PURCHASING POWER OF MONEY

I49

the right to draw money. Yet while a bank note is generally
acceptable in exchange, a check is acceptable only by special
consent of the payee. Real money is what a payee accepts
without question, because he is induced to do so by “legal
tender ’’ laws or by a well-established custom.
Of real money there are two kinds: primary and fidu

ciary. Money is called primary if it is a commodity any
given unit of which has just as much value in some use

other than money as it has in monetary use; that is,
primary money is a commodity which has its full value
even if it is not used as money or even if it is changed to
a form in which it will not circulate as money. For in
stance, gold coins in the United States are primary money,
since their value will be undiminished even if they are
melted into gold bullion. In the same way, the tobacco
money of Virginia in old days was primary, having as much
value as tobacco as it had as money. Fiduciary money,
on the other hand, is money the value of which depends
partly or wholly on the owner's confidence that he can ex
change it for primary money, or at any rate for other goods,
e.g., for primary money at a bank or government office or for
discharge of debts or purchase of goods of merchants. For
instance, a silver dollar in the United States is fiduciary
money, since it is worth a dollar only because of the public
confidence that the government will take it in taxes and the
people in discharge of debts and for other purposes on equal
terms with a dollar of gold. If a silver dollar be melted
into bullion, it will, unlike the gold dollar, lose a large part
of its value.

That is, the bullion in a silver dollar is not

worth a dollar; it is only worth about forty cents. Our
other silver coins are worth as bullion even less in propor
tion to their value as money, and our nickel and bronze coins
are worth still less in proportion. Bank notes, government
notes, and other forms of paper money are still more striking

examples of fiduciary money, being practically worthless as
paper, but having a high value as money, owing to the con

I5o

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VIII

fidence that they can be exchanged for gold at the banks or
the government treasury. The larger part of the money in
use in the United States is fiduciary money, the chief ex
amples being silver dollars, fractional silver, minor coins,
silver certificates, gold certificates, government notes (nick
named “greenbacks”), and bank notes. The exact nature
of these various kinds of money constitutes a subject outside
the purpose of this book. The student can, however, learn
much as to their nature for himself, by reading the inscrip
tions on the various forms of money, which, from time to
time, pass through his hands."
The qualities of primary money which make for exchange
ability are numerous. The most important are portability,
durability, and divisibil
ity. The chief quality of
fiduciary money, which
makes it exchangeable, is
BANK
its redeemability in pri
mary money, or else its
DEPOSITS.
imposed character of
“legal tender.”

Figure 9 indicates the
classification of all circu

lating media in the
United States. It shows
that the total amount of

circulating media is about
eight and one half bil
lions, of which about seven billions are bank deposits sub
ject to check, and one and one half billions, money; and
that of this one and one half billions of money one billion is
FIG. 9.

* Some economists have proposed that what is here called “fiduciary”
money should not be called money at all; that is, that the term “money”
should be restricted to primary money. It seems preferable, however, here
as elsewhere, to follow ordinary usage. There are instances where countries

have for a time had no primary money, but only fiduciary money.

SEc. 3]

PURCHASING POWER OF

MONEY

I5I

fiduciary money and only about half a billion primary
money.

In the present chapter we shall exclude the consideration
of bank deposit or check circulation and confine our atten
tion to the circulation of money, primary and fiduciary. In
the United States, the only primary money is gold coin.
The fiduciary money includes token coins and paper money.
Checks aside, we may classify exchanges into three groups:
the exchange of goods against goods, or barter; the exchange
of money against money, or “changing ” money; and the
exchange of money against goods, or purchase and sale.
Only the last-named species of exchange involves what we

call the circulation of money.) The circulation of money
signifies, therefore, the aggregate amount of its transfers
against goods. All money held for circulation, i.e., for
use in payment for goods purchased is called money in
circulation.

This includes the money in the pockets and

purses of the people or the tills and safes of merchants. In
the United States this includes all money except what is in
the vaults of the banks and of the United States government.
§ 3. The Equation of Exchange Arithmetically Expressed

Having learned something of the nature of money, we
are ready to study the causes which determine the pur
chasing power of money; in other words, the causes which
determine the general level of prices.
If we overlook for the present the influence of checks, we
may say that the price Jevel depends on only three sets of
causes: (1) the quantity of money in circulation; (2) its
“efficiency’’ or velocity of circulation (or the average num
ber of times a year a dollar is exchanged for goods); and (3)
the volume of trade (or amount of goods per year bought by,
money). The so-called “quantity theory” (i.e., the theory
that prices vary proportionally to money) has often been
incorrectly formulated, but it is correct in the sense that

I52

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VIII

the level of prices varies directly with the quantity of

* money in circulation, provided the velocity of circulation of

that money and the volume of trade effected by means of it
are not changed. This theory will be made clearer by the
equation of exchange, which is now to be explained.
The equation of exchange is a statement, in mathematical
form, of the total transactions effected in a certain period
in a given community. It is obtained simply by adding
together the equations of exchange for all individual trans
actions. Suppose, for instance, that a person buys Io
pounds of sugar at 7 cents per pound. This is an exchange
transaction, in which Io pounds of sugar have been regarded

as equivalent to 70 cents, and this fact may be expressed
thus: 70 cents = Io pounds of sugar multiplied by 7 cents
a pound. Every other sale and purchase may be expressed
similarly, and by adding them all together we get the equa
tion of exchange for a certain period in a given community,
that is, the left side represents all the money spent and
the right represents the value of all goods bought within
the given period. During this period, however, the same
money may serve, and usually does serve, for several trans

actions. For that reason the left or money side of the
equation is, of course, greater than the total amount of
money in circulation.
The equation has a goods side and a money side. The
money side is the total money exchanged, and may be con
sidered as the product of the quantity of money multiplied
by the rapidity of its circulation, i.e., the number of times it
is exchanged for goods. This important magnitude, called

the velocity of circulation or rapidity of turnover, means
simply the quotient obtained by dividing the total money
payments for goods in the course of a year by the average
amount in circulation by which these payments are effected.
This velocity of circulation in an entire community is a sort
of average of the rates of turnover of different persons.
Each person has his own rate of turnover which he can

SEc. 3]

PURCHASING

POWER OF MONEY

I53

readily calculate by dividing the amount of money he ex
pends per year by the average amount he carries. The
goods side of the equation is made up of the quantities of
goods multiplied by their respective prices.
Let us begin with the money side. If the number of
dollars in a country is 5,000,ooo, and the velocity of circu
lation of these dollars is twenty times per year, then the
total amount of money expended (for goods) during any
year is $5,000,ooo times twenty, or $100,000,ooo. This is
the money side of the equation of exchange.
Since the money side of the equation is $100,000,ooo, the
goods side must be the same. For if $100,000,000 has been
spent for goods in the course of the year, then $100,000,ooo
worth of goods must have been sold in that year. In order
to avoid the necessity of writing out the quantities and
prices of the innumerable varieties of goods which are actu
ally exchanged, let us assume for the present that there are
only three kinds of goods – bread, coal, and cloth; and
that the sales are : —

200,000,ooo loaves of bread at $ .Io a loaf,
Io,000,000 tons of coal
at 5.oo a ton, and
30,000,000 yards of cloth at I.oo a yard.
The value of these transactions is evidently $100,000,000, −
i.e., $20,000,ooo worth of bread plus $50,000,ooo worth of
coal plus $30,000,ooo worth of cloth. The equation of ex
change, therefore, is as follows:–
-

$5,000,ooox20= 200,ooo,ooo loaves X $ .Io a loaf
+ Io,000,ooo tons

X 5.oo a ton

+30,000,000 yards X I.oo a yard.

This equation contains on the money side two magnitudes,
viz., (1) the quantity of money, and (2) the number of
times it circulates or is “turned over" in a year; and
on the goods side two groups of magnitudes in two columns,

154

ELEMENTARY PRINCIPLES OF ECONOMICs

(CHAP. VIII

viz., (1) the quantities of goods exchanged in a year
(loaves, tons, yards), and (2) the prices of these goods ($.1o
per loaf, $5.oo per ton, and $1.00 per yard). The equation
shows that these four sets of magnitudes are mutually re
lated. Because this equation must be fulfilled, the prices
must bear a relation to the three other sets of magnitudes —
quantity of money, rapidity of circulation, and quantities
of goods exchanged. Consequently, these prices must, as a
whole, vary proportionally with the quantity of money and
with its velocity of circulation, and inversely with the quan
tities of goods exchanged.
Suppose, for instance, that the quantity of money were
doubled, while its velocity of circulation and the quantity of
goods exchanged remained the same. Then, since the equa
tion of exchange must continue to hold true, it would be

quite impossible for prices to remain unchanged. The
money side would now be $10,000,000 × 20 times a year, or
$200,000,ooo; whereas, if prices should not change, the
goods would remain $100,000,ooo and the equation would
be violated. Since exchanges, individually and collectively,

always involve an equivalent quid pro quo, the two sides
must be equal. Not only must purchases and sales be equal
in amount — since every article bought by one person is
necessarily sold by another — but the total value of goods
sold must equal the total amount of money exchanged.
Therefore, under the given conditions, prices must change
in such a way as to raise the goods side from $100,000,000
to $200,000,000. This doubling may be accomplished by
an even or an uneven rise of prices, but some sort of a rise
of prices there must be. If the prices rise evenly, they will
evidently all be exactly doubled, so that the equation
will read : —

$10,000,ooo X 20 = 200,000,ooo loaves X $
-

+ Io,000,000 tons

.20 per loaf

X Io.oo per ton

+ 30,000,ooo yards ×

2.oo per yard.

SEC. 3]

PURCHASING

I55

POWER OF MONEY

If the prices rise unevenly, the doubling must evidently be
brought about by compensation; if some prices rise by
less than double, others must rise by enough more than
double to exactly compensate.
But whether all prices increase uniformly, each being ex
actly doubled, or some prices increase more and some less
(so as still to double the total money-value of the goods pur
chased), the prices are doubled on the average. This proposi
tion is usually expressed by saying that the “general level
of prices” is raised twofold. From the mere fact, therefore,
that the money spent for goods must equal the quantities of
those goods multiplied by their prices, it follows that the level
of prices must rise or fall according to changes in the quan
tity of money, unless there are changes in its velocity of
circulation or in the quantities of goods exchanged.
If changes in the quantity of money affect prices, so will
changes in the other factors — quantities of goods and
velocity of circulation – affect prices. In the case of a
change in the velocity of circulation, the change is very simi
lar to that seen in the case of a change in the quantity of
money. Thus a doubling in the velocity of circulation of
money will double the level of prices, provided the quantity
of money in circulation and the quantities of goods ex
changed for money remain as before. The equation will

change (from its original form) to the following: —
$5,000,ooo X 40 = 200,000,ooo loaves X $ .20 a loaf
+ Io,000,000 tons

+ 30,000,000 yards X

Io.o.o a ton

2.00 a yard;

or else the equation will assume a form in which some of
the prices will more than double, and others less than double
by enough to preserve the same total value of the sales.
Again, a doubling in the quantities of goods exchanged
will cut in two the height of the price level, provided the
quantity of money and its velocity of circulation remain

I56

ELEMENTARY PRINCIPLES OF ECONOMICS

the same.

(CHAP. VIII

Under these circumstances the equation will

change (from its original form) to :
$5,000,000 × 20=400,000,ooo loaves X $ .oS a loaf
+ 20,000,000 tons

+ 60,000,000 yards X

2.5o a ton

.50 a yard;

or else it will assume a form in which some of the prices are
more than halved, and others less than halved, so as to

preserve the equation.
Finally, if there is a simultaneous change in two or all of
the three influences, i.e., quantity of money, velocity of
circulation, and quantities of goods exchanged, the price
level will be a compound or resultant of these various in
fluences. If, for example, the quantity of money is doubled,
and its velocity of circulation is halved, while the quantity

of goods exchanged remains constant, the price level will be
undisturbed. Likewise it will be undisturbed if the quan
tity of money is doubled and the quantity of goods is
doubled, while the velocity of circulation remains the same.
To double the quantity of money, therefore, does not always

double prices.

We must distinctly recognize that the

quantity of money is only one of three factors, all equally
important in determining the price level.
§ 4. The Equation of Exchange Mechanically Expressed
The equation of exchange has now been expressed by an
arithmetical illustration. It may be represented visually by
a mechanical illustration. This is embodied in Figure Io
which represents a mechanical balance in equilibrium, the
two sides of which symbolize respectively the money side
and the goods side of the equation of exchange. The
weight at the left, symbolized by a purse, represents the
money in circulation; the leverage or distance from the
fulcrum at which the purse is hung represents the efficiency
of this money, or its velocity of circulation. The product

SEc. 4)

PURCHASING POWER OF

MONEY

I57

FIG. Io.

of the weight by its leverage is exactly balanced by or
equal to corresponding products on the opposite side. On
the right side are three weights, representing bread, coal,
and cloth, and symbolized respectively by a loaf, a coal
scuttle, and a roll of cloth. The leverage, or distance of
each from the fulcrum, represents its price. In order that
the leverages at the right may not be inordinately long, we
have found it convenient to reduce the unit of measure of

coal from tons to hundredweights, and that of cloth from
yards to feet, and consequently to enlarge correspondingly
the number of units (the measure of coal changing from
Io,ooo,000 tons to 200,000,ooo hundredweights, and that

of the cloth from 30,000,000 yards to 90,000,000 feet).
In these new units the price of coal becomes 25 cents per
hundredweight and that of cloth becomes 33% cents per foot.
If the purse at the left becomes heavier, it is evident
that, in order to maintain the balance, some of the weights
at the right must be heavier also or must be moved
toward the right, or else the purse itself must be moved
toward the right. If, now, we assume that the last and

first of these three changes do not occur, the middle one
must occur. In other words, if the position of the purse
remains unaltered (i.e., if the velocity of circulation of
money does not change) and if the weights at the right
remain unaltered (i.e., if the volume of trade does not

change), then some or all of these weights must move to the
right (i.e., the prices of goods must increase). If these
prices increase uniformly, they will increase in the same ratio
as the increase in money; if they do not increase uniformly,

158

ELEMENTARY PRINCIPLES OF ECONOMICs

(CHAP. VIII

some will increase more and some less than this ratio,
maintaining an average. Likewise it is evident that if the
velocity of circulation of money increases, i.e., if the leverage
at the left lengthens, and if the money in circulation (the
purse) and the trade (the various weights at the right)
remain the same, there must be an increase in prices
(lengthening of the leverages at the right). Again, if there
is an increase in the volume of trade (represented by an
increase in weights at the right), and if the velocity of
circulation of money (left leverage) and the quantity of
money (left weight) remain the same, there must be a
decrease in prices (right leverages).
In general, any change in one of these four sets of mag
nitudes must be accompanied by such a change or changes
in one or more of the other three as shall maintain

equilibrium.
As we are interested in the average change in prices
rather than in the prices individually, we may simplify this
mechanical representation by hanging all the right-hand
weights at one average point, so that the leverage shall rep
resent the average of prices. This average, of Io cents per
loaf, 25 cents per hundredweight, and 33% cents per foot, is
found by dividing the total value (Io cents times 200 million
loaves, plus 25 cents times 200 million hundredweight,
plus 33% cents times 90 million feet, — or $100,000,000)

Cºº

A " ' ' ' ||

IIT

FIG. II.

by the total number of units (200 million plus 200 million
plus 90 million — or 490 million), which is $1oo,000,ooo +

SEc. 5]

PURCHASING POWER OF MONEY

I59

490,000,ooo, or 20.4 cents per unit. This leverage is a so
called “weighted average” of the three original leverages, the
“weights” being literally the weights hanging at the right.
This averaging of prices is represented in Figure II
which visualizes the fact that the average price of goods
(right leverage) varies directly with the quantity of money
(left weight), directly with its velocity of circulation (left
leverage), and inversely with the volume of trade (right
weight).
§ 5. The Equation of Exchange Algebraically Expressed
To put these relations in general terms, let
M stand for money in circulation,
V, its velocity of circulation,

p, p", p", etc., the prices of various goods,
Q, Q', Q", etc., the quantities of those goods sold.
Then we may write the formula as follows:–

MV = ?9.
+

p.9.

+ p"Q
+ etc.

MV evidently represents the amount of money expended
for goods during the year. On the other side of the equa

tion, p(), p Q', and so on, represent the values of the
various goods bought. If in this equation M is doubled
(and V and the Q's remain unchanged), then the p's will,
on the average, be doubled; if V is doubled (and M and
the Q's are unchanged), the p’s will be doubled also; while

if the Q's are doubled (and M and V are unchanged), the
p's will be halved.
The right side of this equation is the sum of terms of
the form p() — a price multiplied by a quantity bought.
It is customary in mathematics to abbreviate a sum of

I6o

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VIII

terms (all of which are of the same form) by using “X”
as a prefix to p(). The Greek letter sigma is the equival
ent of the English letter “S,” the initial letter of sum and

is employed as a symbol of summation. This symbol does
not signify a magnitude as do the symbols M, V, p, Q, etc.
It signifies merely the operation of addition, and should be
read “the sum of terms of the following type.” The equa
tion of exchange may therefore be written: –

MV= XpO.
We may, if we wish, further simplify the right side by
writing it in the form PT, where P is a weighted average of
all the p’s, and T is the sum of all the O's. P then repre
sents in one magnitude the level of prices, and T represents
in one magnitude the volume of trade of the community
within or without its borders. The equation thus simpli
fied (MV = PT) is the algebraic interpretation of the
mechanical illustration given in Figure II, where all the
goods, instead of being hung separately, as in Figure Io,
were combined and hung at an average point representing
their average price.
§ 6. The “Quantity Theory of Money”
To recapitulate, we find then that, under the conditions
assumed, the price level varies: (1) directly as the quantity
of money in circulation (M), (2) directly as the velocity of
its circulation (V), (3) inversely as the volume of trade done.
by it (T). The first of these three relations needs special
emphasis. It constitutes the “quantity theory of money.”
So important is this principle, and so bitterly contested
has it been, that we shall illustrate it further. By “the

quantity of money” is meant the number of dollars (or
other given monetary units) in circulation. This number
may be changed in several ways, of which the four named
below are most important. A statement of these four

SEc. 6]

PURCHASING

POWER OF MONEY

I61

will serve to picture to our mind the meaning of the con
clusions we have reached and to reveal the fundamental

peculiarity of money on which they rest.
I. As a first illustration, let us suppose the government
to double the denominations of all money; that is, let us
suppose that what has been hitherto a half dollar is hence
forth called a dollar, and that what has been hitherto a
dollar is henceforth called two dollars. Evidently the num
ber of “dollars ” in circulation will then be doubled; and

the price level, measured in terms of the new “dollars,”
will be double what it would otherwise be. Every one will
pay out the same coins as if no such law were passed. But he
will, in each case, be paying twice as many “dollars.” For
example, if $3 formerly had to be paid for a pair of shoes,
the price of this same pair of shoes will now become $6.
The proof that prices must in general be doubled rests on

the equation of exchange.

Money in circulation (M)

having doubled (its velocity of circulation (V) and the
volume of trade (T) remaining the same), the average
of the prices (P) must be doubled. The same reasoning
applies to the three illustrations which follow.
II. For a second illustration suppose the government
cuts each dollar in two, coining the halves into new “dol
lars ”; and, recalling all paper notes, replaces them with
double the original number – two new notes for each old
one of the same denomination. In short, suppose money
not only to be renamed, as in the first illustration, but also
reissued. Prices in the debased coinage will again be doubled
just as in the first illustration.

The subdivision and re

coinage is an immaterial circumstance, unless it be carried
so far as to make counting difficult, and thus to interfere
with the convenience of money. Wherever a dollar had been
paid before debasement, two dollars — i.e., two of the old
halves coined into two of the new dollars — will now be

paid instead.

In the first illustration, the increase in quantity was
M

I62

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. VIII

simply nominal, being brought about by renaming coins.
In the second illustration, besides renaming, the further
fact of recoining is introduced. In the first case, the num
ber of actual pieces of money of each kind was unchanged,
but their denominations were doubled. In the second case,
the number of pieces is also doubled by splitting each coin
and reminting it into two coins, each of the same nominal
denomination as the original whole of which it is the half,
and by similarly doubling the paper money.
III. For a third illustration, suppose that, instead of
doubling the number of dollars by splitting them in two and
recoining the halves, the government duplicates each piece
of money in existence and presents the duplicate to the pos
sessor of the original. (We must in this case suppose,
further, that there is some effectual bar to prevent the
melting or exporting of money. Otherwise the quantity of
money in circulation will not be doubled; much of the in
crease will escape.) If the quantity of money is thus
doubled, prices will also be doubled just as truly as in the
second illustration, in which there were exactly the same
number of coins as now under consideration as well as the

same denominations. The only difference between the
second and the third illustrations will be in the size and

weight of the coins. The weights of the individual coins,
instead of being reduced, will remain unchanged; but their
number will be doubled. This doubling of coins must have
the same effect as the fifty per cent debasement; that is,

it must have the effect of doubling prices.
IV. The force of the third illustration becomes even more

evident if, in accordance with the presentation of the great
economist Ricardo, we pass back by means of a seigniorage
from the third illustration to the second.

That is, after

duplicating all money, let the government subtract half of
each coin, thereby reducing the weight to that of the debased
coinage in the second illustration, and removing the only
point of distinction between the two. This “seigniorage ’’

SEc. 6]

PURCHASING POWER OF

MONEY

I63

or charge for coinage made by the sovereign will not affect
the money value of the coins, so long as their number remains
unchanged. Prices will remain at exactly the same level as
before the abstraction of seigniorage.
Thus to double the quantity of money will double prices
in whatever way the doubling may be brought about, —
unless there should occur at the same time some change
in the velocity of circulation of money or in the volume
of trade.

The student may ask whether some change in the
velocity of circulation of money or in the volume of trade
will not necessarily occur as a direct consequence of the
increased quantity of money. The answer to this
question is in the negative, but this answer will be better
understood after we have seen on what causes velocity of
circulation and volume of trade depend. In the present
chapter we are concerned merely to show that an increase
in money will necessitate a rise in prices provided the
velocity of circulation and volume of trade do remain the
Same.

There are many historical instances of raising the prices
by inflating the currency. At present, Argentina has an
inflated paper currency, and prices in paper pesos are a
little more than double the prices in the original gold pesos.
The quantity theory, then, asserts that (provided ve
locity of circulation and volume of trade are unchanged)
if we increase the number of dollars, whether by renaming
coins, by cutting them in two, by duplicating them, or by
any other means, prices will be increased in the same pro
portion. It is the number, and not the weight, that is
essential. This fact needs great emphasis. It is a fact
which differentiates money from all other goods and ex
plains the peculiar manner in which its purchasing power
is related to other goods. The desirability of sugar depends
upon its sweetening power, which is a specific quality in
the sense that a given weight of sugar, such as a pound,

164

ELEMENTARY PRINCIPLES OF EconoMICs

(CHAP. VIII

always possesses the same sweetening power. The desir
ability of money, on the other hand, depends merely on its
purchasing power; but purchasing power is not a specific
quality of gold or of other money, for we cannot say that a
given quantity of gold, such as an ounce, always possesses
the same purchasing power. If the quantity of sugar is
changed from 1,000,000 pounds to 1,000,ooo hundredweight,
it does not follow that a hundredweight will have the value

previously possessed by a pound, for the sweetening power
of a hundredweight cannot be the same as that of a pound.
But if the money in circulation is changed from 1,000,ooo
units of one weight to 1,000,ooo units of a lighter weight,
the value of the new and lighter coins will be just as great
as was the value of the old and heavy ones, for we have
seen from the equation of exchange that their purchasing
power will be unchanged,
The quantity theory of money thus rests, ultimately,
upon the fundamental peculiarity which money alone of all
goods possesses — the fact that it has no definite relation
to the satisfaction of human wants, but only the power to
purchase things which do have such satisfying power.

CHAPTER DYK
INFLUENCE OF DEPOSIT CURRENCY

§ 1. The Mystery of Circulating Credit
WE are now ready to explain the nature of bank-deposit
currency, or circulating credit. Credit, in the sense here
employed, is the promise of one party (called the debtor)
to pay money to another party (called the creditor).
Bank deposits subject to check are the claims against the
bank of a special class of creditors known as depositors,
by virtue of which they may, on demand, draw by check
specified sums of money from the bank. Since no other
kind of bank deposits will be considered by us, we shall
usually refer to “bank deposits subject to check ’’ simply
as “bank deposits.” They are also called “circulating
credit.”

It is to be observed that bank checks are merely
presumptive evidences of rights to draw money on the
basis of bank deposits or to transfer such rights. The
checks themselves are not the ultimate currency. It is
the bank deposits themselves, or credit balances on the
books of the banks, that constitute the ultimate currency.

As has been noted, these deposits subject to check are not
money, since they are not generally acceptable; they always
require the special consent of the payee. But they are cur
rency, because their chief purpose and use is to act as a
medium of exchange. Closely analogous to checks are post
165

I66

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. IX

office orders and money orders issued by express companies.
They are distinguishable only by two facts: that they are
not issued by ordinary banks, and that they originate in
special deposits of money (or checks). For this reason, and
because they are not of great importance, we prefer to
place them in the same category with bank checks rather
than to place them in a separate class, which otherwise
they might occupy.
It is in connection with the transfer of bank deposits
that there arises that so-called “mystery of banking ”
called circulating credit. Many persons, including some
economists, have supposed that credit is a special form of
wealth which may be created out of whole cloth, as it were,
by a bank. Others have maintained that credit has no
foundation in actual wealth at all, but is a kind of unreal

and inflated bubble with a precarious if not wholly illegiti
mate existence. As a matter of fact, bank deposits are as
easy to understand as bank notes, and what is said in this
chapter of bank deposits may in substance be taken as true
also of bank notes.

The chief difference is a formal one,

the notes circulating freely from hand to hand, while the
deposit currency circulates only by means of specially in
dorsed orders called “checks.”

To understand the real nature of bank deposits, let us
imagine a hypothetical institution — a kind of primitive
bank existing mainly for the sake of deposits and the safe
keeping of actual money. The original bank of Amster
dam was somewhat like the bank we are now imagining.
In such a bank a number of people deposit $100,000 in gold,
each accepting a receipt for the amount of his deposit. If
this bank should issue a “capital account” or statement,
it would show $100,000 in its vaults and $100,ooo owed to
depositors, as follows:–
AssETs

Gold .

. . . . . $100,ooo

LIABILITIES

Due depositors

. . $100,000

Sec. 1]

INFLUENCE OF

DEPOSIT CURRENCY

167

The right-hand side of the statement is, of course, made
up of smaller amounts owed to individual depositors.
Assuming that there is owed to A $10,000, to B $10,000,
and to all others $80,000, we may write the bank statement
as follows:–
ASSETs

Gold . . . .

LIABILITIES

. $100,000

$100,000

Due depositor A . . $ 10,000
Due depositor B . .
IO,OOO
Due other depositors.
80,000
$1oo,ooo

Now assume that A wishes to pay B $1ooo. A could go
to the bank with B, present certificates or checks for $10oo,
obtain the gold, and hand it over to B, who might then
redeposit it in the same bank, merely handing it back
through the cashier's window and taking a new certificate
in his own name. Instead, however, of both A and B
visiting the bank and handling the money, A might simply
give B a check for $10oo. B would then send the check
to the bank and the bank would simply reduce A's credit
on its books by $10oo and increase B's by the same
amount.

The transfer in either case would mean that

A's holding in the bank was reduced from $10,000 to $9000,
and that B's was increased from $10,000 to $11,000. The
statement would then read: —
ASSETS

LIABILITIES

Gold . . . . . . $100,ooo

Due depositor A . . $ 9,000
Due depositor B . .
Due other depositors.

$100,ooo

II,000

8o,ooo

$100,000

Thus the certificates, or checks, would circulate in place
of money among the various depositors in the bank. What
really changes ownership, or “circulates,” in such cases is the
right to draw money. The check is merely a presumptive
evidence of this right and of the transfer of this right from

I68

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. IX

one person to another. The man who receives the check
uses it as evidence of a right to draw at the bank against
the account of the man who drew the check.

In the case under consideration, the bank would be con
ducted at a loss. It would be giving the time and labor

of its clerical force for the accommodation of its depositors,
without getting anything in return. But such a hypo
thetical bank would soon find – much as did the bank of

Amsterdam — that it could make profits by lending at
interest some of the gold on deposit. This could not offend
the depositors; for they do not expect or desire to get
back the identical gold they deposited. What they want
is simply to be able at any time to obtain the same amount
of gold. Since, then, their arrangement with the bank calls
for the payment not of any particular gold, but merely of .
a definite amount, and that but occasionally, the bank
finds itself free to lend out part of the gold that otherwise
would lie idle in its vaults. To keep it idle would be a
great and needless waste of opportunity.
Let us suppose, then, that the bank decides to loan out
half the money which it has in its vaults. In this country
this is usually done in exchange for promissory notes of
the borrowers. Now a loan is really an exchange of money
(or credit—which is immediately convertible into money)
for a promissory note which the lender — in this case the
bank — receives in place of the gold. Let us suppose that
so-called borrowers actually draw out $50,000 of gold.
The bank thereby exchanges this money for promises, and
its books will then read: —
ASSETS

Gold . . . . .
Promissory notes .

LIABILITIES

. $ 50,000
.
50,000
$1oo,ooo

Due depositor A . . $ 9,000
Due depositor B . .
II, Ooo
Due other depositors .
8o,ooo
$1oo,ooo

It will be noted that now the gold in bank is only $50,000,

Sec. 1]

INFLUENCE OF DEPOSIT CURRENCY

I69

while the total deposits are still $100,ooo. In other words,
the depositors now have more “money on deposit” than
the bank has in its vaults | But, as will be shown, this
form of expression involves a popular fallacy, in the word
“money.” Something of equivalent value is behind each
loan, but not necessarily money.
Next, suppose the borrowers become, in a sense, lenders

also, by redepositing the $50,000 of money which they bor
rowed, in return for the right to draw out the same sum on
demand, preferring to use the same in making payments
by check rather than by money. In other words, suppose
that after borrowing $50,000 from the bank, they lend it
back to the bank.

The bank's assets will thus be en

larged by $50,000, and its obligations (or credit extended)
will be equally enlarged; and the balance sheet will
become: —
ASSETS

Gold . . . . .
Promissory notes .

LIABILITIES

. $1oo,ooo
.
50,000

$150,000

Due depositor A . . $ 9,ooo
Due depositor B . .
II,000
Due other depositors .
80,000
Due new depositors,
i.e., the borrowers .
50,000
$150,000

What happened in this case was the following: Gold
was borrowed in exchange for a promissory note and then
handed back in exchange for a right to draw. Thus the
gold really did not budge; but the bank received a promis
sory note and the depositor, a right to draw. Evidently,
therefore, the same result would have followed if each bor

rower had merely handed in his promissory note and re
ceived, in exchange, a right to draw. As this operation
most frequently puzzles the beginner in the study of bank
ing, we repeat the tables representing the conditions before
and after these “loans,” i.e., these exchanges of promissory
notes for present rights to draw.

I7o

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. IX

BEFORE THE LOANS
ASSETS

Gold . .

. . .

LIABILITIES

. $100,000

Due depositors.

. $100,ooo

. $150,000

AFTER THE LOANS

Gold . . . . . . $100,ooo
Promissory notes . .
50,000

Due depositors.

Clearly, therefore, the intermediation of the money in
this case is a needless complication, though it may help to
a theoretical understanding of the resultant shifting of
rights and liabilities. Thus the bank may receive deposits of
gold or deposits of promises to pay. In exchange for these
promises it may give, or lend, either a right to draw, or
gold — the same that was deposited by another customer.
Even when the borrower has “deposited ” only a promise
to pay money, by fiction he is still held to have deposited
money; and, like the original depositor of actual money,
he is given the right to make out checks to draw out money.
The total value of rights to draw, in whichever way arising,

is termed “deposits.” Banks more often lend rights to draw
(or deposit-rights) than actual money, partly because of the
greater convenience to borrowers, and partly because the

banks wish to keep their actual money on hand, or “cash
reserves' large, in order to meet large and unexpected
demands. It is true that if a bank loans money, part of
the money so loaned will be redeposited by the persons
to whom the borrowers pay it in the course of business;
but it will not necessarily be redeposited in the same bank.
Hence the average banker prefers that the borrower should
not withdraw actual money.
Besides lending deposit rights, banks may also lend their
own notes, called “bank notes.” And the principle govern
ing bank notes is the same as the principle governing
deposit rights. The holder simply gets a pocketful of bank
notes instead of a credit on his bank account.

The bank

Sec. 21 °

INFLUENCE OF DEPOSIT CURRENCY

I71

must always be ready to pay, on demand, either the note
holders — i.e., to “redeem its notes " — or the depositors,
and in either case the bank exchanges a promise for a
promise. In the case of the note, the bank has exchanged
its bank note for a customer's promissory note. The bank
note carries no interest, but is payable on demand. The
customer's note bears interest, but is payable only at a
definite date.

Assuming that the bank issues $50,000 of bank notes, the
balance sheet will now become: —
ASSETS

Gold

. . . . $100,000
Loans
(promissory
notes) . . . . .
Ioo,ooo
$200,ooo

LIABILITIES

Due depositors

. $150,000

Due bank note holders

50,000
$200,ooo

§ 2. The Basis of Circulating Credit

We repeat that by means of credit the deposits and notes
of a bank may exceed its cash. There would be nothing
mysterious or obscure about this fact, if people could be
induced not to think of banking operations as money
operations. To so represent them is metaphorical and
misleading. They are no more money operations than
they are real estate transactions. A bank depositor, A,
has not ordinarily “deposited money ’’; and whether he
has or not, he certainly cannot properly say that he “has
money in the bank.” What he does have is the bank’s
promise to pay money on demand. The bank owes him
money. When a private person owes money, the creditor
never thinks of saying that he has it on deposit in the
debtor's pocket.
The same principles of property which apply to bank
deposits also apply to bank notes. There is wealth some
where behind the mutual promises, though in different

degrees of accessibility. The note holder's promise (his

I72

ELEMENTARY PRINCIPLES OF ECONOMICS

Mºhap. IX

promissory note) is secured by his assets; and the bank’s
promise (the bank note) is secured by the bank's assets.
The note holder has “swapped ” less-known credit for
better-known credit.

If this fact is borne in mind, the reader will be able to

conquer the doubt which may already have arisen in his
mind – the doubt as to the legitimacy of the bank’s pro
cedure in “lending some of its depositors' money.” It
cannot be too strongly emphasized that, in any balance
sheet, the value of the liabilities rests on that of the assets.

The deposits of a bank are no exception. We must not be
misled by the fact that the cash assets may be less than
the deposits. When the uninitiated first learn that the
number of dollars which note holders and depositors have
the right to draw out of a bank exceeds the number of

dollars in the bank, they are apt to jump to the conclusion
that there is nothing behind the notes or deposit liabilities.
Yet behind all these obligations there is always, in the case
of a solvent bank, full value; if not actual dollars, at any
rate, dollars' worth of property. By no jugglery can the
liabilities exceed the assets except in insolvency, and even
in that case only nominally, for it still holds that the true

value of the liabilities will be only what can be paid on
them — perhaps only 25 cents on the dollar. This true
value of the liabilities will rest upon and be equal to the
true value of the assets behind them by means of which

they will be paid, so far as may be.

Debts which cannot

or will not be paid in full are often called “bad debts";
and the value of “bad debts" is not their face value, but
their actual value to the creditor.

These assets, as already indicated, are, and ought to be,
largely the notes of merchants, although, so far as the prin
ciples here discussed are concerned, they might be any
property whatever. If they consisted in the ownership
of real estate or other wealth unencumbered so that the

tangible wealth which property always represents were

…”

.*
…”

SEC.

INFLUENCE OF

DEPOSIT CURRENCY

I73

clearly evident, all mystery would disappear. But the
effect would not be different. Instead of taking grain,
machines, or steel ingots on deposit, in exchange for the
sums lent, banks prefer to take interest-bearing notes of
corporations and individuals who own, directly or indirectly,

grain, machines, and steel ingots; and by the banking laws
the banks are even compelled to take the notes instead of
the ingots. The bank finds itself with liabilities which
exceed its cash assets; but this excess of liabilities is balanced

by the possession of other assets than cash.

These other

assets of the bank are the liabilities of business men.

These liabilities are in turn supported by the assets of the
business men. If we continue to follow up the chain of
liabilities and assets, we shall find the ultimate basis of

the bank’s liabilities in the concrete tangible wealth of the
world.

This ultimate basis of the entire credit structure is kept
out of sight, but the basis exists. Indeed, we may say that
banking, in a sense, causes this concrete, tangible wealth to
circulate.

If the acres of a landowner or the iron stoves of

a stove dealer cannot circulate in literally the same way
that gold dollars circulate, yet the landowner or stove
dealer may give to the bank a note on which the banker

may base bank notes or deposits; and these bank notes and
deposits will circulate like gold dollars. Through banking,
he who possesses wealth difficult to exchange can create a
circulating medium based upon that wealth. He has only to
give his note, for which, of course, his property is liable, get
in return the right to draw, and lo! his comparatively
unexchangeable wealth becomes liquid currency. To put it
crudely, deposit banking is a device for coining into dol
lars land, stoves, and other wealth not otherwise generally
exchangeable.
,
We began by regarding a bank as substantially a coöpera
tive enterprise, operated for the convenience and at the ex
pense of its depositors. But, as soon as the bank reaches

I74

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. IX

the point of lending money to X, Y, and Z on time, while
itself owing money on demand, it assumes toward X, Y,
and Z risks which the depositors would be unwilling to
assume. To meet this situation, the responsibility and
expense of running the bank are taken by a third class of
people – stockholders – who are willing to assume the
risk for the sake of the chance of profit. Stockholders, in
order to guarantee the depositors against loss, put in some
cash of their own. The object is to make good any loss
to depositors, while reserving the right to keep the profits
earned by loaning at interest. Let us suppose that the
stockholders put in $50,000, viz., $40,000 in gold and $10,000
in the purchase of a bank building. The accounts now
stand:—
ASSETS

LIABILITIES
.*

Gold . . . . . . $140,000 – Due depositors
Loans . . . .
Building . . .

.
.

Ioo,ooo.
Io,ooo

. . $150,000

Due note holders . .
Due stockholders .

$250,000

5O,OOO
o,ooo

$250,000

The accounts as they now stand include the chief features
of an ordinary modern bank — a so-called “bank of deposit,
issue, and discount.”
§ 3. Banking Limitations
We have seen that there are assets to meet the liabilities
We now should note that the form of the assets must be

such as will insure meeting the liabilities promptly. Since
the business of a bank is to furnish easily exchangeable
property (cash or credit) in place of the “slower " prop
erty of its depositors, it fails of its purpose when it is
caught with insufficient cash, by which is meant money.
Yet it makes profits partly by tying up its quick property,

! i.e., lending it out in quarters where it is less accessible.
Its problem in policy is to tie up enough to increase its

SEC. 3]

INFLUENCE OF

DEPOSIT CURRENCY

I75

earnings, but not to tie up so much as to get tied up itself.
So far as anything has yet been said to the contrary, a
bank might increase indefinitely its loans in relation to its
cash or in relation to its capital. If this were so, deposit
currency could be indefinitely inflated.
There are, however, limits to such expansion of loans
imposed by prudence and sound economic policy. Insol
vency and insufficiency of cash must both be avoided. As
has been noted in Chapter III, § 5, insolvency is that condi
tion which threatens when liabilities are extended with in

sufficient capital. Insufficiency of cash is that condition
which threatens when liabilities are extended unduly rela
tively to cash. Insolvency is reached when the assets
no longer cover the liabilities (to others than stockholders),
so that the bank is unable to pay its debts. Insufficiency
of cash is reached when, although the bank's total assets
may be fully equal to its liabilities, the actual cash on
hand is insufficient to meet the needs of the instant, and

the bank is unable to pay its debts on demand.
The risk of insolvency is the greater the less the ratio
of the stockholders' interests to all liabilities to others. The

risk of insufficiency of cash is the greater, the less the ratio
of the cash to the demand liabilities.

In other words, the

leading safeguard against insolvency lies in a large capital
and surplus, but the leading safeguard against insufficiency
of cash lies in a large cash reserve. Insolvency proper
may befall any business enterprise. Insufficiency of cash
relates especially to banks in their function of redeeming
notes and deposits.
Let us illustrate insufficiency of cash. In our bank's
accounts as we left them there appeared cash to the extent
of $140,000, and $200,ooo of demand liabilities (deposits and
notes). The managers of the bank may think this fund of
$140,000 unnecessarily large, or the loans unnecessarily
small. They may then increase their loans (extended to
customers partly in the form of cash and partly in the form

176

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IX

of deposit accounts) until the cash held by the bank is re
duced, say to $40,000, and the liabilities due depositors and
note holders increased to $300,000. If, under these circum
stances, some depositor or note holder demands $50,000
cash, immediate payment will be impossible. It is true that
the assets still equal the liabilities. There is full value be
hind the $50,000 demanded; but the understanding was
that depositors and note holders should be paid in money on
demand. Were this not a stipulation of the deposit con
tract, the bank might pay the claims thus made upon it by
transferring to its creditors the promissory notes due it from
its debtors; or it might ask the customers to wait until it
could turn these securities into cash.

Since a bank cannot follow either of these plans, it tries,
where insufficiency of cash impends, to forestall this condi
tion by “calling in ’’ some of its loans, or if none can be
called in, by selling some of its securities or other property
for cash. But it happens unfortunately that there is a limit
to the amount of cash which a bank can suddenly realize.
No bank could escape failure if a large percentage of its note
holders and depositors should simultaneously demand cash
payment. The paradox of a run on a bank is well expressed
by the case of the man who inquired of his bank whether it
had cash available for paying the amount of his deposit,
saying, “If you can pay me, I don’t want it; but if you
can't, I do.” Such was the situation in 1907 in Wall Street.
All the depositors at one time wanted to be sure their money
“was there.”

Yet it never is there all at one time.

Since, then, insufficiency of cash is so troublesome a con
dition – so difficult to escape when it has arrived, and so
difficult to forestall when it begins to approach — a bank
must so regulate its loans and note issues as to keep on hand
a sufficient cash reserve, and thus prevent insufficiency of
cash from even threatening. It can regulate the reserve in
various ways. For instance, it can increase its reserve rela
tively to its liabilities by “discounting ” less freely — by

SEC. 3]

INFLUENCE OF

DEPOSIT CURRENCY

177

raising the rate of discount and thus discouraging would-be
borrowers, by outright refusal to lend or even to renew old
loans, or by “calling in ’’ loans subject to call. Reversely,
it can decrease its reserve relatively to its liabilities by dis
counting more freely — by lowering the rate of discount
and thus attracting borrowers. The more the loans in pro
portion to the cash on hand, the greater the profits, but the
greater the danger also. In the long run a bank maintains
its necessary reserve by means of adjusting the interest rate
charged for loans. If it has few loans, and a reserve large
enough to support loans of much greater volume, it will
endeavor to extend its loans by lowering the rate of interest.
If its loans are large, and it fears too great demands on the
reserve, it will restrict the loans by a high interest charge.
Thus by alternately raising and lowering the rate of interest,
a bank keeps its loans within the sum which the reserve can
support, but endeavors to keep them (for the sake of profit)
as high as the reserve will support.
If the sums owed to individual depositors are large, rela
tively to the total liabilities, the reserve should be propor
tionately large, since the action of a small number of deposi
tors can deplete it rapidly. The reserve in a large city of
great banking activity needs to be greater in proportion to
its demand liabilities than in a small town with infrequent
banking transactions. No absolute numerical rule can be
given. Arbitrary rules are often imposed by law. Banks
in the United States, for instance, are required to keep a
ratio of reserve to deposits, varying from twelve and a half
per cent to twenty-five per cent, according as they are state
or national banks, and according to their location. For
the whole country the reserves in banks are about one
fifth of the deposits. These reserves are all in defense of

deposits. In defense of bank notes, which are issued only
by national banks, the method of protection is different.
True, the same economic principles apply to both bank notes
and deposits, but the law treats them differently. The gov
n

178

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. IX

ernment itself chooses to undertake to redeem the national

bank notes on demand, imposing on the banks certain obli

gations to deposit with itself a redemption fund and govern
ment bonds.

As previously stated the cash reserves of banks, though
money, are not, properly speaking, money in circulation.
The reason is that they are not held for the purchase of
goods, but for the redemption of another kind of currency
— deposits. Thus the money in any society is divided
into two chief parts; money in circulation and money in
banks. In the United States these two are approximately
equal, both being about one and a half billion dollars."
§4. The Total Currency and its Circulation
The study of banking operations, then, discloses two
species of bank currency: one, bank notes, belonging to the
category of money; and the other, deposits, belonging out
side of that category but constituting an excellent substi
tute. Referring these to the larger category of goods, we
have a threefold classification of goods: first, money; second,

deposit currency, or simply deposits; and third, all other
goods. Among these, then, there are six possible types of
exchange:–
(1) Money against money,
(2) Deposits against deposits,
(3) Goods against goods,
(4) Money against deposits,
(5) Money against goods,
(6) Deposits against goods.
For our purpose, only the last two types of exchange are
important, for these constitute the circulation of currency.
1 In the United States there is a third though smaller stock of money,
the hoard in the United States Treasury, amounting at present to about
a third of a billion of dollars. In other countries the government money

is usually almost all deposited in banks.

SEc. 4)

INFLUENCE

OF DEPOSIT CURRENCY

I79

As regards the other four, the first and third have been pre
viously explained as “money changing ” and “barter,”
respectively. The second and fourth are banking trans
actions: the second being such operations as the selling of
drafts for checks or the mutual cancellation of bank clear

ings; and the fourth being such operations as the depositing
or withdrawing of money, by depositing cash or cashing
checks.

The analysis of the balance sheets of banks has prepared
us for the inclusion of bank deposits or circulating credit in
the equation of exchange. We shall still use M to express
the quantity of actual money, and V to express the velocity
of its circulation. Similarly, we shall now use M' to express

the total deposits subject to transfer by check; and V' to
express the average velocity of their circulation. The total
value of purchases in a year is therefore no longer to be

measured by MV, but by MV + M'W'. The equation of
exchange, therefore, becomes

MV + M'V'-XpO = PT.
Let us again represent the equation of exchange by means
of a mechanical picture. In Figure 12, trade, as before, is
represented on the right by the weight of a miscellaneous
CI-T-I-T-TTT

FIG. 12.

assortment of goods; and their average price by the distance
to the right from the fulcrum, or the leverage at which

this weight hangs. Again at the left, money (M) is repre
sented by a weight in the form of a purse, and its velocity of
circulation (V) by its leverage; but now we have a new

weight at the left, in the form of a bank book, to represent

I8o

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. IX

the bank deposits (M'.). The velocity of circulation (V')
of these bank deposits is represented by its distance from
the fulcrum or the leverage at which the book hangs.
This mechanism makes clear the fact that the average
price (right leverage) increases with the increase of money or
bank deposits and with the velocities of their circulation,
and decreases with the increase in the volume of trade.

Recurring to the left side of the equation of exchange,
or MV + M'V', we see that in a community without bank
deposits the left side of the equation reduces simply to
MV, the formula of Chapter VIII; for in such a community
the term M'W' vanishes.

The introduction of M' tends to

raise prices; that is, the hanging of the bank book on the
left requires a lengthening of the leverage at the right.
§ 5. Deposit Currency Normally Proportional to Money
With the extension of the equation of monetary circula
tion to include deposit circulation, the influence exerted by
the quantity of money on general prices becomes less direct;
and the process of tracing this influence becomes more diffi
cult and complicated. It has even been argued that this
interposition of circulating credit breaks whatever connec
tion there may be between prices and the quantity of money.
This would be true if circulating credit were independent of
money. But the fact is that the quantity of circulating

credit, M', tends to hold a definite relation to M, the quan
tity of money in circulation; that is, deposits are normally
a more or less definite multiple of money.
Two facts normally give deposits a more or less definite
ratio to money. The first has been already explained, viz.,
that bank reserves are kept in a more or less definite ratio
to bank deposits. The second is that individuals, firms,
and corporations preserve more or less definite ratios between
their cash transactions and their check transactions, and also

between their money and deposit balances. These ratios

SEc. 5]

INFLUENCE OF DEPOSIT CURRENCY

I81

are determined by motives of individual convenience and
habit. In general, business firms use money for wage pay
ments, and for small miscellaneous transactions included

under the term “petty cash ’’; while for settlements with
each other they usually prefer checks. These preferences
are so strong that we could not imagine them overridden
except temporarily, and to a small degree. A business firm
would hardly pay car fares with checks and liquidate its
large liabilities with cash. Each person strikes an equilib
rium between his use of the two methods of payment, and
does not greatly disturb it except for short periods of time.
He keeps his stock of money or his bank balance in constant
adjustment to the payments he makes in money or by check.
Whenever his stock of money becomes relatively small and
his bank balance relatively large, he cashes a check. In
the opposite event, he deposits cash. In this way he is
constantly converting one of the two media of exchange into
the other. A private individual usually feeds his purse from
his bank account; a retail commercial firm usually feeds its
bank account from its till. The bank acts as intermediary
for both.

Another reason why money and checks each have sepa
rate spheres, tending at any given time to maintain a fairly
definite relation to each other, is that they are used in

definitely different ways by different classes. Thus wage
earners for the most part use only money, while the pro
fessional and propertied classes and the fictitious persons

(corporations, partnerships, etc.) use mostly checks.

present probably over half of the families in the United
States use no checks.

For any one individual the adjustment of cash-in
pocket to deposits-in-bank will be extremely rough; for
sometimes the one or the other will be much too large or
too small. But, for the community as a whole, the ad
justment of the cash to deposits used will be very deli

cate; for the temporary aberrations of many thousands

I82

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. IX

of individuals will ordinarily almost completely neutralize
each other.

In a given community the quantitative relation of deposit
currency to money is determined by several considerations
of convenience. In the first place, the more highly devel
oped the business of a community, the more prevalent the
use of checks. Where business is conducted on a large scale,
merchants habitually transact their larger operations with
each other by means of checks, and their smaller ones by
means of cash. Again, the more concentrated the popula
tion, the more prevalent the use of checks. In cities it is
more convenient both for the payer and the payee to make
large payments by check; whereas, in the country, trips to
a bank are too expensive in time and effort to be conven
ient, and therefore more money is used in proportion to the
amount of business done. Again, the wealthier the members
of the community, the more largely will they use checks.
Laborers seldom use them; but capitalists, professional and
salaried men, use them habitually, for personal as well as
business transactions.

There is, then, a relation of convenience and custom be
tween check and cash circulation, and a more or less stable
ratio between the deposit balance of the average man or
corporation and the stock of money kept in pocket or till.
This fact, as applied to the country as a whole, means
that by convenience a fairly definite ratio is fixed be
tween M and M'. If that ratio is disturbed temporarily,
there will come into play a tendency to restore it. Indi
viduals will deposit surplus cash, or they will cash surplus
deposits.
Hence, both money in circulation (as shown above) and
money in reserve (as shown previously) tend to keep in a
fixed ratio to deposits. It follows that the two must be in a
more or less definite, though elastic, ratio to each other.

Sec. 6]

INFLUENCE

DEPOSIT

CURRENCY

183

§ 6. Summary
The contents of this chapter may be formulated in a few
simple propositions: —
(1) Banks supply two kinds of currency, viz., bank notes
— which are money; and bank deposits (or rights to draw)
— which are not money.

(2) A bank check is merely presumptive evidence of a
right to draw.
(3) Behind the claims of depositors and note holders
stand, not simply the cash reserve, but all the assets of the
bank.

(4) Deposit banking is a device by which wealth, inca
pable of direct circulation, may be made the basis of the
circulation of rights to draw.
(5) The basis of such circulating rights to draw or de
posits must consist in part of actual money, and it should
consist in part also of quick assets readily exchangeable for
money.

(6) Six sorts of exchange exist among the three classes of
goods, money, deposits, and other goods. Of these six
sorts of exchange, the most important for our present pur
poses are the exchanges of money and deposits against other
goods.

(7) The equation of money circulation, extended so as to
make it include bank deposits, reads thus: MV + M'V'
=XpO = PT.
(8) Bank deposits (M') tend to keep a normal ratio to
bank reserves and to the quantity of money (M); because,
in the first place, cash reserves are necessary to support
bank deposits, and these reserves must bear some more or
less constant ratio to the amount of such deposits; and
because, in the second place, business convenience dictates
that the circulating medium or currency shall be appor
tioned between deposits and money in a certain more or
less definite, even though elastic, ratio.

CHAPTER X
CAUSES AND EFFECTS OF PURCHASING POWER DURING TRANSI
TION PERIODS

§ 1. Transition Periods

IN the preceding chapter it was shown that the quantity
of bank deposits normally maintains a more or less definite
ratio to the quantity of money in circulation and to the
amount of bank reserves. As long as this normal relation
holds, the existence of bank deposits merely magnifies the
effect on the level of prices produced by the quantity of
money in circulation and does not in the least distort that
effect. Moreover, changes in velocity or trade will have the
same kind of effect on prices, whether bank deposits are
included or not.

But during periods of transition this relation between

money (M) and deposits (M") is by no means rigid. By
a period of transition is meant the interval of time during
which a disturbance in any of the six magnitudes in the
equation of exchange (for instance, an increase in the quantity
of money in circulation) works out its effects. It takes time
for any such disturbance to completely work out its results,
just as it takes time after a locomotive engineer has put
on more steam for the full effects to be felt by the train
which is drawn. There is always a transition period which
must elapse before any new cause completes its influence,
and, during this transition period, the effects are somewhat
184

SEc. 1]

TRANSITION PERIODS

185

different from the final result after the transition period is
over. Thus, though the final result of suddenly putting on
the increased steam will be to increase the speed of the train
from thirty miles per hour to forty miles per hour, this effect
will not be felt immediately. There will be a transition
period of several minutes before this speed is attained. Dur
ing this transition period the speed will gradually increase,
the couplings will expand and then contract, the passengers
will feel jolted, and so forth. After the transition period
is over, the train will run smoothly again.
We are now ready to study periods of transition for the
equation of exchange. Our concern is with rising or falling
prices. Rising prices mark the transition between a lower
and a higher level of prices, just as a hill marks the transi
tion between flat lowlands and flat highlands.

The study of these acclivities and declivities is bound up
with the study of business loans. Now when prices are
rising borrowers are benefited and lenders injured, while
when prices are falling the opposite is true. It must be
borne in mind that although business loans are made in the

form of money, yet whenever a man borrows money he
does not do this in order to hoard the money, but to
purchase goods with it. Suppose A borrows $1oo from B.
What has really been borrowed is purchasing power. If
at the end of a year A returns $100 to B, but prices have
meanwhile advanced, then B has lost a fraction of the pur
chasing power originally loaned to A. Even though A
should happen to return to B the identical coins in which

the loan was made, these coins represent somewhat less than
the original quantity of purchasable commodities. Bearing
this in mind, let us suppose that prices are rising. Then
every lender will lose by the rise in prices unless he can safe
guard himself against this loss by making sufficiently hard
terms with the borrower. Usually, however, when prices are
about to rise, neither the lender nor the borrower fully realizes

that prices are going to rise as much as they actually do.

I86

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. X

§ 2. How a Rise of Prices Generates a Further Rise

We are now ready to study temporary or transitional
changes in the factors of our equation of exchange. Let us
begin by assuming a slight initial disturbance, such as would
be produced, for instance, by an increase in the quantity
of gold. This, through the equation of exchange, will cause
a rise in prices. As prices rise, profits of business men
measured in money will rise also, even if the costs of business
were to rise in the same proportion. Thus, if a man who
sold goods for $10,000 which cost $6000, clearing $4000,
could get double prices at double cost, his profit would
double also, being $20,000 – $12,000, which is $8ooo. Of
course, such a rise of profits would be purely nominal, as it
would merely keep pace with the rise in price level. The
business man would gain no advantage, for his larger money
profits would buy no more than his former smaller money
profits bought before. But, as a matter of fact, the busi
ness man's profits will usually rise more than this, because
many of his expenses will tend to remain the same. In
particular his payments to creditors for past loans and his
payments to employees for work will for a time remain
unaffected or little affected by the general rise in prices.
Consequently, he will find himself making greater profits
than usual, and be encouraged to expand his business by
increasing his borrowings. These borrowings are mostly
in the form of short-time loans from banks; and, as we have

seen (Chapter IX, § 1), short-time loans engender deposits.

Therefore, deposit currency (M'.) will increase.

But this

extension of deposit currency tends further to raise the
general level of prices, just as the increase of gold raised it

in the first place. This further rise of prices enables bor
rowers who are now receiving greater profits to receive
still greater profits. Borrowing, already stimulated, is stim
ulated still further.

More loans are demanded, and, with

the resulting expansion of bank loans, deposit currency

SEC. 3]

TRANSITION PERIODS

187

(M), already expanded, expands still more. Hence prices
rise still further.

This sequence of events may be briefly stated as
follows:–

(1) Prices rise (whatever the first cause may be; we have
chosen for illustration an increase in the amount of money
in circulation).
(2) “Enterprisers,” i.e., persons who undertake business
enterprises of various kinds, get much higher prices than
before, without having much greater expenses, and therefore
make much greater profits.
y

(3) Enterpriser-borrowers, encouraged by large profits,
expand their loans.

(4) Deposit currency (M') expands relatively to money
(M).

(5) Because of this expansion of deposit currency (M'.)
prices continue to rise; that is, phenomenon No. 1 is
repeated. Then No. 2 is repeated, and so on.

In other words, a slight initial rise of prices sets in motion
a train of events which tends to repeat itself. Rise of prices
generates rise of prices, and continues to do so as long as the
enterprisers’ profits continue abnormally high.
§ 3. How a Rise of Prices Culminates in a Crisis

The expansion in deposit currency indicated in this cu

mulative movement abnormally increases the ratio of M."
to M. This, however, is not the only disturbance caused
by the increase in M. There are disturbances to some ex

tent in the Q's, in V, and in V’. In particular, trade (the
Q's) will be stimulated by the stimulation of loans. New
constructions of buildings, etc., are entered upon. These
effects are always observed during rising prices, and people
note approvingly that “business is good * and “times are
booming.” Such statements represent the point of view
of the ordinary business man who is an “enterpriser

I88

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. X

borrower.” They do not represent the sentiments of the
creditor, the salaried man, or the laborer, most of whom
are silent but long-suffering, paying higher prices, but not
getting proportionally higher incomes.
But the expansion cannot proceed forever. It must
ultimately spend itself. A check upon its continued opera

tion lies in making loans harder to get. As soon as this
occurs, the whole situation is changed. The banks are
forced in self-defense to refuse loans (or at any rate to dis
courage loans by making harder terms for them) because
they cannot stand so abnormal an expansion of loans rela
tively to reserves. Then borrowers can no longer hope
to make great profits, and loans cease to expand.
There are other forces placing a limitation on further ex
pansion of deposit currency and introducing a tendency to con
traction, but those above mentioned are the most important.

Now an enterprise, as it is started by borrowing, is ex
pected to be continued by renewed borrowing. But with,
loans hard to get, those persons who have counted on re
newing their loans on the former terms and for the former
amounts are unable to do so.

It follows that those of them

who cannot contract new debts and, without contracting
such new debts, cannot pay old ones are destined to be
come insolvent and fail. The failure (or prospect of failure)
of firms that have borrowed heavily from banks induces fear
on the part of many depositors that the banks will not be
able to realize on these loans.

Hence the banks themselves

fall under suspicion, and for this reason depositors demand
cash. Then occur “runs on the banks,” which deplete the
bank reserves at the very moment they are most needed to
pay the demands of the depositors. Being short of reserves,
the banks have to curtail their loans. Renewed borrowing
becomes difficult or impossible, and even the original loans
may be “called ” by the banks. Those enterprisers who
are caught must have currency to liquidate their obligations
or else become insolvent.

Some of them are destined to

Sec. 4)

TRANSITION

PERIODS

189

become bankrupt, and, with their failure, the demand for
loans is correspondingly reduced. This culmination of an
upward price movement is what is called a crisis, a condi
tion characterized by failures which are due to a lack of
cash when it is most needed. Bankruptcies, as shown in
Chapter III, § 5, tend to spread from debtor to creditor.
§ 4. Completion of the Credit Cycle
After the crest of the wave is reached, a reaction sets in.

Bank loans tend to be small, and consequently deposits

(M') are reduced. The contraction of deposit currency
makes prices fall still more. Those who have borrowed
for the purpose of buying stocks of goods, now find they
cannot sell them for enough even to pay back what they
have borrowed. The sequence of events is now the oppo
site of what it was before : —

(1) Prices fall.
(2) Enterprisers get much lower prices than before with
out having much lower expenses, and therefore make much
lower profits.

(3) Enterpriser-borrowers, discouraged by small profits,
contract their borrowings.

(4) Deposit currency (M') contracts relatively to money
(M).
(5) Because of this contraction of deposit currency

(M’) prices continue to fall; that is, phenomenon No. 1 is
repeated. Then No. 2 is repeated, and so on.
Thus a fall of prices generates a further fall of prices.
The cycle evidently repeats itself as long as the enterprisers'
profits remain abnormally low. The man who loses most
is the business man in debt. He is the typical business man,
and he now complains that “business is bad.” There is a
“depression of trade.”
The contraction becomes self-limiting as soon as loans are

easier to get. Banks are led to make loans easy in order to

I90

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. X

get rid of their accumulated reserves. After a time, normal
conditions begin to return. The weakest producers have
been forced out, or have at least been prevented from ex
panding their business by increased loans. The strongest
firms are left to build up a new credit structure. Borrowers
again become willing to take ventures; failures decrease in

number; bank loans cease to decrease; prices cease to fall;
borrowing and carrying on business becomes profitable; loans
are again demanded; prices again begin to rise, and there
occursa repetition of the upward movement already described.
The upward and downward movements taken together
constitute a complete credit cycle, which resembles the for
ward and backward movements of a pendulum.
Many historical examples could be cited. The discovery
of gold in California in the middle of the last century was
followed by an inflation of the world's currency, first through
the new gold and later through expansion of deposit currency
as well. Prices rose rapidly; business men made high prof
its; times were good until 1857, when a crisis occurred both
in the United States and Europe. This was followed by
a sharp fall in prices, a depression in trade, a recovery and
another period of inflation culminating in a second crisis in
1866. Again the pendulum swung back, only to return
again in the crisis of 1873. A more recent example is found
in the gold inflation beginning in 1896 in consequence of the
enormous gold production in the Transvaal, in Cripple Creek,
and in the Klondike. The money in circulation in the
United States doubled in eleven years (1896–1907), bank

deposits subject to check nearly trebled, prices rose 50 per
cent. “Prosperity” (that is, profitable business from the
point of view of the enterpriser) seemed boundless. In
1907 the wave broke in the crisis of that year, followed by
a contraction of deposits and a fall of prices in the next year
with a gradual recovery in the years immediately following.
We have considered the rise, culmination, fall, and re
covery of prices. In most cases the time occupied by the

Sec. 4)

TRANSITION PERIODS

I9I

swing of the commercial pendulum to and fro is about ten
years. While the pendulum is continually seeking a stable
position, practically there is almost always some occurrence
to prevent perfecteduilibrium. Oscillations are set up which,
though tending to be self-corrective, are continually per
petuated by fresh disturbances.
The factors in the equation of exchange are continually
seeking normal adjustment. A ship in a calm sea will
“pitch" only a few times before coming to rest. But in a
high sea the pitching never ceases. While continually
seeking equilibrium, the ship continually encounters causes
which accentuate the oscillation.

The foregoing sketch of prices gives, of course, only the
elementary features of price cycles. In any actual case
numerous special factors enter.

The factors which we have

studied are those in the equation of exchange.

CHAPTER XI
REMOTE INFLUENCES ON PRICES

§ 1. Influences which Conditions of Production and Con
sumption Exert on Trade and therefore on Prices

THUS far we have considered the level of prices as affected
by the volume of trade, by the velocity of circulation of
money and of deposits, and by the quantity of money and
of deposits. These are the only influences which can directly
affect the level of prices. Any other influences on prices
must act through these five. There are myriads of such
influences (outside of the equation of exchange) that af
fect prices through the medium of these five. It is our
purpose in this chapter to note the chief among them,
excepting those that affect the volume of money (M);
the latter will be examined in the next chapter.
We shall first consider the outside influences that affect

the volume of trade and, through it, the price level. The
conditions which determine the extent of trade in the world

or within any particular area are numerous and technical.
The most important may be classified as follows:–

1. Conditions affecting producers.
(a) Geographical differences in natural resources.
(b) The division of labor.
(c) Knowledge of the technique of production.
(d) The accumulation of capital.
2. Conditions affecting consumers.
(a) The extent and variety of human wants.
I92

Sec. 1]

INFLUENCES ON PRICES

I93

3. Conditions connecting producers and consumers.
(a) Facilities for transportation.
(b) Relative freedom of trade.
(c) Character of monetary and banking systems.
(d) Business confidence.
1. (a) Geographical differences. If all localities were
exactly alike in their natural resources, no trade would be
set up between them. Cattle raising in Texas, the produc
tion of coal in Pennsylvania, of oranges in Florida, of
apples in Oregon, etc., promote trade among these com
munities.

1. (b) Division of labor. By division of labor is meant
the system by which different individuals in society per
form different kinds of work. It is based in part on dif
ferences in comparative costs or efforts of different men
producing different goods — corresponding to geographic
differences as between countries.

Because of such differ

ences, natural and acquired, some men devote themselves
to farming, others to weaving, others to carpentry, others
to mason work, plumbing, typesetting, moving pianos, or
driving ačroplanes, and exchange their products.
I. (c) Knowledge of technique. Besides local and personal
differentiation, the state of knowledge of the means and
methods of production will stimulate trade. For instance,
mines of Africa and Australia were left unworked for cen

turies by ignorant natives, but were opened by white men
possessing a knowledge of metallurgy.
1. (d) Accumulation of capital. But knowledge, to be
of use, must be applied; and its application usually re
quires the aid of capital. The greater and the more pro
ductive the stock of capital in any community, the more
goods it can put into the currents of trade. A mill will
make a town a center of trade.

Docks, elevators, ware

houses, and railway terminals help to transform a harbor
into a port of commerce.
O

I94

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XI

Since increase in trade tends to decrease the general level
of prices, it is obvious that anything which tends to
increase trade likewise tends to decrease the general level
of prices. We conclude, therefore, that among the
various causes which tend to decrease prices are greater
geographical or personal specialization, improved produc
tive technique, and the accumulation of capital.
2. (a) Extent and variety of human wants. Wants are,
as it were, the mainsprings of economic activity which in
the last analysis keep the economic world in motion. The
desire to have clothes as fine as the clothes of others, or
finer, or different, leads to the multiplicity of silks, satins,

laces, etc.; and the same principle applies to furniture,
amusements, books, works of art, and every other means
of gratification.
The increase of wants, in so far as it leads to an increase

in trade, tends to lower the price level.
§ 2. Influences which Conditions Connecting Producers
and Consumers Exert on Trade and therefore on
Prices

3. (a) Facilities for transportation. As Macaulay said,
with the exception of the alphabet and the printing press,
no set of inventions has tended to alter civilization so much

as those which abridge distance — such as the railway, the
steamship, the telephone, the telegraph, and that conveyer
of information and advertisements, the newspaper. These
all tend, therefore, to decrease prices.

3. (b) Relative freedom of trade. Trade barriers are not
only physical, but legal. A tariff between countries has
the same influence in decreasing trade as a chain of moun
tains.

The freer the trade, the more of it there will be.

France, many communities have a local tariff (octroi) which
tends to interfere with local trade. In the United States,
trade is free within the country itself, but between the

SEc. 2)

INFLUENCES ON PRICES

I95

United States and other countries there is a high protective
tariff. The very fact of increasing facilities for transporta
tion, lowering or removing physical barriers, has stimulated
nations and communities to erect legal barriers in their
place. Tariffs not only tend to decrease the frequency of
exchanges, but to the extent that they prevent international
or interlocal division of labor and make countries more

alike as well as less productive, they also tend to decrease
the amounts of goods which can be exchanged. The ulti
mate effect is thus to raise prices. This is the effect on
the general level of prices. Besides this general effect are
the particular effects on those articles on which duties are
laid, but with these particular effects we have here nothing
to do.

Another sort of restriction on trade is the “restraint of

trade” of monopolies or combinations. These, of course,
like any other reduction in the amounts of goods sold,
tend to raise the general level of prices.
3. (c) Monetary and banking systems. The development
of efficient monetary and banking systems tends, among
other effects, to increase trade.

There have been times in

the history of the world when the money was in so uncer
tain a state that people hesitated to make many trade
contracts because of the lack of knowledge of what would
be required of them when the contract should be fulfilled.
In the same way, when people cannot depend on the good
faith or stability of banks, they will hesitate to use deposits
and checks.

3. (d) Business confidence. Confidence, not only in banks
in particular, but in business dealings in general, is truly
said to be “the soul of trade.”

In South America there

are many places waiting to be developed simply because
capitalists do not feel any security in contracts there. They
are fearful that by hook or by crook the fruit of any invest
ments they may make will be taken from them.
We see, then, that prices will tend to fall through an

196

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XI

increase in trade, which may in turn be brought about by
improved transportation, by increased freedom of trade,
by improved monetary and banking systems, and by busi
ness confidence.

§ 3. Influence of Individual Habits on Velocities of
Circulation, and therefore on Prices

Having examined those causes outside the equation
which affect the volume of trade, our next task is to consider
those outside causes which affect the velocities of circulation

of money and of deposits.

For the most part, the causes

affecting one of these velocities affect the other also.

These

causes may be classified as follows: —
I. Habits of the individual
(a) As to hoarding,
(b) As to book credit and loans,
(c) As to the use of checks.
2. Systems of payments in the community
(a) As to frequency of receipts and of disbursements,
(b) As to regularity of receipts and of disbursements,
(c) As to correspondence between receipts and dis
bursements.

3. General causes.

(a) Density of population,

(b) Rapidity of transportation.
1. (a) Hoarding. Taking these up in order, we may first
consider what influence hoarding has on the velocity of cir
culation. Velocity of circulation of money is the same
thing as its rate of turnover. It is found (Chapter VIII,
§ 3) by dividing the total payments effected by money in
a year by the average amount of money in circulation in
that year. It is an average of the rates of turnover of the
individuals which compose the society. This velocity of
circulation or rapidity of turnover of money is the greater

Sec. 3]

INFLUENCES ON PRICES

I97

for each individual, the more he expends with a given aver
age amount of cash on hand, or the less average cash he
keeps for a given yearly expenditure. One man keeps an
average of $10 in his pocket and expends $500 a year;
he, therefore, turns over the contents of his pocket fifty
times a year. Another, while expending the same sum
($500), keeps the more prudent average of $20; he, there
fore, turns over his stock of cash only twenty-five times a
year.

Some people are by habit always impecunious or short of
ready money and tend to have a high rate of turnover;
others carry a full purse and have a slow rate of turnover.
When, as used to be the custom in France, people put money

away in stockings and kept it there for months, the velocity
of circulation must have been extremely slow. The same
principle applies to deposits.
Hoarded money is sometimes said to be withdrawn
from circulation, but this is only another way of saying that
hoarding tends to decrease the velocity of circulation. The

only real distinction between “hoarding ” money in a
stocking or safe and “carrying ” money in a purse is one
of degree. The money remains in the stocking or safe
longer than in the purse. In either case it may be said
to be in circulation, but when “hoarded ” it circulates
much more slowly. In the case of individual hoards, as
of misers, it is convenient to consider them as in circula

tion. Only in the case of the larger government hoards is
it worth while to consider them as excluded from “money
in circulation.”

1. (b) Book credit and loans. The habit of “charging,”
i.e., using book credit, tends to increase the velocity of
circulation of money, because the man who gets things.
“charged” does not need to keep on hand as much money
as he would if he made all payments in cash. A man who
daily pays cash needs to keep cash for daily contingencies.
The system of cash payments, unlike the system of book

198

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XI

credit, requires that money shall be kept on hand in advance
of purchases. Evidently, if money must be provided in
advance, it must be provided in larger quantities than
when merely required to liquidate past debts. In the
system of cash payments a man must keep money idle in
advance, lest he be caught in the embarrassing position of
lacking it when he most needs it. With book credit he
knows that even if he should be caught without a cent
in his pocket, he can still get supplies on credit. These
he can pay for when money comes to hand. As soon as
this money is received there is a use awaiting it to pay
debts accumulated. For instance, a laborer receiving and
spending $7 a week, if he cannot “charge,” must make his
week's wages last through the week. If he spends $1 a
day, his weekly cycle must show on hand on successive

days at least $7, $6, $5, $4, $3, $2, and $1, at which time
another $7 comes in. This makes the average balance $4.

The rate of turnover (ratio of expenditure to cash carried)
is $7 + 4 or about twice a week. But if he can charge every
thing, and then wait until pay day to meet the resulting
obligations, he need keep nothing through the week, paying
out his $7 when it comes in. His weekly cycle need show
no higher balances than $7, $o, $o, $o, $o, $o, $o, averaging
only $1, and the turnover is $7 + 1 or seven times a week.
Analogous to book credit is the use of loans of any kind.
In a highly organized center of trade, like the New York
stock or produce exchanges, credit is extended to an extreme
degree in order to facilitate the transactions of a large
volume of business without the necessity of keeping on
hand a large cash balance of money or deposits subject
to check. Credit is extended by loans, by allowing pur
chases on small payments called “margins,” and in other
ways. All these extensions of loan credits tend to increase
the velocity of circulation of money and deposits.
Through book credit and loans, therefore, the average

amount of money or bank deposits which each person must

Sec. 4)

INFLUENCES ON PRICES

I99

keep on hand to meet a given expenditure is made less.
This means that the rate of turnover is increased; for if
people spend the same amounts as before, but keep smaller
amounts on hand, the quotient of the amount spent divided
by the amount on hand must increase,

I. (c) Use of checks. The habit of using checks rather
than money will also affect the velocity of circulation of
money, because a depositor's surplus money will immedi
ately be put in the bank in return for a right to draw by
check.

Banks thus offer an outlet for any surplus pocket money or
surplus till money, and tend to prevent the existence of idle
hoards. In like manner, surplus deposits may be converted
into cash – that is, exchanged for cash — as desired. In
short, those who make use both of cash and deposits have
the opportunity, by adjusting the two, to prevent either
from being idle.
We see, then, that these three habits — the habit of

being impecunious, the habit of charging, and the habit of
using checks — all tend to raise the level of prices through
their effects on the velocity of circulation of money, or of
deposits.
§ 4. Influence of Systems of Payments on Velocities
of Circulation and therefore on Prices

2. (a) Frequency of receipts and of disbursements. The
more frequently money or checks are received and dis
bursed, the shorter is the average interval between the
receipt and the expenditure of money or checks, and the
more rapid is the velocity of circulation.
This may best be seen from an example. A change from
monthly to weekly wage payments tends to increase the
velocity of circulation of money. If a laborer is paid
weekly $7, and reduces this evenly each day, ending each
week empty-handed, his average cash, as we have seen,

2OO

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XI

would be a little over half of $7, or about $4. This makes

his turnover nearly twice a week.

Under monthly pay

ments, the laborer who receives and spends an average
of $1 a day will have to spread the $30, more or less evenly,

over the following thirty days. If, at the next pay day,
he comes out empty-handed, his average money during
the month has been about $15. This makes his turnover
about twice a month.

Thus the rate of turnover is more

rapid under weekly than under monthly payments provided,
of course, the introduction of weekly payments does not
disturb some other factor influencing velocity. If it leads
to cash payments in place of book credit, the rate of turn
over may really decrease instead of increasing.
2. (b) Regularity of receipts and of disbursements. When
the workingman can be fairly certain of both his receipts
and expenditures, he can, by close calculation, adjust them
so precisely as safely to end each payment cycle with an
empty pocket. This habit is extremely common among
certain classes of city laborers.

On the other hand, if

the receipts and expenditures are irregular, either in
amount or in time, prudence requires the worker to keep
a larger sum on hand to insure against mishaps. Even
when foreknown with certainty, irregular receipts require
a larger average sum to be kept on hand. We may, there
fore, conclude that regularity, both of receipts and of pay
ments, tends to increase velocity of circulation.

2. (c) Correspondence between receipts and disbursements.
We next consider the synchronizing of receipts and dis

bursements, i.e., making the payments come at nearly the
same times as the times when receipts are obtained. It
is manifestly a great convenience to the spender of money,
or of deposits, if dealers to whom he is in debt will allow
him to postpone payment until he has received his money
or his check. This arrangement obviates the necessity of
keeping much money or deposits on hand, and therefore
increases their velocity of circulation. Where payments,

SEC. 5

INFLUENCES ON PRICES

2OI

such as rent, interest, insurance, and taxes, occur at
periods irrespective of the times of receipts of money, it
is often necessary to accumulate money or deposits in
advance, thus increasing the average on hand, withdrawing
money from use for a time, and decreasing the velocity
of circulation.

We conclude, then, that synchronizing and regularity of
payment, no less than frequency of payment, tend to in
crease prices by increasing velocity of circulation.
§ 5. Influence of General Causes on Velocities of Circu
lation and therefore on Prices

3. (a) Density of population. The more densely popu
lated a locality, the more rapid will be the velocity of cir
culation, because there will be readier access to people from
whom money is received or to whom it is paid. In the
country, although there are no statistics on this subject,
the velocity of circulation must be much slower than in the
city. A lady who has a city house and a country house
states that in the country she keeps money in her purse
for weeks, whereas in the city she keeps it but a few days.
Pierre des Essars has worked out the velocity of circula
tion at banks in many European cities. Examination of .
his figures reveals the fact that, in almost all cases, the
larger the town in which the bank is situated, the more

active the deposits. The bank of Greece has a turnover
whose rate of rapidity is only four times a year, while that
of the bank of France is over one hundred times a year.
3. (b) Rapidity of transportation. Again, the more ex
tensive and the speedier the transportation in general, the
more rapid the circulation of money. Anything which
makes it easier to pass money from one person to another
will tend to increase the velocity of circulation. Railways
have this effect. The telegraph has increased the velocity
of circulation of deposits, since these can now be trans

2O2

ELEMENTARY PRINCIPLES OF ECONOMICS

ferred thousands of miles in a few minutes.

[CHAP. XI
Mail and

express, by facilitating the transmission of bank deposits
and money, have likewise tended to increase their velocity
of circulation.

We conclude, then, that density of population and rapidity
of communication tend to increase prices by increasing
elocities of circulation.

§ 6. Influences on the Volume of Deposit Currency
and therefore on Prices

We have to consider lastly the specific outside influences
on the volume of deposits subject to check.
These are chiefly: —
(1) The system of banking and the habits of the people
in utilizing that system.
(2) The habit of charging.
(1) Systems and habits of banking. It goes without say
ing that a banking system must be devised and developed
before deposits can affect prices or even exist. The inven
tion of banking has undoubtedly led to a great increase in
deposits and a consequent rise of prices. This has been
true, in spite of the fact that, as pointed out in § 1, the
development of efficient monetary and banking systems
tends to increase trade and to that extent to lower the price
level. Here, as in many other instances, the effects of
improving monetary and banking facilities are complex,
affecting more than one factor in the equation of exchange.
The price-raising effect is far more important than the

price-depressing effect. In the future one of the chief
causes tending to raise prices will doubtless be the expan

sion of deposits subject to check.
(2) Habit of charging. We have already seen that
“charging ” increases the velocity of circulation of money.
It is also a means of increasing the volume of deposits sub

Sec. 6]

INFLUENCES ON PRICES

2O3

ject to check; that is, “charging ” is often a preliminary
to payment by check rather than by cash. If a customer
did not have his obligations “charged,” he would pay by
money and not by check. The ultimate effect of the prac
tice of charging, therefore, is to increase the ratio of check
payments to cash payments and the ratio of deposits to

money carried (M' to M) and therefore to increase the
amount of credit currency which a given quantity of
money can sustain.
This effect, the substitution of checks for cash payments,
is probably by far the most important effect of “charging,”
and exerts a powerful influence toward raising prices.
Anything which tends to increase bank deposits tends,
to that extent, to raise prices. Thus the creation of

“trusts” has resulted in the issue of a great mass of stocks
and bonds which are more readily accepted by bankers as
“collateral” for loans than the stocks and bonds of the

smaller and less known companies from which the “trusts”
are formed. The consequence is: more bank loans, greater
deposits, and a higher level of prices. Besides these and
the other effects of “trusts,\ which have been mentioned
elsewhere, on the general level of prices there are the more
obvious and direct effects on the particular prices of the

goods dealt in by the “trusts.” But we have here nothing
to do with particular prices. We may observe, however,
that when trusts raise particular prices it does not follow
that they raise the general level of prices. Unless they

disturb the five factors, M, M', V, V, or T, they cannot
affect the general level of prices; for, in that case, the
general level of prices, as the equation of exchange shows,
could not be disturbed either, and the raising of prices of
particular trust-made articles would have to result indi

rectly in lowering the prices of some other goods enough
to compensate in the general level.

CHAPTER XII
REMOTE INFLUENCES

(Continued)

§ 1. Influence of “The Balance of Trade ’’ on the
Quantity of Money and therefore on Prices
WE have now considered those influences outside the

equation of exchange which affect the volume of trade (the
Q's), the velocities of circulation of money and deposits (V

and V'), and the amount of deposits (M'). We have re
served for separate treatment in this chapter the outside
influences which affect the quantity of money (M).
The chief of these may be classified as follows:–

(1) Influences operating through the exportation and
importation of money.

(2) Influences operating through the melting or minting
of money.

(3) Influences operating through the production and
consumption of money metals.
(4) Influences of monetary and banking systems.
The first to be considered is the influence of foreign
trade on the quantity of money in a country and therefore
on its price level. Hitherto we have confined our studies
of price levels to an isolated community, having no trade
relations with other communities.

In the modern world,

however, no such community exists, and it is important to
observe that international trade gives present-day problems
of money and of the price level an international character.
2O4

Sec. 1]

REMOTE INFLUENCES

2O5

If all countries had their own irredeemable paper money and
no money that was acceptable elsewhere, price levels in
different countries would have no intimate connection.

Indeed, the connection is actually slight as between coun
tries which have different metallic standards, for exam

ple, between a gold-basis and a silver-basis country. But
where two or more nations trading with each other use

the same standard, there is a tendency for the price levels
of each to influence profoundly the price levels of the other.
The price level in a small country like Switzerland de
pends largely upon the price level in other countries; for if
the price level in these other countries is higher or lower
than in Switzerland, the difference will set up trade currents
which will increase or decrease the quantity of money in
Switzerland and therefore raise or lower its level of prices
to correspond to the levels outside. Gold, which is the pri
mary or full-weight money in most civilized nations, is in
this way constantly sent from one country or community to
another. When a single small country is under considera
tion, while it is quite correct to say that the quantity of
money in that country determines the price level, we must
not fail to note that the quantity of money within its borders
is in turn dependent upon the level of prices outside. An in
dividual country bears the same relation to the world that a
lagoon bears to the ocean. The level of the lagoon depends,
of course, upon the quantity of water in it. But the
quantity of water in it depends in turn upon the level of the
ocean. As the tide in the outside ocean rises and falls, the

quantity of water in the lagoon will adjust itself accordingly.
To simplify the problem of the distribution of money
among different communities, we shall, for the time being,
ignore the fact that money consists ordinarily of material
capable of nonmonetary uses. We shall therefore omit
consideration of the disappearance of money through
melting; likewise, for the present, we shall omit considera
tion of the production of money through minting.

2O6

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XII

Let us, then, consider the causes that determine the

quantity of money in a state like Connecticut. If the level
of prices in Connecticut temporarily falls below that of
the surrounding states, Rhode Island, Massachusetts,

and New York, the effect is to cause an export of money
from these states to Connecticut, because people will buy

goods wherever they are cheapest and sell them wherever
they are dearest. With its low prices, Connecticut becomes
a good place to buy from, and a poor place to sell in. But
if outsiders buy of Connecticut, they will have to bring
money to buy with. There will, therefore, be a tendency
for money to flow to Connecticut until the level of prices
there rises to a level which will arrest the influx.

If, on

the other hand, prices in Connecticut are higher than in
surrounding states, it becomes a good place to sell in and a
poor one to buy from. But if outsiders sell in Connecticut,
they will receive money in exchange. There is then a tend
ency for money to flow out of Connecticut until the level
of prices in Connecticut is lower. In general, money flows
away from places where the level of prices is high, and to
wards places where it is low.l Men'sell goods where they
can get most money, and buy goods where they will have
to give least money. We say “money,” for in the long
run we do not need to consider the interflow of bank de

posits; as we have seen, in the long run deposit currency
in each country will maintain a definite ratio to money
In the long run an increase or decrease of money-in-a
country will increase or decrease its deposi
But it must not be inferred that the prices of various
articles or even the general level of prices will become
precisely the same in different countries. I Distance, igno
rance as to where the best markets are to be found,

tariffs, and costs of transportation, help to maintain

price differences! The native products of each region
tend to be cheaper in that region. They are exported as
long as the excess of prices abroad is enough to more than

SEc. 1]

REMOTE INFLUENCES

207

cover the cost of transportation. Ordinarily a commodity
will not be exported at a price which will not at least be equal

to the price in the country of origin, plus the freight. Many
commodities are shipped only one way. Thus, wheat is
shipped from the United States to England, but not from
England to the United States. It tends to be cheaper in
the United States. Large exportations raise its price in
America toward the price in England, but the American
price will usually remain below the English price by the
cost of transportation. A few commodities may be sent
in either direction, according to market conditions.
But, although international or interlocal trade will never
bring about exact uniformity of price levels, it will, to the
extent that it exists, produce an adjustment of these levels
toward uniformity by regulating, in the manner already
described, the distribution of money. If one commodity
enters to any considerable extent into international trade,
it alone will suffice, though slowly, to act as a regulator
of money distribution; for, in return for that commodity,
money may flow, and, as the price level rises or falls, the
quantity of that commodity sold is correspondingly adjusted.

| In ordinary intercourse between nations, even when a de
liberate attempt is made to interfere with it by protective
tariffs, there will always be a large number of commodities
thus acting as outlets and inlets. And since the quantity
of money itself affects prices for all sorts of commodities,
the regulative effect of international trade applies, not
simply to the commodities which enter into that trade,
but to all others as well.

It follows that nowadays interna

tional or interlocal trade is constantly regulating price
levels throughout the world.

We must not leave this subject without emphasizing
the effects of a tariff on the purchasing power of money.
When a country adopts a duty on imports, the tendency is
for the level of prices in that country to rise. A tariff

obviously raises the prices of the “protected ” goods, Thus

208

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XII

the high duties on wool and woolen goods have kept Amer
ican prices of wool and woolens higher than European
prices. But the tariff does more than that — it tends also
to raise the prices of unprotected goods. Thus, the tariff
first causes a decrease in imports. This sudden decrease in
imports will lead to a corresponding but gradual decrease
in exports. This gradual check on exports will come about
indirectly. The foreigner will, for a time, continue to
buy from the protected country almost as much as before.

This unchecked buying of goods means unchecked export
of goods while the imports have suddenly been checked.
There will result, therefore, a temporary excess of the pro
tected country's exports over its imports, or a so-called
“favorable" balance of trade, that is, a net inflow of

money. This inflow will eventually raise the prices, not
alone of protected goods, but of unprotected goods as well.
The rise will continue till it reaches a point high enough to
put a stop to the “favorable '' balance of trade, – that
is, until foreigners cease to send in their money.
Although the “favorable balance ’’ of trade created by
a tariff is temporary, it leaves behind a permanent in
crease of money and of prices. This is, perhaps, the chief
reason why a protective tariff seems to many a cause of
prosperity. It furnishes a temporary stimulus not only to
protected industries, but to trade in general, which is in
reality simply the stimulus of money inflation. The per
manent effect is to keep prices in general, including wages,
at a higher level in the protected country than in free trade
countries. This is doubtless one reason why American
wages and prices are higher than English.
We have shown how the international or interlocal

equilibrium of prices may be disturbed by changes in the
distribution of money alone. But it may also be disturbed
by changes in the volume of bank deposits, or in the velocity
of circulation of money, or in the velocity of circulation
of bank deposits, or in the volume of trade. But whatever

SEC. 2)

REMOTE INFLUENCES

209

may be the source of the difference in price levels, equi
librium will eventually be restored through an international

or interlocal redistribution of money and goods brought
about by international or interlocal trade. Elements in
the equation of exchange other than money and com
modities cannot be transported from one place to another.

§ 2. Influence of Melting and Minting on the Quantity
of Money and therefore on Prices

We have seen how M in the equation of exchange is
affected by the importation or exportation of money.
Considered with reference to the M in any one of the
countries concerned, the M’s in all the others are “outside
influences.”

Proceeding now one step farther, we must consider those
influences on M that are not only outside of the equation
of exchange for any particular country, but also outside
that for the whole world. Besides the monetary inflow and
outflow through importation and exportation, there is an
inflow and outflow through minting and melting. In other
words, not only do the stocks of money in the world connect
with each other like interconnecting bodies of water, but they
connect in the same way with the outside stock of bullion.
In the modern world one of the precious metals, such as
gold, usually plays the part of primary money, and this
metal has two uses — a monetary use and a commodity use.
That is to say, gold is not only a money material, but a
commodity as well. In their character of commodities, the
precious metals are raw materials for jewelry, works of
art, and other products into which they may be wrought.
It is in this unmanufactured or raw state that they are
called bullion.

Gold money may be changed into gold bullion, and
vice versa. In fact, both changes are going on constantly,

for if the value of gold as compared with other commodities is
P

2IO

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XII

greater in the one use than in the other, gold will immediately
flow toward whichever use is more profitable, and the market
price of gold bullion in terms of gold money will determine

the direction of the flow. Since Ioo ounces of gold, ſº fine,
can be transformed into 1860 gold dollars, the market value

of so much gold bullion, ſº fine, must tend to be $1860. If
it costs nothing to have bullion coined into money, and
nothing to melt money into bullion, there will be an
automatic flux and reflux from money to bullion and
from bullion to money that will prevent the price of
bullion from varying greatly. On the one hand, if the
price of gold bullion is greater than the money which
could be minted from it, for instance, if Ioo ounces of gold
sell for $1861, the users of gold who require bullion—
notably jewelers—will save the $1 difference by melting

$1860 of gold coin into Ioo ounces of bullion. Contrariwise,

if the price of bullion is less than the value of gold coinſ
say $1859, the owners of bullion will save the $1 difference
by taking Ioo ounces of bullion to the mint and having it

coined into 1860 gold dollars. (The effect of melting coin,
on the one hand, is to decrease the amount of gold money
and increase the amount of gold bullion, thereby lowering
the value of gold as bullion and raising the value of gold
as money; and thereby also lowering the price level and
restoring the equality between bullion and money. The
effect of minting bullion into coin is, by the opposite pro
cess, to bring the value of gold as coin and the value of
gold as bullion into equilibrium.
When a charge called “seigniorage" is made for changing
bullion into coin, or where the process involves expense or
delay, the flow of bullion into currency will be to that extent
impeded. But under a modern system of free coinage and
-

with modern methods of reducing coin to bullion, both

melting and minting may be performed so inexpensively
and so quickly that there is practically no cost or delay
involved. In fact, there are few instances of more exact

SEC. 3]

REMOTE INFLUENCES

2II

price adjustment than the adjustment between gold bullion
and gold coin. It follows that the quantity of money, and
therefore its purchasing power, is directly dependent on
that of gold bullion.
This stability of the price of gold bullion expressed in
gold coin causes confusion in the minds of people, giving
them the erroneous impression that there is no change
in the value of money. Indeed, this stability has often
been cited to show that gold is a stable standard of value.
Dealers in objects made of gold seem to misunderstand
the significance of the fact that an ounce of gold (#, fine)
-

always costs $18.60 in the United States or (43 fine) £3,
17s., Iožd. in England. This means nothing more than
the fact that gold in one form and measured in one way
will always bear a constant ratio to gold in another form
and measured in another way. An ounce of gold bullion
is worth a fixed number of gold dollars, for the same reason
that a pound sterling of gold is worth a fixed number of
gold dollars, or that a ton of large steel ingots is worth a
fixed number of pounds of small steel ingots.
Except, then, for extremely slight and temporary fluctu
ations, gold bullion and gold money must always have the
same value. Therefore, in the following discussion re
specting the more considerable fluctuations affecting both,
we shall speak of these values interchangeably as “the
value of gold.”
§ 3. Influence of the Production and Consumption of
Money Metals on the Quantity of Money and there
fore on Prices

The stock of bullion is not the ultimate outside influence

on the quantity of money. As the stock of bullion and the
stock of money influence each other, so the total stock of
both is itself influenced by production and consumption.
The production of gold consists in the output of the mines,

2I 2

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XII

which constantly tends to add to the existing stocks both
of bullion and coin. The consumption of gold consists
in the use of bullion in the arts by being wrought into
jewelry, gilding, etc., and in losses of coin by abrasion, ship
wreck, etc. If we consider the amount of gold coin and
bullion as a sort of reservoir, production would be the in
flow from the mines, and consumption the outflow to the
arts and by destruction and loss. To the inflow from the
mines should be added the re-inflow from forms of art into

which gold had previously been wrought, but which have
since become obsolete. This is illustrated by the business
of producing gold bullion by burning gold picture frames.
- We shall consider, first, the inflow or production, and
afterward the outflow or consumption. The regulator
of the inflow (which practically means the production of
gold from the mines) is its estimated cost of production.
Wherever the estimated cost of producing a dollar of gold
is less than the existing value of a dollar in gold, the gold
will (normally) be produced. Wherever the cost of pro
duction exceeds the existing value of a dollar, the gold

will (normally) not be produced. In the former case the
production of gold is profitable; in the latter it is unprofit
able.

This holds true, in whatever way cost of production is
measured, whether in terms of gold itself, or in terms of
some other commodity such as wheat, or of commodities
in general. In gold-standard countries the gold miner does
actually reckon the cost of producing gold in terms of gold.
From his standpoint it is a needless complication to trans
late the cost of production and the value of the product
into some other standard than gold. He is interested in
the relation between the two, and this relation will be the
same whichever standard is employed. To illustrate how
the producer of gold measures everything in terms of gold,
suppose that the price level rises. He will then have to

pay more dollars for wages, machinery, fuel, etc., while the

SEC. 3]

REMOTE INFLUENCES

213

prices obtained for his product (expressed in those same
dollars) will, as always, remain unchanged. Conversely,
a fall in the price level will lower his cost of production
(measured in dollars), while the price of his product will
still, as always, remain the same. Thus we have a vari
able number expressing the cost of production and a constant
number expressing the price of gold product.
If we express the same phenomena, not in terms of gold,
but in terms of wheat, or rather, let us say, in terms of goods
in general, we shall have the opposite conditions. Then
a fall in the price level cannot be said to affect his cost of

production (measured in goods), while the “price, ” or
purchasing power, of his product over goods will rise. A
constant number expresses the cost of gold and a variable

number, its price (purchasing power).
Thus the comparison between price and cost of production
is the same, whether we use gold or other commodities as our
criterion. In the one view — i.e., when prices of labor and
commodities are measured in gold – a rise of these prices
appears as a rise in the gold miner's cost of production –
the money cost to him of labor and materials — while the
price of his product, gold, appears constant; in the other
view — i.e., when labor and commodities are measured in
other goods — the same phenomenon is expressed as a fall
in the purchasing power of his product, gold, while the cost
of labor and materials in terms of themselves is the constant

quantity. In the one view his costs rise relatively to his prod
uct; in the other his product falls relatively to his costs.
In either view he will be discouraged.

He will look at his

troubles in the former light, i.e., as a rise in the cost of
production; but we shall find it more useful to look at them

in the latter, i.e., as a fall in the purchasing power of the
product. In either case the comparison is between the cost
of the production of gold and the purchasing power of
gold. If this purchasing power is above the cost of pro
duction in any particular mine, it will pay to work that

2I4

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XII

mine. If the purchasing power of gold is lower than the
cost of production in any particular mine, it will not pay
to work that mine.

So much for the inflow of gold and the conditions regulat
ing it. We turn next to outflow or consumption of gold.
This has two forms, viz., consumption in the arts and con
sumption for monetary purposes.
First we consider its consumption in the arts. If objects
made of gold are cheap — that is, if the prices of other
objects are relatively high — then the relative cheapness
of the gold objects will lead to an increase in their use
and consumption. Expressing the matter in terms of money
prices, when prices of everything else are higher and people's
incomes are likewise higher, while gold leaf and gold orna
ments remain at their old prices, people will use and con
sume more gold leaf and ornaments.
These are instances of the consumption of gold in the
form of commodities. The consumption and loss of gold

as coin is a matter of “abrasion ” (gradual waste by wear
ing or rubbing against other coins or the hands, pocket,
or purse), of loss by shipwreck and other accidents. They
change with the changes in the amount of gold in use and
in its rapidity of exchange.
A fall, therefore, in the purchasing power or value of
gold, affects both consumption and production. It stimu
lates consumption (that is, the turning of bullion into
articles of commerce); and it discourages production.
An increase of purchasing power, of course, acts in the
opposite way. Conversely, consumption and production
affect purchasing power. Consumption, or the with
drawal of bullion into commerce, raises the purchasing
power of what is left, while production from the mines
lowers the purchasing power.
The purchasing power of money, being thus played upon
by the opposing forces of production and consumption, is
driven up or down as the case may be.

SEC. 4]

REMOTE INFLUENCES

2I5

§ 4. Mechanical Illustration of these Influences
In any complete picture of the forces determining the
purchasing power of money we need to keep prominently
in view three groups of factors: (1) the production or the
“inflow” of gold (i.e., from the mines); (2) the consumption
or “outflow ’’ (into the arts and through destruction and
loss); and (3) the “stock’ or reservoir of gold (whether

FIG. 13.

coin or bullion) which receives the inflow and suffers the
outflow. The relations among these three sets of magni
tudes can be set forth by means of a mechanical illustration,
as shown in Figure 13. This represents two connected res
ervoirs of liquid, G, and G. The contents of the first
reservoir represent the stock of gold bullion, and the con
tents of the second the stock of gold money. Since pur
chasing power increases with scarcity, the distance from
the top of the cisterns, OO, to the surface of the liquid

(which evidently increases as the liquid grows more scarce)
is taken to represent the purchasing power of gold over
other goods. A lowering of the level of the liquid indicates
the corresponding increase in the purchasing power of

2I6

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XII

money, since we measure this purchasing power downward
from the line OO to the surface of the liquid. We shall not
attempt to represent other forms of currency explicitly in
the diagram. We have seen that normally the quantities of
other currency are proportional to the quantity of primary
money, which we are supposing to be gold. Therefore the
variation in the purchasing power of this primary money
may be taken as representative of the variation of all the
currency. The cistern G, must be of such a form as
will make the distance of the liquid surface below OO de
crease with an increase of the liquid, in exactly the same way
as the purchasing power of gold decreases with an increase in
its quantity. That is, as the quantity of liquid in G,
doubles, the distance of the surface from the line OO should

decrease by one half. In a similar manner the form of
the gold bullion cistern must be such as will make it rep
resent faithfully the facts for which it stands; that is, it
must be such that the distance of the liquid surface below
OO will decrease with an increase of the liquid exactly as
the value of the gold bullion decreases with an increase in
the stock of gold bullion. The shapes of the two cisterns
need not, and ordinarily will not, be the same, for we can
scarcely suppose that doubling the amount of bullion in
existence will always exactly halve its purchasing power.
Both reservoirs have inlets and outlets.

Let us con

sider those belonging to the bullion reservoir (G). Here
each inlet represents a particular mine, supplying bullion,
and each outlet represents a particular use in the arts, con
suming gold bullion. Each mine and each use has its own
distance from OO. There are, therefore, three sets of dis
tances from OO: the inlet-distances, the outlet-distances,

and the liquid-surface-distances. Each inlet-distance rep
resents the cost of production, measured in goods, for
some particular mine; each outlet-distance represents the
value which gold has or would have in the particular use
represented, likewise measured in goods. The surface

SEC. 4)

REMOTE INFLUENCES

217

distance, as we have already explained, represents the value
of bullion, likewise measured in goods—in other words,
its purchasing power.
It is evident that among these three sets of levels there
will be discrepancies. These discrepancies serve to inter
pret the relative state of things as bullion flows in and out.
If an inlet at a given moment be above the surface-level, i.e.,
at a less distance from OO than is the surface, the interpre
tation is that the cost of production is less than the purchas
ing power of the bullion. Hence the mine owner will turn on
his spigot and keep it on until, perchance, the surface-level
rises to the level of his mine — i.e., until the surface-distance

from OO is as small as the inlet-distance — in other words,
until the purchasing power of bullion is as small as the cost
of production. At this point there is no longer any profit in
mining. So much for inlets; now let us consider the outlets.
If an outlet at a given moment be below the surface-level, i.e.,
at a greater distance from OO, the interpretation is that the
value of gold in that particular use is greater than the pur
chasing power of bullion, Hence gold bullion will flow into
those uses where its value may happen for the moment to
be greater than its value as bullion. That is, it will flow
out of all outlets below the surface in the reservoir.

It is evident, therefore, that at any given moment, only
the inlets above the surface-level, and only the outlets

below it, will be called into operation. As the surface
rises, therefore, more outlets will be brought into use, but
fewer inlets. That is to say, the less the purchasing power
of gold as bullion, the more it will be used in the arts, but
the less profitable it will be for the mines to produce it,
and the smaller will be the output of the mines. As the
surface falls, more inlets will come into use and fewer out
lets.

We turn now to the money reservoir (G.). The fact
that gold has the same value either as bullion or as coin,
because of the interflow between them is represented in the

218

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XII

diagram by connecting the bullion and coin reservoirs, in
consequence of which the stock in both will (like water) find
a common level; the surface of the liquid in both reservoirs
will be the same distance below the line OO, and this distance

represents the value of gold (or its purchasing power).
Should the inflow at any time exceed the outflow, the result
will necessarily be an increase in the stock of gold in exist
ence.

This will tend to decrease the purchasing power or

value of gold. But as soon as the surface rises, fewer inlets
and more outlets will operate. That is, the excessive inflow
on the one hand will decrease, and the deficient outflow

or consumption on the other hand will increase, checking
the inequality between the outflow and inflow. If, on the
other hand, the outflow should temporarily be greater
than the inflow, the reservoir will tend to become less full.
The purchasing power will increase; thus the excessive
outflow will be checked, and the deficient inflow stimulated

— restoring equilibrium. The exact point of equilibrium
may seldom or never be realized, but as in the case of a
pendulum swinging back and forth about a position of
equilibrium, there will always be a tendency to seek it.
It need scarcely be said that our mechanical diagram
is intended merely to give a picture of some of the
chief variables involved in the problem under discussion.
It does not of itself constitute an argument, or add any new
element; nor should one pretend that it includes ex
plicitly all the factors which need to be considered. But it
does enable us to grasp the chief factors involved in deter
mining the purchasing power of money. It enables us to
observe and trace the following important variations and
their effects : —

First, if there be an increased production of gold — due,
let us suppose, to the discovery of new mines or improved
methods of working old ones — this may be represented
by an increase in the number or size of the inlets into the
bullion reservoir; the result will evidently be an increase

SEc. 4)

REMOTE INFLUENCES

2I9

of “inflow ’’ into that reservoir, and from that into the

currency reservoir, a consequent gradual filling up of both,
and therefore a decrease in the purchasing power of money.
This process will be checked finally by an increase in con
sumption and by discouraging production. When pro
duction and consumption become equal, an equilibrium will
be established. An exhaustion of gold mines obviously
operates in exactly the reverse manner.

Secondly, if there be an increase in the consumption
of gold – as through some change of fashion – it may be
represented by an increase in the number or size of the out
lets of G. The result will be a draining out of the bullion
reservoir, and consequently a decreased amount in the
currency reservoir; hence an increase in the purchasing
power of gold, which increase will be checked finally by an
increase in the output of the mines as well as by a decrease
in consumption. When the increased production and the
decreased consumption become equal, equilibrium will
again be reached.
If the mints are closed, that is, if the connection be

tween the bullion reservoir and the currency reservoir is
closed by a valve so that gold cannot flow from the for
mer to the latter (although it can flow in the reverse
direction), then the purchasing power of the gold as money
may become greater than its value as bullion. Any in
crease in the production of gold will then tend only to fill
the bullion reservoir and decrease the distance of the sur

face from the line OO, i.e., lower the value of gold bullion.
The surface of the liquid in the money reservoir will not be
brought nearer OO. It may even by gradual loss be lowered
farther away. In other words, the purchasing power of
money will by such a circumstance be made entirely inde
pendent of the value of the bullion out of which it was first
made.

We have now discussed all but one of the outside influences

upon the equation of exchange. That one is the character

22O

ELEMENTARY PRINCIPLEs of EconoMICs

(CHAP. XII

of the monetary and banking system which affects the quan
tity of money and deposits. This we reserve for special
discussion in the following chapter.
Meanwhile, it is noteworthy that almost all of the
influences which at the present time actually affect either
the quantity or the velocities of circulation have been
and are predominantly in the direction of higher prices.
Almost the only opposing influence is the increased volume
of trade. We may also point out that some of those
influences discussed in this and the preceding chapter
operate in more than one way. Consider, for instance,
technical knowledge and invention, which affect the equa
tion of exchange by increasing trade. So far as these
increase trade, the tendency is to decrease prices; but so
far as they develop metallurgy and the other arts which
increase the production and transportation of the precious
metals, they tend to increase prices. So far as they make
the transportation and circulation of money and deposits
quicker, they also tend to increase prices. So far as they
lead to the development of the art of banking, they like
wise tend to increase prices both by increasing deposit

currency (M') and by increasing the velocity of circula
tion both of money and deposits. So far as they lead
to the concentration of population in cities, they tend
to increase prices by accelerating circulation.

CHAPTER XIII
OPERATION OF MONETARY SYSTEMS

§ 1. Gresham's Law
THUS far we have considered the influences that determine

the purchasing power of money when the money in cir
culation is all of one kind.

The illustration given in the

previous chapter shows how the money mechanism operates
when a single metal is used. We have now to consider the
monetary systems in which two or more kinds of money
are used.

One of the first difficulties in the early history of money
was that of keeping two or more metals in circulation at
the same time. The monetary unit in one of the two would
become cheaper than in the other, and the cheaper would
drive out the dearer.

To this tendency has been given the name of “Gresham's
Law " in honor (rather undeservedly) of Sir Thomas
Gresham, a financial adviser of Queen Elizabeth of Eng
land. He called attention to the tendency in the middle
of the sixteenth century, although it is now known that
many others had anticipated him. In fact, the law seems
to have been recognized among the ancient Greeks. It is
mentioned in the “Frogs ’’ of Aristophanes: —
“For your old and standard pieces, valued and approved and tried,
Here among the Grecian nations and in all the world beside

Recognized in every realm for trusty stamp and pure assay,

Are rejected and abandoned for the trash of yesterday;
For a vile, adulterate issue, drossy, counterfeit and base

Which the traffic of the City passes current in their place I’’
-

22I
º

222

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIII

Gresham's Law is ordinarily stated in the form, “Bad
money drives out good money,” for it was usually ob
served that the badly worn, defaced, light-weight, “clipped,”
“sweated,” and otherwise deteriorated money tended to

drive out the full-weight, freshly minted coins. This for
mulation, however, is not accurate. “Bad” coins, e.g.,
worn, bent, defaced, or even clipped coins, will drive out
other money only so far as they are less valuable.

Some

times bright, freshly minted coins drive out old, dull de
faced coins, as, for instance, when new gold drove out
silver from the United States shortly after 1837, the new
gold dollars being cheaper than the old silver dollars. Ac
curately stated, the Law is simply this: The cheaper dollar
(or whatever the monetary unit) tends to drive out the dearer.
The reason why the cheaper of two moneys always prevails

is that the choice of the use of money rests chiefly with
the man who gives it in exchange, not with the man who
receives it. When any one has the choice of paying his
debts in either of two moneys, motives of economy will
evidently prompt him to use the cheaper. If the initiative
and choice lay principally with the person who receives
instead of the person who pays the money, the opposite
would hold true. The dearer or “good "money would
then drive out the cheaper or “bad” money. It is
because the payer of money exercises the choice that the
cheaper money tends to be passed on and the dearer
money to be withdrawn. Any individual into whose
hands the two moneys may chance to fall may exercise
this choice and withdraw the newly minted coins. But
there are two classes especially interested and most instru
mental in withdrawing the “good" money from circula
tion; namely, those who wish it either for export or for
melting, — the bankers and the goldsmiths.
What then becomes of the dearer money? It may be
hoarded, or go into the melting pot, or go abroad — hoarded
and melted from motives of economy, and sent abroad be

SEC. 2]

OPERATION OF MONETARY SYSTEMS

223

cause, where foreign trade is involved, it is the foreigner
receiving the money, rather than ourselves giving it,
who dictates what kind of money shall be accepted. He
will take only the best, because our legal-tender laws do
not bind him.

Until “milling ” the edges of coins (making the edges
finely corrugated so that they cannot be filed or otherwise
rubbed off without detecting) was invented, and a “limit
of tolerance ’’ of the mint (the deviation from the stand
ard weight beyond which the coin is rendered unacceptable
in law as legal tender) was adopted, much embarrass
ment was felt in commerce from the fact that the clipping
and debasing of coin was a common practice. Nowadays,
however, any coin which has been so “sweated ” or
clipped as to reduce its weight appreciably ceases to be
legal tender, and, being commonly rejected by those to
whom it is offered, ceases to be money.

Within the cus

tomary or legal limits of tolerance, however, — that is, as
long as the cheaper money continues to be money, - it
will tend to drive out the dearer.

Gresham's Law applies not only to two rival moneys of
the same metal; it applies to all moneys that circulate con
currently.
§ 2. Bimetallism
The obvious effect of Gresham's Law is to decrease the

purchasing power of money at every opportunity. The
history of the world's currencies is largely a record of money
debasements, often at the behest of the sovereign. Our
chief purpose now, in considering Gresham's Law, is to for
mulate more fully the causes determining the purchasing
power of money under monetary systems subject to the
operation of Gresham's Law. The first application is to

“bimetallism.” Under bimetallism, governments open their
mints to the free coinage of two metals (usually gold and

224

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XIII

silver) at a fixed coinage ratio, and make both sorts of
coin unlimited legal tender at that ratio." Under this sys
tem, the debtor has the option, unless otherwise bound by
contract, of making payment either in gold or in silver
money. These, in fact, are the two requisites of complete
bimetallism, viz.: (1) the free and unlimited coinage of
both metals at a fixed ratio, and (2) the unlimited legal
tender of each metal at that ratio.

The object of bimetallism is to render the purchasing
power of money more stable; but in order to understand
fully the influence of any monetary system on the purchas
ing power of money, we must first understand its mechan
ism and mode of operation. It has been denied that
bimetallism ever did or can work successfully so that gold
and silver dollars circulate side by side at equal values.
This denial is based on Gresham's Law by which the
cheaper metal will drive out the dearer.

Our first task

is to show, quite irrespective of its desirability, that bi
metallism can and does “work ’’ under certain circum

stances, but not under others. To make clear when it will
work and when it will not, we shall state the effects of
a bimetallic law first in words and then, for the sake of

greater clearness and exactness, in terms of a mechanical
illustration.

Suppose that, at first, gold alone is freely coined (and is
unlimited legal tender) and that then (as proposed in the
United States by the “free silver’’ party in 1896 and

1900) silver is put on exactly the same basis, the mints
being opened to its free coinage also.
The results of thus opening the mints to silver at a ratio
of 16 to I with gold will be different, according to the rela
tive market value of gold and silver before the mints are
*By the “coinage ratio” is meant the ratio of the weight of the silver
dollar to that of the gold dollar. This is at present 16 to 1 ; for a silver
dollar weighs 41.2% grains, which is almost exactly sixteen times the weight
of a gold dollar, 25.8 grains.

Sec. 2)

OPERATION OF MONETARY SYSTEMS

opened.

225

If 4123 grains of silver were dearer than 25.8

grains of gold, there would be no silver coined at all, for
no one will take 412; grains of silver to be coined and used
as a dollar of money when he can get more than a gold
dollar for it by selling it as silver bullion.

But if (as happens to be the case to-day) 412; grains of
silver are cheaper than 25.8 grains of gold, every owner of
silver bullion will make a profit by taking it to the mint.
In this way he can get a silver dollar for every 412} grains
of silver bullion, while in the silver bullion market he can

get only, let us say, fifty cents. The result will be a wild
scramble among all owners of silver bullion to get it coined,
in order to transform each 4123 grains of it into a full
fledged dollar instead of the fifty cents which previously
was all they could get for it. It is true that the new
silver dollar may not be worth as much in purchasing
power as a gold dollar; but, being legal tender, it will
have just as great debt-paying power.
There can be no doubt, then, that silver, being cheaper
than gold, will be taken to the mint as soon as the bimetallic
law takes effect. The question now is: What will be the
result? To this question the answer is briefly as follows:–

I. The first effect (as has been emphasized by “mono
metallists”) will be the operation of Gresham's Law, by
which the cheap silver dollars will tend to expel the dear
gold dollars from circulation.

II. But (as emphasized by “bimetallists”) this very
operation of Gresham's Law tends to reduce the disparity
between the values of the gold and silver dollars. Owing
to the eagerness of debtors to use silver instead of gold in
paying their debts, the value of silver is increased and
that of gold decreased. This mutual approach of the values
of gold and silver dollars may result in making them equal.

III. But (as pointed out by the “monometallists”) the
next result will be a great stimulus to the mining of silver
and a great discouragement to the mining of gold. Con
Q

226

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIII

sequently, silver will gradually become more plentiful, and
therefore cheaper again, and gold scarcer, and therefore

dearer again.

Consequently, silver will again tend to

expel gold.
IV. But (as insisted by “bimetallists”) this increase
of the stock of silver (coin and bullion) and decrease of
the stock of gold are self-limiting; for the increased
production of silver will be checked by increased cost of
production, and consumption will tend to overtake pro
duction, while the opposite adjustments apply to gold.
We shall consider these results in their order.

§ 3. When Bimetallism Fails
I. In accordance with Gresham's Law, the cheap silver
money will drive the dearer gold money out of circulation
— either abroad or into the melting pot, or both. If there
is a sufficient amount of silver bullion available, it will
drive gold completely out of circulation, and the coun
try which enacted the law will find itself converted from
a gold standard country into a silver standard country.
There are many historical examples of such a breakdown
of bimetallism, both in the United States and elsewhere.

But even when bimetallism thus fails of its object (keep
ing both metals in circulation, with silver and gold dollars
of equal value), it will, nevertheless, have had the effect of
making them more nearly equal. A tendency toward equal
ization will have come about from two causes, one the
fact that from the world's stock of silver bullion there

has been taken away a great mass of silver (i.e., the silver
turned into coin), thus making the remaining silver bullion
scarcer and dearer; and the other the fact that to the world's

stock of gold bullion there is suddenly added a great mass
of gold (i.e., the gold melted from coin), thus making the
gold bullion more abundant and cheaper in its purchasing
power over other things. The result is that, though the

SEc. 3]

OPERATION OF MONETARY SYSTEMS

227

law has failed to raise 412; grains of silver from the equiva
lent of half a dollar of gold to the equivalent of a whole
dollar of gold, it may at any rate raise it a little.
These effects can be more exactly shown by means of
the mechanical illustration of the last chapter carried a little
further. In this the amount of gold bullion is represented
by the contents of reservoir G. (Figs. 14, 15). Here, as
before, we represent the purchasing power or value of
gold by the distance of the liquid level below the zero level,
OO. In the last chapter, our figure represented only one
metal, gold, and represented that metal in two reservoirs
— the bullion reservoir and the coin reservoir.

We shall

now, one step at a time, elaborate that figure. First we
add a reservoir for silver bullion (S). This reservoir
may be used to show the relation between the value or
purchasing power of silver and its quantity considered as
bullion.

Here, then, are three reservoirs. At first (Fig. 14a) the
silver reservoir is entirely isolated. For the present, let us
suppose that the middle one, which contains money, is filled
with gold money only (Figs. 14a, 15a), no silver being yet
used as money. In other words, the monetary system is
the same as that discussed in the last chapter.

The only

change here introduced is to add to the picture another
reservoir (S), entirely detached, showing the quantity and
value of silver bullion.

We next suppose a pipe opened at the right, connecting
S, with the money reservoir; that is, we introduce bimetal
lism. These new conditions are represented in Figure 14b,
where a pipe gives silver an entrance into the money or
central reservoir. Thus the a part of the figure represents
conditions before the mints are opened to silver. The b part
represents conditions after they have been opened.
The liquids representing gold and silver money are sepa
rated by a movable film f. In Figure 14a this film is at the
extreme right; in Figure 14b, at the extreme left.

228

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIII

We may disregard for the present all inlets and outlets ex
cept the connections between the bullion reservoirs and the

coin reservoir; because what we are about to represent is
merely the relations between bullion (two kinds) and coins.
Now in these reservoirs the surface-distances below OO

represent, as has been said, the purchasing powers of gold
and silver. A unit of liquid represents that quantity of
gold or of silver which constitutes a unit of money. Of

(•)

FIG. I.4.

course a silver dollar is physically larger than a gold dollar,

but they are both represented in our diagram by the same
unit, or drop, of liquid; that is, each drop of liquid on the

right side of the film f represents a dollar of silver (412}
grains), while each drop of liquid on the left of this film
represents a dollar of gold (25.8 grains).

Sec. 3]

OPERATION OF MONETARY SYSTEMS

229

In the figure the situation represented is such that the
level of the silver bullion in the right reservoir is above the
level of the other two reservoirs, which are filled with gold;
that is, the silver bullion is so abundant and cheap as to be

ready to flow into the money reservoir as soon as the mint or
connecting pipe is opened. Were this not the case (that is,
if the silver level in the right reservoir were below the gold
level in the other two reservoirs), it is evident that the

statute introducing bimetallism would be inoperative; the
silver bullion would not, as it were, flow uphill into the money
reservoir. But if, as is represented in Figure 14a, the silver
level is the higher, then, as soon as the mints are opened to
silver (that is, as soon as the connecting pipe is inserted),

23o

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XIII

silver will flow into circulation (into the money reservoir),
and in accordance with Gresham's Law, will displace gold.

It will continue to displace gold as long as it is cheaper than
gold (that is, as long as the level of the inflowing silver

liquid is above that of the gold liquid which it displaces).
The gold money will be melted and turned into bullion
(that is, pushed out through the left tube into the bullion
market).
It is evident that this operation of Gresham's Law may
proceed so far that the money reservoir will be wholly
cleared of gold and filled instead with silver, the film f having
been swept completely to the left. This result is pictured
in Figure 14b, which illustrates the failure of bimetallism.
§ 4. When Bimetallism. Succeeds
II. But such a result would not in all cases occur.

will occur only when, as is represented in Figure 14, there
exists, to start with, a sufficiently great disparity between
the silver and gold levels and a sufficiently large amount of
silver bullion.

These conditions need not always hold true. Let us sup
pose, for instance, that prior to the introduction of bimetal
lism 4.12% grains of silver bullion, instead of being worth only
fifty cents in terms of gold, should be worth ninety-five
cents.

Under these conditions the introduction of the free

coinage of silver would mean introducing a new dollar
worth, at the outset, at least ninety-five cents, or nearly par.
It would still be true that the owner of silver bullion would

be impelled to take it to the mint by the prospect of a profit

of five cents on each 412; grains, but it would not require
much such coinage to raise the price of silver to par. The
eagerness to get the new silver dollars would tend to raise

their value, while the discarding of the old gold dollars
would tend to lower their value. Just as soon as enough
silver dollars had been coined out of silver bullion to bring

SEc. 4)

OPERATION OF MONETARY SYSTEMS

231

them up to par in terms of gold, Gresham's Law would, of
course, cease to operate, and we should have both silver
and gold dollars circulating on equal terms, side by side.
This result is pictured in Figure 15. The upper part
(Fig. 15a) shows the situation before the introduction
of free coinage of silver, and the lower part (Fig. 15b)
shows what will be the result if silver has been allowed to

flow into circulation. In this case the film f has been pushed
only part way to the left, — to such a point as to bring the
silver and gold levels into coincidence. As the film has
been swept to the left, and more room has thus been made
for silver, the silver level has fallen, while as the film has

crowded out gold, the gold level has risen and the two levels
have come into coincidence on the line mm.

In other words,

the premium on gold bullion has disappeared, and bimet
allism has, for the time being at least, succeeded.
While such an equality in the value of gold and silver dol
lars continues, neither completely expels the other, although
both are freely coined. If the levels of the two metals on
opposite sides of the film f should, for a moment, differ
slightly, the difference would be automatically corrected, for
the cheaper metal having the higher level would simply crowd
against the dearer metal having the lower level and the
separating film f would need to shift only a little before the
two levels would again coincide. For these reasons, no mat
ter which of the metals tends from time to time to become

more plentiful and cheaper, and, therefore, to expel the other,
the only result would be a slight shifting of the film. This
will move from right to left or left to right, as the case may be,
but as long as it does not move completely to the right or
the left limit, bimetallism will continue to be successful.

The film being movable (that is, gold and silver being
mutually replaceable as money), the three reservoirs act as
one and keep a common level for all three.

We see, then, that those are wrong who maintain that
Gresham's Law always results in complete expulsion from

232

ELEMENTARY PRINCIPLES OF EconoMICs

ICHAP. XIII

circulation of one metal by the other. The expulsion can
continue only so long as there is a difference in value between
the two metals, but as the expelling proceeds (that is, as
the film f shifts) the very difference of level which shifts
it tends to disappear. Sometimes (as in Fig. 14b) the film
will be pushed to its extreme limit before the difference of
level between the two liquids disappears, but sometimes
on the other hand (as in Fig. 15b) the difference of level
between the two liquids will disappear before the film reaches
its limit. Which of these two results will happen, depends
on circumstances. To distinguish the two cases we may
suppose the line mm to be drawn in all of the four cases
(Figs. I4a, 14b, 15a, 15b). This line is the mean level of the
liquids in the reservoirs (that is, the common level which the
liquids contained in the three reservoirs would find if inter
communication among them were entirely free).
The case represented in Figure 14 is the case where the
amount of silver bullion a above the mean line mm equals or
exceeds the total capacity of the money reservoir below that
line.

In such a case, as soon as a is allowed to flow into the

money reservoir it is sufficiently great to wholly displace all
the gold in that reservoir.
The case represented in Figure 15 is the case where
the amount of silver bullion a above the line mm is less

than the total contents of the money reservoir below the
line mm. In this case when a is given access to the
money reservoir it is inadequate to wholly sweep gold out
of circulation.

The first case undoubtedly represents what would have
happened in the United States if we had attempted free
coinage of silver, at 16 to 1, as proposed by one political
party in 1896 and 1900. It also represents what actually
did occur in the United States after the adoption of the
Bimetallic Law (at a ratio of 15 to 1) in 1792. In that case
it was gold which expelled silver.

SEC. 5]

OPERATION OF

MONETARY SYSTEMS

233

§ 5. Changes in Production and Consumption
III. Thus far in our discussion we have taken no account

of the production and consumption of the precious metals.
We have taken account only of the distribution of the
existing stocks of these metals as between money in circula
tion and gold and silver bullion. As has already been hinted,
as soon as the first effects of free coinage have been felt and

the existing available stock of silver has been coined, there
will be at once a great stimulus to silver mining and dis
couragement to gold mining. If, for instance, as above sup
posed, before the introduction of bimetallism, the value of

412; grains of silver had been ninety-five cents in gold, but, as
a consequence of the free coinage of silver, its value has im
proved to a dollar, it is evident that producers of silver will,
in consequence of this rise in price of their product, be
encouraged to mine a larger product than before the intro
duction of bimetallism. Through its new monetary use
their market for silver has been greatly increased. At the
same time the market for gold will have been decreased and
its production discouraged. While the value of silver in terms
of gold has increased, the value of gold in terms of silver
has decreased, or, what is more to the point, while the value
of silver in terms of goods in general has increased, the value
of gold in terms of goods in general has decreased. We
have already seen (in Chapter XII, § 4) that this decrease in
the value of gold will discourage its production just as the
increase in the value of silver will encourage its production.
Since, then, the output of silver increases and that of
gold decreases, there will be a still further expulsion of gold
by silver. In the mechanical illustration some of the silver

inlets at the right, formerly unused (below the liquid surface)
will have been uncovered and will pour their streams into
the reservoir S, while some gold inlets at the left formerly
open will be submerged and cease their flow. Consequently,
the film will be shifted toward the left.

234

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIII

IV. But this movement of the film, or displacement of

gold by silver, will not necessarily proceed far. The in
creased production of silver will tend to be self-limiting, for
with increased production comes increased cost. The con
Sumption of silver on the other hand may increase and over
take production; for the greater the stock of silver in
circulation, the larger the amount which will be used up by
abrasion, losses, etc. Therefore it may soon come about
that the production and consumption of silver will again
be equal. When this occurs the stock of silver will again
be stationary. The same may happen to gold by the op
posite process. Its lessened production is self-limiting, for
the mines where gold is most cheaply produced will con
tinue to operate at a profit; moreover, the lessening in pro
duction will be followed by a lessening of stock, and the
lessening of stock may lead to a lessening of consumption
which may fall to equality with production. When this
occurs the stock of gold will again be stationary.
As a matter of fact, however, such ideal equilibrium, in
which the stocks of both metals remain stationary, never
occurs. Changes in production and consumption of the
precious metals are constantly adding to and subtracting
from the stocks of these metals in the form of money and
bullion. Any such disturbance of the stocks of the precious
metals will, as we have seen, tend to make one metal dis

place the other, but whether the displacement will be com
plete or not depends, as we have seen, upon circumstances.
Consequently, the film will be driven to the right or the
left as gold or silver flows in from one side or the other. In
this way, by moving the film back and forth, bimetallism may
remain in successful operation for a long time, as, in fact, it
did in France for three fourths of a century ending in 1873.
In this period gold and silver money circulated at par in
France, sometimes silver partially displacing gold and
sometimes gold partially displacing silver. Never until
the end of the period did either completely displace the

Sec. 6]

OPERATION OF MONETARY SYSTEMS

235

other. For a long time the film shifted back and forth
without reaching its limit on either side.

But such a fate

is in the end almost inevitable. This is what happened in
France in 1873.
§ 6. The “Limping” Standard
Bimetallism is to-day a subject of historical interest only.
It is no longer practiced; but its former prevalence has
left behind it in many countries, including France and the
United States, a monetary system which is sometimes

called the “limping ”standard. Such a system comes about

when, in a system of bimetallism, before either metal can
wholly expel the other, the mint is closed to the cheaper of
them, but the coinage that has been accomplished up to
date is not recalled. Suppose silver to be the metal thus
excluded — as in France and the United States. Any
money of that metal already coined and in circulation is

kept in circulation at par with gold. This parity may
continue even if limited additional amounts of silver be
coined from time to time. There will then result a differ

ence in value between silver bullion and silver coin, the

silver coin being overvalued. This situation is represented

in Figure 16. Here the pipe connection between the money

236

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIII

reservoir and the silver bullion reservoir has been, as it

were, cut off, or, let us say, stopped by a valve which re
fuses passage of silver from the bullion reservoir to the
money reservoir, but not the reverse (for no law ever can

prevent the melting down of silver coins into bullion).
Newly mined silver cannot now become money, and thus
lower the purchasing power of money.
On the other hand, new supplies of gold continue to affect
the value of currency as before — the value, not only of
the gold, but also of the concurrently circulating over
valued silver. If more gold should flow into the money
reservoir, it would raise the currency level. Should this
level ever become higher than the level of the silver bullion
reservoir, silver would flow from the money reservoir into
the bullion reservoir; for the passage in that direction (i.e.,
melting) is still free. So long, however, as the money
level is below the silver level, i.e., so long as the coined
silver is worth more than the uncoined, there will be no flow

of silver in either direction. The legal prohibition prevents
the inflow of silver, and the loss which would be sustained
by melting prevents its outflow.
In the case just discussed, the value of the coined silver
will be equal to the value of gold at the legal ratio. Pre
cisely the same principle applies in the case of any money
the coined value of which is greater than the value of its
constituent material. Take the case, for instance, of paper
money. So long as it has the distinctive characteristic of
money — general acceptability at its legal value — and is
limited in quantity, its value will ordinarily be equal to that
of its legal equivalent in gold. If its quantity increases
indefinitely, it will gradually push out all the gold and
entirely fill the money reservoir, just as silver would do
under bimetallism if produced in sufficiently large amounts.
Likewise credit money and credit in the form of bank
deposits would have this effect. To the extent that they
are used, they lessen the need for gold, decrease its value

SEC. 6]

OPERATION OF MONETARY SYSTEMS

237

as money, and cause more of it to go into the arts or to
other countries.

So long as the quantity of silver or other token money,
e.g., paper money, is too small to displace gold completely,
gold will continue in circulation. The value of other
money in this case cannot fall below that of gold. For if it
should, it would by Gresham's Law displace gold, which we
have supposed it is not of sufficient quantity to do. The
parity between silver coin and gold coin, under this “limp
ing” standard is, therefore, not necessarily dependent on any
redeemability in gold, but may result merely from limita
tion in the amount of silver coin. Such limitation is usually
sufficient to maintain parity, despite irredeemability. This
is not always true, however; for if for any reason (such as
its novelty and strangeness or rumors of further inflation)
the people should not have confidence in some form of
irredeemable paper or token money, even though it were
not overissued, it would depreciate and be nearly as cheap
in money form as it is in the raw state. It might even be
so completely rejected that it would cease to circulate and
cease to be money. A man is willing to accept money at its
face value so long as he has confidence that every one else is
ready to do the same. But it is possible, for instance, for a
mere fear of overissue to destroy this confidence. The payee,
who under ordinary circumstances submits patiently to
whatever money is a customary or legal tender, may then
take a hand and insist on “contracting out ’’ of the offend
ing standard. That is, he may insist on making all his
future contracts in terms of the better metal — gold, for
instance – and thus contribute to the further downfall in

value of the depreciated paper.
Irredeemable paper money, then, like our irredeemable
silver dollars, may circulate at par with other money if
limited in quantity and not too unpopular. If it is gradu
ally increased in amount, such irredeemable money may
expel all metallic money and be left in undisputed posses

238

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIII

sion of the field. But though such a result — a condition
of irredeemable paper money as the sole currency — is pos
sible, it has never proved desirable. On the contrary, irre
deemability is a constant temptation toward abuse, and this
fact alone causes business distrust and discourages long-time
contracts and enterprises. Irredeemable paper money has
almost invariably proved a curse to the country employing
it. While, therefore, redeemability is not absolutely essen
tial to produce parity of value with the primary money, it
is practically a wise precaution.
The lack of redeemability of silver dollars in the United
States is one of the chief defects in our unsatisfactory
monetary system. Our paper silver certificates are re
deemable in silver dollars, but these silver dollars are not
redeemable in gold. The absurdity of the situation consists

in the fiction that somehow the redemption of the silver cer
tificates in silver dollars keeps them both at par with gold.

The truth is that the paper would keep its parity with
gold just as well if there were no redemption in silver.
A silver dollar as silver is worth less than a gold dollar just
as truly as a paper dollar, as paper, is worth less than a
gold dollar. The fact that the silver is worth half a dollar,
while the paper is worth only a fraction of a cent, will not
avail in the least to make either the silver or the paper
worth a whole dollar. A pillar which reaches halfway to
the ceiling cannot hold the ceiling up any more than a
pillar an inch high. The silver certificates and silver dol
lars keep at par with gold merely because they are not
sufficient in quantity to displace gold. If their quantity
should ever be made great enough, they would displace gold
and depreciate; and the redeemability of one of them in
the other will not avail to prevent such depreciation.

The system of the limping standard, now obtaining in
the United States and some other countries, logically forms
a connecting link between complete bimetallism and those

“composite ” systems by which any number of different

Sec. 6]

OPERATION OF

MONETARY SYSTEMS

239

kinds of money may be simultaneously kept in circulation.
Most modern civilized states have solved the problem of
concurrent circulation by using gold as a standard and
silver, nickel, and copper chiefly as a subsidiary money,
limited in quantity, with, in most cases, limited amounts
of paper money, the latter being usually redeemable. The
possible variations of this composite system are unlimited.
In the United States at present we have a system which
is very complicated, consisting of gold dollars freely coined,
silver dollars, fractional silver, minor coins of nickel and of

copper, United States notes, national bank notes, gold cer
tificates and silver certificates. The system is not only com
plicated, but objectionable in many of its features, especially
in its lack of elasticity, which characteristic is due to the
fact that national bank notes are based upon the inelastic
national debt rather than upon the elastic general assets
of the bank.

CHAPTER XIV
CONCLUSIONS ON MONEY

§ 1. Can “Other Things Remain Equal”?
THE chief purpose of the preceding six chapters is to set
forth the causes determining the purchasing power of money.
This purchasing power has been studied as the effect of
three, and only three, groups of causes. The three groups
center on currency, on its velocity, and on the volume of
trade. These and their effects, namely, prices, we saw to be
connected by an equation called the equation of exchange,
MV + M'V' = Xpo. The three causes, in turn, we found
to be themselves effects of antecedent causes lying entirely
outside of the equation of exchange, as follows: the volume
of trade will be increased, and therefore the price level
correspondingly decreased by the differentiation of human
wants; by diversification of industry; and by facilitation
of communication.

The velocities of circulation will be in

creased, and therefore the price level increased by improv
ident habits; by the use of book credit; and by rapid
transportation. The quantity of money will be increased,
and therefore the price level increased, by the import and
minting of money, and, antecedently, by the mining of the
money metal; by the introduction of another and initially
cheaper money metal through bimetallism; and by the issue
of bank notes and other paper money. The quantity of
deposits will be increased, and therefore the price level
increased, by extension of the banking system and by the
-

24o

Sec. 1]

CONCLUSIONS ON MONEY

24I

use of book credit. The reverse causes produce, of course,
reverse effects.

Thus, behind the three sets of causes which alone affect

the purchasing power of money, we find over a dozen ante
cedent causes. If we chose to pursue the inquiry to still
remoter stages, the number of causes would be found to

increase at each stage in much the same way as the number
of one's ancestors increases with each generation into the
past. In the last analysis myriads of factors play upon the
purchasing power of money; but it would be neither feasible
nor profitable to catalogue them. The value of our analysis
consists rather in simplifying the problem by setting forth
clearly the three proximate causes through which all others
whatsoever must operate. At the close of our study, as at
the beginning, stands forth the equation of exchange as the
great determinant of the purchasing power of money. With
its aid we see that normally the quantity of deposit currency
varies directly with the quantity of money, and that there
fore the introduction of deposits does not disturb the re
lations we found to hold true before.

That is, it is still true

that (1) prices vary directly as the quantity of money, pro
vided the volume of trade and the velocities of circulation

remain unchanged; (2) that prices vary directly as the
velocities of circulation (if these velocities vary together),
provided the quantity. of money — and therefore deposits
— and the volume of trade remain unchanged; and (3) that
prices vary inversely as the volume of trade, provided the
quantity of money and therefore deposits and the veloc
ities of circulation remain unchanged.
But the question now arises, Can the factors supposed
to “remain unchanged” in these three cases actually remain
unchanged? To this question the answer is, “Yes, with
one exception.” A change in the volume of trade per
capita seems to affect, besides prices, the velocities of
circulation, so that these velocities cannot “remain un
changed.” At a given price level, the greater the per
r

242

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIV

capita trade, the more rapid is the individual turnover.
Statistics seem to show this.

Thus an increase in trade, unlike an increase in currency
or in velocities, may have other effects than simply on
prices; for, in fact, it may increase the magnitudes on
the opposite side of the equation. But with this exception
and apart from transition periods, the three groups of

magnitudes which determine the price level — (1) money
and deposits, (2) their velocities, (3) volume of trade – are
independent of each other. That is to say, a change in
the quantity of money, - and therefore of deposits, –
though it may temporarily affect velocities and trade, will
not do so in the long run. Instead it will expend all its
effects on prices, which will therefore change in the same
proportions. Similarly, a change in velocities, though it
may temporarily affect money and deposits as well as
trade, will not do so in the long run, but will also expend
all its effects on prices.
The proof of these conclusions consists simply in the fact
that investigation fails to show any other relations among
the factors in the equation of exchange than those
which have been mentioned.

§ 2. An Increase of Money does not Decrease its Velocity
It cannot be shown, for instance, that (except during
transition periods) there is any tendency for an increase in
the quantity of money to decrease its velocity of circulation.
Some persons who have never investigated the subject
imagine that if money were suddenly doubled in quantity,
prices need not rise at all, as the effect might be simply to
cut the velocity of circulation in two. This would be true
if the public should, for some unaccountable reason, decide
to carry double the former quantity of money while expend
ing precisely the same amounts, but we have found that the
velocity of circulation of money is determined by the habits
of the people. They find for themselves what is the most

SEc. 2)

CONCLUSIONS

MONEY

243

convenient amount to carry in order that it shall be best
adapted to meet their particular expenditures. If, then,
money and expenditure are mutually adjusted to suit the

convenience of the people, this implies that any increase in
the amounts carried would (for a given price level), be
inconveniently large.
To make the picture definite, let us suppose that the aver
age per capita amount of money in actual circulation in the
United States, outside of the United States Treasury and
the banks, is about $15, and that some mysterious Santa
Claus suddenly doubles the amount in the possession of
each individual.

This means that the average individual

will have $30 where before he had $15. Now, statistics
show that the average per capita amount in circulation
changes only slightly from month to month. While the
amount of money carried by an individual will necessarily
fluctuate because of his expenditures and receipts, in a large
group of people the average amount carried by the several
individuals composing the group will fluctuate but little.
If, then, so large an addition to the total circulation is
suddenly made as to put fifteen extra dollars per capita in
the hands of the public, the first thought of most people will
be how to get rid of this inconvenient addition to the money
which they are carrying. If they should be inclined to hoard
it in stockings or safes or to bury it in the earth or to drop
it into the sea, it would have no tendency to raise prices.
Instead, however, they will seek to make some use of it
either by expending it for goods or by depositing it in banks.
Thus a few days after the supposed visit of Santa Claus, the
surprised recipients of the extra money will, in most cases,

have disposed of it in one of these two ways. To the extent
that they dispose of it in the first way — in the purchase of
goods – it is evident that there will be a tendency to raise
prices, for the sudden expenditure of $15 per capita, even

by a small fraction of the people of the United States, will
mean a phenomenal rush upon the shops.

244

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIV

The average individual does not expend in actual money
more than $15 in two weeks. This is about a dollar a day,
or about $100,000,ooo a day for the entire country. If
within, let us say, five days from his windfall of $15 the
average man should try to spend this extra sum, the result
would be $3 per day per capita, or $300,000,ooo a day for the
nation. This, in addition to the usual $100,000,ooo a day,
would make $400,000,000 a day, or four times the ordinary
rate of expenditure. Such a sudden briskness in trade
would astonish the shopkeepers and lead them promptly to
raise their prices; otherwise, in many cases their stocks
would be entirely depleted.
At first sight, it might seem that it would only require a
few days for each one to get rid of his extra money so that
the flurry in prices would, therefore, be only temporary;
but such reasoning would be fallacious; for we must not
forget that the only way in which the individual can get rid of
his money is by handing it over to somebody else. Society
is not rid of it. If the shopkeepers, who under our Santa
Claus hypothesis have already had their till money doubled
mysteriously, receive in addition the surplus cash of their
customers, they will now be the ones embarrassed with a
surplus of cash and will, in their turn, endeavor to get rid
of it, by purchasing goods for their business or by depositing
it in banks. Since, then, the effort to get rid of money by
transferring it merely results in somebody else having a
surplus, the surplus in the community remains unchanged.
Therefore, the effort to get rid of it and the consequent effect
on prices will continue until prices have reached a sufficiently
high level.
This conclusion cannot be avoided by supposing that
most of the money is not spent in trade, but deposited in
banks. The bankers whose deposits are thus suddenly
swollen will now be the ones who will strive to get rid of the
surplus cash. No banker wishes to have idle reserves, and
-

each will make the increase in reserves the basis for an in

SEc. 2)

CONCLUSIONS ON

MONEY

245

crease of business, including an increase of deposits. We have
seen that this tendency results ultimately in preserving the
relative amounts of the three magnitudes: money in circula
tion, money in bank reserves, and deposits based on these re
serves. In the end, then, the doubling of society's money will
mean a doubling (1) of the money in circulation, (2) of the
money in banks, and (3) of the deposits based on this money.
In a short time it will also mean a doubling of prices, for as
long as prices fail to be double what they were, there will
be the same phenomenon of inconvenient surpluses. Indi
viduals, tradesmen, bankers, etc., will be trying to get rid
of these surpluses, and their efforts to get rid of them must
tend to raise prices. When, however, prices have reached
double their original level, there will be no longer any effort
to get rid of surplus cash; for there will be no surplus cash.
The $30 per capita which has thus been created will no
longer seem excessive, in view of the fact that prices are
double what they formerly were and that the persons carry
ing this money will, on the average, find their wages or
incomes doubled likewise. Thus, if formerly the average
individual was accustomed to spend $300 and to carry an
average balance of $15, he will now spend $600 and carry
an average balance of $30. The adjustment of the $30 to
$600 is exactly the same as the former adjustment of the
$15 to $300. In either case the relation is one to twenty,
which means that the individual turns his money over, on the
average, twenty times a year. Thus, in the end, a doubling
of the quantity of money does not expend its effect in dis
turbing the velocity of circulation, but in raising the general
level of prices.
It is worth noting that the imaginary example we have
given represents, except in its details, exactly what actually
happens when new gold is discovered. Gold miners convert
their product into money, sometimes using it as such in the
form of nuggets or gold dust and sometimes taking it to the
mint and converting it into coin. They find themselves in

246

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIV

possession of bags full of money far beyond what they need
as the most convenient amount of pocket money. If, for
instance, one of these men has just received from the mint

a thousand dollars in gold, he is almost sure to get rid of
at least $950 of it as speedily as possible, either by spending
it or by depositing it in the bank. In either case, he and
the hundreds of others who are doing the same thing tend to
raise prices in the community where they are spending their
money or where they and others spend checks on the banks
in which they deposit their money.
It was thus that prices rose in the mining camps of Cali
fornia a half dozen decades ago and one or two decades ago
in Colorado and the Klondike. This local rise of prices then
communicated itself to other places; for, as we have seen, the
price level cannot in one locality greatly exceed that in a
neighboring locality without causing an export of money
to the cheaper locality. Thus, new money gradually finds
its way into circulation throughout the world, raising prices
as it flows from place to place, the process consisting in
all cases of the effort to get rid of an inconvenient surplus and
one which cannot be permanently got rid of by transferring
it from hand to hand, but only by a rise of prices.
This picture of the manner in which an increase of money
causes a rise of prices is here given to show clearly that an
increase in the amount of money (M) does not result in a
mere decrease in its velocity (V). Its velocity depends, not
on its quantity, but on the factors given in Chapter XI,
§§ 3, 4, 5.

In the same way it might be shown that an increase in the
quantity of money will not affect the velocity (V') of circu
lation of bank deposits nor the volume of trade (the Q's).
It will merely affect the volume of deposits (M') and the
level of prices (P).
A change of M does not, of course, prevent other causes

from at the same time affecting M", V, V, and the Q's, and
thus aggravating or neutralizing the effect of M on the p’s.

SEc. 3]

CONCLUSIONS ON MONEY

247

But these are not the effects of M. So far as M by itself is

concerned, its effect is only on M and the p's and is propor
tional to its quantity. The importance and reality of this
proposition is not diminished in the least by the fact that
these other causes do not, as a matter of fact, remain qui
escent and allow the effect on the p's of an increase in M
to be seen separately from effects of other causes. The
effects of changes in M are blended with the effects of
changes in the other factors in the equation of exchange,
just as the effects of gravity upon a falling body are
blended with the effects of the resistance of the atmosphere.
Our main conclusion, then, is that we find nothing to

interfere with the truth of the quantity theory: that varia
tions in money (M) produce, normally, proportional changes
in prices.
We have now finished with the principles determining
the purchasing power of money. By the aid of these prin
ciples the student should be able to avoid hereafter most
of the fallacies and pitfalls which beset the subject. He
will find it a useful exercise to turn back to Chapter I and
test himself by analyzing as many as he can of the money
fallacies there stated. The others we hope to clear up in
later chapters.
§ 3. An Index Number of Prices

We have been studying the causes determining the pur
chasing power of money, or its reciprocal, the level of prices.
Hitherto we have not defined exactly what a “general level.”
of prices may mean. There was no need of such a definition
so long as we assumed, as we have usually done hitherto,
that all prices move in perfect unison. But practically,
prices never do move in perfect unison. If some p's do not

rise enough to preserve our equation, others must rise more.
If some rise too much, others must rise less. The case is

further complicated by the fact that some prices cannot

248

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIV

adjust themselves at all and some can adjust themselves
but tardily. A price fixed by contract cannot be affected
by any change coming into operation between the date
of the contract and that of its fulfillment.

The existence of

such contracts constitutes one of the chief arguments for a

system of currency such that the uncertainties of its pur
chasing power are the least possible. Contracts are a
useful device; and an uncertain monetary standard dis
arranges them and discourages their formation. Even in
the absence of explicit contracts, prices may be kept from
adjustment by implied understandings and by the mere
inertia of habit.

And besides these restrictions on free

movement of prices there are often legal restrictions; as,
for example, when railroads are prohibited from charging :
over two cents per passenger per mile, or when street rail
ways are limited to five-cent or three-cent fares. What
ever the causes of non-adjustment, the result is that the
prices which do change will have to change in a greater ratio
than they would were there no prices which do not change.
Just as an obstruction put across one half of a stream
causes an increase of current in the other half, so any de
ficiency in the movement of some prices must cause an
excess in the movement of others.

Another class of goods, the price of which cannot fluctu
ate greatly with other prices, are those special commodi
ties which consist largely of the money metal. Thus, in a
country employing a gold standard, the prices of gold for
dentistry, of gold rings and ornaments, gold watches, gold
rimmed spectacles, gilded picture frames, etc., instead of
varying in proportion to other prices, always vary in a
smaller proportion. The range of variation is the nar
rower, the more predominantly the price of the article de
pends upon the gold as one of its raw materials.
From the fact that gold-made articles are thus more or

less securely tied in value to the gold standard, it follows
also that the prices of substitutes for such articles will tend

SEC. 3]

CONCLUSIONS ON MONEY

249

to vary less than prices in general. These substitute articles
will include silver watches, ornaments of silver, and various

other forms of jewelry, whether containing gold or not.
A further dispersion of prices is produced by the fact that
the special forces of supply and demand are playing on
each individual price, and causing relative variations among
them, and although these variations cannot affect the
general price level they can affect the number and extent
of individual divergencies above and below that general
level.

It is evident, therefore, that prices must constantly
change relatively to each other, whatever happens to their
general level. It would be as idle to expect a uniform move
ment in prices as a uniform movement for allbees in a swarm.
On the other hand, it would be as idle to deny the existence
of a general movement of prices because they do not all
move alike as to deny a general movement of a swarm of
bees because the individual bees have different movements.

The general movement of prices is expressed by an “index
number '' which gives the average level of prices at any time
as compared with some other time used for comparison.
Besides the changes in individual prices, there will be
corresponding changes in the quantities of the commodities
which are exchanged at these prices respectively. In other
words, as each p changes, the Q connected with it will
change also, because usually any influence affecting the
price of a commodity will also affect the consumption of it.
We see, therefore, that it is well-nigh useless to speak of
uniform changes in prices (p’s) or of uniform changes in
quantities exchanged (Q's). Therefore, instead of sup
posing such uniform changes, we must now proceed to the
problem of developing some convenient method of indicating
by an average the general trend of the changes in prices or in
quantities. We must formulate two composite or average
magnitudes: the price level (index number) and the vol
ume of trade.

* >
25o

ELEMENTARY PRINCIPLES OF

ECONOMICS

*...

XIV

It is desired, then, in the equation of exchange, to ºne
vert the right side, Xp(), into the form PT, where T measures
the volume of trade, and P is the “index number '' ex
pressing the price level at which this trade is carried on.
T is conceived as the sum of all the Q's, and P as the
average of all the p’s.
To carry out these definitions in practice, suitable units
of measure for the various articles must be selected.

The

ordinary units in which the various Q's are measured will
not be the most suitable. Coal is sold by the ton, sugar
by the pound, wheat by the bushel, etc. If we should
merely add together these tons, pounds, bushels, etc., and
call their grand total so many “units " of commodities, we
should have a very arbitrary summation. It will make a
difference to the result whether we measure coal by tons
or hundredweights. The system becomes less arbitrary
and more useful for the purpose of comparing price levels
in different years if we use, as the unit for measuring any
commodity, not the unit in which it is commonly sold, but
the amount which constitutes a “dollar's worth” at some partic
ular year called the base year. Then every price in the base
year becomes exactly one dollar, and the average of all
prices in that year also becomes exactly one dollar. In any
other year, the average price (i.e., the average of the prices
of the arbitrarily chosen units which in the base year were
worth a dollar) will be the index number representing the
price level, while the number of such units will be the volume
of trade. Thus, let us suppose, for simplicity, that there

are only three commodities (bread, coal, and cloth), and let
us use the table on the next page for facts to start with.
We wish to compare the average price or price level in
the year 1912 with that in 1909 as the base year, and
also to reckon the total volume of trade in 1912 in com
parison with that in 1909. If we were not desirous of taking
great pains to secure the best results, we could use the above
figures just as they stand – averaging the prices and adding

..º
-

ſº
SEc. 3]

25I

CONCLUSIONS ON MONEY

*ther the quantities. By this rough-and-ready method
the average price per unit for 1909 would be (.1o + 5.oo
PRICEs (IN Dollars)

QUANTITIES Exchanged

YEAR

Bread (per | Coal (per | Cloth (per | Bread (Mil- Coal (Mil- Cloth (Mil

Ton)

Yard)

lions of
Tons)

lions of

Loaves)

lions of

Yards)

IQO9

..IO

5.oo

I.OO

2OO

1912

. I5

6.oo

I. Io

2IO

+ 1.oo) + 3, or $2.03; and for 1912 (.15+6.oo + 1.10) +3,
or $2.42; the total trade for 1909 would be 200 + Io + 30,
or 240 million units; and for 1912, 2Io + II + 35, or 256.
That is, the price level would show a rise between 1909 and
1912 from $2.03 to $2.42, or a rise of nineteen and two tenths
per cent, while the volume of trade would show a rise from

24o to 256, or six and six tenths per cent. But the simple
method just used gives too much weight in the price
comparison to coal, the price of which happens to be
expressed by a large number simply because it is measured
by a large unit. One way to remedy this disproportionate
weighting is to measure all articles by one unit, as the
pound; but a better way is that already described above,
viz., to use as our unit “the dollar's worth in 1909.” The
dollar's worth of bread in 1909 was evidently ten loaves,
the dollar's worth of coal, the fifth of a ton, and that of

cloth, the yard. Taking these units, we now have:–
PRICEs (IN Dollars)

QUANTITIES

YEAR

Bread (Mil- Coal (MilBread (per | Coal (per | Cloth (per j :
-

Ten Loaves)|

: Ton)

$º

º º

Cloth (Mil
-

§§

IQOQ

I.O.O.

I.OO

I.O.O.

I912

I.5o

I.2O

I. IO

252

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIV

The average price in 1909, on the basis of these new units,
is simply $1, since this is the price of each individual article;
while the average price in 1912 is — if we take the simple
arithmetical average—($1.5o +$1.20 + $1.10) + 3, or $1.27.

The total volume of trade in 1909 is (in millions of units)
20 + 50 + 30, or Ioo; and in 1912, 21 + 55 + 35, or III.
Thus, according to this reckoning, the price level has risen
from $1.oo to $1.27, or, as it is usually expressed, from a base
of one hundred per cent to a height of one hundred and
twenty-seven per cent — a rise of twenty-seven per cent;
while trade has increased from Ioo million units to III

million units, an increase of eleven per cent.
We may slightly improve the above method by taking
for 1912 a “weighted ” average of prices instead of a
simple average. It is found by dividing the total value of
all the goods by their total quantity. This is a better
method because, in the result, it gives less weight to the
commodities less dealt in, such as bread. The average for
1909 will still be $1.oo, for that is the price for each in
dividual commodity; but the average for 1912 will be
slightly different. The total value is (in millions of dollars)
1.5o X 21 + 1.20 X 55 + 1. Io X 35, or 136 million dollars,
and the total quantity is, as we have already seen, 21 + 55
+ 35, or III million units; consequently the average price
is 136 + III, or $1.23. According to this last and best
method, then, the price level has risen from $1 (or one
hundred per cent) to $1.23 (or one hundred and twenty
three per cent); this indicates a rise of twenty-three per
cent. The index numbers are one hundred per cent for
1909 and one hundred and twenty-three per cent for 1912.
The results of the three methods of reckoning the average
rise of prices differ slightly, showing respectively a rise of
nineteen, twenty-seven, and twenty-three per cent. Other
methods, of which many are possible, would also differ
slightly. No method gives an absolutely perfect index of
changes in price levels, but the last one worked out above is

SEC. 4)

CONCLUSIONS ON MONEY

253

as good as any. The main point in any system of averages
is to give great weight to the great staples of trade, and little
weight to the insignificant articles. Radium has fallen
in price enormously in the last few years, but radium is
so unimportant as an article of commerce that its great
fall ought not to be allowed in our reckoning to have
much effect on the index number for the general price
level.

Introducing, then, our newly found magnitudes, P and
T, into the equation of exchange, it assumes the form
MV + M'V' = PT,
its right member being the product of the index number,
P (or the average of prices), multiplied by the volume of
trade, T (or the sum total of “units'' sold).
§ 4. The History of Price Levels

It is impossible to have absolutely accurate index num
bers, but those constructed for recent years by the United
States Bureau of Labor are accurate enough for all practical
purposes. For the remote past we have only very rough
index numbers, because the records of prices in past times
are so defective. These rough index numbers are suffi
cient, however, to show that the general trend of prices dur
ing the last ten centuries has usually been upward. We
may say that prices are now five to ten times as high as a
thousand years ago. Since the discovery of America, prices
have almost steadily risen. The successive opening of

mines has been largely responsible for this rise.
For recent years (1896–1910) we are able to construct
fairly accurate estimates of all the factors in the equation

of exchange, M, M', V, V', P, T. The statistics of these
magnitudes for the fifteen years mentioned are all presented
in Figure 17. In this diagram the equation of exchange

254

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIV

for each year is represented by the mechanical balance
described in a previous chapter.

We note that in the years considered every factor has
greatly increased. The quantity of money in circulation
(M, represented by the purse) has about doubled; bank

deposits subject to check (M', represented by the bank
book) have about trebled; the volume of trade (T, repre
sented by the weight at the right) has about doubled; the
velocity of circulation of money (V, represented by the
leverage of the purse, or its distance from the fulcrum) has
increased slightly, and the velocity of circulation of bank

deposits (V', represented by the leverage of the bank book)
has increased considerably. As the net result of these
changes, the index number of prices (P, or the leverage of
the weight at the right) has increased about two thirds.
As in the above illustration, the price level of 1909 is taken
as Ioo 9%. On this scale the price level of 1896 is 60%, and
that of the other years, as indicated. The volume of trade
for any year is represented as the number of “dollars'
worth '' on the basis of the prices in 1909. Thus the actual
value of trade in 1909 was $387,000,000,000, or over a bil
lion a day, i.e., 387 billion units of goods of various kinds,
the units being such as to be each worth one dollar in 1909.
The trade in 1910 was 399,000,ooo,000 of these same units
(i.e., such as were worth $1 in 1909). Similarly, the trade
in 1896 was 191,000,000,ooo of these units. As the index
number of prices shows that the price level of 1896 was .
only aboutsixty per cent of the price level of 1909, the actual
value of the trade in 1896 was only $114,600,000,ooo.
This is PT for 1896, i.e., 191 billion units (each worth $1
in 1909) at 60 cents each, the price in 1896.
Let us express the matter in terms of cause and effect.
The diagram affords a picture of the fact that the increases
in money and deposits and in their velocities (represented,
respectively, by the increased weights of purse and bank
book, and their increased distances from the fulcrum) have

Sec. 4)

CONCLUSIONS ON MONEY

255

necessitated an increase in average prices (represented by the
increased distance of the tray from the fulcrum) in spite of
the increased volume of business which has been transacted

(represented by the increased weight of the tray).
It is interesting to observe the changes in all the factors
before and after the crisis of 1907. These changes, it will
be noted, fulfill the principles explained in the chapter on
crises.

From 1896 to the present time, the extraordinary increase
in the world's gold production, chiefly in South Africa,
Cripple Creek, and other parts of the Rocky Mountain
Plateau, together with the Klondike region, has caused,
and is still causing, a rapid rise of prices.
The history of prices has in substance been a race between
the increase in media of exchange (M and M') and the
increase in trade (T), while the velocities of circulation
have changed in a much less degree. Sometimes the
circulating media shoot ahead of trade, and then prices
rise. Sometimes, on the other hand, circulating media
lag behind trade, and then prices fall.
The outlook for the future apparently promises a con
tinued rise of prices due to a continued increase in the gold' p : « /
supply and in the use of deposit banking.
The most careful review of present gold-mining conditions
shows that we may expect a continuance of gold inflation
for a generation or more. De Launay, an excellent authority,
says, “For at least thirty years we may count on an output
of gold higher than, or at least comparable to, that of the
last few years.” This gold will come from the United
States, Alaska, Mexico, the Transvaal, and other parts of
Africa and Australia, and later from Colombia, Bolivia,
Chili, the Ural Province, Siberia, and Korea.

It is difficult to predict the future growth of trade, and
therefore impossible to say for how long gold and deposit
expansion will keep ahead of trade. That for many years,
however, they will outrun trade seems probable, for the

256

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIV

reason that there is no immediate prospect of a reduction
in the percentage growth of money and deposits, nor an
increase in the percentage growth of trade. Not only do
mining engineers report immense workable deposits in out
lying regions, but any long look ahead must reckon with
possible and probable cheapening of gold extraction. The
cyanide process, for instance, has made low-grade ores pay
which did not pay before. If we let imagination run a
little ahead of our times, we may expect similar improve
ments in the future whereby still lower grades may be
worked, or the gold bearing clays of the South made to
pay, or possibly even the sea compelled to give up its gold.
Like the surface of the continents, the waters of the sea con

tain many thousand times as much gold as all the gold thus
far extracted in the whole history of the world. We have
seen that inflation is, in general, an evil, likely to culminate
in a crisis. It is therefore to be hoped that the knowledge
of how to get this hidden treasure may be secured but
gradually, - unless its sudden acquisition may give the
needed stimulus to governments to devise a more scientific
standard of value than the yellow metal.
It is unfortunate that the purchasing power of money
should be always at the mercy of every chance in gold
mining. There are few enterprises more subject to chance
than gold mining. There are always chances of finding
new gold deposits, chances of their “panning out ’’ well or
ill, and chances of new methods of metallurgy. On these
fitful conditions the purchasing power of money is dependent.
Consequently every one interested in long-time contracts,
whether debtor or creditor, stockholder or bondholder, wage
earner or savings bank depositor, is made to Some extent
a partaker in these chances. In a sense every one of us who
uses gold as a standard for deferred payments becomes a
gold speculator. We all take our chances as to what the
future dollar will buy. The problem of making the pur
chasing power of money stable so that a dollar may be a

SEC. 4)

CONCLUSIONS ON MONEY

257

dollar — the same in value at one time as another — is one

of the most serious problems in applied economics. As yet
it has received very little attention. The advocates of
bimetallism have claimed that “the bimetallic standard ”

possesses greater stability than either the gold or silver
standard. Many other and very ingenious schemes for
a more stable currency have been proposed, but have re
ceived very little attention.

As the consideration of these

schemes belongs to applied economics, we shall not discuss
them here.

CHAPTER XV
SUPPLY AND DEMAND

§ 1. Individual Prices Presuppose a Price Level

WE have completed our study of the purchasing power of
money, which, as has been noted, is really a study of price
levels. Our next topic will be individual prices. Prices,
as we find them in the market, are facts of everyday ex
perience. As students of economics, we are seeking the
explanation of these facts. Why, for instance, is the
price of sugar six cents a pound at one time and seven or
five at another?

It has already been shown (Chapter VIII, § 1) that
individual prices, such, for instance, as the price of sugar,

presuppose a price level. This fact is one reason why we
have considered price levels before considering individual
prices. Before proceeding to the causes determining in

dividual prices, it will be advisable to explain more fully
this proposition that an individual price presupposes a price
level.

The price of sugar is a ratio between sugar and money.
Any one who buys sugar balances in his mind the impor
tance of the sugar to him against the importance of the
money which he has to pay for it. In making this com
parison, the money stands in his mind for the other things
which it might buy if not spent for sugar. If this general
purchasing power of money is great, money will seem
258

Sec. 1]

SUPPLY AND

DEMAND

259

precious in his mind, and he will be more loath to part
with a given amount of it than if its purchasing power is
small; that is, the greater the power of money to purchase

things in general, the less of it will be offered for sugar in
particular, and the lower the price of sugar will therefore
become. In other words, the lower the general price level,

the lower will be the price of sugar. In still other words,
the price of sugar must sympathize with prices in general.
If they are high, it will tend to be high, and if they are low,
it will tend to be low. Before the purchaser of sugar can
decide how much money he is willing to exchange for it,
he must have some idea of what else he could buy for his
money. This explains why a traveler feels at first so help
less in a foreign country when he is told the prices of goods
in terms of unfamiliar units.

If the traveler has never,

heard before of kroner, gulden, rubles, or milreis, any
prices expressed in these units will mean nothing to him.
He cannot say how many of any one of these units he is
willing to pay for any given article until he knows how the
purchasing power of that unit compares with the unit to
which he is accustomed. There must thus always be in
the minds of those who use money some idea of its pur
chasing power. The sellers and buyers of sugar express the
prices at which they are willing to supply or to demand in
terms of money, and money means to them merely pur

chasing power over other things. It is often said that supply
and demand of sugar or of any other commodity determine
its price, and this is true, at a given price level; for those
who supply or demand sugar, in deciding how much
money they will take or give for it, are influenced by their

idea of the general purchasing power of money.

This
•

needs emphasis because it is so often overlooked. Although.”
the purchasing power of money is assumed, we are usually
as unconscious of it as we are of the background of a picture
against which we see and unconsciously measure the figures
in the foreground.

26o

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

§ 2. A Market and Competition

The terms “ supply ” and “demand,” say, of sugar,
thus imply a concealed reference to the purchasing power
of money, i.e., to prices in general, as well as to the price of
sugar in particular. As we have, through several previous
chapters, already studied the subject of prices in general,
we shall hereafter assume that the general level of prices
has been determined in accordance with the principles set
forth in those chapters relating to the equation of exchange.

We are now ready to leave these general relations and to
study the determination of a particular price (such as that
of sugar) so far as this depends upon its own particular
supply and demand in its own particular market.

A market for any good is any assemblage of buyers and
sellers of that good. The buyers and sellers may be, and
usually are, physically near each other, as on the New York
Stock Exchange, or they may be merely connected by tele
graph, telephone, or other means of communication, as in
the stock market as a whole; for the stock market as a

whole includes not only the members of the stock exchange,
but also all other buyers and sellers of stock both in and
out of the city. It is in the market that questions of supply
and demand which we are about to discuss work them
selves out.

Our study of price determination will fall under two
heads, according as there is competition or monopoly.
For the present we shall assume a condition of perfect
competition; that is, we shall assume that there are a

*...* number of buyers and sellers each of whom offers to buy
t ...”. , or sell independently of the others. Thus, if self-interest
º, ſº. leads him to do so, a buyer will bid a higher price than
tº-

"others.

irrespective of their wishes in the matter, and

likewise a seller will ask a lower price if his independent
self-interest so leads him.

Sec. 3]

SUPPLY AND DEMAND

261

When there is perfect competition, there is (in a given
market) only one resultant price for all buyers and all
sellers.

This is evident; for if there were more than one

price, no buyers would buy at any of the higher prices
which had first been asked (and so these must fall), and no
seller would sell at the lower prices which had been bidden
(and so these must rise). The watchfulness of one com
petitor toward the others will eliminate differences in
price. Even though not all buyers and sellers are careful
to note slight differences in price, the more watchful bring
about the same result by the operation of what is called
“arbitrage.” They buy at the lowest prices and sell at
the highest. Their buying raises the lowest prices, and
their selling lowers the highest.
In these ways differences in prices are reduced or entirely
eliminated. It is true that in practice there often remain
slight differences in price, even in the same or closely as
sociated markets. This fact merely means that competi
tion is often imperfect. In our discussion we shall not take
account of those cases, but consider only the simple case
where competition is perfect.
§ 3. Demand and Supply Schedules
The terms “supply ’’ and “demand ” have a definite and
technical meaning in economics, and the reader should note
the following definitions carefully.
In any market there is a different demand for sugar at
different prices. We may define the demand at a given
price as the amount of sugar which people are willing to
buy at that price. In the same way the supply at a
given price is the amount which people are willing to
sell at that price. If the price of sugar is 8 cents a pound,
the demand for sugar in a given community at a given time
may be, let us say, 9oo pounds a week. If the price falls
to 7 cents, the demand would increase, say, to 940 pounds.

262

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

If the price falls to 6 cents, the demand would rise, say, to
Iooo pounds; and so on.

The supply of sugar, we shall suppose, changes in the
opposite way. At 8 cents it may be 11oo pounds; at 7
cents, IoSo; at 6 cents, Iooo; etc. The following table
shows these figures and others, and constitutes what are
called “Schedules" of demand and supply in relation to
various prices.
The schedule of demand is the second column considered

relatively to the first. It shows the largest quantity which
will be taken at each given price, or, what amounts to the
same thing, the highest price at which a given quantity will
be taken. When the relationship between the two columns
is expressed in the latter of these two ways, it is more con
venient to place the second column first, and the first, second;
but their order is immaterial. It is their relation to each
other which constitutes the demand schedule.

.o8

900

IIOO

.o?
.o6
.O5

94o

IoSo

IOOO

IOoo

I IOO

900

.O4

I25o

75o

In the same way the relation between the first and third
columns constitutes the supply schedule. This tells us the
largest quantities which will be supplied at stated prices,
or, what amounts to the same thing, the lowest prices at
which stated quantities will be supplied.
Running the eye down the table, we see that, although
the supply at first exceeds the demand, as the price falls
the demand increases and the supply decreases, until,
when the price reaches 6 cents, supply and demand are

SEC. 4)

equal.

SUPPLY AND DEMAND

263

For prices lower than 6 cents we find the reverse

condition, demand exceeding supply.
If the foregoing figures represent the demand and supply
schedules showing the amounts that buyers are willing to
take and sellers to give at different prices, it is clear that there
is only one price that will make supply and demand equal.
That price is 6 cents, and that is the price that supply and
demand will finally fix. The price cannot long be above
6 cents, for then supply would exceed demand, and the
price would immediately fall. Nor can it be below, for then
demand would exceed supply, and the price would rise. For
instance, if the price were 8 cents, the supply (11oo pounds)
would exceed the demand (900 pounds) by 200 pounds.
Those wishing to sell this extra amount would then be unable
to do so except by offering it at a lower price, and their com
petition would drive the price down. On the other hand,
if the price were 4 cents, the demand (1250 pounds) would
exceed the supply (750 pounds) by 5oo pounds, and those
demanding this extra amount would be unable to get it ex
cept by bidding a higher price, and their competition would
then drive the price up.
Since, then, the price cannot really be either above or
below 6 cents, it must be finally fixed at 6 cents. A price
which thus makes supply and demand equal is said to
“clear the market,” and is called the market price. The
amounts supplied and demanded at the market price are
called the amount marketed, i.e., the amount actually bought
by buyers and sold by sellers. This amount marketed is,
therefore, at once the market demand and the market supply.

§ 4. Demand and Supply Curves
The relations discussed in § 3 above can be seen more
clearly by means of a diagram. In Figure 18 is repre
sented the demand for sugar at different prices.

The two axes OX and OY are drawn simply for

264

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

reference, like the equator and the Greenwich meridian in
a map. The intersection O of the two axes is called the
“origin.” The diagram is a “map” of demand on which
the “latitude,” or
Y

the distance above

the line OX, repre

sents any price;

and the “longi
tude,” or the dis

tance to the right
of the line OV,

represents the
amount demanded

at that price. Let
O

aoo

4oo 6oo

Boo looo 1200

FIG. 18 (Demand).

us, for instance,
X represent an as
sumed price, Say

8 cents, by
measuring off the “latitude " Oy from the origin O.
At this price of 8 cents, the demand, which we have seen
to be 9oo pounds, is represented by the “longitude ’’ yD.
We have thus located a point D, the “latitude" of which
represents a particular price (8 cents), and the “longitude”
of which represents the demand (900 pounds) at that
price. It will be seen that the “latitude” is simply the
elevation above the base axis OX, whether we measure
this “latitude " by the line Oy or by a D. Likewise the
“longitude '' is simply the distance of D to the right of
the axis OV, whether this distance be measured by y D or
by Ox. Having found one point, D, the “latitude ’’ and
“longitude" of which represent, respectively, a price and
the demand at that price, we may find in like manner
other points, the “latitudes" and “longitudes " of which
will represent other particular prices and the demands
corresponding to those prices. Several such points are
indicated in Figure 18. It will be seen that the lower in

SEC. 4)

SUPPLY AND DEMAND

265

the diagram the points, the farther they are to the right.
This represents the fact that the lower the price, the greater
the demand. We may suppose the spaces between those
various points to be filled by other points, all together
forming what is called the demand curve.
A demand curve, then, is a curve such that the “lati

tude” of any one of its points represents a particular price,
and the “longitude” of that point the particular demand
corresponding to that price. Thus a demand curve is a
graphic picture of
---

a demand schedule.

In precisely the

Y
12

same way we may

treat supply. In
Figure 19 let us
represent any par

ticular price, say
8 cents, by the
“latitude” Oy,
and the supply
corresponding to O
20o 4oo soo Boo loooºlzoo
X
this price (11oo
FIG. 19 (Supply).
pounds) by the
“longitude '' yS. Thus we locate a point S such that its
“latitude '' (Oy or zS) represents a particular price, and
the “longitude” (yS or Ox) represents the supply at that
particular price. In like manner we may locate other
points, the “latitudes" of which represent other prices
and the “longitudes" of which represent the amounts
which would be supplied at these respective prices.

These

points are so arranged that the higher their “latitude,” the
greater their “longitude.” This represents our assumption
that the higher the price, the greater the supply. The
curve which these points form is called a supply curve and
is a graphic picture of a supply schedule.

266

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XV

In Figure 20 are drawn both the supply and the
demand curves, the demand curve being DD", and the
supply curve SS'. We have seen that the demand curve
shows many different demands at many different prices,
and that, similarly, the supply curve shows many differ
ent supplies at
Y
many different
prices; but that
there is only one
price at which
supply and de
mand are equal.
We can see this

clearly in Figure
20; for there is

only one point(P)
in which the two
curves intersect.

The “latitude ’’
FIG. 2d.

(OP') of the in

tersection (P) of the curves DD’ and SS' represents the
market price. The “longitude" of P represents the amount
marketed, which is at once the supply at that price and the
demand at that price. The point P may be called the
market point.

The market price, OP', clears the market, and no other
price will.

If, for instance, we take a higher price, such

as OP", the supply will be represented by the long line
P"S", and the demand by the short line P"D", leaving the
difference between them, or D"S", as the excess of supply
over demand. The effort of sellers to get rid of this excess
will drive the price down. Thus the market price cannot

exceed OP’. In like manner, the market price cannot be
lower than OP’. If, for instance, it were only OP", the
demand would be P"D", and the supply only P"S",
leaving an excess of demand over supply of D"S", which
*

SEc. 4)

SUPPLY AND

DEMAND

267

at that price the buyers are unable to obtain. They will
therefore bid up the price. We see, then, that the only real

price is OP'. The point P, at which the two curves in
tersect, is the only real point, the latitude of which repre
sents the market price and the longitude the actual amount
demanded and sold. All the other points in the two curves
are hypothetical, representing, not what demand and supply
actually are, but what they would be at other prices than the
real market price.
All demand curves descend to the right. But they de
scend at different rates.

Those demand curves which are

steep – descend very rapidly — represent the demand
schedules of those goods which are called necessities, for .

the rapid descent means that it requires a great fall of
price to affect demand materially. They have an “in
elastic” demand, which will “stretch” but little whatever
the change in price. We know that the demand for a
necessity such as salt does not change greatly, even if the
price changes much. Otherwise expressed, a necessity has
an “inelastic” demand which will “stretch” or expand
but little for a given fall in price. At the other extreme
are luxuries, the demand curves of which descend very
slowly, thus interpreting the fact that a slight fall in price
produces a great expansion in demand. Otherwise ex
pressed, a luxury has an “elastic” demand which will
“stretch” or expand much for a given fall in price. If
the price of champagne, for instance, is slightly changed,
the amount of it consumed will be materially affected.
In the same way supply curves may ascend at different
rates, the steep ones representing commodities the supply
of which is “inelastic,” that is, cannot expand very much
for a given increase in price. At the opposite extreme are
the supply curves which ascend very slowly, being those of
commodities, the supply of which is very “elastic”— can
be greatly increased by a given increase in price.
Most of the articles produced in extractive industries

268

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

such as agriculture or mining are of the rapidly ascending
type, while manufactured articles often illustrate the
slightly ascending type. It requires a great increase in the
price of coal to affect materially the output of coal mines,
but it requires only a slight rise in price of manufactured
products to lead to an enormous increase in the output.
§ 5. Shifting of Demand or Supply

Having represented supply and demand by curves, we
are now in a position to understand more clearly what is
meant by “increase of demand ”or “increase of supply.”
These phrases are often used loosely, without realization
that they are ambiguous. Sometimes we hear it said
that “ demand has increased ” when the speaker merely
means that demand has increased as a consequence of
a fall in the market price; that is, the demand at a new
and lower market price is greater than the demand at
the old and higher market price, although the demand
at this old price remains unchanged. Thus if the price
of sugar falls from 8 cents to 5 cents per pound, the
demand at the new market price, 5 cents, will exceed
the old demand at the old market price, 8 cents, al
though the amounts demanded at 8 cents may remain
unaltered and the amount demanded at 5 cents may
remain unaltered.

In this case the demand schedule

remains unchanged. Only the particular demand in that
schedule which corresponds to the market price is shifted

downward in the second column (see §3).
Again, and more properly, we hear it said that
“demand has increased ” when the speaker means that the
demand at a specified price has increased; as, for instance,
that more sugar is demanded at 8 cents than formerly,
and more, likewise, at 5 cents, or any other price; that in
short the demand schedule has changed through the in
crease of the figures in the second column.

SEc. 5]

SUPPLY AND DEMAND

269

The two meanings
which have been distin

guished may be desig
nated respectively as “in
crease of the market
demand” and as “increase
of the demand schedule.”

We have spoken only of
changes in demand. But
o
X
the same distinctions apply,
FIG. 21 (Demand).
of course, to two meanings
of the phrase “increase of supply,” one, an increase in

Y| A

the market supply, and the

other, an increase in the
supply schedule.
We may see clearly the
distinction

between

these

two meanings of the phrase
“increase of demand ” and
avoid their confusion if we

FIG. 22 (Demand).

express them by means of
X diagrams. Increase of de
mand may mean a mere

shifting of the market point from one position A to another
position B, farther to the
right on the same demand Y
curve (Fig. 21), or it may
mean a shifting of the entire

demand curve from the posi
tion A to the position B,
farther to the right (Fig. 22).
Both of these meanings
are admissible, but they are
entirely distinct. In the

same way, “increase of

supply ’’ may mean one of

FIG. 23 (Supply).

27o

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

two things, either a shifting of the market point A to another
position B, farther to the right, on the same supply curve
(Fig. 23), or a shifting of
Y
, the entire supply curve from
the position A to the posi
tion B farther to the right,
as in Figure 24. We see,
therefore,

that

“in

crease of supply” or of
demand may mean either
a change of the market
point on the same curve
or a change of the curve

itself.
FIG. 24 (Supply).

It will be seen that an

increase of demand in the market sense is nothing else than
an increase of supply in the schedule sense; for we have
already made it clear that there is only one point which is
the intersection of the two
s

curves, and that this point
cannot be shifted to the right

º
º
a
-º

from A to B on the demand

º
º

curve unless the whole sup

ply curve has shifted so as
to change the intersection.
Such a shifting is seen in
Figure 25. Here the demand
has increased in the market

sense, having changed from
the longitude of A to the

FIG. 25.

longitude of B on the same
demand curve; but this increased demand comes about

only because the supply has incłeased in the schedule sense,
having shifted from the position of the unbroken supply
curve to the position of the dotted curve.
To express these changes in terms of the schedules of

SEc. 5]

SUPPLY AND DEMAND

271

$3, let us suppose that the supply schedule is changed by
the addition of 200 pounds of sugar to each quantity
given in the third column.

It is evident that the market

price will fall from six cents (at which supply and demand
were each Iooo) to five cents (at which supply and de
mand are each IIoo). Thus the demand at the market
price has increased from
Iooo to IIoo as a COnY
sequence of the increases
in the supply schedule.
Again, to say that Sup
ply has increased in the
market sense is the same

thing as to say that the
demand has increased in
the schedule sense.

This

is shown in Figure 26,

where the market point
A on the supply curve

~x.

O
FIG. 26.

has shifted to B on the same curve, because the demand

curve had shifted from the unbroken to the dotted posi
tion. The same result can, of course, be expressed in
terms of a change in the demand schedule of § 3.
We should, therefore, be careful to know, when we speak
of a change in demand or supply, whether we mean that the
change is in the market sense or in the schedule sense. It
seems odd at first to think that an increase of demand in

one sense is really an increase of supply in another sense,
and vice versa. Because of this ambiguity, when one
person speaks of an increase of supply, it means the same
thing as when another speaks of an increase of demand.
To illustrate the two meanings, let us suppose that the
demand considered is the demand for automobiles, and
that, given the same price, people would demand auto
mobiles now no more and no less than they did a few years

ago, but that the conditions of the supply have changed, so

272

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

that now more automobiles can be supplied for the same
price. That would mean that the supply curve had
shifted to the right, so that its point of intersection with
the same demand curve has also shifted to the right
(Fig. 25). Therefore two things have happened on the
demand side. The market price has fallen, and as a con
sequence of that fall of price the number of automobiles
demanded has increased. The demand at the market price
has increased, but the demand schedule has not changed
at all. People are just as willing as before to take an
automobile at any given price, but they are willing to
take more automobiles at present low prices than at
former high prices. There have been no changes in the
conditions of demand, i.e., the demand schedule.

What

have changed are the conditions of supply, i.e., the supply
schedule.

On the other hand, let us take as our illustration works of

art.

In the past few years there has been a great change

in the attitude of Americans toward works of art.

Of these

we are much more appreciative than we used to be, and are
willing to pay more, for instance, for a fine painting than
previously. Thus, for works of art the demand schedule
has shifted; the demand for works of art has increased

in the schedule sense (Fig. 26). Consequently, the supply
has increased in the market sense; namely, on account
of the greater demand the price has risen, and therefore
owners and makers of works of art have offered more
for sale.

Thus increase of demand in the schedule sense brings
about increase of supply in the market sense, and vice
versa. An increase in the supply of automobiles in the
schedule sense brought about an increase in the demand
for automobiles in the market sense, while an increase in
the demand for works of art in the schedule sense brought
about an increase in the supply of works of art in the
market sense. In either case the original change is in a

Sec. 5]

SUPPLY AND DEMAND

275

schedule or curve. There can evidently be no change of
points of intersection except by a change in at least one of
the two curves.

Hereafter we shall use the phrases “in

crease of supply ” or “increase of demand ” only in the
sense of shifting to the right the supply or demand curve; in
other words, of increasing the figures of demand or supply
in the demand or supply schedules.
When we shift demand or supply curves, the effect on
the intersection, i.e., on the market price, and the amount
marketed, will, as is evident from the figures, depend greatly
on the character of the curves; whether, for instance, one

or both of them ascend rapidly or slowly. It will be in
structive for the student to draw on paper various pairs of
intersecting curves, making one or both nearly horizontal,
and again one or both nearly vertical, and to observe the
various effects then obtained, first, by shifting the demand
curve a given distance to the right or left, and second, by
shifting the supply curve a given distance to the right or
left." In actual fact, demand and supply curves are con
stantly shifting, with the result that their point of inter
section is constantly shifting, sometimes to the right,
sometimes to the left, sometimes up and sometimes down.
Consequently the market price and the amount marketed
are changing from time to time.
The causes which shift the curves are innumerable.

Changes in taste or fashion will affect demand curves, while
changes in methods of production will affect the supply
curves. For instance, fashion and outdoor sports, includ
ing motoring, have increased the demand for fur coats,
and have, therefore, raised their price; while improved
machinery has increased the supply of shoes and has
consequently lowered their price.
*Observe that when the demand curve is shifted, the change in price
involved depends upon the steepness of the supply curve; and, vice versa,

that when the supply curve is shifted, the change in price involved depends
upon the steepness of the demand curve.
T

274

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

As to the variable point of intersection, we are more in
terested in its latitude than in its longitude, for the latitude
represents the market price. This market price will evi
dently rise with a rise in either curve, and fall with a fall in
either curve. It will also rise with a shifting of the demand
curve to the right, or with a shifting of the supply curve
to the left; and will fall with a shifting of the demand curve
to the left, or of the supply curve to the right. In fact,
by a leftward change in the demand curve or a rightward
change in the supply curve, the price may fall to zero. A
standard example of such a case is furnished by the air we
breathe, the supply of which is so much greater than
the demand that it bears no price. The same is often true
of water and of
land of inferior

qualities.

There

are millions of
acres of land which

may be had for
practically nothing
(a fact of much
importance to be
emphasized in a
future chapter).
One cause of

shifting demand
and supply curves
-

X mentioned in a

general way at the
beginning of this
chapter we wish especially to emphasize. This cause is a
change in the general purchasing power of money. Let us
suppose that we change our monetary unit so that what is
now fifty cents should be called a dollar. This would mean
that the purchasing power of a dollar had been cut in two,
or that the level of prices had been doubled. We ought,
FIG. 27.

SEC. 5]

275

SUPPLY AND DEMAND

therefore, to find that the demand and supply of sugar will
have been affected so as to double its price—the latitude of
the point of intersection — and this will be, in fact, the
result, unless prevented by some interfering cause. As soon
as the half-dollar becomes a dollar, the price in “dollars”

at which any given amount of sugar, such as Oz (in Fig. 27),
is demanded, will evidently bedoubled, becoming zE, which is
twice acA. If previously people were willing to take Ox at one
price, they are now willing to take it at double that price, be
cause this double price means in purchasing power exactly the
same thing as the original price. And, in fact, all points in
the demand curve will be shifted to be twice as high as before.
In the same way and for the same reasons, those who
have sugar to sell

will require twice Y
as high a price as
before for a given
amount; because,

otherwise,
they
would not get the
same

purchasing

power as before in
return.

Thus, as

indicated in Figure
28, each point,
such as A, in the
supply curve, will

be shifted to twice To

as highan elevation
FIG. 28.

above the base,OX.
When the two curves thus shifted are drawn on the same axes

(see Fig. 29), it is evident that the new point of intersection,
B, will be vertically over the old point of intersection, A.
The market price of sugar is therefore doubled, though
the amount marketed is unchanged. Simply the doubling
of the general price level carries with it a doubling in the

276

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XV

price of sugar. While the supply and demand curves for
sugar may change for many other reasons than the dou
bling in general price level, so far as this cause, taken by
itself, is concerned, its effect on prices is to double them.
Our analysis of demand and supply curves then brings us
back to the fact already stated, that the price of any par
ticular good, like sugar, depends partly on the general
level of prices, or the purchasing power of money.
We can now see more clearly than before the shallowness
of the idea that the supply and demand of each individ
ual commodity fix its price independently of other com
modities. According to this view, the general price level
is regarded as the effect of innumerable individual pairs of
supply and demand curves, each pair being supposed to
completely determine some one price. The opposite is the
truth. The general price level is not the result of the supply.
and demand of sugar in relation to money, but is itself one

of the causes affecting the supply and demand of sugar in
relation to money;
for we have seen
Y
(Figs. 27, 28 and
29, and discussion)
that, as the price
level rises or falls,

the price of sugar
rises and falls cor

respondingly.
We end

this

chapter, therefore,
with the state
ment with which

we began; name
ly, that it is im

portant to distin
guish between the
influences determining the general price level and the
FIG. 29.

SEc. 5]

SUPPLY AND

DEMAND

277

influences determining an individual price. The price
level is determined by a comparatively simple mechanism,
that of the equation of exchange. It is the result of the
quantity of money and deposits, the velocities of their cir
culation, and the volume of trade. The general price
level then helps to fix individual prices, although not in
terfering with relative variations among them, just as the
general level of the ocean helps fix the level of individual
waves and troughs without interfering with variations among
them.

The tides determine whether a wave shall be as

a whole high or low, and so the general level of prices, while
it does not fully fix the price of sugar, determines whether

it shall be in general high or low.

A rise in the general price

level is one of the many causes raising the demand and supply
curves of sugar; and, reversely, a fall in that level is a cause
lowering those curves.

CHAPTER XVI
THE INFLUENCES

BEEIIND DEMAND

§ 1. Individual Demand Schedules and Curves

WE have seen that the market price of any particular
good is that price in the demand and supply schedules which
will just “clear the market.” By this phrase is meant,
of course, that the price will make supply and demand
equal. Both the market price and the quantity marketed
are determined by the intersection of the supply and de
mand curves. We have therefore explained how the market

price (as well as quantity marketed) of any particular good
is fixed by supply and demand.
But supply and demand are not the ultimate influences
determining prices. They are only the proximate influ
ences.

Beneath and behind them lie influences more re

mote and more fundamental. In this chapter we shall
trace back these influences so far as they have to do with
the demand side of the market. We shall find (1) that
the demand schedule explained in the last chapter is formed
out of a large number of individual demand schedules, and

(2) that each individual demand schedule is in turn formed
out of two “desirability’’ schedules.
In the first place, then, what we have called the demand
schedule is only an aggregate demand schedule. It is for
the whole market, and resolvable into constituent demand

schedules, one for each particular person in the market.
The total demand at any price is merely the sum of the indi
vidual demands at that price. For instance, let the follow
ing table represent the demand schedules for coal of two in
278

Sec. 1]

THE INFLUENCES

279

BEHIND DEMAND

dividuals distinguished as Individual No. I and Individual
No. II, at prices of from $12 to $2 per ton: –
DEMAND SCHEDULES

No. I
(a)

PRICE

No. II
(b)

TotAL

(a + b)

$12

The table tells us that at a price of $12 a ton Individual No.
I will take only one ton, and Individual No. II will not
take any; that at
a price of $6 a
ton

Individual

No. I will

take
6

four tons, and In
dividual

No.

will take one ton;
and so on.

The

last column gives
3
the sum of the
demands of these
two individuals.
If we should ex

tend such a table
to include the de

! 2 3 4 5 6 7 6 9 ſo iſ 12 [3 (4.

mands of all the
FIG. 30.

individuals in the

community, we would obtain in the last column the total
demand in the community. The total demand schedule
is thus merely the sum of the individual demand schedules

28o

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

found by adding together all the individual amounts de
manded at any given price. Behind the total demand
schedule, therefore, are a number of constituent demand
schedules.

The same relation, of course, holds between total and

individual demand curves. In Figure 3o let the curve did,'
represent the demand curve for Individual No. I, and dºd,'
the demand curve for Individual No. II. At a given
price, represented by the vertical distancé or “latitude,”
Oy, the demands of these two individuals are represented
respectively by the horizon
tal distances or “longi
D
e
tudes,” yd, and yds. The
sum of these two demands

is represented by the longer
horizontal distance, y D.
Thus we add the longitudes
of

the two individual de

C mand curves together to get

the longitude of the com
Q

bined curve DD’. If, in
stead of two individual de

FIG. 31.

mand curves, we should have

all the demand curves in the market, and should add together
the longitudes corresponding to given latitudes, i.e., the de
mands corresponding to given prices, we should thereby
obtain the total demand curve of the market.

We may pause here to note the fact that, ordinarily, any
one individual plays so small a part in the demand for any
commodity that he regards the price as beyond the influence
of any act of his. He finds this price ready made in the
market and adjusts his demand to it. To him the price is
a fixed fact and entirely beyond his control, while his de
mand, the quantity he chooses to take at that price, is
the only thing which he can adjust. It is of course true
that each individual, however insignificant his demand,

Sec. 2]

THE INFLUENCES

BEHIND

DEMAND

281

has theoretically an influence upon the general price, but
the influence is so small as to be practically negligible. While,
for the market as a whole, price is effect and not cause, yet
for the individual it is cause rather than effect.

To show more clearly these relations to the individual
and to the total, we have drawn in Figure 31 an individual

demand curve da', the total demand curve DD", and the
total supply curve SS". The intersection of the last two

determines the market price PX (or OP', or pr); and this
price determines for the individual the amount, P'p (or Ox),
which he will take at that price.
§ 2. Desirability
We have now found that back of the demand curve or

schedule in any market lie the individual demand curves

or schedules of all the people who compose that market.
The next step is to find what causes lie back of the indi
vidual demand curves or schedules. Taking, for instance,
the demand curve of Individual No. I, we may ask: What

are the conditions which determine its shape and size?
The answer is that it depends upon the desires or “wants”
of Individual No. I. It is true that a man may have a
strong desire for something without having any demand for

it in the economic sense. But this is simply because he
desires still more the money he would have to spend for it.
Every purchaser of goods balances two desires, the desire
for the goods and the desire for the money they would cost.
On the relative strength of these desires depends the price
he is willing to pay. We have, therefore, to investigate
these two desires, the one for goods, the other for money.
We shall begin with the desire for the goods.
Desire for goods implies desirability in those goods. The
term “desirability’ is synonymous with what is usually
called “utility” in textbooks. “Desirability” is preferred
here as a better term to express the idea intended. If there

282

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

exists a keen desire to purchase a certain piece of land, we
say that the land is especially desirable or has great desir
ability. Likewise precious stones have great desirability
to many people. Tobacco has great desirability to a smoker;
silks and satins to ladies of fashion; books to scholars; and

so on. The concept “desirability” is so important that it
ought to be defined with great care. The desirability of
any particular good, at any particular time, to any partic
wlar individual, under any particular conditions, is the

strength or intensity of his desire for that good at that time
and under those conditions. The desirability of any good is
one of the most important factors in determining its price.
The connection, however, between desirability and price
was for a long time overlooked because of the puzzling fact
that many of the most desirable articles are the cheapest, and
many of the least desirable are the dearest. Thus water is
so desirable as to be indispensable; yet there are few things
which are cheaper. On the other hand; jewelry, which could
easily be dispensed with, bears high prices. This paradox,
however, is easily explained. While it is true that water as
a whole is very desirable, the desirability of any one quart
of water, to be added to or taken away from the whole
amount, is negligible. This one quart could make little dif
ference to anybody because there are so many other quarts
which could take its place. Were any one quart of water
indispensable, water would bear a high price. On the other
hand, while all the jewels of the world could be more easily
dispensed with than all the water, yet any one jewel is
more desired than any one quart of water. The desira
bility of any one diamond, to be added to or taken away
from the few which the owner possesses, is very great.
Jewels are rare, and one jewel more or less may make a
great deal of difference. It is the desirability of any one
unit of water or of jewelry which influences its price and
not the desirability of all the water in our possession or of
all the jewelry.

Sec. 3]

THE INFLUENCES BEHIND

DEMAND

283

We see, then, that the desirability of water or of any
other sort of good may mean either (1) the desirability of
the whole or (2) the desirability of one unit more or less.
The desirability of the whole is called the total desirability;
the desirability of one unit more or less is called the mar
ginal desirability. The marginal desirability of any good is
the desirability of one unit more or less of it. In economic
science we have more to do with marginal than with total
desirability, and it is therefore important that the concept
of marginal desirability should be thoroughly understood.
§ 3. Illustration
To illustrate in detail the distinction between total and

marginal desirability, let us suppose a person wishing to fur
nish his house with chairs. As presumably he does not wish
to sit or compel his friends to sit on the floor, it is extremely
desirable that he should have some chairs; but each succes
sive chair that he introduces will lessen the need for more.

One chair is so highly desirable as to be almost indispen

sable. It provides a seat for at least one person. A second
chair, though not quite so indispensable as the first, is also
extremely desirable, as it is likely that he will often wish
seating capacity for at least two. A third chair, though
less urgently needed than the second, will be highly desir
able; and so on — each successive chair having a lower

desirability than the preceding. The number of chairs
which he will buy will depend, among other things, upon
their price. To fix our ideas, let us suppose that he decides

to buy ten. Then the tenth chair is called the marginal
chair of the ten, and its desirability is called the marginal

desirability of the ten. It is this tenth or marginal chair
which gives him the most concern when he attempts to .
decide how many to buy. He has no difficulty, for instance,
in deciding that he does not want thirty or forty chairs ; the
question which requires careful consideration in his mind

284

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

is whether he shall stop buying at the tenth chair or at a
slightly earlier or later point. He will consider carefully
what difference it will make whether he has nine chairs or

ten, or what difference it will make whether he has ten or
eleven.

If he decides on ten rather than nine, it is because

he thinks the tenth chair will make enough difference to him
to be worth the price he pays, and if he decides against the
eleventh chair, it will be because he thinks this will not make

enough difference to compensate him for the price. For
instance, let us suppose that the price of the chairs is $1o
each ; then the fact that he decides to take the tenth chair
shows that this tenth chair has at least $10 worth of desira

bility, while the fact that he decides against the eleventh
chair shows that this eleventh chair does not have as much

as $10 worth of desirability. Practically money is used in
just this way to measure the comparative desirabilities of
various goods.
As has been stated, the last or tenth chair bought is called
the marginal chair of the ten, and the desirability of this
last or tenth chair is called the marginal desirability of the
ten chairs. The total desirability, on the other hand, of the
ten chairs is evidently quite another matter. This is not
Io x $10.

It is the sum of the desirabilities of the first

chair, second, third, etc., considered, as above, in succession
up to the tenth. The householder will not ordinarily be
as definitely aware of total desirability as he is of marginal
desirability. As we have seen, he will, in order to decide
how many chairs to buy, have to give careful attention
to the desirability of the tenth chair; it is so easy to
decide upon the first few chairs that he will not ordinarily
stop to reckon exactly how desirable the ten chairs as a

whole may be. Should he wish to reckon this desirability,
he would do so by thinking how much difference it makes
to him whether he has ten chairs or none at all.

For

instance, he might think that to have ten chairs rather

than none at all is worth about $150 to him. Then $150

SEc. 3]

THE INFLUENCES BEHIND

DEMAND

285

would measure the total desirability of the ten chairs, while
the marginal desirability, that is, the desirability of the last
or tenth chair, is only about $10. From what has been said
it will be evident that the total desirability is of only theo
retical importance, while marginal desirability is of great
practical importance. It is of little practical importance to
any purchaser to know how much is the total desirability of
the chairs he owns; namely, how great is the difference in
comfort and convenience between having the number of
chairs which he actually does have and having none at all.

He finds it difficult to imagine how it would seem to have
none at all. Such a condition can be considered only hypo
thetically. It never enters into his calculations as a practi.
cal possibility.
On the other hand, marginal desirability enters daily
into practical life. The question which every purchaser of
goods asks himself is where to stop—where to draw the line
or margin beyond which he will not buy. He has to fix a
margin in every purchase, and in fixing it he has to settle
the question whether one unit more or less is or is not as
desirable as the money which he will have to pay for it.
In other words, with the desirability of this unit he has to

compare the desirability of the money which it will cost.
He can only solve the question of how much to buy by
weighing carefully in his mind the desirability of the last
few units, balancing each against the desirability of the
money which it costs. At last he decides to limit his
purchase at a certain point beyond which the next unit
would not be worth to him what it would cost. The pre
ceding unit — the last which he decides to buy — is ad
judged as barely worth its cost, affording, perhaps, a slight
advantage or surplus desirability. On the unit next pre
ceding, the advantage or surplus desirability is greater and
so on backward; but the further back we go the less care
fully are the desirabilities weighed.

286

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

§ 4. Some Remarks on Desirability
The total quantity of goods whose marginal desirability
is under consideration may be any specified quantity of
goods whatever. It may be a specified quantity of goods
now existing, or a specified quantity of goods in the future,
or a specified flow of goods through a period of time. For
instance, by the marginal desirability of coal to an individ

ual may be meant the marginal desirability of the particular
stock of coal in his bin at the present moment. If this stock
consists of fifteen tons, its marginal desirability is the
desirability of the fifteenth ton, or the difference to him
between the desirability of having fifteen and of having
fourteen tons. Again, if a person is consuming in his house
hold fifteen tons of coal a year, its marginal desirability
at any time is the desirability of the fifteenth ton, or the
sacrifice which, in his estimation at that time, would be
occasioned were he to reduce his yearly consumption from
fifteen tons to fourteen.

A stock of fifteen tons and a con

sumption of fifteen tons a year are evidently quite distinct.
It is, therefore, necessary in each case to specify the particu
lar quantity of goods referred to, whether it be a stock in
the present or a stock in the future or a flow through a
period of time.
Undesirability is the opposite of desirability. Often we
may express the very same fact by either word. For
instance, it does not matter whether we speak of the
desirability of keeping money, or the undesirability of
losing it.
One of the most important general facts in regard to
marginal desirability is that an increase in the quantity of
goods whose marginal desirability is under consideration
results in a decrease in the marginal desirability. This we
have noted in the case of the chairs.

Each unit in addition

is less desirable than the preceding unit.

Sec. 5]

THE INFLUENCES BEHIND

DEMAND

287

Marginal desirability is, as we have seen, often expressed
as the desirability of the “last’ unit.

But this word

“last” is used metaphorically and not in any literal sense
of sequence in time. All of the supposed ten chairs may
be bought at the very same instant. The desirability of the
tenth chair simply means the difference in desirability be
tween having ten chairs and having only nine. Any one
of the ten chairs may be considered as the tenth.
A special and important instance of marginal desira
bility is the marginal desirability of money. The marginal
desirability of money at any particular time, to any par
ticular individual, under any particular conditions, has the
same sort of meaning as the marginal desirability of any
other good. It means, therefore, the strength or intensity
of a man's desire for an additional dollar, or, what amounts

to the same thing, his reluctance to part with it. Briefly,
the marginal desirability of money to him is the desira
bility of a dollar to him. Whenever he thinks of making
a purchase, this desire comes into play, and the question
of whether or not to buy is, as implied in the preceding
discussion, determined by his judgment as to whether or
not the marginal desirability of the goods exceeds the mar
ginal desirability of money multiplied by the price in money
required to secure those goods.
§ 5. Individual Demands derived from Marginal
Desirabilities

It is on such comparison of the marginal desirabilities
of goods and money that the demand curve of each individ
ual depends. We shall now illustrate in detail how demand
depends on desirability by taking the desires and demand
of a given individual (whom we shall call No. I) for a given
good (such as coal). As in the case of the chairs, the price
Individual No. I is willing to pay is simply the ratio between
two marginal desirabilities, that of coal and that of money.

288

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

We are to find how each individual demand schedule, as

given in § 1, depends upon two antecedent schedules of
“ desirability.” If Individual No. I thinks that one ton of
coal is a dozen times as desirable to him as a dollar, he

will evidently be willing to pay any price up to $12 for that
ton. If the price is over $12, he will not buy even a ton
of coal. If it is just $12, he is willing to buy just one ton.
A second ton will be worth less, in his estimation, being, let
us say, only ten times as desirable as a dollar. He will
then be willing to pay up to $10 for this second ton. If,
then, the price is $10, he will buy up to two tons; for at
that price it will evidently be more than worth his while
to buy the first ton and just worth his while to buy the
second. If the desirability of a third ton is eight times
the desirability of a dollar, he will be willing to pay up to

$8 per ton for three tons; for at that price the first and
second tons are more desirable than the money, and the
third, just as desirable. If the desirability of the fourth
ton is six times that of a dollar, he is willing to pay a
price up to $6 per ton for four tons."
* He will stop buying at that point at which the last unit bought has
slightly more desirability than the money it costs, and the next unit (left
unbought) has slightly less desirability than the money it costs. Thus, if
the price of coal is $5.5o per ton, he will buy four tons because the fourth
ton is slightly more desirable than $5.5o (being, according to the figures
supposed above, as desirable as $6.oo) while the fifth ton is slightly less

desirable than $5.5o (being only as desirable as $5.oo). In the case of
most purchases, the desirability of the last of the units bought and that

of the first of those unbought differ so slightly that we may call either of
them the marginal desirability. That is why we have spoken of marginal
desirability as the desirability of one unit more or less. Strictly speaking,
however, the margin lies between the last of the units bought and the first

of those unbought, and the marginal desirability may be called a mean of
the desirabilities of these two units rather than the desirability of either.

In some cases the desirability of the last unit bought and the next unit
(first unbought) are widely different. This is true when the units are large
and are not subdivisible into smaller units. For instance, pianos are large
units and not subdivisible. One cannot buy one and a half pianos, but
must choose between buying one and buying two. Only one piano is

usually bought by a family. A second piano would have little or no desira

SEC. 5]

289

THE INFLUENCES BEHIND DEMAND

In each case the highest price he is willing to pay for a given
quantity is measured by the ratio of the desirability of the last
ton to the desirability of a dollar. The consequent deriva
tion of prices from desirabilities is summarized in the fol
lowing table: —

1. r...] "iſº"; "|*:::::" ":::::::::::
PURCHASED

(a)

willING TO PAY

(b)

(a + b)

$12

8
6
5

5
6

As indicated, the last column is found by taking the ratio
of the figures in the second to those in the third; that is,
dividing (a) by (b). As there are no standard units of
desirability, it will not matter what unit we select. In the
table, for simplicity of division, we have taken as our unit
for measuring desirability the marginal desirability of money
to Individual No. I himself.

We thus derive the individ

ual's demand schedule from his schedule of desirabilities.

The resulting demand schedule is the fourth column con
sidered with respect to the first column.

It tells us the

highest prices (column 4) Individual No. I is willing to
pay for stated quantities of coal (column 1), or, what
amounts to the same thing, the largest quantities of coal
he is willing to take at stated prices. As shown in the
bility. In this case the difference between the desirability of the piano
which is bought and that of the next which is not bought, is very great.

The family might be willing to give $10oo, if need be, to get one piano
but only $10 to get a second.
U

290

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

preceding chapter, it does not matter which way the rela
tion is expressed.
In the preceding table the numbers expressing desirabil
ities of coal and those expressing price are the same, be
cause we arbitrarily represented the desirability of a dollar
by “ I”; i.e., we took the marginal desirability of money as
our unit of desirability. In this case we may say that the
marginal desirability of any point in the table is measured
numerically by the money the individual is willing to pay
for the marginal unit at that point. But imagine another
individual (No. II) – an individual who has precisely the
same intensities of desire as No. I for coal, but who, on

account of relative poverty, prizes each dollar twice as
much as does Individual No.I. In comparing the two
men, we shall have to use the same unit of desirability,
viz., the marginal desirability of money to Individual No. I.
For Individual No. II the desirability of money is, there
fore, two such units. The result is the following table for
Individual No. II: —

Tons PURCHASED

DESIRABILITY OF
EACH SUCCESSIVE
TON

DESIRABILITY of
A Dollar

PRICE PER Ton THE
CUSTOMER would
BE willing to PAY

(a)

(b)

(a + b)

8
6

2.5o

5
6

The first ton has a desirability of 12 units just as did the
first ton for Individual No. I, but the desirability of a dollar
to Individual No. II is twice as great as the desirability of
a dollar to Individual No. I.

Hence the first ton, instead

of being twelve times as desirable as a dollar, is only six

SEc. 5]

THE

INFLUENCES

times as desirable.
to $6 for it.

BEHIND DEMAND

29I

Therefore he is willing to pay only up

Just as in the case of Individual No. I, the

prices in the last column are found by dividing the figures
in the second column by those in the third. In this case,
however, the figures in the last column are not identical with
those in the second column, but are only half as great.

And in general the higher the marginal desirability of money,
the lower the schedule of prices which buyers are willing to
give.

We see, then, that the two individuals, though they have
precisely the same intensities of desire for coal, have very
different demands for coal. If the price of coal is $5 a ton,
Individual No. I will buy up to the fifth ton; for when he
reaches the fifth ton, and not before, the marginal desirability

of coal (5) to him will be just five times that of a dollar (1).
But at this same price of $5, Individual No. II will buy only
up to two tons; for in his case the second ton is the point
at which the marginal desirability of coal (Io) is five times

the marginal desirability of a dollar (2).

This contrast

interprets the fact that the poor “cannot afford ” to buy
as much as the rich. The poor, like Individual No. II,
have a relatively high marginal desirability of money.
It is easy to express these same relations by curves. A
demand curve is, as we know, merely a graphic picture
of a demand schedule. We may likewise draw desirability
curves as graphic pictures of desirability schedules. And
just as the demand schedule is derived by simple division
from desirability schedules, so is the demand curve derived
by simple division from desirability curves.

In Figure 32 the curve da' is the desirability curve of coal
for Individual No. I; that is, it represents the desirability
to him of each successive ton of coal as given in the pre
ceding table. Thus the latitude or height (12) of d repre

sents the desirability of the first ton. The height (10) of
the next point to the right represents the desirability of

the second ton; and so on to d", the height of which (5)

292

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

represents the desirability of the fifth ton. The desira
bility of the fifth ton is, as we know, the “marginal desira
d
bility” of five tons, the
Y
desirability of the fourth,

the marginal desirability of

four tons, etc.
8||N

Ys
a

sirability of the amount of

"-----|--|--|----------frº

coal corresponding to the
longitude of that point.
The heights of the points
which form a horizontal

6
5

That is, the

latitude or height of each
of the points from d to d’
represents the marginal de

3T3T3Tā K

row one unit above the

base represent the marginal
desirability of money.
From the heights of these two sets of points—the upper ones
representing the marginal desirability of coal and the lower
ones representing the marginal desirability of money —
by simple division of the numbers indicated, we derive the
heights of the set of points constituting the demand curve
for Individual No. I. As the divisor is in this case unity,
FIG. 32.

the demand curve so derived will coincide with the curve

dd'. Hence da' will serve not only as the desirability curve
for coal for Individual No. I, but also as the demand
curve for Individual No. I.

Figure 33 represents the corresponding curves for In
dividual No. II, for whom, by hypothesis, there are precisely
the same marginal desirabilities of coal, but for whom the
marginal desirability of money is twice as great. The

upper points, r to r", represent the marginal desirability of
coal, and are at the same heights as the upper points d to
d' in Figure 32. The lower points in Figure 33, however,
are now two units high instead of one. Hence, when we

divide the numbers 12, etc., for rr' by the number 2, we

SEc. 5]

293

THE INFLUENCES BEHIND DEMAND

shall get as our demand curve a curve did", which, unlike
the demand curve for Individual No. I, will not coincide

with rr', but will be everywhere only half as high.
We see, then, how to derive an individual demand sched
ule (or curve) by dividing, so to speak, one desirability
schedule (or curve) by an
r,
other. The resulting deN.
mand schedule (or curve) of
2”.
coal will coincide with the

schedule (or curve) of marginal desirability of coal if
the marginal desirability of
money be taken as unity.

to “,
w

**,

&"--

Otherwise the demand

schedule (or curve) will have
its figures all standing in a
given ratio to those of the
schedule (or curve) of mar- 0
ginal desirability of coal.

5'---J

*-i------------

TzT3T a T5 x
FIG. 33.

In either case the demand

curve is, or is equal to, a desirability curve translated into
terms of money.

This is all true on the assumption that the marginal
desirability of money for each individual remains constant,
as represented in our tables or curves, being always unity for
Individual No. I and always 2 for Individual No. II. In
other words, we have assumed that the marginal desirability
of money is not appreciably affected by a large or small pur
chase of coal. Of course, a purchase might be made so large
and at so high a price that the marginal desirability of money

would be appreciably affected. Theoretically, the marginal
desirability of money increases with every expenditure;
the less money there is left, the more precious it becomes.
But there are so many ways to spend money, and the ex
penditure on any one thing, such as coal, requires ordinarily
so small a drain on the total power to spend, that the

294

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

marginal desirability of money is not very different whether
a man buys no coal at all or all the coal he can afford.
Consequently in considering the purchase of any particular
good, the desirability of a dollar may be regarded as prac
tically a constant quantity, represented, as in Figures 32
and 33, by the heights of a horizontal row of points.
In the last chapter we considered the price of coal as the
effect of supply and demand and expressed by two curves.
In this chapter we have seen that one of these two curves, the
demand curve, is in turn the result of innumerable individ
ual demand curves; and, finally, that each of these indi
vidual demand curves is in turn the result of two desirability
curves—one for coal and another for money—which charac

terize the given individual. These desirability curves are
the ultimate curves lying back of demand, and the demand

curve is, as it were, a desirability curve translated into
terms of money.

§ 6. Relation of Market Price to Desirability
We are now ready to see clearly that the market price
of coal is equal to the ratio between two intensities of
desire in the mind of each purchaser — the ratio of the

marginal desirability of coal to that of money. No indi
vidual demander of coal can, of course, determine the
market price of coal. On the contrary, to him the market
price seems to be fixed, and all that he can do is to adjust
his purchase to it. But this adjustment, when practiced
by all the numerous persons who demand coal, constitutes
the whole demand side of the market, and exerts, therefore,

a very powerful influence on said existing market price.
Market price, we have seen, must “clear the market,” and,
applied to the demand side of the market, this means that
the market price must be such that when each individual
on the demand side adjusts his purchase to it in such a
manner that the ratio of his marginal desirability of coal to

SEc. 6]

THE INFLUENCES BEHIND DEMAND

295

his marginal desirability of money is equal to the price, the
sum total of all such purchases (i.e., the total demand) shall
equal the total supply.)
This principle that the market price of any good is equal to
the ratio between its marginal desirability and the marginal
desirability of money for each and every buyer is so important
that it will be advisable to restate it in as many forms as
possible.

(Any one of the following statements will show where the
stopping point of each purchaser is: —
1. Each purchaser buys until the ratio of the marginal
desirability of the good to the marginal desirability of
money is brought into equality with the price.
2. Each purchaser buys until the desirability of the
marginal unit becomes equal to the desirability of the
money spent for this marginal unit.

3. Each purchaser buys until his marginal gain (of de
sirability) is reduced to nothing.
4. Each purchaser buys until he makes his total gain (or
surplus desirability) a maximum."
The last two may require further explanation.
Evidently it is the same thing to say that a purchaser
stops buying when the desirability of the last ton pur

chased is equal to the desirability of the money paid for
this last ton, as to say that he stops buying when the last
ton has no excess of desirability over the desirability of the
money paid for it.
Let us examine the nature of the gain which the pur
chaser makes, and which is thus reduced to zero on the last
ton. Evidently he gains no money; on the contrary, he
loses it. What he does gain is desirability. His gain in
desirability and his “surplus desirability" is the difference
between the total desirability of the coal he buys and the
total desirability of the money he has to sacrifice.

\ If the price is $5 per ton, in which case Individual No. I,
as his schedule (or curve) shows, buys 5 tons, the total de

296

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XVI

sirability of these 5 tons to him is 41 units of desirability,
being the sum of the desirabilities as given in the schedule

(or curve) for these 5 consecutive tons, viz., 12 + Io-H8+
6+ 5, or 41 ; the sacrificed desirability is the desirability
of the $25 spent, which, as we assume that each dollar has
I unit of desirability, is 25 units; the surplus desirability is

the excess of the total over the sacrificed desirability, or
41 – 25 = 16 units.
Now this gain of 16 consists of diminishing gains on suc
cessive tons. On the first ton the gain is the difference be
tween the 12 units which the ton is worth and the 5 units
he must sacrifice to get it; this is 12 – 5, or 7 units. Likewise
the gain on the second ton is Io – 5, or 5 units; on the third,
8–5, or 3 units; on the fourth, 6–5, or I unit; and on the
fifth, 5–5, or zero. He stops his purchase at this point,
for, if he should extend it further, he would lose desirability.
The sixth ton, for instance, would yield only 4 units and
cost him 5, and the seventh and later tons would cause
greater losses.
Likewise for Individual No. II, who can only afford to buy
2 tons, the total desirability of these two tons is 12 + Io,
or 22 units; the sacrificed desirability is the desirability of
the $10 paid, which, as each dollar is supposed to have 2
units of desirability, is 20 units; and the surplus desirability
is 22 – 20, or 2 units. This gain is all on the first ton, as the
-

second is worth only its cost.
Individual No. I thus gains more than Individual No. II,
though both gain something.
The last method of stating the principle was that each
buys so as to make the greatest possible gain in desirability.
Evidently, Individual No. I gets his greatest gain by buying
5 tons. His gains on these 5 tons were, respectively, 7, 5,3, 1,
and o units, making, as we have seen, an aggregate gain of
16 units. Had he stopped buying at the third ton, his gain
would have been one unit less, i.e., 7 + 5 + 3, or 15 units.
On the other hand, if he had bought 6 tons, he would have

sur-r-------,

Sec. 6]

THE INFLUENCES

BEHIND

DEMAND

297

lost one unit on the sixth ton, which would have reduced

his gain from 16 to 15. Thus by stopping at the fifth
ton he gains the most he can.
The idea of something, not money, gained in a trade is
important to grasp. By its aid we have no difficulty in
understanding that both parties usually gain by a trade.

Trade does not imply that one of the two parties gains at
the expense of the other. This is true when one of the two
parties cheats the other, but ordinary trade is not cheating.
Nevertheless, the idea that only one party can gain by a
trade is an old and persistent one. It was largely responsible
for attempts to regulate prices in the Middle Ages, to make
the price “just" and prevent one party gaining at the ex
pense of the other; it was also largely responsible for the
sentiment in favor of encouraging the export trade and dis

couraging the import trade,--a practice which implied that...~~
a nation was winning when it sold more than it bought,
but losing when it bought more than it sold. In fact, the
phrases “favorable balance of trade ’’ and “unfavorable
balance of trade,” based on this idea, are still in use, al

though their original implication of gain or loss is gone.
We now recognize that the country parting with money by
buying goods from abroad may gain desirability just as
the man who parts with money by buying coal gains
desirability.
Those who were misled as to a balance of foreign trade
being “favorable" or “unfavorable" were also misled as
to the nature of domestic trade. They convinced them
selves that trade within a nation was of no consequence to
that nation. They said it merely changed money and
goods from one man's hands to another's in the same

country, and therefore could not increase the wealth of the
nation as a whole. They failed to see that every exchange

affords “surplus desirability” to both parties engaging in
it. Each man gets the goods he wants in preference to
those he already has. The values of the goods exchanged

* 298

ELEMENTARY PRINCIPLES OF EconoMICs (CHAP. XVI

are equal and, as we saw in Chapter V, § 6, these values
may be canceled against each other when we are making
up accounts involving values; but, as then stated, this
does not imply that there is no gain of any kind. We now
see clearly that there is actual gain and that this gain

consists in “surplus desirability.”
§ 7. Importance of the Marginal Desirability of Money
The student will have noticed that the money element
was present in all the stages of our study, and is still present
even when we carry our analysis down to each individual

mind. (A halving of the purchasing power of money halves
its marginal desirability to each person. But as we have
seen in the desirability schedules (and curves) of Individuals
I and II, the marginal desirability of money to the indi
vidual is a divisor to be divided into the marginal desira

bility of coal to him in order to give the price the individual
is willing to pay for coal. Therefore, to halve this divisor
for each individual will result in doubling the quotient-the price he is willing to pay. In other words, the prices
in each individual's demand schedule (or curve) will all be
doubled by halving the purchasing power of money. Con
sequently the same is true of the total demand schedule
(or curve). This is merely restating what has been said .

before, except that before we considered the demand as a
whole, whereas now we trace back the effects of a change
in the purchasing power of money to each individual on
the demand side of the market.

We can now see more clearly than in Chapter I how care
ful we should be when measuring values in terms of money. ,
If our object is to compare desirabilities, we must correct
our money comparisons for differences in the desirability of
money. We must make allowance for differences in the
importance of a dollar (1) among different people according
to differences in wealth and needs, and (2) between different

Sec. 7]

THE INFLUENCES

BEHIND

DEMAND

299

times or countries according to differences in purchasing
power of money.
(1) If a millionaire's wife pays $10,000 for a brooch, while
her poor neighbor pays $1o for a gown, we should not infer
that the rich woman prizes her brooch a thousand times as
much as the poor woman prizes her gown. This would be
true if the desirability of a dollar were the same in the two
cases, but as it is likely that the poorer woman prizes a dol
lar more than a thousand times as highly as does the richer
woman, it is altogether probable that the gown is of more im
portance to the poor woman than the broochis to the rich one.
From the fact that the richer an individual is, the less the

marginal desirability of money to him or her, it further
follows that
difference in

the
de

sirability of two
fortunes is much

less than their

money

values

would suggest. A
man whose income
has increased from

$1ooo to $10,000 a

year is better off
than when it was

$1ooo a year, but
he is not ten times

better off. The
extra $9000 may

DK
FIG. 34.

not be worth as much as the original $10oo, in which case
he is not even twice as well off.

It is still truer that a man

with a fortune of $500,000,ooo is only slightly better off (if
at all) than one with only $1,000,ooo. Were these facts

better appreciated, “great riches,” though desirable, would
be less dazzling to those who have never possessed them.
In Figure 34, longitude represents the income of a man,

3oo

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVI

and latitude represents its marginal desirability to him.
The curve is purely illustrative, as we do not know in
figures what exact difference in the marginal desirability of
money is caused by a given increase in a man's income. It
is intended merely to express the fact that the marginal

desirability of money (assuming a given purchasing power)
decreases very rapidly with an increase in income; that is,
the richer a person, the less — and very much less — he
prizes an individual dollar. The curve probably continues
to the right indefinitely, though approaching closer and
closer to the base; no matter how rich a man becomes, an
additional dollar will still have some desirability in his eyes.
Man is literally insatiable.
(2) So much for the allowance to be made between dif
ferent individuals.

To illustrate the allowance to be made

for differences in different price levels, we note that money
wages in the United States are higher, for instance, than
money wages in England; but that it is misleading to make
any comparisons unless we first correct for differences in the
price levels or purchasing power. In some occupations it
would seem that the difference in wages only just corresponds
to the difference in the purchasing power of money, so that
in those cases the American workman is really no better off

than the English. In such cases he has more money in
wages, but its marginal desirability is so much less that he
has no more desirable food, lodging, or comforts. In most
cases, however, it is a fact that, after all allowances are made

for difference in price levels, the lot of the American work
man is better than that of the English.
§ 8. Desires or Wants, the Foundation of Demand
Evidently desirability is a far more fundamental concept
than the concept of mere money value. Human desires
are very real economic influences, and the variations in their
intensity are definitely registered by variations in the de

SEc. 8]

THE INFLUENCES BEEIIND DEMAND

3OI

mand for goods. Although, therefore, “desirabilities” of
goods and money are somewhat elusive to grasp, they are
by no means unreal, unimportant, or imaginary. Like the
heights of the clouds they are difficult to measure, yet
definite magnitudes. They are, however, magnitudes per
taining to separate individuals personally, not to society
in the mass. It is not surprising, therefore, that as yet we
have no means of measuring desirabilities by actual statistics
except in terms of money, and such measurement is mislead
ing because it takes no account of differences in the desirabil
ity of money to different people or to the same person at
different times.

Moreover, to measure desirability in terms of money is
merely to measure a cause by its effect; for all money
valuations depend on desirabilities. Although desirability
is extremely difficult of measurement, even for the individual
concerned, it is sufficiently measurable to make its study of
great and fundamental importance in economics. Each in
dividual who buys is compelled, in fact, to decide upon the
relative importance to him of the goods he buys and the
money he pays for them. It is these decisions, based
entirely on desirability, which among millions of human
beings make up the forces on the demand side of the
market, on which forces the market prices depend. While
desirabilities seem fleeting and indefinite as compared with
the “hard cash” in terms of which we daily express our
valuations, yet these very cash transactions are simply the
resultant of innumerable “desirabilities.”

While the indi

vidual desire is fitful, the resultant of the desires of all the
purchasers is relatively steady, -just as, in physics, the force
of the individual molecules of the atmosphere which bombard
our bodies are variable and fitful, but the aggregate resultant
atmospheric pressure is a steady fifteen pounds per Square
inch.

In this chapter we have endeavored to discover the in
fluences at work behind demand. We have found, back of

3O2

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVI

the demand schedule (or curve), the demand schedules (or
curves) of individuals; and we have further found, back of
each individual schedule (or curve), a pair of desirability
schedules (or curves), one member of each pair representing
the desirability of the good, and the other the desirability
of the dollar. By comparing these two desirabilities, the
individual finds how many dollars the good is worth to him.
In other words, he translates the desirability of the good
into terms of money, which is, as it were, the universal
language of commerce.
In some cases the individual is saved the trouble of

translating into money by the fact that he finds the trans
lation has already been made. Thus a commission mer
chant, buying on an order from a customer who has already
told him at what price to buy, has little difficulty in
making up his mind as to how much money he is willing
to give. He is willing to give the price at which he is to
resell to his customer, — less, of course, a slight margin
for his own commission.

So, also, a wholesale dealer, in

buying of a jobber, is guided largely in his decision as to
what prices to pay by the prices which he expects to get from
the retailer, and the retailer is similarly guided by what he

expects to get from his customer. But even in such cases,
So far as the dealer finds money valuations ready made for
him, these must, of course, have been made by some one,
such as the ultimate customer, through the painful process
of comparing the marginal desirability of the good with
the desirability of the dollar.

CHAPTER XVII
THE INFLUENCES

BEHIND SUPPLY

§ 1. Analogies between Supply and Demand
IN the last chapter we have seen that a total demand
schedule (or curve) for any particular good is derived from
innumerable individual demand schedules (or curves), and
that each individual demand schedule (or curve) is derived
from a pair of desirability schedules (or curves), one relating
to the marginal desirability of the particular good under
consideration and the other relating to the marginal desir
ability of money.
With certain exceptions to be explained later, precisely
these same propositions are true of the supply side of the
market.

First of all, then, the total supply at any price is merely
the sum of the individual supplies at that price, as illus
trated in the following “supply schedules" for coal for two
individuals. As before, we distinguish them as Individual
No. I and Individual No. II (without meaning to imply, of
course, that they are the same individuals as those called

No. I and No. II in Chapter XVI).
SUPPLY SCHEDULEs. Tons which
would BE supplied BY INDIVIDUALS
PRICE

(a)

$4
5
6
7

15oo
16oo
18oo
2IOO

ToTAL

(a + b)

(b)

3O3

2OOO

35oo

24oo

4OOO

3OOO

48oo

3900

6ooo

3o4

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XVII

The table tells us that at a price of $4 a ton, Individual
No. I will supply only 1500 tons and Individual No. II,
20oo tons; that at $5 a ton Individual No. I will supply
16oo tons and Individual No. II, 2400 tons; and so on.

The last column gives the sum of the figures in the two pre
ceding columns. If we should include in our table not
simply two but all suppliers in the market, we should ob
tain in this way the total supply schedule.
The same relations are indicated graphically in Figure 35,
where sisi' is the supply curve for coal of Individual No. I,
i.e., a curve such that if the latitude of any point on it
represents a given price, the longitude of that point will
represent the amount of coal the individual is willing to
supply Similarly,
at that
Y
price.
s2s2' shows the

supply curve for
coal of Individual

No. II.

If, as in

the case of demand

curves, we add

longitudes (e.g.,
Sy = sly-H sy), we

obtain SS" as the

curve representing
the total supply of
both individuals.

looo zooo-oooºooo sooo ecoo

If, in like man
ner, we add to

FIG. 35.

gether all the
individual curves of all the individuals in the market, we
shall obtain the total supply curve of the market.

Having thus derived the total supply schedule (or curve)
from its constituent individual supply schedules (or curves),
we next seek, as in the case of demand schedules (or curves),
to derive each individual supply schedule (or curve) from a

Sec. 1]

THE INFLUENCES

305

BEHIND SUPPLY

pair of desirability schedules (or curves). In the case of
the seller, however, it is not desirability, but undesirability
which needs to be considered, - the undesirability of the

trouble and expense of supplying coal. Marginal undesir
ability is also called marginal cost.
The following table illustrates the derivation of the seller's
undesirability curve or marginal cost curve. The figures
in the last column, found from the second and third by
simple division, give the prices a coal dealer would be willing
to take in view of the undesirability of the trouble and ex
pense involved in providing coal and the desirability to
him of the money he seeks to get by selling coal. If the
15ooth ton costs him 8 units of undesirability, and a dollar
\

represents to him 2 units of desirability, he will evidently

be willing to take $4 a ton up to the 15ooth ton; and so on
for the other figures in the table.

Tons SoLD

UNDESIRABILITY OF
SUPPLYING LAST
ToN

(a)

DEs

ILITY OF

IRAb

PRICE THE DEALER
would BE WILLING

A Dollar

TO TAKE

(b)

(a + b)

15oo
16oo
18oo

2IOO

5
6
7

The same relations may, of course, be represented graph
ically. In Figure 36, the latitudes of the points on the

line rr' represent the undesirability per ton of providing
the coal, and those of the lower line mm' represent the
desirability per dollar of obtaining the money. The result

of dividing the latitudes of the points of rr' by those of

mm (i.e., by 2) gives us the supply curve ss', the height
of which at different points will be proportional to the
height of corresponding points of the curve rr'. The lati
x

306

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XVII

tude of the curve rr' represents the undesirability of the
efforts and sacrifices of furnishing each successive unit, or

*
...i

“marginal undesirability,”
and

the latitude of

the

curve ss' represents, in
terms of money, this same
marginal undesirability or

--"

... • *
•*

...sº

r. “

...”

marginal cost of produc
tion; that is, the supply
curve is the undesirability

..!.....}”
:...!.... ..!---...}.....}...tº curve translated into money.

This translation of unde

sirability into money may,
O

X to a large extent, have

FIG. 36.

been already made for the

dealer by others. In fact, it will usually happen that the
larger part of any individual's costs are in the form of
money expenditures,-expenditures for labor and for ma
terials.

But these money valuations have themselves

come about by the process, in the minds of laborers and
others, of comparing the undesirability of efforts with the
desirability of the dollar. The prices or “latitudes" of
the supply curve are found, therefore, by translating into
the universal language of money miscellaneous undesira
bilities of all kinds. That is, marginal cost of production
comprises everything undesirable involved in supplying the
article under consideration, including all discounted future

costs, the money equivalent of all labor and trouble, as
well as all actual money expenses. The seller is more apt
to think and talk in terms of money than the buyer, since
the seller has to do with costs, and his costs, as above

stated, are usually in the form of money costs. Ulti
mately, however, as we have seen in previous chapters,
back of all money costs lie labor costs. Money costs in
the last analysis are merely the accumulated translations
into money of labor costs. Labor or human efforts thus

Sec. 2)

THE INFLUENCES BEHIND SUPPLY

3O7

stand at the end of our analysis of supply just as satisfac
tions stand at the end of our analysis of demand. Supply
and demand are thus, in a sense, the money equivalents of
efforts and satisfactions.

§ 2. Principle of Marginal Cost
Hitherto we have considered the marginal desirability
of money as the same whatever the amount of coal bought
or sold. Expressed in the terms of the diagram we have
considered the marginal desirability curve for money as a
horizontal straight line. As explained in the last chapter,
this was essentially true for the purchaser; but for the
seller it is often untrue. The purchaser of, let us say,
sugar will prize a dollar substantially as much whether he
buys ten or twenty or thirty pounds of sugar a week or
none at all; the reason is that this one commodity cuts
little figure in his total budget; it can make so little inroad
on his income that it can scarcely affect the desirability of
money to him.

Even in the case of coal, where the ex

penditure may perhaps be large enough to pinch the pur
chaser appreciably, the desirability of a dollar would prob
ably not be noticeably greater if ten tons a year are bought
rather than five. Each consumer expends his money in so
many different directions that the part he can, under or
dinary circumstances, expend on any one commodity is too
small to make him feel appreciably poorer as a consequence.
With the seller of sugar or coal, on the other hand, the
situation is altogether different.

Whereas the consumer

expends his money in the purchase of a great many differ
ent goods, the producer receives his money by the sale of
a very few. In fact, he may concentrate on one only.
The coal dealer, for instance, usually makes his living by
selling coal and nothing else.

To him, therefore, changes

in the amount of coal sold and in the price of coal will
make a great difference in the total amount of money he

308

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVII

gets, and therefore in its marginal desirability. If, for
instance, the price of coal changes a dollar a ton, though
to the purchaser this fact will not appreciably affect the
marginal desirability of money, to the seller it may make
all the difference between poverty and affluence.
Therefore, in treating supply, we cannot always assume
that the marginal desirability of money remains constant
and may be represented by a horizontal straight line. In
stead, the greater the sales, and the more money conse
quently obtained, the less will be the marginal desirability

of money. Therefore, the line mm', representing the
marginal desirability of money, should, strictly speaking,
descend to the right as the sales increase, and the rate of
descent will depend on the price concerned. This descend
ing character of the curve representing the marginal de
sirability of money will make the diagram less simple, but
it will still be possible to derive the supply curve from the
desirability curves of coal and of money.
The supply curves thus far considered ascend to the
right. In such supply curves the price is a minimum rela
tively to the supply; that is, the curve shows the lowest
prices at which given amounts will be supplied. Express
ing this same truth the other way around, we may say that
the supply is a maximum relatively to the price, i.e., the
curve shows the greatest amounts which will be supplied
at given prices.
We see, then, that the total supply curve, analogously to
the total demand curve, may be derived from a number of in
dividual supply curves (Fig. 35); that each such individual
supply curve may be derived from (1) curves of marginal
undesirability of furnishing the article, and (2) curves of
marginal desirability of money; and that, therefore, the
supply curve is, or is equal to, an undesirability curve
translated into terms of money.
The important result is that the market price, as finally
determined by supply and demand, is not only equal to the

SEc. 2)

THE

INFLUENCES BEHIND SUPPLY

3O9

marginal desirability of getting coal for each buyer, but
also to the marginal undesirability of furnishing it for each
seller, both the desirability and the undesirability being
measured in terms of money. Thus, if the price of coal is
$5 a ton, the last ton bought by each buyer is worth barely

$5 to him, while the last ton sold by each seller costs him
about $5 worth of expense and trouble.
These equalities on the margin of all sales and purchases,
and the fact that the price must be such as will equalize
supply and demand, i.e., “clear the market,” are among
the fundamental principles which determine the market
price of any particular good.
It may be worth while here to emphasize the fact that
there is a separate market at each stage in the operations
by which coal passes from producer to consumer. At
each stage supply and demand fix a price for the market at
that stage. The first market for coal is at the mine, the
sellers being the producers and the buyers, middlemen, who
later will resell. The market price at the mine is, of
course, quite different from the market price later in the
wholesale market, and the latter market price is different
in turn from that in the retail market.

But the same

principles apply to all these market prices.
We may summarize these principles as follows: —
(1) The equalization of all marginal desirabilities and
undesirabilities (both being measured in money).
(2) The equalization of supply and demand.
We cannot neglect either of these two principles. Nor
can we omit either half of the first principle; it is a mistake
to think that price can be determined by marginal desira
bility alone or by marginal undesirability alone. It takes
two sides to make a bargain and a market price.
The present chapter, however, is especially devoted to
the supply side. On the supply side of the market, there
fore, the great determinant of market price (in terms of
money) is marginal cost (in terms of money).

3Io

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XVII

These two determinants of price — marginal desirability
and marginal cost – are, as has been explained, human
desires translated into money. Marginal desirability rep
resents the desire to secure something agreeable, while
marginal cost represents the desire to avoid something
disagreeable.
* In this connection it is important to remember that both

the “something agreeable” which we desire to secure, and
the “something disagreeable" which we desire to avoid, lie
in the future. When an intending purchaser of an orchard
speaks of it as a desirable object, he means that he has a
desire in the present for certain expected satisfactions in the
future, — satisfactions from eating the apples or other future
benefits which the ownership of the orchard is expected to
bring. Likewise when the owner of a coal mine decides
which leads or galleries he shall exploit, he bases his decision
on what he expects the extraction of coal to cost. The
marginal desirability to the purchaser of the orchard repre
sents future satisfactions translated into present cash by
the usual process of discount, and the marginal cost of coal
extraction represents future expected costs translated into
cash by the same process. Later, when the expected satisfac
tions or the expected costs have become past history, they
no longer control marginal desirability or marginal cost. It
is the costs of the future, and not of the past, which always
control. After the coal miner has exploited the lead or
gallery, and it turns out to have cost more than he ex
pected, he will not on that account obtain a higher price
for the coal than he originally calculated. Again, if a rail
way has been built and located unwisely, its value may fall
far short of its original cost. It is important that the
student should carefully avoid the error of believing that
the prices and values are controlled by what things have
cost to produce in the past. In the case of staple articles,
however, which are constantly being reproduced, and of
which the cost does not greatly vary from time to time, the

SEC. 2]

THE

INFLUENCES BEHIND SUPPLY

3II

price will come to be approximately equal to this cost; for
the cost of reproducing in the future will be practically the
same as the cost which has been experienced in the past.
Even in these cases, however, it is the cost which is ex

pected to continue in the future rather than the cost which
has been experienced in the past, that furnishes the con
trolling motive to the producer in determining at what
price he will supply his product.
We may here call attention to the fact that the principle
of marginal cost applies to the particular case of gold as a
commodity, priced in terms of wheat, or priced in terms
of all other commodities in general – which is the same

thing as saying, priced in terms of its general “purchasing
power.” During part of our discussion of money, we did
thus treat gold as a commodity. If the student will turn
to Figures 13–16, he will see that the distance below the
line OO of the highest outlet in operation from any
bullion reservoir is simply what we would now call the mar
ginal desirability of gold for use in the arts (measured in
terms of general purchasing power over goods), and that
the distance from OO to the lowest inlet in operation is the
marginal cost of production or undesirability of gold (meas
ured likewise in terms of general purchasing power over
goods). That is, the mechanical representation there em
ployed is merely another way of representing what we
would now express in terms of supply and demand of gold.
We may now add that the differences in costs of producing
gold, represented by the differences in heights of the inlets,
are not altogether due to differences between mines, but
also to differences in working the same mine. There is a
marginal cost of production for each mine. The higher the
speed of extracting, the higher the cost per ounce. This is
called the law of increasing cost." It applies, of course,
* It is also called the “law of diminishing returns.” The two expres
sions are evidently equivalent.

Each statement expresses the effect of

increasing production on the relation between product and cost.

If with

312

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVII

more generally than to gold and silver alone. In this
chapter we have taken coal as our typical example. We
might have taken numerous other examples. If the price
of wheat rises, its marginal cost will rise. Such a rise in
price acts as an encouragement to the production of wheat.
Just as we have seen that an encouragement in the produc
tion of gold leads to an opening of the poorer mines, so an
encouragement to the production of wheat will lead to the
cultivation of the poorer wheat lands. At a given price,
there are always some lands on which it will not pay to
produce wheat because of the prohibitive cost of production
upon these lands. In gold mines, as in wheat fields, there
is a marginal point of production beyond which production
will not pay.
§ 3. Upward Supply Curves which Turn Back
In spite of the analogies we have noted between the supply
and the demand side of the market, the differences between

them are so great and important that the rest of this chapter
will be devoted to them.

Practically all demand curves descend to the right, and

we have hitherto assumed that all supply curves ascend to
the right. But not all supply curves do ascend to the right.
One peculiar type of supply curve grows out of the fact re
cently noted, that there is a descending curve of marginal
desirability of money dependent on the price assumed.
This fact, when combined with the ascending curve of un
desirability of efforts and sacrifices (as in Fig. 36), tends to
bend the supply curve upward – sometimes so much as to
cause it to curl back to the left, as in Figure 37. Such a
curve, although it ascends, does not, throughout all its
increasing production the ratio of cost to product increases it is the same thing
to say that the ratio of product to cost decreases. The one form of statement
is that there is greater and greater cost per unit of product returned; the

other, that there is less and less product per unit of cost incurred.

Sec. 3]

THE INFLUENCES BEHIND SUPPLY

3I3

course, ascend to the right. It applies especially to the sup
ply of labor. The meaning of such a supply curve is that a
rise of price does
not always cause

an increase of

supply. At first

it does, but be-

yond the point 5 sº
where the curve 245

begins to curl = 4o
back, a rise of

price evidently

results in reduc- “2.
ing the supply.

J.5

If wages are
low, a rise in

wages
will at first
stimulate him to
work longer

TOT

2-e 4.5 Fe...:
to " OurS
IG. 37.

hours, but after a certain point, he will prefer to rest on his
oars.

He earns so much in a few hours that he feels it is

no longer necessary to work so hard. In South America,
for instance, traders from Europe were once buying native
made baskets of a peculiar kind. In order to increase the
supply of baskets, which was far less than they could mar
ket in Europe, the traders decided to raise the price that
they would offer to the makers, thinking to stimulate the
production of baskets by inducing the men to work more
hours. Exactly the opposite result followed. As soon as
these workmen were offered high prices for the baskets,
they worked fewer hours and made fewer baskets than
before; they could now get more money even for doing less
work, and they did not need or want more money. Their
wants were so few and simple that the marginal desirability
of money to them decreased very rapidly with an increased
amount of it; and their disinclination to work was so

3.14

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XVII

great that, combined with the feeble desirability of its
rewards to them, they would supply less of it when
the rewards were great than when they were small. Similar
instances have been cited among the Filipinos and among
the negroes in the South. Recent experiments in coal
mines show that a slight increase in wages stimulates the
men to work longer, but that a large increase (sixty per

cent beyond the ordinary wage) results in irregularity of
work and the desire to reduce the number of hours.

That

is (as shown in Fig. 37), as the price rose from the

height of s' to that of s”, the supply of labor or number
of hours spent in making baskets decreased from the longi

tude of s' to the longitude of s”.
Now this same principle applies to all labor. Experience
indicates that as wages go up workmen demand shorter
hours. The eight-hour movement of to-day is at bottom
due to the fact that wages are high. When wages were low,
men worked twelve hours a day; now that they are
high, they work only ten, nine, or even eight hours a day.
The same principle explains why men with the highest
salaries, instead of working longer hours than others, usually
work shorter hours. The most highly paid grades of work
men work the fewest hours and take the longest vacations.
The exact point in wages at which the curve begins to
bend back, so that if wages are raised any higher the supply
of work will diminish, depends on the particular conditions
in each case, the size of the workman's family, the range
and character of their wants or their “standard of living,”
and other similar conditions. The more wants a man has,
the higher the point at which the curve begins to bend back,
i.e., the less easily is he satisfied with more money.
§ 4. Downward Supply Curves

The typical supply curve, with which we began, ascends
continually to the right. A different type was just consid

SEC. 4)

THE INFLUENCES BEHIND SUPPLY

3I5

ered, one in which the rightward movement was arrested
and turned into a leftward movement.

A still different

type is that in which the curve does not even ascend, but
descends. Such descending supply curves are common
under modern conditions of factory production. It is often

found that a large product costs less trouble, per unit, than
a small product. In such cases, the marginal undesira
bility of furnishing the good decreases with an increase of
supply, and not only decreases, but decreases in a faster
ratio than does the marginal desirability of money; so that
the ratio of the one to the other, i.e., the marginal cost
expressed in money, decreases with an increase of supply.
When the marginal cost decreases with an increase of
supply, the supply curve also descends, but its relation to
the curve of marginal cost is now quite different from what
it was in the case previously considered in which the curves
ascend. The supply curve is no longer the curve of margi
nal costs, but must be constructed on an entirely new

principle. The principle that market price is equal to
marginal cost will no longer hold true. Only when the
supply curve ascends is it true that the price at which the
seller is willing to supply a given amount is equal to its
marginal cost, and is therefore derived from the curves of
undesirability. Descending supply curves, which we are
about to consider, depend not on marginal cost at all, but
on average cost. The reason is that no seller is willing regu
larly to sell at a loss, and this is what he would be doing
if he should offer to sell at prices corresponding to marginal
cost when the marginal cost decreases with the amount sold.

It is clear that, if the cost of supplying the 3oooth ton of
coal is $5, and the cost of all preceding tons is greater than
$5, not even one ton of coal could be sold at $5 a ton with
out a loss, and if 3000 tons were sold at that price, there
would be a loss on every ton except the last. Rather than
sell 3ooo tons or any less number at $5 a ton, the dealer
would choose to sell none at all.

Contrast this result with

316

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVII

that which obtains in the case of an ascending curve. In
this case, if the cost of supplying the 3oooth ton were $5,
the cost of all preceding tons would be less than $5, so that
instead of a loss there would be a gain on each of these pre
ceding tons. Not only could he afford at $5 to sell 3ooo,
but this amount gives him the maximum profit — more, for
instance, than if he should sell 2000 or 4ooo tons.

Now whether the cost curve ascends or descends, it is
clear that any dealer to sell at all, must expect to get back
at least the total cost.

This means that he must, therefore,

charge a price at least as high as the average cost per ton.
When the cost of each successive ton is greater than that of
the preceding ton, the cost of the last, or marginal cost, is the
greatest cost of all, and therefore exceeds the average cost.
Consequently, the dealer is assured a profit when selling at a
price equal to the marginal cost. But when the cost of each
successive ton is less than that of the preceding ton, the
cost of the last ton (marginal cost) is the least of all, and
therefore is less than the average cost. To sell at a
price equal to marginal cost would, in this case, mean to
sell at a loss.
In either case, whether the curve ascends or descends,
the seller will seek to determine his price on the basis of

the higher of the two costs (marginal and average). Which
ever of the two is the higher will show itself in the supply
curve. When the marginal cost increases with supply,
marginal cost is the higher, and will rule supply. When
the opposite is true, average cost is the higher, and will
rule supply.

In the latter case the supply schedule (or curve) is a
schedule (or curve) of average costs. We need not describe
in detail how to construct such a schedule (or curve). This
presents no difficulty, since we already know how to con
struct a schedule (or curve) of marginal costs which gives

the cost individually of each separate ton. The simple
average of any specified number of these is the average

SEC. 5]

THE INFLUENCES

317

BEHIND SUPPLY

cost of that number. This average-cost-curve will descend,
though it will be higher than the marginal-cost-curve from
which it is calculated."
/

§ 5. Resulting Cutthroat Competition
But, besides the fact that ascending supply curves are
based on marginal costs, and descending supply curves are
based on average costs, the two types of supply curves offer
another and even more important point of contrast. The
supply at a price is in the first case the maximum which
the seller is willing to offer at that price, whereas in
the second case it is the minimum. In the first case,
the more the seller can sell, the more he charges. In the
second, the more he can sell, the less he charges. When
we consider simply ascending types of supply, we may ex
press the relation between the price and supply in two
ways, either —
(1) Given the quantity, the price is the minimum price
at which that quantity will be supplied; or
(2) Given the price, the quantity is the maximum which
will be supplied at that price.
The first of these two propositions still holds true when
the supply curve is descending instead of ascending; but
the second will not hold true until we have changed the
word “maximum ” to “minimum.” In other words, when,
as originally supposed, the supply curve ascends, the seller
*The relation between cost and product represented by a descending
supply curve is sometimes called the “law of decreasing cost” and some
times the law of “increasing returns”; for, it is evidently the same thing
to say that the ratio of cost to product decreases as to say that the ratio of
product to cost increases. The one form of statement is that there is less
and less cost per unit of product returned; the other that there is greater
and greater product per unit of cost incurred. These expressions are in

antithesis to the “law of increasing cost” (or, the “law of diminishing
returns”) of § 2. There is, theoretically, an intermediate condition
called the “law of constant cost” (or “law of gonstant returns”).

318

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVII

is willing at any given price to supply a certain amount
or less; but, when the supply curve descends, he is willing
at any given price to supply a certain amount or more.
In the case of demand we found no such two classes as

ascending and descending curves.

In all cases demand de

creases as price increases. Consequently we found only
one sort of relation between price and demand. The
amount demanded at a price is always the maximum
amount which will be taken at that price; and the price
is always the maximum price which will be given for that
amount.

Let us then summarize our results, expressing each on
the basis of a given price:–
I. At a given price, each buyer is willing to take a certain
maximum amount or less at that price.
II. At a given price, each seller is willing
(1) (in case marginal cost increases with an increase
of supply) to offer a certain amount or less at
that price.

(2) (in case marginal– and therefore also average—
cost decreases with an increase of supply) to
offer a certain amount or more at that price.

The contrast between the two types of supply, II (1) and
II (2), is illustrated graphically in Figures 38 and 39. Figure
38 illustrates case I and Figure 39, case 2. The curve in the
first case is seen to be the maximum limit of longitude, and
in the second case the minimum limit. The longitude of
any point in the shaded area represents an amount which
the seller is willing to supply at the price corresponding to
the latitude of that point. Thus, if we take any given
horizontal line, such as ab, in the shaded area of Figure 38,
its latitude represents an assumed price at which the seller
is willing to supply any amount, from nothing at the left
end, a, of the horizontal line, to the maximum amount at

the right end, b, where the line is limited by the curve.
Taking any given horizontal line, such as ab, in the shaded

SEc. 5]

THE

INFLUENCES

BEHIND

SUPPLY

3I9

area of Figure 39, the seller is willing to supply any amount

from the minimum longitude (that of the point a at the left)
up to an indefi
nite

amount

the right; or,

dropping

the

symbolism of the
curve, the seller is

willing at a given
price to sell any
a mount from a
certain minimum

upward.
In the latter

case, i.e., when
the cost of each

additional unit of
FIG. 38 (Supply).

product is less
than that of the preceding unit, the more the seller can sell
at a given price, the better he likes it. If he sells only the
minimum which he

is willing to sell at
that price, he gets
back only his
average cost of

production, and
makes no profit.
Any sales beyond

this bring him a
profit, and the
larger the sales, the
larger the profit.
He stands ready to
sell an indefinitely
great amount at
FIG. 39 (Supply).

the given price.

32O

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVII

This fact introduces us to an unexpected conclusion, viz.,
that if the total supply curve descends, the price repre
sented at the intersection of the supply and demand curves,
although it clears the market, is not a stable price, but
tends always to fall. Whether the price is above, at, or
below, the latitude of the
intersection, it will tend to

fall so long as the supply
curve descends.
Let us
consider each of these

three cases separately, i.e.,
the price above, at, or be
low the intersection, allow

ing the demand curve to

s descend

O
FIG. 4o.

faster

than

the

D supply curve. If the price
(Fig. 40) is OP, higher
than the intersection, the
demand exceeds the mini

mum supply and stimulates each supplier to furnish more
than his minimum, which, of course, he is only too glad
to do. Consequently, supply will soon overtake demand.
Those competing to supply will strive to underbid each
other, and the price will fall.
But it will not stop falling at the intersection. For, sup
pose it is below, as at OP’. It is evident that it will con
tinue to fall; because then even the minimum supply exceeds
the demand, and all who compete to supply will be very eager
not to be left with unsold goods or unused productive capac
ity. A rise of price would, it is true, remedy the difficulty.
But no individual can apply this remedy. The individual
competitor cannot raise prices without securing the agree
ment of others; but to do this would be to create a combina
tion which is contrary to our present hypothesis of independ
ent action. If he should individually raise his price, he would
be committing commercial suicide, for people would not buy

Sec. 6]

THE INFLUENCES BEHIND SUPPLY

32I

of him when they could buy more cheaply of his competitors.
His only hope of achieving his purpose of increased sales
lies in adopting the opposite course, and underselling his
competitors, regardless of the consequences to them and to
the market price." His hope is that before they can meet his
cut in price, he may win the patronage he needs to make it
worth his while to stay in the market, and that he may thus
drive some of his competitors out of business. If he fails
to get the needed patronage, he must go out of business him
self. He therefore offers his wares at a price below OP’.
If at this point many of his competitors should go out of
business, he could succeed; for though the total demand
does not quite reach the supply curve, it will reach and pass
his supply curve, which lies much to the left of the total
supply curve shown in the figure. But his competitors
remain, and under these conditions, as we have seen, there

cannot be two prices in the same market at the same time.
Hence all his competitors must reduce their prices to his.
Whatever the effect of this action may be on the indi
vidual who first cuts the price, the result on the whole is
evidently to make matters worse; for, according to con
ditions shown in the diagram, the lower the price, the more
will the supply exceed the demand.

We have here what is known as “cutthroat competition ”
or a “rate war,” i.e., competition the effect of which is not
simply to reduce profits, but to create losses.
§ 6. Resulting Tendency toward Monopoly
But we have not yet reached the ultimate result of such
competition. Some competitors must sooner or later see
that there is no hope to secure the large sales necessary

to make business worth while. They withdraw. This re
duces the losses for the rest; for, by removing their supply
curves, the total supply curve is reduced in longitude, i.e.,
is shifted leftward, and the discrepancy between supply and
y

322

ELEMENTARY PRINCIPLES OF EconoMICs

(CHAP. XVI,

demand is lessened, if not done away with entirely. But
even so, the tendency of the price to fall is not hindered; for
we have seen that, as long as the supply curve decreases,
competition forces the prices down on whichever side of
the intersection the price may be. In the case of a descend
ing supply curve, the intersection has nothing to do with
the case. Competition with descending supply curves will
always lower the price so long as there are any competitors
with descending supply curves. No check to this fall is
possible until either competition ceases or the supply curve
ceases to descend. If the supply curve at some point at
the right reaches a minimum point, this marks the lowest
point to which the price can fall; or if the crowding out
of competitors finally leaves only one supplier in the field,
he at that moment becomes a monopolist, and the prices will
cease falling on that account.
Not only may monopoly come about by this process of

“the survival of the fittest,” but it may also come about
in another way, as already suggested, i.e., by combination.
When there is cutthroat competition, the motive to combine
is strong. No one of the competitors relishes the prospect
of being crowded out any more than he relishes the prospect
of continued cutthroat competition. Whether combination
will actually result or not depends on a variety of circum
stances. One or more of the competitors may flatter himself
that the rate war will end in crowding out all suppliers except
himself, and prefer to keep up the fight to the bitter end.

Others may keep on from other motives, being prevented by
pride or resentment either from withdrawing from the contest
or from begging their rivals to form a combination. But for
our present purpose it does not matter much whether the
monopoly which finally results comes from the final survival
of one supplier or from deliberate combination of many sup
pliers. In either case the result is monopoly.
We find, then, from our study of the supply side of the
market that supply curves sometimes descend, and that in

SEc. 7]

THE INFLUENCES

323

BEHIND SUPPLY

such cases competition is “cutthroat” competition, and re
sults in losses and tends toward monopoly.

In all our reasoning we have assumed perfect competition
to start with.

It should be noted that in actual fact com

petition is always somewhat imperfect. The slight under
cutting of prices by one grocer will not ruin the trade of
another in another part of the same town for the reason
that the two are not absolutely in the same market. Each
has a sphere which the other can only partially reach, not
only because of distance, but also because each has his own
“custom,” i.e., the patronage of people who, from habit
or from other reasons, would not change grocers merely
because of a slight difference in price. Thus each is pro
tected by his partial isolation. We see, then, that even when
supply curves descend, competition may be so limited as to
prevent any very fierce rate war, the rate war being pre
vented by partial or local monopolies among the suppliers
in the first
rate war, therefore, is never a perma
nent or normal cohdition. If not avoided at first by imper

fect competition or by partial monopoly, it is brought to an
end eventually by the monopoly to which it leads.
~

§ 7. Fixed and Running Costs
We have now to notice another peculiarity on the supply
side of the market. The peculiarity referred to is the fact
that there are often costs which do not vary with supply, but
remain unchanged whether the supply is large or small or
nothing. These are called the fixed costs as contrasted
with the costs which vary with supply, which are called the
running costs. If all costs are in the form of actual money
expenses, the two classes are also called respectively fixed
expenses and running expenses. The fixed expenses of a
railway company, for instance, consist of the interest on
its bonds. The running expenses consist of the salaries,
wages, and payments for fuel, materials, etc. The only

324

ELEMENTARY PRINCIPLES OF EconoMICs

(CHAP. XVII

costs hitherto included in our discussions were running costs.
The fixed costs were not included, because they have no
effect on variations in supply curves. We shall now study
fixed costs merely to show that they do not have any effect
on supply after once they have been incurred, a fact at first
surprising.
In general, fixed costs of production of any given goods
consist simply of interest on past costs which have been
“sunk ’’ in the business, i.e., which cannot now be reim

bursed to the owner except as the sale of his goods may re
imburse him in part or in whole. As we have seen in a
previous chapter, interest is not a cost to society, for it is
merely a payment from one person to another, an interac
tion. (See p. 76.) To society as a whole the only cost is
the “sunk" cost, which, in the last analysis, consists, as
has been explained, of the labor expended at various times
in the past. But to the individual supplier — and his is
the only cost in which we are at present interested — in
terest is a cost. If he pays no interest, he must have in
curred the “sunk ’’ cost himself, in which case this past
sunk cost constitutes his only fixed cost; there is then no
fixed annual cost. In one of the two ways he must bear
the burden of sunk cost. That is, either he must have

borne it in the past directly, or he must now be paying
interest to some one else who so bore it. The two ways are
equivalent in the same sense that two goods are equivalent
which exchange for one another.

That is, a sunk cost of

$1oo,ooo is equivalent, if interest is five per cent, to a
fixed cost of $5000 a year. Whether the individual person
or company has sunk the $100,000 in the past or is paying
$5000 a year to some one else who did — in neither case
does this cost enter into the cost (or undesirability) curve,
or the resultant supply curve, or the resultant price.
We shall cite some examples which have been almost
literally realized in actual life.

A man once sunk about

$100,000 in a hotel on the top of a mountain. He found

SEC. 7]

THE INFLUENCES BEHIND SUPPLY

325

that so few guests wanted to go there that the most he

could earn was $2000 beyond his running expenses. He
never succeeded in recovering the sunk cost, and the fact
that he had sunk $100,000 gave him no power to com
mand prices high enough to enable him to succeed. Nor
could he withdraw from the business and recover his

$1oo,ooo. His building was worth nothing except for
hotel purposes. He could only make the best of his mis
investment and run his hotel for $2000 a year. This
was better than nothing at all, which would have been
the result of going out of business. The $100,000 sunk

in the past was sunk just the same, whether the hotel
Was run Or not.

Another hotel keeper borrowed $100,000 on bonds and
paid interest at five per cent, i.e., $5000 a year, to
the bondholders. His business paid running costs, but
only $2000 beyond those costs, so that he failed by $3000
to earn enough to pay his interest to the bondholders.
The hotel was losing, in actual money expended, $3000 a
year. But even in this case the hotel could not be aban
doned. The only result was to change owners. The bond
holders foreclosed their mortgage and ran the hotel them
selves.

As it still earned $2000 beyond running expenses,

they found it more profitable to continue the business and
get two fifths of their interest than to close and get nothing.
In either of these two cases, whether the hotel was built

by the owner out of his own purse or whether it was built
out of borrowed money, there was a loss equivalent to three
fifths of the original cost, or, what amounts to the same
thing, three fifths of the interest thereon. Yet this cost
could not be avoided, whether the hotel business were large

or small or abandoned altogether, and it “paid " to run at
a loss rather than to close down at a greater loss. This
paradox, that “it sometimes pays to run at a loss,” is im
portant to analyze and to understand.
A third hotel keeper made a lucky hit with his $1oo,ooo.

326

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XVII

He got not only his running expenses and interest on the
$100,000, but a handsome profit besides. But this fact did
not affect the prices at which he was willing to supply ac
commodations. He still charged as much as he could.
The point to be emphasized is that in all three cases the
past fixed costs had no influence on prices. Whether these
costs are easy to carry, as in the last case, or burdensome,
as in the other two, they have no influence on prices. In
each case the owner tries to make the most he can.

The

fixed costs take out the same amount, whatever he does, and

may therefore be disregarded in deciding what is best to do.
It follows that fixed costs will not even prevent prices,
under the stress of competition, from going below what will
pay those costs. A railway may be making money enough
to pay both its running and fixed expenses and a handsome
surplus besides, until a parallel road is built. Then each
tries to take business away from the other; a rate war en

sues, and prices of freight and passenger services are driven
down. Each road is now running behind on its interest
payments, yet neither can afford to stop running, for then
it would run behind still further.

We have here the same

cutthroat competition as when the supply curve descends,
except that in this case it is “cutthroat” because of the
fixed costs. If also the supply curve descends, then there
are two conditions tending toward cutthroat competition;
namely, the existence of the descending supply curve and
the existence of fixed costs. As a matter of fact, these two
conditions are often united.

§ 8. General and Particular Running Costs
The two costs – fixed costs and running costs—are not
only often associated, but are at bottom very similar to
each other. This may best be seen if we divide one of
the two classes of costs, running costs, into two subclasses,
“general ” costs and “particular ” costs. By general

SEc. 8]

THE INFLUENCES BEHIND SUPPLY

327

costs, also called “overhead costs,” are meant costs which,

though they could be got rid of if the business ceased, will
not greatly vary whether the business is large or small.
They include the labor of superintendence, salaries of the
chief officers, rent of rented quarters, interest on short
time loans for stock carried, etc., power, lighting and heat
ing, insurance and repairs. By particular costs are meant
those which apply to each particular unit so that their total
amount will vary almost or quite in proportion to the
amount of product sold. They include cost of raw mate
rials and ordinary wages.
Now when the supply curve descends, i.e., when running
costs decrease with increase of supply, the reason is usually
found in the “general costs.” As the total “general costs’
remain little changed by an extension of the supply, the
general costs per unit supplied grow smaller, the larger the
supply. These costs, added to the particular costs, which re
main practically the same, evidently cause the total running
cost per unit to decline with an increase in production. For
instance, let us suppose a shoe factory in which the general
costs (for office salaries, heating, lighting, rent, insurance,
etc.) amount to $100,000 a year, while the particular costs
for materials (leather, etc.) and labor applied to the mate
rials (cutting, sewing, etc.) amount to $1 per pair of shoes.
It is evident that the greater the product, the less the cost
of shoes per pair. If Io,000 pairs are produced per an
num, the share of the general costs ($100,000) which each
pair must bear will be $10. This, added to the particular
cost for each pair ($1), will make a total cost per pair of
$11; but if the output of the factory is Ioo,000 pairs, the
share of the general cost ($100,000) which each pair must
bear will be only $1, which, added to the particular cost ($1
per pair), will make a total cost per pair of $2. Thus we
see that the total cost per pair will in each case be the
particular cost, $1, plus the share in the general cost, which
will be large for a small output and small for a large output.
*

328

ELEMENTARY PRINCIPLES OF EconoMICs

(CHAP. XVII

Now the reason that fixed costs were not treated like

general costs and included in the computation of the
average cost per unit, was that, as we have seen, fixed
costs could make no difference in the price at which the
supplier is willing to supply a given amount. The supplier
is not willing to sell at prices below what is necessary to
cover general costs, for he has the option to escape these
general expenses by going out of business entirely. But
he is willing, if need be, to sell at prices below what is nec
essary to cover fixed costs in addition to general costs; for
from these there is no way of escape, not, at any rate, as
long as the capital representing fixed costs lasts. He
might have escaped them once had he not made the
original investment, but now it is too late.

The differ

ence between fixed and general expenses, then, is chiefly
one of dates. When a man is contemplating building a
hotel, and forecasting his possible profits or losses, he will
try to make his prospective prices cover fixed costs, for they
are then in the future; but after the hotel is built, he will

no longer do this. The fixed costs are then past and beyond
recall, and he must let bygones be bygones.
Since, then, his running cost and supply curves are inde
pendent of fixed costs, the price which results from this
supply curve and the demand curve will also be independent
of the fixed costs.

This conclusion is consistent with what

has been said in previous chapters as to price and value being
dependent on the future and not on the past. We have
seen that, on the demand side, people who buy any good
buy it on the basis of what benefit it will do them in the
future; now we see that, on the supply side, those who
sell it, sell it on the basis of what it will cost them in the
future to continue in the business, and not on the basis of
costs which were sunk in the past. The principle has been
stated (somewhat imperfectly) as follows: —

“The price of any article (when once it has been produced)
is not determined by its cost of production, but only by its

SEC. 9]

THE

INFLUENCES BEHIND

SUPPLY

329

benefits.” The imperfection in this statement is its failure
to discriminate past from future. The costs of production,
if they be future, do enter into value, precisely as future
benefits enter.

Future costs are estimated in advance

just as future benefits are. For instance, the value of the
great irrigation plants in the West now in process of con

struction is dependent upon their future expected bene
fits, taken in connection with the future expected cost of
completion. Past elements are without significance. The
future elements being given, the value of the irrigation will
be the same whether the past cost was large or small, or noth
ing whatever. Of course it is true that the future expected
cost of completing the plants is less than if some of the work
had not been already accomplished, so that the greater the
past cost has been, the less the future cost ought to be, and
hence the greater the present value of the plants. But what
ever causes may increaseor decrease future benefits and costs,
it remains true that the present value of anything depends
exclusively on the future benefits and costs which it yields.
§ 9. Monopoly Price
The Supreme principle which guides economic action is
the principle of maximum gain. This principle applies
both to competition and monopoly, but its application is
different in the two cases. In the case of competition the
price set by a man's competitors is an important element
which must be reckoned with by that man, while in the case
of monopoly he has no such element to reckon with. In
fact, monopoly is best defined as absence of competition.
In explaining the principle on which monopoly price is
fixed, we shall first assume that competition is entirely
absent, there being no fear even that high prices will lead
to competition in the future.

Under these circumstances the monopolist will fix his
price with an eye to the expected effect on demand. He

33o

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVII

will charge “what the traffic will bear,” i.e., will put up
his price to the point which will give him a maximum profit.
The higher the price, the larger the profit per unit sold.
But, if he makes his price too high, he kills the sales. If,
on the other hand, he makes it too low, he kills his profit
per unit. By trial and error or by exercise of his best judg
ment, he steers a middle course, and selects that price
which he thinks will render his profit a maximum.
In general, the price under monopoly will be higher than
under competition, but this will not always be the case if,
as may happen, the costs under monopoly are less than the
costs under competition. In some cases monopolymay result
in lowering costs so much that the greatest profit is secured
by setting the price lower than under competition. Such
economies in cost come from getting rid of duplications in
plant, management, and advertising, and by having the
advantages in general of large-scale production.
When monopoly price exceeds price under competition,
there is usually danger that competition will thereby be
invited.

Practically such danger is seldom absent.

Com

petition which is feared, but not in actual existence, is called
potential competition. This potential competition has an
effect similar to real competition, so that under monopoly
the price is usually not quite “all the traffic will bear,” but
something between that and the price that would result from
actual competition. In general, prices are seldom deter
mined under conditions either of perfect monopoly or of
perfect competition. There is usually a partial monopoly,
or, what is the same thing, imperfect competition.
There are many and obvious evils in monopoly. Some
monopolies originate in a deliberate plan to do evil, in a

“conspiracy” to raise prices and without any excuse from
cutthroat competition. But the evils of high prices are
among the least of the evils of monopoly. There are also the
evils involved in the ruthless process of crushing competitors
by first lowering prices and then raising them; there are

SEC. 9]

THE INFLUENCES BEHIND SUPPLY

33I

the evils of discrimination, or charging different prices to
different persons or localities. There are also the dangers
of political corruption and control. The reader will have
an opportunity in other books to study these evils and the
proposed remedies; we cannot properly discuss them here.
We may, however, take space to warn him to avoid the

common but false conclusion that all monopolies are evil.
In fact, a chief lesson from this chapter is that, on the
contrary, competition itself is sometimes an evil, i.e., when
it is of the cutthroat kind, for which some form of mo–

nopoly is the only remedy. When any business involves a
large sunk cost or has a descending cost curve, and there
fore a descending supply curve, competition becomes of the

cutthroat kind. Even if we deny our sympathy to those
producers who lose by such competition, we must not fail
to note that in the end consumers will lose also.

The

reason is that when cutthroat competition is feared, pro
ducers will avoid sinking capital in the enterprise. It
is largely in recognition of this fact and in order to en
courage such investment that patents and copyrights are
given. These are monopolies expressly fostered by the
government. Herbert Spencer once invented an excellent
invalid chair, and, thinking to give it to the world without

recompense to himself, did not patent it. The result was
that no manufacturer dared risk undertaking its manu
facture. Each knew that, if it succeeded, competitors would
spring up and rob him of most or all of his profits, while,
on the other hand, it might fail. Enforced railway com
petition has sometimes resulted in killing railway enterprise.
The rise of trusts, pools, and rate agreements is largely
due to the necessity of protection from competition, pre
cisely analogous to the protection given by patents and
copyrights.

Combinations are largely the result of the two conditions
we have been considering — the fact that the supply curve
descends, and the fact that there is large invested capital.

332

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVII

The antitrust movement, in so far as it aims to compel
competition, does not take these facts into account; nor does
it understand the necessities which have led to monopoly.
So considerable are the lines of business in which either

there is a large sunk capital or a descending supply curve,
that if we do not allow some form of trade agreements

many kinds of trade are to-day practically impossible.
Restrictive measures should be directed toward the control

of monopolies and combinations, not to the restoration of
competition. At the present time the general tendency is
towards those forms of production in which cutthroat com
petition figures and in which monopoly will ultimately
rule. It must not be supposed, however, that all or even
most of productive enterprise is of this character. There is
an immense field in which the older form of competition
still holds sway; that is, in which marginal cost increases
with increased production so that the supply curve is of the
ascending, not the descending, type. In such cases com
petition is still the “life of trade ’’ and affords a safeguard
for the consumer against exorbitant prices. Such com
petition needs no regulation, and in general is better off
without it.

CHAPTER XVIII
MUTUALLY RELATED PRICES

§ 1. Arbitrage
WE have seen how the price of any particular good is
determined under varying conditions of competition and
under monopoly. In each case the particular price has been
considered, quite apart from other prices. We found that
each price was determined by its own supply and demand.
But “supply and demand ” were expressed by schedules
(or curves) which in turn depend upon schedules (or curves)
of desirability which themselves depend on innumerable
outside conditions – among them being other prices than
the particular price in question. In fact, we have seen that
these separate curves are affected by the general level of

prices. We now have to observe that they are also affected
by other particular prices.
In the first place it is evident that the prices of the same
article in different markets act and react on each other.

Thus, the price of wheat in Chicago affects the price of wheat
in New York, Liverpool, and elsewhere. The fact that wheat
can be transported quickly and cheaply from one market
to another prevents the possibility of great differences in
prices. Any considerable difference in prices between two
markets such as Chicago and New York will soon correct
itself through the transportation of wheat from the cheaper
to the dearer market.

If all communication between the

markets could be cut off so as to prevent absolutely such
333

334

ELEMENTARY PRINCIPLES OF EconoMICs (CHAP. XVIII

transportation of wheat, the supply and demand schedules
or curves in each market would be independent of those in
the other, and the resultant prices in the two would fluctuate
independently of each other. But, given cheap and rapid
transportation, the supply and demand in one market will
closely affect and be affected by the supply and demand in
the other, and there will be a tendency toward equalization
of prices. In the two this tendency to equalization works
itself out chiefly through a special class of men who make
it their business to watch prices in different markets, en
deavoring always to buy in the cheaper and sell in the
dearer. Such transactions are called arbitrage transactions.
These men engage in the business of arbitrage in order to
take advantage of price differences; and while it is not
their object or wish to equalize prices (for it is on the in
equalities of prices that they live), nevertheless, to equalize
prices is the effect of their action.
Suppose, for instance, that the price of wheat in Chicago
is 75 cents per bushel and in New York $1 a bushel. Such
a situation offers an opportunity for an arbitrage merchant
to make money rapidly by buying wheat in Chicago at 75
cents and selling it in New York at $1. He therefore appears
in Chicago on the demand side of the market, being willing
to take a large amount of wheat at 75 cents per bushel. He
appears in New York, on the other hand, on the supply side
of the market, being willing to sell a large amount of wheat
at $1 per bushel. Thus he increases the demand for wheat
in Chicago and increases the supply in New York. The
effect, as we have seen, must be to increase the price in
Chicago and decrease the price in New York.
The former may rise from 75 cents to 80 cents per bushel,
and the latter may fall from $1 to 95 cents per bushel. But,
even at these prices, the arbitrage merchant will be able to
reap a rich harvest and will continue to do so until the dif
ference in price is sufficiently reduced. Instead of the prices
remaining 80 cents and 95 cents, they become, let us say,

SEc. 1]

MUTUALLY RELATED PRICES

335

82 cents and 93 cents and then 84 cents and 90 cents. This
leaves the merchant a margin or difference of only 6 cents.
But as the cost of transporting wheat from Chicago to New
York is, we shall suppose, about 6 cents per bushel, there
is no longer profit to the arbitrage merchant, and thus the
equalization of prices will be limited by the cost of trans
portation. The price in New York can never be above
that in Chicago by more than 6 cents per bushel. For
similar reasons, the prices in Chicago cannot exceed those
in New York by more than the cost of transportation;
otherwise the arbitrage merchant would buy wheat in
New York and sell it in Chicago.
It is by such arbitrage transactions that the prices of the
same commodity in different markets seek a common level,
just as water flowing from one reservoir to another tends to
equalize the levels of the two. The more the costs of trans
portation are reduced, the more nearly equal will the prices
of any commodity in different markets become. With
the progress of civilization, and especially with the improved
means of transportation by railway and steamships, the
equalization of prices of transportable goods has proceeded
with great rapidity. The commercial world still consists
of a number of separate markets, but the communication

between these markets is becoming constantly more cheap
and rapid, so that, in a sense, the whole world almost forms
one great market for certain staples like wheat, other grains,
and the precious metals. For articles which are difficult of
transportation, bulky, and otherwise subject to expenses of
transportation large relatively to their value, the tendency
to the equalization of prices is less striking. This is partic
ularly true of human services by “labor,” which can only
be transported through migration. Nevertheless, there is
a constant tendency for migration to take place in order
to take advantage of differences in the price of labor. Both
the European and Oriental workmen often leave their low
wages for the higher wages in America or other new countries.

336

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVIII

Before the days of rapid transportation it was not uncom
mon for wheat to command famine prices in one country,
while, at the same time, it was a glut on the market in
another.

It is evident that the equalization of prices is an advan
tage to the world as a whole, for it is better that there
should be a moderate supply of wheat, and therefore of
bread, throughout the world than that there should be in
some places feast and in others famine. Therefore the
intercommunication of markets and the resulting equaliza
tion of prices must be regarded as an advantage to Society.
It does not follow, however, that it is an advantage to
every individual in society.
For instance, when the fertile lands of the Mississippi
Valley were tapped by building railways from the East,
the cheap wheat from these lands began to enter the markets
of the East, where the price of wheat had been relatively
high. The result was to lower the price of wheatin the East.
This reduction in price injured the New England farmer.
Such injury of individuals almost inevitably happens with

every economic readjustment of conditions.

Rapid and

cheap transportation by connecting all lands and countries
has, in spite of the general good accomplished for the
world as a whole, injured great groups of producers by
subjecting them to competition from which the barriers of
nature had previously protected them. These producers
have therefore asked the government to protect them by
raising artificial barriers in place of the natural barriers
which have been destroyed, and the protective tariff has
as its chief source of popularity the fact that it protects
the local producer of particular articles against the importa
tion of such articles from abroad. The policy of protection
is thus an attempt to interfere with the equalization of
prices which the improvement in transportation is con
stantly producing.

But just as this progress of equalization of prices creates a

SEc. 1]

MUTUALLY RELATED

PRICES

337

special injury to some particular producers, it creates special
benefits to others. The transcontinental railways have not
only injured the owners of the rocky farms in New England,
but have vastly benefited the owners of the alluvial lands in
the Mississippi Valley; for they have given them an oppor
tunity to sell their products to advantage in the more rocky
parts of the world. In general we may say that the equal
ization of prices constantly going on through improvement .
in transportation facilities injures the producer in those
regions where prices were previously high, but benefits the
producer in regions where those prices were previously
low. The former group have, therefore, an interest in pro
tection; the latter, an interest in freedom of trade: the

one, an interest which tends to prevent, and the other, an
interest which tends to promote, the intercommunication
of markets. Among consumers, on the other hand, opposite
results ensue. Those particular consumers who were enjoy
ing the lowest prices are injured by the rise which equaliza
tion brings to them, while those who had to pay high prices
are benefited by the fall which equalization brings to them.
In general, the inevitable effect on society as a whole is a

gain, for the reason that a larger quantity of goods is
obtained with a smaller expenditure of effort. It is evi
dently more economical for the world to grow its wheat
in the Mississippi Valley than on the refractory soil of
New England, and the transportation facilities which have
brought about this condition have been of the same nature
as labor-saving machinery.
It is not within the scope of this book to discuss the argu
ment for or against the protective tariff, but the student
can at this point realize that the movement for protection
is of the same nature as the movement against labor-saving
machinery, which is a protest against the cheapening pro
cesses which come from inventions, the protest being made
by the special interests which are injured by the introduction
of these processes.
Z

338

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVIII
§ 2. Speculation

We have spoken of the equalization of prices as between
different places. We have next to consider equalization of
prices as between different times. Corresponding to the
tendency to the equalization of the prices of a given com
modity between different places, that is, between the places
where it is abundant and cheap and the places where it is

scarce and dear, there exists a tendency to the equalization
of the prices of a given commodity at different times. More
over, the method of equalization of prices between times
corresponds somewhat to the method of equalization of
prices between different places. Just as the equalization
between places is accomplished by the transportation of
commodities, so the equalization between times is accom
plished by keeping the commodity from the time when
it is abundant, and therefore cheap, to the time when it is
scarce, and therefore dear. For instance, ice is abundant
and cheap in winter, but scarce and dear in summer. Con
sequently much of it is stored in ice houses in winter and
kept for use in the summer; that is, the part which is thus
stored is subtracted from the winter supply and added to
the summer supply. The effect tends to equalize the prices
of ice at different seasons. In the same way many vege
tables and fruits, such as potatoes and apples, which are
abundant and cheap in the summer and fall, are to a large
extent stored for use in winter when they will be scarce and
dear. The effect is to subtract a certain quantity from use
in the summer and fall and to add to the amount used in
the winter.

Just as the equalization of prices between places is largely
due to the work of a special class of business men who engage
in arbitrage transactions, so the equalization of prices be
tween different times is largely accomplished by a special
class called speculators. A wheat speculator, for instance,
withdraws wheat from the market when it is abundant and

SEC. 2)

MUTUALLY RELATED

PRICES

339

cheap, and supplies it when it is scarce and dear. At the
former times he appears on the demand side of the market

as a wheat buyer; at the latter he appears on the supply
side as a seller. By adding to the demand when the price
is low, he tends to raise prices, and by adding to the supply
when the price is high, he tends to lower prices, thus acting
as an equalizing agent.
We need to distinguish two chief kinds of speculation
according as the price of the given commodity is expected to
rise or fall. Speculators who try to profit by any expected
rise of price are called “bulls.” Their operations consist
simply in buying wheat in the present, keeping it until the
future, and then selling it again at higher prices. Specu
lators, on the other hand, who try to benefit by an ex

pected fall in prices are called “bears.” Their operations
are somewhat more complicated. It is easy to decrease the
present consumption of any commodity and increase corre
spondingly future consumption, i.e., to withdraw certain
stocks and hold them until the future. But when the
reverse operation is needed, namely, to increase present
consumption at the expense of future, the operation is more
difficult. We cannot lay hold of a future stock of wheat
before it exists. The best we can do is to use up our
present wheat as completely as possible. This is what is
needed when prices are falling. Speculators will then add to

the present supply by selling out any stocks from previous
holdings. They and all who deal in wheat will refrain as far
as possible from intentionally carrying over any of the pres
ent stock of wheat into the period when they expect it to be
abundant, and therefore cheap. But this is not all; the
speculators will also speculate for a fall by “selling future
wheat short.” This operation of “selling short ’’ consists
in agreeing to sell wheat in advance of the time of delivery,
depending on its expected fall in price to enable them to se
cure the wheat in time to fulfill their contracts.

It is called

“selling short,” because the speculators are selling some

34o

ELEMENTARY PRINCIPLES OF ECONOMICs

(CHAP. XVIII

thing which they do not yet possess, i.e., of which they are
“short.” The speculator who sells short hopes to make a
profit by buying at a lower price than the price at which
he sells short. If, for instance, in January the price of
wheat is high, say $1 a bushel, he sells July wheat, that
is, wheat deliverable in July, at 90 cents a bushel. This is
because he expects that when July comes, wheat will be
worth less than 90 cents a bushel, say 85 cents, so that
he can buy it for 85 cents and sell it immediately to his
customer for the 90 cents previously agreed upon.
The effect of selling wheat short is to encourage still
further the using up of present supplies, the speculator thus
guaranteeing the delivery of wheat to those who buy of
him so that these persons will not need to accumulate the
wheat in advance for themselves. Of course, the speculator
must take good care that the wheat is available at the time
agreed, but, being presumably an expert as to the conditions
of wheat supply, he can manage to get the wheat in the nick
of time or, at any rate, with less preliminary accumulation
than those who are not experts. The effect is therefore to
obviate the necessity of any one's keeping wastefully on hand
any large stock. Where such a speculative market exists, a
miller can, when wheat is scarce, use up his existing stock
without replenishing it until the last minute, at which time
he has the assurance of those who have sold him wheat short
that the wheat will be on hand. Without such assurance

from experts in wheat speculation, the miller would have
feared to have run his stock so low and would have laid in

wheat in advance even at high prices. He defers his stock
ing up by means of the short selling of wheat to him by the
speculator.

In the same way a woolen manufacturer is enabled in
a speculative market to lay in his supply of wool in the
most advantageous manner. If the price of wool is fall
ing, he will wait before stocking up, merely contracting
in advance with a speculator for the immediate delivery of

SEc. 2)

MUTUALLY RELATED PRICES

34I

new wool, when his present stock is exhausted. In the same
way builders use the speculative market to assure them
selves of building materials when needed. The builder
arranges in advance with dealers in building materials
for the delivery to him of the lumber, bricks, and stones
needed. By thus selling short or making contracts for
delivery in advance of possession, and sometimes even
in advance of the actual existence of the commodity
sold, there is a great saving accomplished in the stocks
which need to be carried. Without such selling of futures
the miller, the woolen manufacturer, the builder, and

great classes of merchants would be under the necessity
of carrying far larger stocks than they now carry. In
other words, the speculative operation known as selling
short enables the community to economize its capital exist
ing in the form of accumulated stocks of goods, especially
at times when these goods are scarce and dear and most
need to be economized. This selling short has the effect of
deferring the demand for a commodity. The miller, the
woolen manufacturer, the builder, and all others who buy
futures – the wheat, the wool, the building materials, etc. —
do so instead of buying present wheat, wool, building mate
rials, etc. The fact that they find a speculative market in
which they can buy futures has therefore, as its effect, less
buying in the present. In other words, it reduces the pres
ent demand, and therefore reduces the present price, while
it increases the future demand and the future price. Thus
it tends to reduce the gap between the present high prices
and the future low prices.
But while speculation normally tends to mitigate either
an impending rise or fall of prices, its power to do so is
limited, just as is the power of equalizing prices among dif
ferent places by arbitrage. The latter operation does not
pay when the difference in price is reduced to the cost of
transporting from place to place. Likewise speculation

does not pay when the expected difference in price becomes

342

ELEMENTARY PRINCIPLES OF ECONOMICS

[CHAP. XVIII

too small. One of the costs to the speculator for a rise is
interest on the capital he locks up when he withdraws a
commodity from the market and holds it for a certain period.
Suppose, for instance, that he borrows money in order to
speculate for a rise. The anticipated rise must be sufficient
to cover the interest he pays and all the other costs involved
in the operation. Otherwise the speculation promises a ,
loss instead of a gain. Likewise, if he is to speculate for
a fall, he must anticipate a fall sufficiently below the price
at which he sells short to enable him to make a profit.
Speculation, therefore, is a function in equalizing prices
between times, very analogous to the function of arbitrage
transactions in equalizing prices between different places.
But there is one important distinction between speculation
and arbitrage. Speculation, by the nature of the case, in
*volves uncertainty in a far greater degree than arbitrage.
The prices among different places can easily be known, but
the prices between different times are far more difficult to
know, for the future is always uncertain. All we can do is
to predict according to the best information we can get. It
therefore often happens that the speculator makes a mistake
in his forecast of the future. He may believe that prices
are going to rise when they are going to fall, or to fall when
they are going to rise If, acting on a mistaken belief that
prices are rising, he holds wheat for a rise, the result of his

action will be to aggravate the fall; for buying in the present
will raise prices now when they are already high, and selling
in the future will lower them then when they will be low.
In like manner, if he makes the mistake of selling short when

prices are rising, he will aggravate the rise, for he will lower
the prices in the present when prices are already low and
raise them in the future when they are already high.
Therefore speculation may do either good or harm. It
does good when it reduces the inequality of prices at different
times. It does harm when it aggravates this inequality.
Fortunately, the interests of the speculator and the public

Sec. 2)

MUTUALLY RELATED PRICES

are to a large extent identical.

343

It is evident that when the

speculator is correct in his prognostications, he will make
a profit. His object is to make a profit when prices are rising,
but he can do so only by mitigating the rise. Likewise his
object is to make a profit when prices are falling, but he can
do so only by mitigating the fall. His profits are, as it were,
a reward paid him by the community for mitigating price
changes. If he makes a mistake in either form of specula
tion, he suffers losses, and these losses may be regarded as
a sort of penalty he suffers for aggravating the inequalities
in prices. Since the interests of the speculator and of the
public are thus parallel, there is a premium put on wise and
beneficial speculation and a penalty on unwise and injurious
speculation.
It is unfortunately true, however, that in spite of the
penalties for unwise and injurious speculation, much specu
lation is of this character. This is largely due to the fact
that many engage in speculation who have no adequate
equipment for so doing and no independent judgment as to
the causes making for a rise or a fall in prices. The ultimate
justification for speculation must rest in the wisdom and
independence of those who speculate. Speculation which
merely follows a “tip” has no independent value. If
every person who speculates for a rise or a fall should do so
on a basis of his own best independent judgment, the chances

mistakes of those who are overconfident in either

rection would largely offset each other.
During recent years the general public have been beguiled
into the folly of entering the speculative market, but the
public have no special knowledge of market conditions, and
their participation in speculation is almost as apt to
aggravate as to alleviate the inequalities in prices. In such
cases speculation becomes mere gambling. In fact, it is
worse than gambling, for the evils are more extensive, being

shared by the consumers and producers and all who are
affected by the price fluctuations thus caused. Such evils of

344

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVIII

speculation are especially grave when, as usually happens,
the general public speculate in a mass, i.e., all in the same
direction. Like sheep, they tend to follow the same
leader, and the great bulk of their mistakes are apt to be in
the same direction, first in one direction and then in the
other.

The effect of their movements is like that of a

sudden rush of the passengers of a ferryboat first to one
side and then to the other, – it may cause a capsize.
We see, then, that the chief evils of speculation are largely
the work of the unprofessional speculators, just as the chief
evils of reckless automobile driving are due to untrained.
chauffeurs. It must not be supposed, however, that the
professional speculator is always a public benefactor. Not
only may he also make mistakes which cost him and
society dear, but he may sometimes “rig the market” and
manipulate prices. When a professional speculator merely
attempts to take advantage of an impending rise or fall of
prices, he is usually a public benefactor; but when he
attempts to create the rise or fall, of which he is to take

advantage, by false reports, by “cornering,” or by other
means, he is apt to be a mischief-maker.
This is not the place, however, to discuss the benefits and
evils of speculation further than to warn the student against
the wholesale condemnation of speculation so common in the
public press. Like most other industrial operations, specula
tion may be either good or bad. So far as it is good or bad,
the discussion of the two belongs to applied economics. Our
object here is to show that speculation, so far as it is good,
tends to equalize prices in time.
§ 3. Prices of Goods which Compete on the Demand Side
As a result of our study of arbitrage and of speculation,
we see that the price of any particular commodity at any
time and place, though directly fixed by its supply and de
mand at that time and place, is indirectly affected by the

Sec. 3]

MUTUALLY RELATED PRICES

345

supply and demand at other times and places; for these
react upon supply and demand at the particular time and
place under consideration. The price of wheat in Chicago
on January 1, 1912, is determined by the intersection of the
supply and demand curves in Chicago on that date; but
those supply and demand curves depend, as we now see, upon
the price of wheat in St. Louis, New York, Liverpool, and
other places, and depend likewise on the prices of wheat
on dates before and after January first. The price of
wheat in Chicago on January first tends to be close to
the price of wheat in neighboring places and at neighbor
ing times.
Not only does the supply and demand of wheat at any.
time or place depend upon the price of wheat at other times
and places, but it depends likewise on the prices of other
things than wheat. In particular the price of wheat de
pends on the prices of substitutes for wheat. Substitutes for
wheat will resemble wheat in affecting the price of wheat,
but the effect will not be so direct if the substitutes are only

substitutes on one side of the market; for instance, if they
are like wheat so far as the use to the consumer is concerned,

but unlike wheat so far as the cost to the producer is con
cerned. Thus sugar and honey are substitutes for each
other to the consumer, for they serve similar needs so far
as the consumer is concerned, though on the supply side
they are produced in totally different ways.
Two sorts of wealth are said to be substitutes on the de

mand side when they fill similar needs. It follows that the
satisfaction of needs by one of the two substitutes not only
reduces its marginal desirability, but affects the marginal
desirability of the other in a similar fashion. Consequently,
the marginal desirabilities of the two tend to fall or rise in
unison. Therefore also the prices of the two tend to fall or
rise in unison. It is evident, for instance, that the price
of coal will affect the demand for coke, since coal and coke

are often substitutes, or competing articles. The more

346

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XVIII

nearly either of the two articles comes to filling the office
of the other, the more closely do their prices keep pace
with each other. If two articles are absolutely perfect
substitutes, they are, to all intents and purposes, the same
article, and have the same price.
... There is scarcely an article which does not have its sub
h

stitutes. The two fuel substitutes, coal and coke, include
numerous subclasses and varieties, such as anthracite and

bituminous coal. Other fuel substitutes are wood, petro
leum, gasoline, alcohol, and gas. A change in the price of
any one of these tends to produce a similar change in the
prices of the rest. Likewise the prices of food substitutes
are sympathetic among themselves – the prices of such sub
stitutes as wheat, corn, oats, rice, and barley; of fish, meat,
and fowl; of the various fruits and the various vegetables.
Similar sympathetic relations exist among clothing sub
stitutes, such as woolen, cotton, linen, and silk; or among
ornamental substitutes, such as diamonds, pearls, rubies, and
amethysts.

The closest substitutes, though still sufficiently distin
guishable to prevent their being quite classed as the same
article, are the various “qualities,” “grades,” or “brands."
of any particular class of articles. The various breakfast
foods prepared from wheat are close substitutes. There
are many grades of wheat, of sugar, of coffee, of meat, of silk,
and, in fact, of almostany class of articles which can be named.
Among different grades the prices are usually so closely paral

lel that trade journals often give the price of one staple grade
only — as of a standard grade of coffee – leaving it to the
reader to infer what the prices of the other grades must be.
But the prices of different qualities of any good, though
they rise and fall together, may be wide apart among them
selves. Various qualities of land, for instance, bring very
different prices, ranging from almost nothing to thousands
of dollars per square foot. When the various “qualities”
yield precisely the same sort of benefit, the only differences

SEC. 4)

MUTUALLY RELATED PRICES

347

among them are differences in the quantities of benefits
which flow from them. In this case the prices of the goods
will evidently be proportioned to the net benefits they yield.
Wheat lands, for instance, of different fertility, will be worth

prices proportioned to the net value of wheat which they
yield.
§ 4. Prices of Goods which are Complementary on
the Demand Side

Substitutes may be said to compete with each other. We
now consider articles which complete each other or, in
other words, are complementary. Complementary articles
jointly serve the same want. We have seen that of two
substitutes one is used instead of the other for a given pur
pose. But of two complementary articles one is used in
conjunction with the other for a given purpose. Horses and
mules are substitutes, so far as either may be used for
the purpose of drawing loads. A horse and a cart are
complementary, for this same purpose.
We have seen that the essential attribute of substitutes

is the tendency of their marginal desirabilities to keep
pace with each other, and the consequent tendency of their
prices to correspond. In the case of complementary articles
it is the quantities of the articles which tend to maintain
a constant ratio. In the case of perfect substitutes the ratio
of their prices is absolutely constant. In the case of perfect
complementary articles it is the ratio of the units used that

is absolutely constant. Table knives and forks are practi
cally perfect complementary articles, as are cups and saucers

or “hooks” and “eyes.” A “hook” without an “eye ’’
is of little or no use and the number of “hooks” and the

number of “eyes” will always be substantially equal.
The prices of two substitutes tend to move sympathetically,
but the prices of two complementary articles tend to move
inversely. If horses are abundant, and therefore cheap,

348

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XVIII

the tendency is to make mules, which are a substitute, cheap
also, but to make the complementary carts dear; for the
more horses used, the more carts will be needed, and the

increased demand for them will tend to raise the price.
Articles which are related to each other in this comple
mentary fashion are almost as common as those which are
related to each other in competitive fashion. Various articles
of food are used in combination, as, for instance, bread and
butter, or the elements of which a sandwich is composed.
A daily diet is usually constructed with regard to the fitting
together of the different courses served, and of the meals
as a whole. Similarly, the various parts of one's wardrobe
are arranged with reference to one another; and again, a
dwelling and its various furnishings are mutually adapted.
The tables and chairs, crockery, knives and forks, beds
and bedding, rugs and wall paper, are severally arranged in

relation to one another in their respective groups, and to the
house to which they all constitute a complement.
§ 5. Similar Relations on the Supply Side
Thus far we have considered only goods which compete
with each other, or complete each other, in respect to
demand. Turning now to the supply side of the market,
we find similar relations.

Two goods compete in supply when they occasion similar
efforts or costs to those who sell them. Thus, hay and
wheat — though far from being substitutes on the demand
side, satisfying dissimilar wants — are to some extent sub
stitutes on the supply side, for they require similar costs.
Both require the use of farm land and the labor of mowing
or reaping. The prices of such articles competing in supply,
like those of articles competing in demand, tend to rise

or fall together because their costs tend to rise or fall
together. The best example of competition of costs is
found in the services of laborers. The wages, or the prices

SEc. 5]

MUTUALLY RELATED PRICES

349

paid for various kinds of work, tend to keep pace with each
other.

Man is so versatile a machine that one kind of

workman can readily substitute for another. On a pinch,
the same man may be a factory employee, a farm hand, a
coachman, carpenter, mason, plumber, or clerk. Conse
quently, these various sorts of work, though filling very
unlike wants on the demand side, compete on the supply
side, and tend to bear similar prices. If the wages of clerks
rise, the wages of carpenters will rise also, because otherwise

many carpenters would want to become clerks. The con
sequence is that wages of all sorts usually rise or fall
together. If labor of all kinds could be perfectly sub
stituted, wages of all kinds would remain in absolutely fixed
ratios to each other, i.e., would rise or fall together in exactly

the same ratios. Such “perfect mobility of labor,” however,
never exists. On the contrary, labor may be classified
into several more or less “noncompeting groups,” such as
brain work, skilled work, and unskilled work.

Two goods complete each other in supply, or are comple
mentary on the supply side, when jointly they involve
the same cost, i.e., when the supply of one tends to carry
with it the supply of the other. The less important of the
two is then called the by-product of the other. Tallow
is a by-product of beef and hides. Other examples of
articles completing each other in supply are mutton and
wool; coal, coke, and gas.
The prices of two completing goods on the supply side
tend to move in opposite directions, just as we saw was
the case on the other side of the market.

instance, beef and hides.

Consider, for

If the price of beef rises, the

amount supplied at the higher price will increase. Hence
the supply of hides will be increased at the same time. Con
sequently their price will fall.
We see, therefore, that two articles may be substitutes
on the demand side by replacing each other in satisfying
the same sort of desires, or on the supply side by requiring

350

ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. XVIII

the same sort of costs; and also that they may be com
plementary on the demand side by jointly satisfying the
same desire, or on the supply side by jointly requiring the
Same COStS.

§ 6. Prices of Goods in Series
In all the cases thus far considered, the relationship
between articles is on the same side of the market.

We next

proceed to consider goods, the relation between which in
volves both sides of the market.

The supply of one article may have relationship to the
demand of another.

This is true of two articles, one of

which is used in producing the other. Such goods may
be called goods “in series,” because one follows after
the other in the process of manufacture. In this respect
their relationship differs from the others discussed. Sub
stitutes or complementary articles are, as it were, “abreast”
of each other on the same side of the market, whereas

wool and woolen cloth, for instance, “go tandem ’’ on
opposite sides of the market. Wool is used (as raw material)
in producing woolen cloth. Hence the prices of wool and
woolen cloth are intimately related to each other. The
relation, however, is different from those relations hitherto
considered.

Wool and woolen cloth are neither substitutes

nor complementary goods on the same side of the market.
Their relation consists in the fact that the producers or sellers
of woolen cloth are the consumers or buyers of wool. Both
the demand and the supply side are involved.

Certain

people demand wool in order to supply woolen cloth.
The prices of goods in series move in sympathy. It is
evident, for instance, that given a high price for wool, the
prices in the supply schedule (or curve) for woolen cloth
will be higher than otherwise, and as a consequence the
market price of woolen cloth will rise. Conversely, given
a high price for woolen cloth, the prices in the demand

SEC. 7]

MUTUALLY RELATED

PRICES

35I

schedule (or curve) for wool will be higher than otherwise,
and as a consequence the market price of wool will rise.
Thus, any change in price of either of these two articles
will tend, sooner or later, to make the price of the other move
in the same direction.

In the same way cotton and cotton cloth are goods
in series, and their prices are likely to move in sympathy
with each other; likewise the prices of wood and houses, of
wheat, flour, and bread; or of iron mines, iron ore, pig
iron, rolled iron, steel, steel rails, and railways. This
chainlike or serial relationship comprises many other ele

ments than raw materials and finished products. Thus,
steel is related to the labor and coal consumed in its manu

facture in much the same way as it is to the iron ore out of
which it is wrought. The price of steel therefore moves in
sympathy not only with the price of iron, but with that of
coal and labor as well and of all the other goods employed
in its production. The series or chain of goods is the chain
of productive processes already discussed under the head
of successive interactions.

§ 7. Efforts and Satisfactions the Ultimate Factors
This serial relationship enables us to see clearly the fact

that, at bottom, supply rests on efforts, and demand on
satisfactions. We have seen in economic accounting that
all items of income and outgo cancel among themselves,
except efforts and satisfactions.

We now see this same

truth in its application to supply and demand. As simple
as this truth is, it is commonly overlooked, because people
are blinded by the all-pervading presence of money receipts
and expenses. The business man, reckoning in money,
comes to think of money expenses and money receipts as

though they were real costs and benefits in the productive
process, whereas they are only the representatives of real
costs (efforts) and real benefits (satisfactions). We disen

352

ELEMENTARY PRINCIPLES OF EconoMICs (CHAP. XVIII

tangle ourselves from the meshes of this money snare when
we see that the controlling factors in determining prices are
satisfactions on the demand side and efforts on the supply
side. Between efforts and satisfactions there may be in
numerable intermediate stages, at each one of which supply
and demand result in a market price; but each such price
represents simply anticipated satisfactions or efforts trans
lated into money valuations. Any dealer at intermediate
stages, between efforts preceding him and satisfactions fol
lowing after, has but little independent influence on price.
He is like a link in a chain or a cogwheel in a machine,
merely receiving and transmitting. If some real cost of
production earlier in the chain, i.e., some effort (labor),
is saved, he receives the cheapening effect from those of
whom he buys, and passes it on to those to whom he sells.
If some real benefit is reduced, i.e., some satisfaction di

minished, as by a change of fashion, he receives the cheapen
ing effect from those to whom he sells, and passes it back
to those from whom he buys. The supply and demand of
wheat in the Chicago wheat pit, for instance, is chiefly
dependent on the labor of growing wheat and the satisfaction
of eating bread. If a new labor-saving reaping machine
is devised which reduces the actual effort of producing
wheat, the effect is soon felt by the Chicago wheat dealer and
transmitted to his customer. Or if people turn to a rice
diet and no longer care much for bread, this effect is also
soon felt by the Chicago dealer and passed back to the
wheat producer.
An intermediate dealer may not know the ultimate causes
of the changes in supply and demand which affect his business
on either side, and sometimes he does not try to think beyond
what he immediately observes. Wholesale merchants gen
erally offer to their customers, the retailers, as an expla
nation of the rise in their charges, the fact that they have
to pay higher prices to the jobber; or, again, they may offer
to the jobber as an explanation of the fact that they cannot

Sec. 7]

MUTUALLY

RELATED PRICES

353

pay as much as before, the fact that they cannot get as
much from the retailers. Any such explanation of prices is
shallow, for it goes no farther than explaining one price
by another in the next link in the chain of prices.
We see, then, that everything intermediate which happens
in the economic machinery represents merely steps in the
connection between effort and satisfaction.

When Robinson

Crusoe supplied his wants, there was a direct connection
between his efforts in picking berries, for instance, and the
satisfaction of eating them. To-day there are a number of
links between these, but the same principle still applies.
Supply and demand at intermediate points merely reflect
final efforts and satisfactions.

CHAPTER XDK
INTEREST AND MONEY

§ 1. The Importance of Interest
WE have seen that, in the last analysis, prices depend on
comparisons between satisfactions, or efforts, or both. But,
since these satisfactions and efforts are not all simultaneous,

but are distributed in time, their comparison requires us to
take account of interest. Consequently our study of prices
will not be complete without a study of the rate of interest.
It is only by means of the rate of interest, explicitly or
implicitly employed, that the prices of most goods are
reckoned. The rate of interest, as previously explained

(Chapter VI, § 1), is itself a sort of price. So far as it has
been used in Chapter VI and elsewhere for capitalizing
income, it was taken ready made just as all prices were
taken ready made. We are now about to inquire how this
peculiarly important price, called the rate of interest, is
actually determined, just as we have already inquired how
other prices are determined. And it is by far the most
important sort of price with which economics has to deal.
Most people have an idea that the rate of interest is a
technical Wall Street phenomenon, concerning nobody ex
cept money lenders or borrowers. This is partially true of
explicit or contract interest. But there is implicit interest
to be considered. An explicit rate of interest is the rate
of interest explicitly stated in a contract. An implicit rate
of interest is the rate of interest which an investor expects
to realize who makes sacrifices at one time for the sake of

compensating benefits at a later time. Implicit interest
is also called profits. As was shown in Chapter VI, if we
354

SEc. 1]

INTEREST AND MONEY

355

invest in a bond, the price that we pay carries with it the
implication of a rate of interest we expect to realize on
the investment. The implicit rate of interest, or the rate
which we realize, is that rate of interest which, when used
for discounting the income of the bond, will give the price
at which we bought the bond. For instance, if a bond
yielding $5 a year for Io years, and then redeemable for
$1oo, sells now for $102, we know that the rate of interest
realized is not five per cent, as it would be if it sold at par.
It is less than five per cent — about 4.8 per cent (see
Chapter VI, § 4). The implicit rate of interest we realize
on such a bond may be found, as we have already seen,
from a mathematical table. The man who buys the bond
mentioned receives 4.8 per cent interest on his investment
just as truly as though he had lent out his $102 at that
rate. In fact, to buy a bond of a corporation or a

government is often spoken of as “lending money” to
that corporation or government. Again the buyer of
land who pays “twenty years' purchase” (for instance,
$20,000 for land from which he expects an annual
rental of $10oo) is making five per cent just as though
he were lending out his $20,000 at that rate. In the
same way a man who buys stock realizes a certain rate per
cent on his investment just as if he were lending money
at interest. Similarly the purchaser of a house gets a
return on the money he spent for it quite analogous to
the return he would have received had he lent that
money.

In short, every investment is analogous to a loan and
involves a rate of interest on the purchase price just as
truly as does the loan. As every purchase is really an
investment of present money for future benefits in money
or measurable in money, every purchase price implies a
rate of interest. A man cannot even buy a piano or an
overcoat or a hat without virtually discounting the value of
the uses which he expects to make of that particular article.

356

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIX

The rate of interest, then, is not confined to Wall Street,

but is something that touches the daily life of us all.
How, then, is this important magnitude, the rate of
interest, determined? The problem of interest is one of
the most perplexing problems with which economic science
has had to deal, and for two thousand years people have
been trying to solve the riddle.
§ 2. A Common Money Fallacy

Among the earliest explanations of the rate of interest
was that it is a payment simply for money, and that con

sequently it depends upon the quantity of money on the
market.

We commonly speak of interest as the “price of

money,” and the trade journals tell us that “money is
easy” in Wall Street, meaning that interest is low, or that
it is easy to borrow money. Or we are told that “the
money market is tight,” meaning that it is hard to borrow
money.

We often hear the argument that the present

high cost of living cannot be due to any plentifulness of
money, because, if money were really plentiful, it would
be cheap, meaning that the rate of interest would be low.
Probably the great majority of unthinking business men
believe that interest is low when money is plentiful, and
high when money is scarce.
This view, however, is fallacious, and the fallacy consists
in forgetting that plentiful money ultimately raises the
demand for loans just as much as it raises the supply,
and therefore has just as much tendency to raise interest
as to lower it. Suppose, for instance, a piano dealer wishes
to stock up his store with pianos (the price of pianos being
$200 apiece), and that he wishes to have a stock of 50
pianos in his salesroom. To accomplish this he evidently
will have to borrow $10,000. He goes to the bank and
borrows it. Now, let us suppose that money becomes twice
as abundant. This man, wanting to borrow again, will have

SEC. 2]

INTEREST AND MONEY

357

an idea that in some way he will this time get a lower rate
of interest at the bank, because, he reasons, the bank will

have more money in its vaults and will be more anxious

to lend it out. What he forgets is that the result of the
very abundance of money will be that prices in general
will rise, and presumably the price of pianos in particular
will rise; therefore, in order to get 50 pianos, he will have

to borrow twice as much money to enable him to pay for
his pianos at the doubled prices. In order to buy 50 pianos,
he will need $20,000 instead of $10,000. Likewise every
other borrowing tradesman will need to borrow twice as
much to conduct the same business.

The fact that the

banker has twice as much to lend is therefore completely
offset by the fact that the borrowers will want to borrow
twice as much. The consequence is that, in the end,

doubling the amount of money will not affect the rate of

interest.

It will simply affect the amount of money lent

and borrowed.

We must remember that interest is not only the price
of money, but it is the price in money. Interest is unlike
any other price in that it is the price of money, but it
is like all other prices in that it is the price in money.
Thus the rate of interest is found by dividing, say, the
$5 paid per year by the $100 cash for which it is paid.
Both the numerator and the denominator of this fraction

are expressed in terms of money. If we pay attention only
to the denominator, we are apt to think that an increased
supply of money should decrease the rate of interest. But
if we are to have a one-sided view, we might just as well fix
our attention only on the numerator, and maintain that an
increased quantity of money, instead of decreasing the rate
of interest, ought to increase it. The truth is, inflation of
money ultimately works equally on both sides. In mechan
ics one of the first things we learn is that a man cannot
raise himself by pulling up on his boot straps. The reason
is that he is pulling himself down as much as up. The in

358

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIX

flation of the currency pulls interest up on the demand side
as hard as it pulls it down on the supply side.
We should beware of the phrase “the price of money,”
for it has two meanings. It may mean the rate of interest,
which is a ratio of exchange between two moneys — the
price of money-capital in terms of money-income; or it
may mean the purchasing power of money over other goods
— the amount of other goods for which a given amount of
money can be exchanged. The abundance of money will,
as we have seen, reduce its price in the sense of purchasing
power over goods, but it need not on that account reduce

its price in the sense of the rate of interest. Yet the idea
that the plentifulness of money tends to make interest
low is a persistent one among business men.
One reason for this idea is that bankers usually look upon

money in relation to their reserves, and if bank reserves
are low, they have to raise the rate of interest to “protect ’’

those reserves. If the reserves are abundant, bankers
reduce the rate of interest in order to get rid of the reserves.
The banker is constantly watching his reserve, and has to
adjust the rate of interest with respect thereto. One
way to get rid of a plethora of money in the reserve is to
lower the rate of interest, and one way to protect a de
pleted reserve is to raise the rate of interest. But the banker
should not measure the amount of money circulating
outside by the amount of money inside the bank vaults.
What he forgets is that a larger reserve in his vaults does
not necessarily mean more plentiful money in the country;
nor when we have, as at present, for instance, a great
quantity of money throughout the world, does this fact
necessarily imply that Banker Smith will have more gold
in his vaults. The money may get into the pockets of
people first; it may in that way raise prices so high that
the borrowers at banks may demand, for the reasons ex
plained, larger loans. And yet, if for some reason a due

share of the money has not at the start flowed into the

SEc. 3]

INTEREST AND MONEY

359

banks, the result will be that Banker Smith will, for a time,
have too little reserve in relation to the greater loans that

are now demanded of him. The consequence, then, will
be actually to raise the rate of interest. When, therefore,
the banker says that more money lowers the bank rate
of interest, he ought to say, “When bank reserves get an
undue fraction of money, the bank rate of interest will
be low; but when an undue fraction goes into circulation
outside of banks, the rate will be high.” In other words,
an increase of money will operate in two different ways,

according to where it happens to go first. Normally and
eventually, as we have seen in a previous chapter, an in
crease of money distributes itself between pockets, tills,
and bank reserves, so as not to disturb the normal ratios

between them. When this happens, the rate of interest
will not be affected at all.

This conclusion is not based merely on theory. As a
matter of statistical fact, the rate of interest does not go

up when money is scarce and down when money is abundant.
For instance, an examination of the figures for per capita
circulation of money in the United States for thirty-five
years shows that in about half of the cases, when money grows
more abundant, interest is higher, and in half of the cases
it is lower. In other words, interest changes with abso
lutely no relation to the quantity of money in circulation.
§ 3. Effect during Appreciation or Depreciation
We conclude, then, that an inflation of the currency does
not affect the rate of interest, provided, however, the inflation
affects the loan at the time the loan is made just as much as
it affects the repayment at the time the repayment is made.

But the loan and the repayment do not occur at the same
time; there is an interval of time between them, and it

may be that the degree of inflation is greater or less at
the end than at the beginning of this period, in which

360

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIX

case the change in the inflation may, through its effect
on the values borrowed and repaid, affect the rate of interest
during the process of change. While inflation is taking place
there is an effect on the rate of interest, because the effect
of inflation on the sum loaned is different from the effect

on the sum repaid.
This brings us back to the consideration of the transition
periods of rising and falling prices and discloses a phenome
non which we were not ready to discuss in Chapter X. This
phenomenon is that the rate of interest tends to be high
during a transition period when prices are rising from one
level to a higher level and, reversely, that it tends to be low
while prices are falling from one level to another. Suppose,
for instance, that prices are rising at the rate of one per cent
per annum. Then $100 lent to-day is equivalent in pur
chasing power, not to $10o repayable next year, but to $101
repayable next year. If prices had not risen, the borrower,
when he paid back his principal of $100, would be
paying back the same amount of goods as were repre
sented by the $100 when he borrowed it.

In terms of

goods he would have been in the same position at the
end as at the beginning, and so would the lender. But we
are supposing that prices are rising. Then the lender, when
he gets back his principal of $100, does not get back as
much purchasing power as he lent, and the borrower does
not pay back as much purchasing power as he borrowed.
In other words, the fact that prices have risen during the year
has made things easier for the borrower and harder for the
lender. During the Civil War the United States govern
ment issued a great many “greenbacks.” The result was
an inflation of the currency and a consequent rise of prices,
and the result of that was that men who had mortgaged
their farms in the West found it very easy to pay back
their loans. As they said, the mortgages on their farms
“disappeared like smoke.” Five thousand dollars paid
back in 1864 for $5000 loaned in 1860 really represented only

SEc. 3]

INTEREST AND MONEY

361

half as much purchasing power over goods, for prices had
doubled; the inflation of the currency freed the borrowers
from half their debts.

We see, then, that when prices are rising, the principal
of a debt becomes less and less valuable. If prices are rising
one per cent per annum, that is, if the principal of the
debt, in terms of goods, is falling about one per cent, then
the interest on the debt ought to be increased about one

per cent in order that there should be the same burden
on the borrower as there would have been if prices had
not risen. If prices are rising two per cent per annum,
two per cent would have to be added to the rate of in
terest in order to compensate for the rise; and so on for

other rates of rise in prices. On the other hand, if prices
are falling, we must reduce the rate of interest to offset
the appreciation of the principal.
This ideal compensation in the rate of interest would oc
cur if man's foresight were perfect. If we knew absolutely,
for instance, that next year's prices were going to be two

per cent higher than this year's, the rate of interest might
be two per cent greater than otherwise. So also, if we
knew absolutely that all prices would be one per cent less a
year from to-day, than to-day, the rate of interest during the
year might be, on that account, one per cent less than other
wise. As a matter of fact, an approximation at such ad
justment does actually occur. A study of the periods of
rising and falling prices in the United States, England,
Germany, France, China, Japan, and India shows that, in
general, when prices are rising, the rate of interest is high,
and when prices are falling, it is low. But the adjust
ment is never perfect. Men never know the future exactly;
they can only guess. People are apparently reluctant to
believe that prices are going to change very much in either
direction. The result of this inadequacy of foresight is
that, when prices are rising, the rate of interest is usually
high, but not so high as it should be to make a perfect

362

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIX

compensation for the rise; and that, on the other hand,
when prices are falling, the rate of interest is usually low,
but not so low as it should be to make a perfect compensa

tion for the fall. Thus the rate of interest, though par
tially adjusted during transition periods, is not sufficiently
adjusted to alter the essential fact emphasized in Chapter
X; namely, that during rising prices the burden of debts
grows lighter on borrowers, and that, consequently, “enter
priser borrowers” tend to be prosperous; while, reversely,
when prices are falling, the same people lose, and “business
is dull.”

§ 4. Effect of Unequal Foresight
Besides being inadequate, foresight is unequally dis
tributed. Different persons differ greatly in their power
to foresee; and, in general, borrowers foresee better than

lenders. The great borrowers of to-day are not, as is often
supposed, the ignorant poor, but the alert and well-informed
rich. It is the function of these people to look ahead, and
the consequence is that they foresee a rise or fall of prices
more quickly than the lenders or bondholders, who are only
silent partners in business. Now, a consequence of the
superiority in foresight of borrowers over lenders is that
the borrowers are willing, during rising prices, to pay a
higher rate than they have to pay, whereas the lenders do
not see any reason for raising the rate of interest. Sup
pose that the rate of interest, on a basis of stationary
prices, is five per cent, and that prices are rising two per
cent per annum. We know that the rate of interest ought
to be seven per cent in order to make things even; but
let us suppose that the borrowers foresee that prices are
going to rise two per cent per annum, and that they are per
fectly willing to pay seven per cent, where otherwise they
would pay five per cent. Let us suppose, also, that the
lenders are not alert enough to see why interest should be

SEC. 4)

INTEREST AND MONEY

363

any more than five per cent. The consequence will be that
the rate of interest will not rise as high as seven per cent, but
will be something like six per cent. The consequence of this,
in turn, is that the borrowers, who are willing to pay seven
per cent to get the same loans that they used to get at five
per cent, when they find that they do not have to pay seven
per cent, but can get loans at six per cent, will increase
the size of their loans. Thus borrowers are encouraged
to borrow more. Likewise lenders are encouraged to lend
more, for they find that they can get six per cent when they
are willing to take five per cent. This six per cent is low
in the eyes of the borrowers, but high in the eyes of the
deluded lenders. The consequence, therefore, is an infla
tion of loans stimulated from both sides of the market.

In a previous chapter we saw that an increase of loans of
banks produces an increase of deposits, inflates the currency,
and makes prices rise further, and so on around the circle of
inflation, loans, deposits, and inflation again. The circular
process has to come to a stop sometime, but it never does
come to a stop until the rate of interest is adjusted. As long
as the rate of interest still stays too low, borrowing will
continue too high. When presently people wake up to the
danger of this condition of inflated loans and deposits, the
rate of interest does go up, discouraging loans and precipitat
ing a crisis. Then we have the back-flow: prices decreas
ing, interest falling, and discouragement of business. This
has all been explained in a previous chapter. What needs
emphasis here is that an essential factor in all these
changes is the rate of interest. The rate of interest is
the key to the situation. Were the rate of interest properly
adjusted, there would be less trouble, if, indeed, there were
any at all. Crises would be fewer, and they would be less
Severe.

How, then, can we get a better adjustment of the rate of
interest? One way is to prevent these changes in price
levels as much as possible. This we have already discussed.

304

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XIX

Another is to have men more alive to the future and more

quick to predict what is going to happen to prices. Edu
cation on this line will go on and is going on through the
trade journals. Still another way is through the removal
of the existing prejudice against raising the rate of interest.
We still inherit the old idea that interest is “usury’’ or
robbery. If we could once get rid of the prejudice against
allowing the rate of interest to rise high as well as to fall

low, that is, could regard the rate of interest as properly
subject to fluctuation and as being a market price changing
day by day, like any other price, a long step would be taken
toward preventing crises.

CHAPTER XX
IMPATIENCE FOR INCOME

THE

BASIS OF INTEREST

§ 1. The Productivity Theory
IN the preceding chapter we have considered the relation
of money to the rate of interest.

We saw that the money

supply has no effect on the rate of interest, except during
transition periods. The real riddle of interest, therefore, still
remains unsolved. Why is there such a thing as a rate of
interest, even when the purchasing power of money is con
stant, and what, then, determines that rate?

What other

factors besides changes in the purchasing power of money

affect the rate of interest? We must now go back of money
and study the supply and demand of loans.

In our study of prices we began by considering first the
part played by money, and then undertook an analysis of
supply and demand of goods. We are following the same
order in our study of that peculiar price called the rate of
interest. We have thus far considered only the part played
by money, and now are ready to undertake an analysis of
the supply and demand of loans. We shall find that, con
trasted with the supply and demand of goods, which resolves
itself in the last analysis into a comparison between dif
ferent marginal desirabilities and undesirabilities, which are
simultaneous, the supply and demand of loans resolves itself
in the last analysis into a comparison between different mar
ginal desirabilities and undesirabilities, which are not simul
taneous, but are distributed at different points in time.
365

366

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XX

Before, however, we can fully justify these propositions,
we shall need to clear the way by removing some of the many
fallacies and pitfalls which surround the subject.
There is, perhaps, no other “nut” so hard to “crack” in
all economics as this one of the rate of interest; and before

most persons have grown old enough to consider the subject
philosophically, they have absorbed, more or less uncon
sciously, anumber of untenable and even conflicting theories.
Next to the money fallacies which were considered in the
last chapter, one of the most persistent fallacies is that
the rate of interest represents the “rate of productivity of
capital.” If a man who has never thought on the subject
is asked why the rate of interest is five per cent, he will
almost invariably answer, “because capital produces five
per cent.” A $100,000 mill will produce a net income of
$5000 a year; a $100,000 piece of land will produce a
net crop worth $5000 a year; and so on. When the
rate of interest is five per cent, nothing at first sight seems
more obvious than that it is five per cent because capital
yields five per cent. Since capital is productive, it seems
self-evident that an investment of $100,ooo in productive
land, machinery, or any other form of capital will yield a rate
of interest proportionate to its productivity. This proposi
tion looks attractive, but it is superficial. Why is the land
worth $100,ooo? Simply because $100,ooo is the discounted
value of the expected $5000 a year. We have seen in pre

vious chapters that the value of capital is derived from the
value of its income, not the value of the income from that of

the capital.

Capital value is merely the present or dis

counted value of income.

But whenever we discount

income, we have to assume a rate of interest.

If we have

wealth yielding a given perpetual income of $5000 a year
and capitalize this income at five per cent, we get $100,000 as
the value of the wealth.

It would be reasoning in a circle

to derive the rate of interest (five per cent) by dividing
the $5000 by the $100,ooo; for this $1oo,000 was itself

Sec. 1]

THE

BASIS OF INTEREST

367

derived by assuming the rate to be five per cent in the

first place. Again, if we have wealth yielding $10oo for
50 years, and capitalize it at five per cent, we find its
present value to be $18,300. One year later, by the same
process, its value will be $18,215, showing a depreciation
of $85. If we subtract this depreciation from the $10oo
of income, we obtain $915 as the interest accrued, which
is exactly five per cent of the $18,300, but this result, five

per cent, is a necessary consequence of the assumption
of five per cent when we calculated the present value as
$18,300 and $18,215. Had we assumed four per cent for
this calculation, we would have gotten four per cent of
accrued interest as a result. We always find at the end
exactly what we assumed at the beginning; but if we are
not careful, we delude ourselves into thinking that we are
finding something new.
It is evident that if an orchard of ten acres yields Ioo
barrels of apples a year, the physical-productivity, Io
barrels per acre, does not of itself give any clew to what
rate of return on its value the orchard yields. Even as
suming a given value for the Ioo barrels of apples as, say,
$200, we are still unable to state what the rate of interest

is. We can only say that the orchard yields $2 per acre.
We cannot say it yields so much per cent. What then is
the rate of interest yielded by the orchard? This ques
tion cannot be answered without a knowledge of the value

of the orchard; and the value of the orchard cannot be
obtained without assuming a rate of interest and using it
in discounting the income which the orchard yields. The
orchard produces the apples, but the value of the orchard
does not produce the value of the apples; on the contrary,
the value of the apples produces the value of the orchard.
The following diagram shows the typical relation between
capital and the productivity of capital in the physical sense
and also in the value sense — which latter sense is the

important factor in studying the rate of interest.

368

ELEMENTARY PRINCIPLES OF ECONOMICS
PRESENT CAPITAL

Instruments
Value of instruments

(CHAP. XX

FUTURE INCOME
->

Benefits

-6-

Value of benefits

This scheme signifies (1) Any physical instrument, such,
for instance, as land, railways, factories, dwellings, or food, is
the means for obtaining benefits in the future; this first
step in the sequence pertains to the study of the “tech
nique" of production, and involves no rate of interest.
(2) The benefits are valued in money; this step pertains
to the study of prices. (3) From the value of the benefits
thus obtained is computed the value of the original instru
ment by the process of discounting; it is clearly with this
last process that we are concerned in the study of
interest.

The paradox that, when we come to the value of capital, it is
value of income which produces the value of capital, and not

the reverse, is, then, the stumbling-block of the productivity
theorists. It is clear, of course, in any particular investment,
that the selling value of the stock or bond is dependent on

its expected income. And yet business men, although con
stantly employing this discount process in specific cases, usu
ally cherish the illusion that they do so because their capital
value, if invested in some vague “other use,” would actually

produce interest. They fail to observe that the principle of
discounting the future is universal, and applies to any invest
ment whatsoever, and that in such a discount-process there
is necessarily assumed the very rate of interest we are seek
ing to explain. It is futile to derive the rate of interest from
the productivity of capital.
The futility of this productivity theory may be further
illustrated by observing the effect of a change of productivity.
If productivity makes interest, then a change in produc
tivity ought to make a corresponding change in the rate
of interest. Yet, if an orchard could in some way be
made to yield double its original crop, though its yield in

Sec. 2)

THE

BASIS OF INTEREST

369

the physical sense would be doubled, in the sense of the
rate of interest its yield would not be necessarily
affected at all — certainly not doubled. For the orchard
whose yield of apples should increase from $1000 worth to
$2000 worth would itself correspondingly increase in value.
For some reason or other, people would find themselves call

ing it a $40,000 orchard instead of a $20,000 orchard; and
the ratio of theincome to the capital-value would then remain
just what it was before, namely, five per cent.

Of course

it is true that if an orchard which had already been bought

for $20,000 on the assumption that it would yield only $10oo
worth of crops per year should in some way be doubled
in productivity, the owner would be making ten per cent
on his original investment, for his original investment was
made before either he or the man who sold it to him knew

that the orchard would increase in productivity. Had the
purchaser known this fact in advance, he would have
been quite willing to pay more than the $20,000 which we
have supposed him to pay; and as soon as this new knowl
edge is acquired, he will revalue the orchard according to
his new expectations. Realizations do not always or even
usually correspond to expectations. Properly speaking, the
rate of interest applies only to expectations. To raise the
productivity of the orchard or of any other article of
wealth will raise its value also.

The idea of raising the

rate of interest by increasing the productivity of capital is,
therefore, like the idea of raising one's self by one's boot
straps.

§ 2. The Socialist Theory
So much for the productivity theory. We have next the
socialist theory. The socialist has the idea that interest
is robbery. He says “it is all wrong that the capitalist who
does not lift a finger should get any pay; he is getting
something for nothing, and that is interest; interest is
2 B

37o

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XX

robbery; interest is sucking the blood out of somebody
else, viz., the workman.” According to the socialist theory,
especially as represented by Karl Marx, interest is exploi
tation. The socialists say that labor produces capital, and
therefore produces the interest from capital, and therefore
labor should get all the income from capital; and since
the laborer does not get it all, it must be true that it
is held back by somebody who is in a position of van
tage to steal it. This is the key of so-called “scientific
socialism.” There are many motives for socialism, but so
far as it has an economic theory behind it, this is that theory.
According to it, the capitalist holds a club over the
workman and virtually says: “If you will come to-day and
work for me, I will give you half of what you produce; I
have got the capital, and you can’t get on without me, and
therefore I am in a position to rob you. Take what you
can get, or get nothing.”
The socialist theory involves two propositions: first, that
all income and all capital are practically produced by labor;
and, secondly, that all the resulting income should be paid
to the laborer. Now the first proposition is much more
nearly correct than the second. We need not contest it in
order to see the fundamental error in the theory of socialism.
Let it be granted that practically every instrument of pro
duction is produced by labor; let it be granted that the
i capitalist is always living on the product of past labor;
that a millionaire who gets his income from railroads, ships,
and houses, all products of labor, is reaping what labor
sowed; that the capitalists of to-day are receiving compound
interest on the labor of bygone times.

It does not follow, however, that injustice has been done
to the laborer.

Let us consider the case of a tree which is

planted with one dollar's worth of labor, and twenty-five
years later is worth three dollars. The socialist virtually
asks, “Why should not the laborer who planted the tree
receive three dollars instead of one dollar for his work?”

SEC. 3]

THE

BASIS OF INTEREST

37 I

The answer is that he may receive it, provided he will wait
twenty-five years for it ! As Böhm-Bawerk, an authority
on interest, says: “The perfectly just proposition that the
laborer should receive the entire value of his product may
be understood to mean either that the laborer should now

receive the entire present value of his product, or should
receive the entire future value of his product in the future.

But Rodbertus and the socialists expound it as if it meant
that the laborer should now receive the entire future value
of his product.”
It would be a mistake to say that there is no exploitation
of laboring men by capitalists, because we know the contrary
to be a fact, but it would likewise be a mistake to condemn

all interest on the ground of exploitation. The basis of
interest is much deeper. It lies in the preference for
present over future goods. Neither the employer nor the
employee likes to wait a long time for the fruits of any
enterprise in which he engages. But somebody must
wait, and whoever does so is clearly entitled to some
reward.

§ 3. Impatience the Source of Interest
The essence of interest is impatience, the desire to obtain
gratifications earlier than we can get them, the preference for
present over future goods. It is a fundamental attribute of
human nature; and as long as it exists, so long will there
be a rate of interest.

Interest is, as it were, human impatience crystallized into a
market rate. The market rate of interest is formed out of the

various degrees or rates of impatience in the minds of different
people. The rate of impatience in any individual's mind is
his preference for an additional dollar, or one dollar's worth of
goods, available to-day, over an additional dollar, or dollar's
worth of goods, available a year from to-day. In other
words, it is the excess of the marginal desirability of

372

ELEMENTARY PRINCIPLES OF EconoMICS (CHAP. XX

to-day's goods over the marginal desirability of next year's
goods viewed from to-day’s standpoint. It can be expressed
in numbers as the premium that a man is willing to pay for
this year's over next year's goods. If, for instance, in order
to get $1 to-day he is willing to promise to pay $1.05 next
year, then his rate or degree of impatience is said to be five
per cent. The present $1 is worth to him so much that in
order to get it he is willing to pay for it five per cent more
than $1 in the future; it is the willingness to do this to

gratify one's impatience which causes the phenomenon of a
rate of interest. A man will prefer to have a machine to-day
rather than a machine in the future; a house to-day rather

than a house a year from now ; a piece of land to-day rather
than a piece of land when he is ten years older; he would
rather have some food to-day than wait until next year for
it, or for a suit of clothes, or stocks or bonds, or anything
else.

But what are these present and future “goods” which are
thus contrasted 2 At first sight it might seem that the
“goods” compared may be indiscriminately wealth, prop
erty, or benefits. But when present capital (whether
capital-wealth or capital-property) is preferred to future
capital, this preference is really a preference for the income

of the first capital as compared with the income of the second.
The reason why we would choose a present fruit tree rather
than a similar fruit tree available in ten years is that the
fruit of the first will be available earlier than that of the

second. The reason we prefer immediate tenancy of a house
to the right to occupy it in six months is that the uses of the
house will begin six months earlier in the one case than in the

other. In short, capital-wealth available early is preferred
to capital-wealth of like kind available at a more remote
time, simply because the income of the former is available
earlier than the income of the latter.

For the same reason

early capital-property is preferred to late capital-property
of a similar kind; for property is merely a claim to future

SEc. 3]

THE BASIS OF INTEREST

373

income; and the earlier the property is acquired, the earlier
will the income accrue, the right to which constitutes the
property in question.
Thus, impatience for goods of any kind resolves itself into
impatience for income, – i.e., preference for immediate in
come over remote income. Moreover, the preference for
immediate income over remote income resolves itself into the

preference for present enjoyable income over future enjoyable
income. The income from an article of capital which consists

merely of an “interaction” is desired for the sake of the final
income to which that interaction paves the way.

We prefer

present bread-baking to future bread-baking because the
enjoyment of the resulting bread is available earlier in the

one case than in the other. Present weaving is preferred
to future weaving, because the earlier the weaving takes
place, the sooner will the cloth be manufactured, and the
sooner will the clothing made from it be worn by the con
Sulmer.

When, as is usually the case, exchange intervenes between
the weaving and the use of the clothes, the goal in the process
is somewhat obscured by the fact that the manufacturer
regards his preference for present weaving over future weav
ing as due not to the fact that the clothes will be more
early available to those who will wear them, but to the fact
that he will be enabled to obtain a quicker income by selling
the cloth earlier. To him early sales are more advantageous
than deferred sales, because the earlier the money is received,

the earlier can he spend it for his own personal uses, – the
shelter and the comforts of various kinds constituting his
real income. It is not he, but his customers, whose prefer
ence for present cloth over future cloth is based on the earlier
availability of the clothes which can be made from it. But in
both cases the mind's eye is fixed on some ultimate enjoy
able income, i.e., benefits, to which the interaction in ques
tion is a mere preparatory step.
-

The same principles apply where corporations or firms

374

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XX

borrow and lend.

Here the relation of enjoyable income

is more indirect, and yet it is still the guiding force. For
borrowing and lending, when directed by the directors of a
company on behalf of the stockholders or bondholders, have
reference to the enjoyable income, not of the directors, but of
the stockholders and bondholders.

We thus see that all preference for present over future
goods resolves itself, in the last analysis, into a preference
for early enjoyable income over late enjoyable income. Every
preference for present over future goods reduces itself,
therefore, to this preference for present over future satis
factions.

The preference for present over future goods, when thus
reduced to its lowest terms, rids the values of the contrasted

present and future goods of the interest element, which,
in all other attempts at explanation, is so unconsciously
presupposed. When any other goods than enjoyable in
come are considered, their values already imply a rate of
interest. When, for instance, we say that interest is the
premium on the value of a present house over that of a future
house, we still leave the problem of interest unsolved; for
we forget that the value of each house — the future one not
less than the present one — is itself based on a rate of in
terest. As we have seen, the price of a house is the dis
counted value of its future income, and in the process of
discounting there always lurks a rate of interest. When
we compare the values of present and future houses, there
fore, both terms of the comparison involve the rate of
interest. But when present enjoyable income is compared
with future enjoyable income, the case is different, for the
value of enjoyable income involves no interest whatever.

We have thus reduced the problem of determining the
rate of interest to the problem of determining the premium
which people are willing to pay for present enjoyable in
come in terms of future enjoyable income.
-

* //,

(*)

tº-

ºf 44- // .

/*, *...*

2%. , ,

CHAPTER XXI
INFLUENCES ON IMPATIENCE FOR INCOME

§ 1. Differences in Impatience Due to Differences in
Human Nature

BUT we have not yet wholly solved the problem of interest.
It is not enough to know that the more impatient a people
are, the higher will be their rate of interest, and the more
patient they are, the lower will be their rate of interest.
We must also know on what causes the degree or rate of
impatience depends. It depends principally upon the
character of the individual and the character of the income

which he possesses. It is clear that the degree of impa
tience which corresponds to a specific income-stream will not
be the same for everybody. One man may have a degree
or rate of impatience of five per cent and another a rate of
impatience of ten per cent, although both have the same
income. The difference will be due to a difference in the

personal characteristics of the individuals.

These charac

teristics are chiefly five in number: (1) foresight, (2) self

control, (3) habit, (4) expectation of life, (5) love for pos
terity.

We shall take these up in order.

(1) First, as to foresight. Generally speaking, the greater
the foresight, the less the impatience, and vice versa.
In the case of primitive races and uninstructed classes

of Society, the future is seldom considered in its true pro
portions. The story is told of a shiftless householder who
would not mend his leaky roof when it was raining, for fear of
375

376

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXI

getting more wet, nor when it was not raining, because he
did not then need shelter. Among such persons impatience

for present gratification is powerful because their compre
hension of the future is weak. If we compare the Scotch
and the Irish, we shall find a contrast in this respect.
The Irish, in general, lack foresight and are improvident,
and the Scotch have foresight and are provident. Conse
quently the rate of interest is high in Ireland and low in
Scotland.

These differences in degrees of foresight produce corre

sponding differences in the dependence of impatience on
the character of income. Thus, for a given income, say
$1000 a year, the reckless might have a rate of impatience

of ten per cent, when the forehanded would experience a
rate of only five per cent. Therefore, impatience, in
general, will be greater in a community consisting of
reckless individuals than in one consisting of the opposite
type.

(2) We come next to self-control. This trait, though
distinct from foresight, is usually associated with it and has
very similar effects. Foresight has to do with thinking, self
control with willing. A weak will usually goes with a weak
intellect, though not necessarily, and not always. The
effect of a weak will is similar to the effect of inferior fore

sight.

Like those workingmen who cannot carry their pay

home Saturday night, but spend it in a grogshop on the
way, many persons cannot deny themselves any present

indulgence, even when they know definitely what the con
sequences will be in the future. Others, on the contrary,
have no difficulty in controlling themselves in the face of
all temptations.
(3) The third characteristic of human nature which needs
-

to be considered is habit.

That to which one is accus

tomed exerts necessarily a powerful influence upon his
valuations and therefore upon his impatience. This
influence may be in either direction. A rich man's

Sec. 1]

INFLUENCES ON IMPATIENCE FOR INCOME

377

son who has been brought up with expensive habits,
when he finds himself with a smaller income than his

father provided him during his formative years, will be
more impatient for income than a man who has this
same income but who has climbed up instead of climbed
down.

(4) The expectation of life will affect a man's degree of
impatience. A man who looks forward to a long life will have
a relatively high appreciation of the future, which means
a relatively low appreciation of the present, i.e., a low degree
of impatience; whereas a man who has a short life to look

forward to will want it at least to be a merry one. “Eat,
drink, and be merry, for to-morrow we die ’’ is the motto

applying to this type.
(5) The fifth circumstance is love for posterity. Prob
, ably the most powerful cause tending to reduce the rate of
interest is love for one's children and the desire to provide
for their good. When these sentiments decay, as they did
decay at the time of the decline and fall of the Roman
Empire, and it becomes the fashion to exhaust wealth in
self-indulgence and leave little or nothing to offspring, the
rate of impatience and the rate of interest will be high.
At such times the motto, “After us the deluge,” indicates
the feverish desire to squander in the present, at whatever
cost to the future. A noted gambler, who had led a wild
and selfish life, once said, when life insurance was first

explained to him, “I have seen many schemes for making
money, but this is the first time I have seen a scheme where
you had to die before you could rake in the pile.” That
man did not care for a payment which would come in after
his death. But there are many men who do, and in fact
care much more for it than for anything else in the world.
This care leads them to insure their lives in order that they
may leave the money to their families. Their desire to
provide for those who survive them tends to make them
more patient, i.e., tends to reduce their impatience to enjoy

378

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXI

income immediately. Life insurance, by training people to
provide for posterity, is acting as one of the most powerful
means of lowering the rate of impatience and therefore the
rate of interest. At presentin the United States theinsurance
on lives amounts to $20,000,000,ooo. This represents, for
the most part, future income to be received by the next

generation by reason of sacrifices of income made by the
present generation. These sacrifices spring from a low
rate of impatience, and tend to produce a low rate of
interest.

Thus we see that men may differ in many ways which
affect the rate of interest and the rate of impatience.
We may contrast two extreme types of men. Men who
are shortsighted, or weak willed, or have the habits of a
spendthrift, or look forward to a short or uncertain life,
or are selfish and have no regard for posterity, will (other

things equal) have a high degree of impatience.

Men

who possess foresight, self-control, habits of thrift, con

fidence in length of life, and altruism with respect to
posterity, will (other things equal) have a low degree of
impatience.
§ 2.

Differences in Impatience Due to Differences in
Income

But not only does impatience vary as between different
individuals; it varies also for the same individual according
to circumstances. The most important circumstance affect
ing a person's degree of impatience is the character of his
expected income in the immediate and in the remote future.
One's impatience for satisfactions will vary inversely as
the abundance of his immediate as compared with his remote
Satisfactions. If the future satisfactions which he expects
and looks forward to are very great, and his present satis
factions are very small, he will be impatient to hurry from
his present scarcity and arrive at the expected future abun
º

SEC. 3)

INFLUENCES ON IMPATIENCE FOR INCOME

379

dance; that is, he will have a high rate of preference
for present over future satisfactions. This is on the same
principle that prices are high when goods are scarce. The
preference for present satisfactions is high if present satis
factions are scarce. Now one's impatience to bring future
satisfactions nearer the present will depend on one's whole
future stream of satisfactions, i.e., what we call his final

enjoyable income. It will depend on three chief charac
teristics of that income: first, as just said, it will depend on
its distribution in time, i.e., the relative abundance of his

immediate as compared with his remote satisfactions;
secondly, on the amount of the income, i.e., whether his satis
factions are, as a whole, scant or abundant; thirdly, on the
wncertainties of the income, i.e., to what extent his satisfac

tions throughout future years are subject to chance, that is,
may turn out to be greater or less than he first expected.
§ 3. Influence of the Distribution in Time of the Income
Stream

Wehave first to 23.
consider the in- 2400
fluence which the

distribution
-

22Oo

in ****
18Co

time of income isoo
has upon the im- 14oo

patience for in- 12oo
come. Three dif- "99

ferent types of

distribution

4oo

time

may

distinguished:

1910

'll

'12

'ſs

'15

'17

uniform income,
FIG. 41.
consisting of equal yearly items, as represented by
the dark lines in Figure 41 (in which, as in
previous diagrams, the heights of the successive vertical
-

380

ELEMENTARY

PRINCIPLES

OF ECONOMICS

[CHAP. XXI

lines represent the amounts of the successive installments
of income, say $1900 a year); increasing income, as
represented

3ooo

Figure

28Oo

which the income

24OO

increase from

is supposed

(in
to

22OO

$1200 a year in
1911 to nearly
$3ooo in 1917);
decreasing
and
income, as repre

2OOO
1 Boo
16oo

J2OO
looo

sented in Figure

8Oo

43 (in which the
income is sup

6OO

posed to decrease
from almost $3000

2OO

1910 'll

'12

'13

'15

'I6

in 1911 to about
$1200 in 1917).

FIG. 42.

The effect of possessing an increasing income (Fig. 42) is, as
we have already
indicated, tomake

the possessor im
patient to get
the larger income

Sp
3OOO
28OO
26OO
24OO

which the future
2OOO

holds or keeps

t 800

back. Aman who

! GOO

is now enjoying

1. 4-OO

an income of only

t 2OO
t

$1000 a year, but
Boo

expects

ten

years to be
enjoying one of
$10,000 a year,

will be impatient

6Oo
4-OO

20C

ISIO 'll

’12

’13

'14

FIG. 43.

'15

'16

ºz.

SEc. 4)

INFLUENCES ON IMPATIENCE FOR INCOME

381

to have those ten years elapse. He has “great expecta
tions.” He may, to satisfy his impatience, borrow money
to eke out this year's income, and make repayment by
sacrificing from his more abundant income ten years later.
Reversely, a gradually decreasing income (Fig. 43), mak
ing, as it does, the earlier income relatively abundant, and
the remoter income relatively scarce, tends to reduce impa
tience, or the preference for present as compared with future
income. The man with a descending income already has
a high income without being compelled to wait for it. With
him there is little reason for impatience — there is nothing
to be impatient for; on the contrary, the future does not
look at all inviting. The outlook, so far from tending to
make him borrow, tends to make him wish to save from

his present abundance to provide for his coming need.
The extent of these effects will, as we have already seen,

vary greatly with different individuals. Corresponding to
a given ascending income, one individual may have a rate
of impatience of ten per cent and another of only four per
cent. What we need here to emphasize is merely that,
in the case of both of these individuals, a descending in
come causes a lower degree of impatience than an ascend
ing income.
§4. Influence of the Size of the Income-stream
We have considered the dependence of impatience for
expected income on the

distribution of that income

in time. Our next topic is the dependence of impa
tience on the size of income. In general, it may
be said that the smaller the income a man has, the higher is
his preference for present over future income. It is true
that a small income implies a keen appreciation of future
wants as well as of immediate wants. Poverty bears down
heavily on all parts of a man's life, both that which is
immediate and that which is remote.

But it enhances the

382

ELEMENTARY PRINCIPLES OF ECONOMICS

CHAP. XXI

desirability of immediate income even more than of future
income.

This result is partly rational, because of the importance
of supplying present needs in order to keep up the con
tinuity of life and the ability to cope with the future; and
partly irrational, because the pressure of present needs
blinds one to the needs of the future.

As to the rational side, it is clear that present income is
absolutely indispensable, not only for the present, but even
as a precondition to the attainment of future income. One
break in the thread of life is sufficient to destroy all future
enjoyment. It is of the utmost importance, therefore, to
keep up life. As the phrase is, “a man must live,” and in
the present a man must keep his hold on life in order to have
any life in the future. If, then, a man were on a desert
island and had only such rations as would last a few months,

he would naturally prefer to use them immediately —
sparingly, but immediately—rather than to put off their con
sumption ten years; because if he put off consuming them
he could not consume them at all; he would die in the mean

time. And in general, a man who is poor, and upon whom
poverty presses so as to make it hard to make both ends

meet, will always have a higher realization and apprecia
tion of the present than a man who is rich.
As to the irrational side, the poorer a man, the more his
eyes are blinded to future needs. He is too much occupied
with the need of the present, and shuts his eyes to the
future. To him “sufficient unto the day is the evil thereof.”
We all suffer from lack of perspective, and tend to exaggerate
the needs of the present. Poverty especially tends to distort
the perspective. Its effect is to relax foresight and self
control, and tempt one to “trust to luck” for the future,
if only the all-absorbing clamor of present necessities may
thus be satisfied.

We see, then, that a small income tends

roduce a

high degree of impatience, partly from lack of foresight
-

2^44 A-, 2/->>~
SEc. 5]

**** ****** arº i º ºwn 4,

** ca…º.

INFLUENCES ON IMPATIENCE FOR INCOME

383

and self-control, and partly from the thought that pro
vision for the present is necessary both for itself and for
the future as well.

§ 5. Influence of Uncertainties of Income
The next influence on impatience and therefore on the
rate of interest consists in the risks or uncertainties attach

ing to prospective incomes. Now uncertainties affect im
patience in several different ways. In general, risks tend
to raise the degree of impatience. There are four ways
in which risk tends to increase impatience, and one in which
it tends to decrease impatience.
First, we know that if a loan is risky, the rate of interest
has to be high. If the repayment of a loan is regarded as
uncertain, this uncertainty to the lender will have to be
offset by an increase in the rate of interest, and produces
a correspondingly high rate of impatience in the case of
risky loans. The rate of interest on risky loans thus in
cludes, as it were, an element of insurance against loss.
Strictly speaking, such a rate is not pure interest; for we
have defined a rate of interest as the premium paid for
present money in future money, on the assumption that
both sums are certain.

But even the pure rate of interest – the rate in riskless
loans — will be raised by risk in certain ways. One way in
which risk tends to raise the rate of impatience has already

been mentioned in § 1, namely, when the risk is of life,
— that is, of its terminating before the lender finds himself
able to enjoy the fruits of his loan. This acts like the
risk in the loan itself. You may tell a man he is perfectly
sure of being repaid his loan fifty years from now. But
will he live so long?

It is cold comfort to tell him he is

sure to get his money after he is dead '

A sailor is a type

of man who is constantly taking this fact into account.

knows that almost any day he may be shipwrecked, and the

384

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXI

consequence is that he prefers money ready to spend to-day
to money available only next year. Sailors are proverbial
spendthrifts and have a proverbially high degree of impa
tience.

The third case is where the receipt of the income itself
is uncertain, its uncertainty applying alike to all times.
Such a condition largely explains why salaries and wages are
lower than the average earnings of those who work for them
selves. Those who choose salaries rather than profits are
willing to accept a small but sure income in order to get
rid of a precarious though possibly larger one. Since a
risky income, if the risk applies evenly to all parts of the
income-stream, is nearly equivalent to a low income, and
since a low income, as we have seen, tends to intensify im
patience, risk, if uniformly distributed in time, must tend
to increase impatience.
The fourth way in which risk tends to increase impatience
is seen where immediate income is risky as compared with
remote income. A man in time of war, when there is pros
pect of peace in the future, looking forward to a relatively
safe income in the future, will have a high degree of im
patience for that future to arrive, because the present risky
income is in his eyes not equivalent to the future safe income.
These, then, are four ways in which risk tends to
increase impatience. There is, however, one way in which
risk tends to decrease impatience. The instance just given
is one in which income in the immediate future is risky, but
income thereafter safe. That sometimes happens, as just
indicated, where in time of war man expects peace in the
future, or in time of sickness he expects to get well and re
sume his regular earning power. Nevertheless, there are
numerous examples of the opposite type, where the risk
applies to the future and not to the present. If a ship owner,
for instance, has his ship in port to-day, but is going to sail
within a few months, his risks are high in the future as com
pared with the present. His future looks dubious, and

Sec. 5]

INFLUENCES ON IMPATIENCE FOR INCOME

385

that will cause him to be less impatient, because a risky
future income is like a small future income, and we
have

seen

that a

small

future income

tends

to les

sen impatience. An income which gets more and more
risky in the future is therefore like an income which gets
smaller and smaller in the future.

In actual fact, such a

type is not uncommon. The remote future is usually less
known than the immediate future.

This means that the

risk connected with distant income is greater than that con
nected with income near at hand.

The chance of disease,

accident, disability, or death is always to be reckoned with,
but under ordinary circumstances is greater in the remote
future than in the immediate future. Consequently there
is usually a tendency, so far as this influence goes, toward
a low degree of impatience. This tendency is expressed in
the phrase to “lay up for a rainy day.”
Risk, then, operates in diverse ways according to diverse
circumstances.

We see that risk tends in some cases to in

crease and in others to decrease the degree of impatience.
There is a common principle, however, in all these cases.
Whether the result is a high or a low degree of impatience,
the primary fact is that the risk of losing the income in a
particular period of time operates as a virtual impoverish
ment of the income in that period, and hence increases the
estimation in which it is held. If that period is a remote
one, the risk to which it is subject makes for a high appre
ciation of remote income and a low degree of impatience; if
the period is the immediate future, the risk makes for a
high appreciation of immediate income and a high degree of
impatience; if the risk is in all periods of time, it acts as
a virtual decrease of income all along the line and promotes
a high degree of impatience. From a practical point of
view, there is no factor affecting the rate of interest more
important than the factor called risk. This is because
interest always has to do with the future and the future is
always uncertain.
2C

386

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXI

§ 6. Summary
The impatience of any individual depends, then, partly
on the character of that individual's income, i.e., on three
characteristics of income: —

(1) its distribution in time,
(2) its amount,
(3) its uncertainties.
This proposition — that the preference of any individual
for immediate over remote income depends upon the nature
of his prospective enjoyable income — corresponds to the
proposition in the theory of prices, that the marginal desir
ability of any article depends upon the quantity of that
article; both propositions are fundamental in their respec
tive spheres.
We see, then, that a man's impatience depends (1)
upon his nature, and (2) upon his income. In the following
+.

illustrative table we see contrasted the supposed extreme

types of income and of human nature, and see how
impatience will differ among the four extreme cases here
represented.
DESCRIPTION of INCOME

CoRRESPONDING RATE of IMPATIENCE
To AN INDIVIDUAL who Is

Short-sighted, weak-| Far-sighted, self-con
willed, accustomed
to spend, without
heirs

Small
Large

Increasing | Precarious
Decreasing | Assured

20%
5%

trolled, accustomed to
save, desirous to pro
vide for heirs

5%
1%

If we compare the figures in the same vertical column, we
see that the lower figure is the smaller, expressing the in
fluence of the character of income. If we compare the figures

in the same horizontal line, we see that the right-hand figure

SEc. 6]

INFLUENCES ON IMPATIENCE FOR INCOME

387

is the smaller, expressing the influence of human nature.
But a man may have an income-stream of a kind which
tends to inflame his impatience, and at the same time a
nature of a kind which tends to allay his impatience. The
result will then be a compromise rate of impatience, say
five per cent. Or a man may have an income-stream which
tends to keep his impatience low, and a nature which tends
to keep it high. Thus five per cent is found twice in the
table forming a diagonal. The other diagonal shows the con
trast between the extreme where both the character of the

income and the nature of the individual conspire to make a
very high degree of impatience, and the opposite extreme
where they conspire to make a very low degree of impatience.
The same individual may, in the course of his life, change
from one extreme of impatience for income to the other.
Such a change may be due to a change in the person's
nature (as when a spendthrift is reformed or a man, origi
nally prudent, becomes, through intemperance, reckless and

thriftless), or to a change in his income, whether in respect
to size, distribution in time, or uncertainty. Every one at
some times in his life doubtless changes his degree of impa
tience for income. In the course of an ordinary lifetime the
changes in a man's degree of impatience are probably of
the following general character: As a child he will have a
high degree of impatience because of his lack of foresight and
self-control. When he reaches the age of young manhood
he may still have a high degree of impatience, but for a dif
ferent reason, viz. because he then expects a large future
income. He expects to get on in the world, and he will
have a high degree of impatience because of the relative
abundance of the imagined future as compared with the
realized present. When he gets a little farther along, and
has a family, the result will be a low degree of impatience,
because then the needs of the future rather than the endow

ment of the future will appeal to him. He will not think
that he is going to be so very rich in the future; on the

388

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXI

contrary, he will wonder how he is going to get along in the
future because he will have so many mouths to feed.

looks forward to the future expenses of his wife and children
with the idea of providing for them—an idea which makes
for a high relative regard for the future and a low relative
regard for the present. Then when he gets a little older,
and his children are married and gone out into the world
and are taking care of themselves, he again has a high
degree of impatience for income, because he expects to
die, and he thinks, “Why shouldn't I enjoy myself during
the few years that remain instead of piling up for the
remote future ?”

CHAPTER XXII
THE DETERMINATION OF THE RATE OF INTEREST

§ 1. Equalizing Marginal Rates of Impatience by
Borrowing and Lending

IN the preceding chapter we saw that the rate of prefer
ence for present over future goods is, in the last analysis,
a preference for immediate over remote income; that this
preference depends, for any given individual, upon the
character of his income-stream, - its size, its distribution
in time, and its uncertainties; and that the nature of this

dependence varies with different individuals.
The question now arises: What relation do these differ
ent “rates of preference ’’ of different individuals have to
the rate of interest ?
For the moment let us assume a perfect market, in
which the element of risk is entirely lacking, both with
respect to the certainty of the expected income-streams
belonging to the different individuals, and with respect to
the certainty of repayment for loans. In other words, we
assume that all individuals are initially possessed of fore
known income-streams, and are free to exchange any parts
of them, that is any present or immediate income for any
future or remote income. Prior to such exchange, the
income-stream is supposed to be fixed in size and distri
bution in time; that is, the capital instruments which the
individual possesses are each supposed to be capable of
only a single definite series of benefits contributing to his
income-stream.
389

390

ELEMENTARY PRINCIPLES OF ECONOMICs (CHAP. XXII

Under these hypothetical conditions, the rates of impa
tience for different individuals would become perfectly
equalized.
For if any particular individual has a rate of impatience
above the market rate, he will sell some of his surplus
future income to obtain (i.e., “borrow”) an addition to his
present meager income. This will have the effect of de
creasing the desirability of his present income and increas
ing the desirability of the remaining future income. The
process will continue until the rate of impatience of this
individual is equal to the rate of interest. In other
words, a person whose impatience rate exceeds the cur
rent rate of interest will borrow up to the point at which
the two rates will be equal. Reversely, a man who, with
a given income-stream, has a rate of impatience below the
market rate, will sell (i.e., “lend") some of his abundant
present income to eke out the future, the effect being to
increase his rate of impatience until it also harmonizes
with the rate of interest.

To put the matter in figures, let us suppose the rate of
interest is five per cent, whereas the rate of impatience of a
particular individual is at first ten per cent. Then, by
hypothesis, the individual is willing to sacrifice $1.1o of next
year's income in exchange for $1 of this year’s. But in the
market he is able to obtain $1 for this year by sacrificing only
$1.05 of next year's income. This ratio is, to him, a cheap
price. He therefore borrows, say, $100 for a year, agreeing
to return $105; that is, he contracts a loan at five per cent
when he would be willing to pay ten per cent. This
loan, by increasing his present income and decreasing his
future, tends to reduce his rate of impatience from ten
per cent to, say, eight per cent. Under these circum
stances he will borrow another $100, being now willing to
pay eight per cent, but actually paying only five per
cent.

This loan will still further reduce his rate of im

patience.

He will continue to borrow until his rate of

Sec. 1] DETERMINATION OF THE RATE OF INTEREST

391

impatience has been finally brought down to five per cent.
Then for the last or “marginal ’’ $1oo, his rate of im
patience will agree with the market rate of interest. As
in the general theory of prices, this marginal rate, five
per cent, being once established, applies indifferently to all
his valuations of present and future income. Every com
parative estimate of present and future which he actually
makes must be “marginal,” i.e., relative to small additions
to or subtractions from his present and future income.
In like manner, if another individual, entering the loan
market from the other side, has at first a rate of impatience
of two per cent, he will become a lender instead of a borrower.

He will bewilling to accept $102 of next year's income for $10o
of this year's income, but in the market he is able, instead of
the $102, to get $105. As he can lend at five per cent when
he would gladly do so at two per cent, he jumps at the
chance to get five per cent and invests, not one $100
only, but another and another. His present income, be
ing reduced by the process, is now more highly esteemed
than before, and his future income, being increased, is less
highly esteemed. The result will be a higher relative
valuation of the present, i.e., a higher rate of impatience,
which, under the influence of successive additions to the

sums lent, will rise gradually to the level of the market
rate of interest.

In such an ideal loan market, therefore, where every in
dividual could freely borrow or lend, the rates of impatience
for all the different individuals will become equal to each
other and to the rate of interest.

To illustrate these principles by diagrams, let us suppose
a man has a given income-stream, as indicated in Figure 44.
It is assumed that his income-stream is an ascending one,
as between one year and the next; that is, that the in
come for the year 1910 is relatively small and that for
1911 is relatively large. It may be that in 1910 he is
ill, and therefore does not earn his usual amount of

392

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXII

money, but that the year after he expects to get an unusual
income from some particular source. This man will then
probably be im
$
patient to get
the large income
he anticipates.
He does not wish
to wait till next

*oo

isio

1911

FIG. 44.

1912

1913

year if he can
avoid waiting.
His impatience is
due to a scarcity

of income this year and an abundance of income next year.
He will wish to adjust his income or rectify the disparity by
increasing this year's income at the expense of next year's in
come. He will borrow, but borrowing changes the distribu
tion in time of his income-stream. His original income in
the first year is $3oo, indicated by the dark line for the
year 1910. Next year his income is $600, indicated by the
dark line for that year. The effect of borrowing will be
to elevate the first line by $100 and to depress the second
by $105. These two adjustments will lessen both the
scarcity of this year's income and the abundance of next
year's income. This will therefore modify the distribution
in time of his income and lessen the valuation he puts on
a dollar this year as compared with next year. This re
duces the premium he puts on this year's dollar, i.e., his
rate of impatience. By increasing his loan he can evidently
reduce this premium to conform to the rate of interest.
He can also make other loan contracts, or plan to make
them later, by which he can increase or decrease any
year's income at the expense of an opposite change in that
of some other year or years. In this way he can alter the
distribution in time of his income-stream at will, and he
will always so alter it as to make his rate of impatience
equal to the rate of interest. He began with a rate of

Sec. 1] DETERMINATION OF THE RATE OF INTEREST

393

impatience greater than the market rate of interest, but
ended in harmony with that rate.
Figure 45 represents the income-stream of a man sup
posed to have a rate of impatience at first less than the
rate of interest. If we choose, we may suppose that he
has just received a small legacy which makes this year's
available income unusually large, say $600, while he expects
next year to have an unusually small income. Looking for
ward to next year, he sees that it will be hard to get along
comfortably, while this year he has more than he needs.
He therefore invests some of his present abundance to the
extent of $100 in order to eke out his future scarcity by $105.
He will do so, however, only provided his rate of impatience
is less than the market rate of interest, five per cent, and
he will do so only
up to the point
which will reduce e
his

rate

patience to the
level of this rate
of interest.
The two men
started out with
rates
of
im

49io

4911
FIG. 45.

patience different from the market rate of interest. The
market rate was five per cent, while the first man had a rate
of impatience above this, and the second a rate of impatience
below this. But when they finished their loan operations or
readjustments of the distribution in time of their income
streams, they brought their rates of impatience each into
harmony with the rate of interest and therefore with each

other. Therefore, as long as there is a market in which
everybody can borrow or lend at will at five per cent,
everybody will have at the margin a rate of impatience
of five per cent. Nobody will have a rate of impatience
above five per cent, because, if it is at first above it, he

394

ELEMENTARY PRINCIPLES OF EconoMICs (CHAP. XXII
\

will borrow enough to bring it down to the market rate;
and nobody will have a rate below it, because, if it is at
first below it, he will lend enough to bring it up to the
rate of interest.

Even men of widely different natures as to foresight,
self-control, etc., will have the same marginal rates of im
patience. If such different men start with precisely the
same sorts of income, they will have different rates of im
patience. But in that case they will not continue to have
the same sorts of income. They will severally modify
their income-streams until equal degrees of impatience are
effected. They will then have, instead of different degrees
impatience, different sorts of income-streams.

§ 2. Equalizing Marginal Rates of Impatience by
Spending and Investing

It must not be imagined that the classes of borrowers and
lenders correspond respectively with the classes of poor and
rich. Personal and natural idiosyncrasies, early training,
and acquired habits, accustomed style of living, the usages
of the country, and other circumstances will, by influencing
foresight, self-control, regard for posterity, etc., determine
whether a man's degree of impatience is high or low, and
whether he becomes a borrower or a lender.

It should be noted that borrowing and lending are not
the only ways in which one's income-stream may be modi

fied. The same result may be accomplished simply by buy
ing and selling property; for, since property rights are
merely rights to particular income-streams, their exchange
substitutes one such stream for another of equal value but
differing in distribution in time, or certainty. This method
of modifying one's income-stream, which we shall call the
method of sale, really includes the method of loan; for
a loan contract is at bottom a sale; that is, it is the ex

change of the right to present or immediately ensuing in

SEc. 2)

DETERMINATION OF THE RATE OF INTEREST

come for the right to more remote or future income.

395

borrower is a seller of a note of which the lender is the buyer.
A bondholder is regarded indifferently as a lender and as a
buyer of the bond.
The concept of a loan may therefore now be dispensed
with by being merged in that of sale. At bottom every
“loan ’’ is a sale.

Thus when a bank “ lends” to a

customer, it really buys that customer's note, i.e., buys
(for present cash) the right to receive a sum of money in
the future. In the same example the customer or “bor
rower” is really a seller of future income for present cash;
he sells his note which is a promise of a future payment.
In short, every so-called “ loan' is merely an exchange of
present money for future money. These two moneys are,
of course, not the same; so that only by a fiction is the
original money “lent” and afterward “returned.” The
original money is not actually lent but absolutely trans
ferred, never to be actually returned, but simply to be
replaced by other money.
By selling some property rights and buying others it is
always possible to transform one's income-stream at will,
whether the transformation be in respect to distribution
in time or in respect to certainty. Thus, if a man buys
an orchard, he is providing himself with future income
in the use of apples. If, instead, he buys apples, he is
providing himself with similar but more immediate income.
If he buys “securities,” he is providing himself with

future money, convertible when received into final or
enjoyable income. If his security is a share in a mine, his
income-stream is less lasting, though it may be larger,
than if the security is stock in a railway.
Purchasing the right to remote enjoyable income is called
investing; purchasing the right to immediate enjoyable
income is called spending. The antithesis between “spend
ing ” and “investing ” rests upon the antithesis between
immediate and remote income.

The adjustment between

396

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXII

the two determines the distribution in time of one’s in

come-stream. Spending increases immediate income, but
robs the future, whereas investing provides for the future
to the detriment of the present.

From what has been said it is clear that by buying and
selling property an individual may change the conformation
of his income-stream precisely as though he were specifically
lending or borrowing. Thus, if a man's original income
stream consists of $1000 this year and $1500 next year,
and if, selling this income-stream, he buys with the proceeds
another income-stream yielding $11oo this year and $1395
next year, he has not, nominally, borrowed $100 and repaid
$105, but he has done what amounts to the same thing—
increased his income-stream of this year by $100 and
decreased that of next year by $105, the $100 being the
modification produced in his income for the first year by
selling his original income-stream and substituting the
second one, and $105 being the reverse modification in
next year's income.
§ 3. Futility of Prohibiting Interest
We may now note that interest taking cannot be pre
vented by prohibiting loan contracts. To forbid the par
ticular form of sale, called a loan contract, would leave
possible other forms of sale, and, as has been shown, the
valuation of every property right involves interest. If the
prohibition should leave individuals free to deal in bonds,
it is clear that virtually they would be still borrowing and
lending, but under the name of “sale”; and if “bonds” were
tabooed, they could merely make the slight change to “pre
ferred stock.” It can scarcely be supposed that any pro
hibition of interest-taking would extend to the prohibition
of all buying and selling; but as long as buying and
selling of any kind were permitted, the virtual effect of
lending and borrowing would be retained. The possessor

Sec. 31 DETERMINATION OF THE RATE OF INTEREST

397

of a forest of young trees, not being able to mortgage their
future return, and being in need of an income-stream of a less
deferred type than that receivable from the forest itself,
would simply sell his forest, and with the proceeds buy,
say, a farm with a uniform flow of income, or a mine with
a decreasing one. On the other hand, the possessor of a
capital which is depreciating, that is, which represents an
income-stream great now but steadily declining, and who
is anxious to “save * instead of “spend,” would sell his
depreciating wealth and invest the proceeds in some such
instrument as the forest already mentioned.
It was in such ways, as, for instance, by “rent-purchase,”
that the medieval prohibitions of usury were rendered
nugatory.

Practically, at the worst, the effect of restrictive

laws is simply to hamper and make difficult the finer
adjustments of the income-stream, compelling would-be
borrowers to sell wealth yielding distant returns instead of
mortgaging it, and would-be lenders to buy the same, instead
of lending to the present owners. It is conceivable that
“explicit ’’ interest might disappear under such restrictions,
but “implicit” interest would remain. The young forest sold
for $10,000 would bear this price, as now, because it would be
the discounted value of the estimated future income; and

the price of the farm bought for $10,000 would be determined
in like manner.

The rate of discount in the two cases must

tend to be the same, because, by buying and selling, the
various parties in the community would adjust their rates of
impatience to a common level — an implicit rate of interest
thus lurking in every contract, though never specifically ap
pearing therein. Interest is too omnipresent a phenomenon
to be eradicated by attacking any particular form; nor would
any one undertake it who perceived the substance as well as
the form. In substance, the rate of interest represents the
terms on which the earlier and later elements of income

streams are exchangeable against each other. Interest can
never disappear until present and future dollars will exchange

398

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXII

at par. This would imply that human beings were no longer
impatient, but considered it no hardship to wait indefinitely.
We have hitherto supposed, for simplicity, that the in
come from each instrument is fixed in size and distribution

in time. But often the same article may be used in any
one of several ways producing any one of several different
income-streams.

In such a case the owner merely chooses

the particular way which gives the capital the highest value.
Since any man's income may be transformed as to its dis
tribution in time by the process of borrowing and lending
or buying and selling, he need not be deterred from select
ing an income by an inconvenient distribution in time. He
can choose it exclusively on the basis of maximum present
value and later correct any inconvenience of its distribution
in time by borrowing and lending or buying and selling.
§ 4. Clearing the Loan Market

We have seen that from the standpoint of the individual,
when a rate of interest is given, he will adjust his rate of
impatience to correspond with that rate of interest.
For him the rate of interest is a relatively fixed fact,
since his own rate of impatience and resulting action can
affect it only infinitesimally. All he can do is to adjust his
rate of impatience to the rate of interest as he finds it. For
Society as a whole, however, these rates of impatience deter
mine the rate of interest. This corresponds to what was
said as to the determination of prices. We have seen that
each individual regards the market price, say, of coal, as
fixed, and adjusts his marginal desirability or undesirability
to it; whereas, for the entire market, we know that these

marginal desirabilities and undesirabilities fix the price of coal.
In the same way, while for the individual the rate of interest
determines the rate of impatience, for society the rates of
impatience of the individuals determine the rate of interest.

The rate of interest is simply the rate of impatience upon

SEc. 4)

DETERMINATION OF THE RATE OF INTEREST

399

which the whole community may concur in order that the
market of loans may be exactly cleared. Supply and de
mand will work this out.

To put the matter in figures: if the rate of interest is set
very high, say twenty per cent, there will be relatively few
borrowers and many would-be lenders, so that the total
extent to which would-be lenders are willing to reduce their
income-streams for the present year for the sake of a much
larger future income will be, say, $100,000,ooo; whereas,
those who are willing to add to their present income at the
high price of twenty per cent interest will borrow only, say,
SI,ooo,000.

Under such conditions the demand for loans

is far short of the supply, and the rate of interest will there
fore go down. At an interest rate of ten per cent, the present

year's income offered as loans might be $50,000,ooo, and the
amount which would be taken at that rate only $20,000,ooo.

There is still an excess of supply over demand, and interest
must needs fall further. At five per cent we may suppose
the market cleared, borrowers and lenders being willing to

take or give, respectively, $30,000,ooo. In like manner it
can be shown that the rate would not fall below this, as in
that case it would result in an excess of demand over supply,

and cause the rate to rise again.
Thus the rate of interest is the common market rate of
-

impatience for income, as determined by the supply and
demand of present and future income. Those who are
very impatient strive to acquire more present income at
the cost of future income, and tend to raise the rate of

interest. These are the borrowers, the spenders, the buyers
of goods which afford immediate gratification, the sellers
of property yielding remote income, such as bonds and
stocks. On the other hand, those who — being relatively
patient — strive to acquire more future income at the
cost of present income, tend to lower the rate of interest.
These are the lenders, the savers, the investors.

The mechanism just described will not only result in a

4oo

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXII

rate which will clear the market for loans connecting the
present with next year, but, applied to exchanges between
the present and the remoter future, it will make similar
adjustments. While some individuals may wish to ex
change this year's income for next year's, others wish to
exchange this year's income for that of the year after next,
or for income several years in the future. The rates of
interest for these various periods are so adjusted as to clear
the market for all the periods of time for which contracts
are made. That is, supply and demand must be equal, so
as to clear the market for every period of time.
§ 5. The Conditions Determining the Rate of Interest
We have sketched the main principles determining the rate
of interest. Some have not been mentioned save by im
plication. In summary we may say that the rate of inter
est, considered independently of fluctuations in the monetary
standard, is determined by six conditions. Those which we
have above considered and explained are the following three:
(1) the dependence of impatience upon prospective income —
its size, distribution in time, and uncertainties; (2) the
tendency of the rates of impatience for different individ
uals to seek a common level in the resulting rate of
interest; (3) the fact that supply and demand must be
equal so that the modifications in the income-streams of
individuals, through buying and selling, or borrowing and
lending, must “clear the market.”
Of the remaining three determining conditions the most
important may be stated in the following form: (4) of all
the optional uses to which a man may put his capital he
will choose that one which at the market rate of interest

makes the present value of his capital the largest possible. ,
Thus a farmer may have the option of using a certain
piece of land as wheatland or as woodland. If he uses

it as wheatland, he can get an income from it every year;

SEc. 5I

DETERMINATION OF THE RATE OF INTEREST

4OI

but if he plants a young forest on it, he must wait per
haps a generation before receiving any return. To
compare the relative merits of these two uses of the land,
he will need to calculate, as well as he can, the total
present values of the incomes he would get in the two
ways. If he reckons that the present value of the future
income he can get by growing wheat is about $10,000, but
that the present value of the future income he can get by
growing timber is $12,000, he will prefer to grow timber.
Evidently these calculations of present value can be made
only by employing a rate of interest, and, if the rate of
interest falls, the comparison may be reversed; timber
growing might then become more profitable than wheat
growing. Thus the farmer's decision as to which of the
optional uses of his capital is the best will depend, in
part, on the rate of interest. Reciprocally the rate of
interest in the community will depend in part on the
choice of uses of capital. Thus, if a fall in the rate of
interest leads many people to abandon wheat-growing in
order to take up the timber business, this shifting of part
of the income of the community from the immediate to
the remote future will tend to check the fall in the rate

of interest on the principle already explained — that an
increase of a remotely future income increases human im
patience. To be more specific, if a fall in the rate of
interest makes timber-growing pay, where before it was
unprofitable as compared to wheat production, then many
of the farmers who turn to timber will need to borrow

money while they are waiting for their slow-growing
crop. They will therefore add to the demand for loans,
and tend to raise the rate of interest.

Thus we see that

the choice between different uses of capital is one of the
influences determining the rate of interest.
The remaining two conditions are very obvious ones; one
condition being that (5) what is borrowed at any time by
some persons equals what is loaned at that time by other
2 D

402

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXII

persons, and the other condition being that (6) what any
person borrows at one time must be repaid by that person
at another time with interest at the market rate.

These six conditions would fully determine the rate of

interest under the assumption we have made of a perfect
loan market. But in practice these conditions are some
what modified.

For instance, the last or sixth condition

(that the loan is to be repaid) is not always actually met,
and the fear that it may not be met affects the rate of
interest and often decides whether at the outset a loan

shall be made or not. Some sort of security is required
for almost every loan. Here, as in other instances, the
element of risk is intertwined with the rate of interest.

Again, the second condition (that the degrees of impa
tience of all persons become equal to the rate of interest)
may not be fully met; for a would-be borrower may not
be able (owing to lack of security satisfactory to the lender)
to secure a large enough loan to reduce his impatience to
equality with the market rate of interest. Or he may be
affected by laws restricting loans. Those thus shut out
of the loan market will continue to have an impatience for
income higher than the market rate of interest.
Again, the fourth condition (that the use of one's capi
tal chosen will be that use of which the present value is
greater than the present value of any rival use) is not
always met, either because the owner is mistaken in his
forecasts or because he is unable to obtain a loan by which to
finance his choice. For instance, certain land may be worth
most as timberland and yet actually used as grazing land, be
cause the owner cannot provide by loans or otherwise for
the lean years which must pass while the timber is growing.
One result of these and other imperfections in the loan
market is that there are really many rates of interest
instead of one rate only. One rate, or rather group of
rates of interest, is that realized on bonds; another is that

used in short-time bank loans; a third, that in “call ”

SEc. 5l DETERMINATION OF THE RATE OF INTEREST

loans.

403

Perhaps the most representative rate of interest is

the rate on two or three months' loans at banks on indorsed

notes of merchants called “commercial paper.”
Another result of the imperfections of the loan market
is that the minor fluctuations in any particular rate of in
terest are more often due to varying imperfections of the
market adjustment than to variations of income, human
impatience, and the other factors enumerated as the fun
damental conditions determining the rate of interest. For
instance, the rate of interest on bank loans varies from

time to time with the changes in the ratio of reserves to
deposits, especially if there be a legal requirement as to
this ratio. A bank may refuse a loan to avoid increasing
its deposits (in relation to reserves) above the legal ratio
or, before this becomes necessary, it may raise its rate
in anticipation. Thus the Bank of England raises its

rate when necessary to “protect” its reserve.

The daily

variations in bank rates are usually due more to the need
of readjusting the ratio of reserves to deposits than to
changes in its customers' impatience or in their incomes.
But in the long run the rate of interest is a fairly
faithful register of human impatience as modified by
mutual loans and borrowings in conformity with the six
conditions mentioned.

While the surface causes men

tioned in the preceding paragraph are necessary to explain
slight local variations of interest as between New York

and Boston, or to explain slight daily or monthly changes
of interest rates by a fraction of one per cent, the differ
ences in human impatience in incomes and in price move
ments are the underlying influences which explain why the
rates in America or China are several per cent higher than
in England or Holland, and why the rates in one epoch of
history are two or three times as high as in some other
epoch. In short, interest rates are like the ocean, the
level of which is slightly and temporarily influenced by
winds, but more fundamentally by great tidal forces.

lºt.

404

ELEMENTARY PRINCIPLES OF ECONOMICS

(CHAP. XXII

§ 6. Historical Illustrations

We have now completed our study of the causes deter
mining the ratedf interest. If they are correct, we should find

that the rate of interest is low (1) if in general the people are
by nature thrifty, farsighted, self-controlled, or thought
ful for the future welfare of their children, or (2) if they have
large or descending income-streams; and that it is high (1)
if the people are shiftless, shortsighted, impulsive, selfish,
or (2) if they have small or ascending income-streams.
History shows that facts accord with these conclusions.
The communities and nationalities which are most noted

for the qualities mentioned — foresight, self-control, and
regard for posterity — are probably Holland, Scotland,
England, and France. Among these people interest has been
low. Moreover, they have been money lenders; they have
the habit of thrift or accumulation, and their instruments

of wealth are in general of a durable kind.
On the other hand, among communities and peoples noted
for lack of foresight and for negligence with respect to the
future are China, India, Java, the negro communities in
the Southern states, the peasant communities of Russia,
and the North and South American Indians, both before

and after they had been pushed to the wall by the white
men.

In all of these communities we find that interest is

high, that there is a tendency to run into debt and to dis
sipate rather than accumulate capital, and that their dwell
ings and other instruments are of a very flimsy and perishable
character, built for immediate, not remote, gratifications.
This is true even where, as in China, the people are
industrious. Industry without patience will result in hard
work, but this work will be for immediate and not remote

gratifications.
These examples illustrate the effect on the rate of in
terest of differences in human nature. We now turn to
illustrations of differences in the distribution in time of

SEc. 6]

DETERMINATION OF THE RATE OF INTEREST

405

incomes. The most striking examples of increasing income
streams are found in new countries. It may be said that the
United States has almost always belonged to this category.
In America we see exemplified on a very large scale the
truth of the theory that a rising income-stream raises, and
a falling income-stream depresses, the rate of interest, or
that these conformations of the income-stream work out

their effects in other equivalent forms. A similar causation
may be seen in particular localities in the United States,
especially where changes have been rapid, as in mining
communities.

In California, in the two decades between

1850 and 1870, following the discovery of gold, the income
stream of that state was increasing at a prodigious rate.
During this period the rates of interest were abnormally
high. The current rates in the “early days’ were quoted
at one and one half to two per cent a month. “The thrifty
Michael Reese is said to have half repented of a generous
gift to the University of California, with the exclamation,
“Ah, but I lose the interest,’ a very natural regret when in
terest was twenty-four per cent per annum.” After railway
connection in 1869, Eastern loans began to flow in. The
decade 1870–188o was one of transition during which the
phenomenon of high interest was gradually replaced by the
phenomenon of borrowing from outside. The residents of
California were thus able to change the distribution in time
of their income-streams. The rate of interest consequently
dropped from eleven per cent to six per cent.
The same phenomena of enormous interest rates were
also exemplified in Colorado and the Klondike.

There were

many instances in both these places during the transition
period from poverty to affluence, when loans were contracted
at over fifty per cent per annum, and the borrowers regarded
themselves as lucky to get rates so “low.” In general the
pioneer is willing to pay a high rate of interest so long as

he cherishes the “great expectations” characteristic of new
countries.

406

ELEMENTARY PRINCIPLES OF ECONOMICS ICHAP. XXII
§ 7. Interest and Prices

We have seen that the rate of interest is not a mere tech

nical phenomenon, restricted to Wall Street and other
“money markets,” but that it permeates all economic re
lations.

It is the link which binds man to the future and

by which he makes all his far-reaching decisions.
The rate of interest is itself a sort of price and plays a
central rôle in the theory of other prices. It operates in
the determination of the price of wealth, property, and bene
fits. It enters into the price of securities, real estate, and
commodities, as well as into rent, wages, and the value of all
“interactions.” As was shown in previous chapters, the
price of any article of wealth or property is equal to the dis
counted value of its expected future benefits. If the value of
these benefits remains the same, a rise or fall in the rate of

interest will cause a fall or rise respectively in the value of
all instruments of wealth.

The extent of this fall or rise

will be the greater, the farther into the future the benefits
of wealth extend.

As to the influence of the rate of interest on the price of
benefits, we first observe that benefits may be interactions
or satisfactions.

The value of interactions is derived from

the succeeding future benefits to which they lead. For
\**instance, the value to a farmer of the benefits of his land in

ºtº,
{x}

affording pasture for sheep will depend upon the discounted

value of the benefits from the flock in producing wool. The
value of the wool output to the woolen manufacturer is in
turn influenced by the discounted value of the output of
woolen cloth to which it contributes. In the next stage, the
value of the production of woolen cloth will depend upon
the discounted value of the income from the production of
woolen clothing.

Finally, the value of the last named will

depend upon the expected income which the clothing will
bring to its wearers – in other words, upon the use of the
clothes.

SEc. 7]

DETERMINATION OF THE RATE OF INTEREST

4O7

Thus the final benefits, consisting of the use of the clothes,
will have an influence on the value of all the anterior benefits

of tailoring, manufacturing cloth, producing wool, and
pasturing sheep, while each of these anterior benefits, when
discounted, will give the value of the respective capital
which yields it; namely, the clothes, cloth, wool, sheep,
and pasture. We find, therefore, that not only all articles
of wealth, but also all the “interactions " which they render,
are dependent, for their value, upon final enjoyable uses,
and are linked to these final uses by the rate of interest.
If the rate of interest rises or falls, this chain will shrink or

expand. The chain hangs, so to speak, by its final link of
enjoyable benefits, and its shrinkage or expansion will there
fore be most felt by the links most distant from these final
benefits.

At the close of Chapter VI it was shown that a

change in the rate of interest only slightly affects the value of
a suit of clothes, the benefits from which are soon realized,

but greatly affects the value of land, the benefits of which
stretch out into the distant future. So a change in the rate
of interest will affect but slightly the price of making clothing
since the final benefits from making clothing will occur in a
short time, but it will affect materially the price of pasture
for sheep since the final benefits from the pasturing will re
quire a long time.
A study, therefore, of the theory of prices involves (1) a
study of the laws which determine the prices of final
benefits on which the prices of anterior interactions de
pend; (2) a study of the prices of these anterior inter
actions, as dependent, through the rate of interest, on the
final benefits; (3) a study of the price of capital-instru
ments and capital-property as dependent, through the rate
of interest, upon the prices of their benefits. The first
study, which seeks merely to determine the laws regulat
ing the price of final benefits, is relatively independent
of the rate of interest.

The second and third, which

seek to show the dependence on final benefits of the anterior

CHAPTER XXIII
INCOME

FROM CAPITAL

§ 1. Distribution according to Agents of Production and
according to Owners

WE began this book with a study of economic accounting.
In this way we obtained a bird's-eye view of the whole field
of economic science. At that time we had to take ready
made the material for constructing our capital and income
accounts.

This material consisted of the values of various

items, whether of capital or of income. These values are,
in each case, the product of two factors, the quantity of
the good valued and the price of that good. We have
now finished the study of one of these two factors, price,
and there remains for us only the study of the other,
quantity. We have explained how the price of instruments,
property rights, and benefits, which enter into capital and
income accounts, is determined. We have still to explain
how the quantities of instruments, property rights, and
benefits are determined.

What determines, for instance,

the quantity of wheat which a given wheat field will pro
duce; what determines the quantity of the wheat fields;
what determines the quantities of human beings on a given
area; what determines the quantities of the necessities,
comforts, luxuries, and amusements of life which a nation
or an individual possesses? Once we can explain these

quantities, we have completed our task of explaining
economic quantities, prices, and values. We shall then
be able to explain — at least in general terms — why,
for instance, the quantities and values of the capital or
income, in capital-accounts or in income-accounts, of some
4Io

Sec. 1)

INCOME FROM CAPITAL

4II

communities or individuals are so great, and those of others
so little; why the benefits flowing from one piece of land
are so great, and from another so small; and so forth.
Our purpose is not so much to reach absolute, as rela
tive, results. We care less about the absolute population
of the globe than about population relatively to land. We
care less about the world's total yield of wood than about
the yield per capita, or per acre; less about the total yield
of cloth than about the yield per capita or per loom. In
general, we care less about the total amount of the yield
from the aggregate of any kind of capital than about the
yield per capita and per unit of that particular kind of
capital.
Our present search, then, is for relative quantities, or
for relative values. There are two sets of such quantities,
or of such values, which are of special importance in our
study. One is the quantity and value of income per
unit of capital which yields the income, and the other
is the quantity and value of income and of capital per
human being who owns the capital and the income from it.
The first represents the distribution of income relatively to
the agents which produce it. The second represents the
distribution of income and of capital among their owners.
The study of the first will occupy our attention in this and
the following chapter. In the present chapter we shall
consider income produced by capital (in its narrow sense,
i.e., exclusive of human beings); in the following chapter we
shall consider income produced by labor, or human beings.
It is well to bear in mind that income is usually a joint

product of labor and capital; for labor and capital are
usually “complementary” to each other, each helping the
other to produce the joint product of both. It is con
venient, however, in thought to separate the two.
Our immediate task, therefore, is to study the ratios of
income to capital.

We take up first the ratio of the

value of the income to the quantity of capital which yields it.

412

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

This ratio is called rent.

| Rent as here

used means the

value of income yielded per physical unit of capital. Thus,
| land
may yield a “rent” of $10 a year per acre; or

houses, of $10oo a month per house.--The concept of rent
here employed is somewhat broader than the popular con
cept; for it includes, besides the rent explicitly named in
a lease between landlord and tenant, the rent which is

implicit when there are not two persons involved, but
landlord and tenant are one and the same person. Explicit
rent is rent in the usual and strict sense of the term.

Implicit rent is often called capitalists’ profits. That is,

rent is explicit when the income is stipulated; it consists of
.#"#. of the instrument. This
*-*-a---

occurs when the owner of the instrument sells its use,
i.e., “lets” or “rents” it to another person and gets
from it a definite money-income.

*:::::::::.

when the income is not stipulated, and therefore can

only be appraised. When a landlord rents his lañrto
-

tenant for $10oo a year, the rent is explicitly $10oo a
ear; when, instead, he works the land himself and makes
from it an income which consists in the production of
crops, the rent is only implicit. Before he can state its
amount he must appraise the crops, including both those
portions which he sells and those consumed by himself and his
family." If he appraises the crops and other benefits which
he receives from the land at $3000 and the costs at $2000, his
net income is $1ooo, and therefore his implicit rent is $1ooo.
A “rented ” house bears explicit rent, but a house lived
in by the owner has an implicit rent, i.e., whatever benefits
it yields to the owner reckoned over and above its costs.
The most common kind of instruments explicitly rented is
real estate, although many other more or less durable com
modities, such as furniture, horses and carriages, telephones,
pianos, typewriters, and even clothing, may sometimes be
explicitly rented.
Explicit rent, being stipulated, is usually fixed and certain

Sec. 2)

INCOME FROM CAPITAL

4I3

– at least for all practical purposes; implicit rent, on the
other hand, is variable and uncertain.
§ 2. The Rent of Land

Although a piece of real estate is usually rented as a
whole, including both land and improvements thereon,
sometimes the land and the improvements are rented
separately. Thus a man may lease an empty building
lot and then make a supplementary contract to lease a
building to be erected thereon by the landlord. The
rent of land separately is called ground rent. Even
when ground rent is not separated in contract, it may,
for purposes of discussion, be separated in thought; so
that all land bears ground rent, either explicit or implicit.
Ground rent has been the subject of a vast amount of dis
cussion. It underlies, for instance, “the single tax" propa
ganda, which advocates that taxes shall be laid on ground
rent alone.

There are two important peculiarities of land which are
shared by very few other instruments. One of these peculiar

ities is that, practically speaking, the land in the world is
fixed in quantity.” Except by filling in tidal lands, as in
Holland, and in a few other instances, we cannot add

to the world's acreage; nor can we subtract from it. It
is true that in some cases we may materially increase its
productivity by irrigation, fertilizing, etc., on the one
hand, or decrease it by erosion and exhaustion of the soil
and other abuses on the other. These alterations in land

are more important than has sometimes been recognized,
and their importance is increasing. For the present,
however, we shall assume a community in which the
land remains unchanged, both in quality and quantity,
possessing, as Ricardo expressed it, “natural and inde
structible powers of the soil.” For our purpose it is enough
to assume that the land is indestructible.

Whether it be

414

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

natural or not is a matter of indifference; precisely the same
principles of valuation apply to the land which was wrested
by our ancestors from the wilderness as apply to land which
y; solely a gift of nature.
^ The second peculiarity of land is that its different
qualities cannot, in most cases, be as fully separated and
classified, as the different qualities of most other kinds of
wealth.

| We can sort wool, for instance, into different

kinds or categories and label and sell each kind separately.
The same is true of wheat or coffee or automobiles.

Each

separate kind is then regarded as a separate commodity.
But it is not practicable to sort different kinds of land,
because the different kinds are inextricably intermingled
and cannot be moved apart, and because one element in
the character of land – its situation — differs materially
with every individual piece of land. Any classification
which would really “standardize" lands, – that is, make
the lands in any one class sufficiently homogeneous as to
bear substantially the same price per acre, — would have
to be too minute a classification to be of any practical
value. In the case of ordinary commodities which are

“standardized ” there exists but one price for each cate
gory. But the price of land differs with each individual
piece, varying almost continuously from nothing up to
$87o a square foot, the record recently set in New York
City.
The prices of land, for the most part, follow the
principles of substitutes or competing articles. It is
true that the various lands are not all substitutes.

city building site is not a substitute for wheat land, nor
is it a substitute for forest or mineral lands. But here,
again, for the sake of simplicity, we first consider only
wheat lands, and shall assume that all these wheat lands

are incapable of any other product and differ only as to
productivity of wheat.

We therefore assume: —

(1) That these wheat lands are fixed in quantity.

SEc. al

INCOME FROM CAPITAL

4IS

(2) That they differ in quality (i.e., productivity) by
continuous gradation from very fertile to very infertile
lands, each fixed and invariable as to wheat productivity
and having no other product.

(3) That the cost of tilling each acre is likewise fixed and
invariable, say $10.

(4) That the lands are substantially equal in accessibility
(thus being in a common land-market and contributing
wheat to a common wheat-market).
Let us suppose, as represented in Figure 46, an island
fulfilling the three conditions above mentioned. In order

Çº
FIG. 46.

further to simplify the picture, let us suppose the most
fertile land situated in the center capable of producing 25

416

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

bushels of wheat per acre per year, and the other lands
arranged around it spiral fashion in the order of descend
ing productivity. If there is a superabundance of the
25-bushel-per-acre land so that it can be had merely for the
trouble of occupying it, and there is no prospect that any
inferior grades will ever need to be used, the land will be,
like air, without value, and will yield no rent. The reason
is that the supply of land of the first quality, which
may be had free, exceeds the amount demanded. We
have seen that under such extreme conditions of supply
and demand the price is low. No one will pay for the
use of land when, without traveling farther than across
a field, there is plenty of equally good land to be had
for nothing. The wheat, however, will have a price equal,
as previously explained, to its marginal-desirability meas
ured in money and also to its marginal cost measured in
money.

But we have already assumed that this cost is

fixed for each grade of land and is the same for every bushel.
Consequently the price of wheat is in this case simply equal
to the marginal cost of producing the wheat. For, if sellers
should try to sell above this cost, buyers would prefer to
grow the wheat at that cost themselves.

Hence the value of

a bushel produced on an acre of the first-grade land is only
just equal to the cost of producing wheat there, which, at $10
per acre for 25 bushels, is $10 + 25, or 40 cents per bushel.
But if the population so changes as to create a demand
for wheat which cannot be supplied from the most fertile
land, some of the next grade of land will be used, yielding
24 bushels per acre. What was before true of only the
first-grade land will then be true of this second-grade land.
It will be valueless, and will yield no rent. But no longer
will this be true of the first-grade land. It will have a
value and yield a rent. For there will be a rise in the
price of wheat. The price will still be equal to the mar
ginal cost, but now the marginal cost is the cost of producing
a bushel on the second-grade land. The value of the 24

SEc. 2)

INCOME FROM CAPITAL

4I7

bushels produced on this land will now be equal to the
cost of producing 24 bushels on that land, i.e., $10. The
marginal cost is, therefore, $10 + 24, or 41.6 cents a bushel.
But since there cannot be two prices for the same article
in the same market, the price of the wheat produced on
the first-grade land must be the same as that produced on
the second grade. Consequently, the owners of the first
grade land now have a crop worth more than the cost of
producing it, and can now, if they choose, obtain a rent for
it equal to the excess, i.e., one bushel per acre; for a tenant
paying the equivalent of one bushel per acre would have
24 bushels for himself, which is exactly the same as he
would get if he took up a claim for himself on the second
grade land; and if the landlord should attempt to charge
more, he would lose his tenant, as the latter would then

be better off on the second-grade land. If he charged less,
he would be besieged by applications, and would put up
his price. The market would be cleared by a rent of one
bushel per acre. In money this is 41.6 cents per acre. If
the owner does not rent his land to another, but enjoys the
product himself, he is still said to obtain 41.6 cents an acre
of implicit rent.
If the population changes again so as to require a resort
to the third-grade land, the price will be still higher, viz.,
$10 + 23, or 43% cents per bushel; and the rent of the first
grade land will rise to equal the difference between its pro
ductivity and that of the third-grade land, viz., 2 bushels

per acre or 2 x 43% cents, i.e., 87 cents per acre. Likewise
the second-grade land will now bear a rent equal to its
superiority over the third grade, viz., one bushel per acre,
or 43% cents. In the same way we may reckon the rent
under other states of land-occupation. In each case the
rent of any grade of land is the difference between its pro
ductivity and the productivity of the worst or marginal land
occupied. If, for instance, the lowest grade of land occu
pied is that indicated in the table as having a productivity
2E

4.18

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

of 9 bushels per acre, the rent of the first grade is now 25 —
9, or 16 bushels per acre; that of the second grade, 24 — 9,
or 15 bushels per acre; that of the next, 23 – 9, or 14 bushels
per acre; and so on down to the worst land, which bears no
rent. Since the price of wheat is, in all cases, its cost of pro
duction on the worst, or no-rent land, it will now be $1o for

9 bushels, or $1.11 per bushel. Therefore in money the rents
of the various lands from the best to the worst will be: —
16 × $1.11 or $17.76 per acre,
15 × $1.11 or $16.65 per acre,
14 × $1.11 or $15.54 per acre,
etc.

The last, worst, or no-rent land, is sometimes also called
the “Ricardian acre" in honor of Ricardo, who first stated
this doctrine of land rent. Its scientific designation is
“marginal acre”; that is, it is the last acre whose cultivation
can be made to pay. This marginal land in a sense forms a
standard by reference to which the rent of all other land
may be measured, and the cost of producing wheat on this
marginal land sets the price of wheat for all lands,-for
there can be but one price of wheat in the same market.
We have reached, then, two important results true under
the conditions supposed, -

(1) The price of wheat is equal to its cost of production on
the margin of cultivation.

(2) Ground rent of any land is the difference between the
productivity of that land and the productivity of land on
the margin of cultivation (i.e., the poorest land cultivated).
With an increase of population, then, the price of wheat
and the rent of wheat land will rise, and the owner of good
land will become gradually wealthier merely through the
increase in population. He receives an increase in rent;
and therefore the value of land — i.e., the capitalized or dis
counted rent — will increase also. This increase in the
value of the land is sometimes called the “unearned incre

ment" because it is due to no labor on the part of the

SEc. 2]

INCOME

FROM CAPITAL

4I9

landowner. (It should be noted, however, that during the
transition of rents from low to high, those who foresee a
rise in rent will discount in advance the larger future rents;

not all so-called “unearned increments" are unexpected.)
These conclusions hold absolutely under the conditions
assumed.

But in the actual world these conditions are

ºver exactly realized. Instead, we find:—
(1) Land is not absolutely fixed in quantity.
(2) The productivity of any piece of land is not fixed, but
varies from time to time both in kind and in degree, and this
productivity will vary with the price of its product, e.g.,
wheat.

(3) The cost of tilling land is not fixed, but varies with
different land, and, indeed, as we shall presently show, is
influenced by the price of the product.
(4) Some lands are much more distant to reach and
occupy than others and their product much more difficult
to bring to market.
(5) The land may be capable of more than the one use
of wheat-growing, and a change in the price of wheat may
shift the use to which certain lands are put. No theory of
land rent is complete which assumes that the difference in

quality among lands is merely a matter of different amounts
of one product, like wheat.
We have already discussed the first of these points and
find it to be of little practical importance. The second is
that the productivity of land is not solely a matter of natural
fertility. This might be the case with some mineral springs
or oil wells; but in most cases each piece of land may be more
or less intensively cultivated, and a rise in the price of wheat
will stimulate wheat production on all lands, the better
grades included. Thus, if the first grade produced 25 bushels
when no other land was in use, it would, with more outlay,

produce more than 25 bushels as soon as the next grade
was in use; and the poorer the worst grade was, and
the higher the price of wheat, the greater would be the

420

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

amount grown by those cultivating the superior grades of
land. In other words, a change in the price of wheat would
not only affect the amount of land under cultivation, but
would affect also the intensity of cultivation of each piece
of land. The productivity of each acre is not a constant
quantity, but is indirectly dependent on the price. Each
acre will be cultivated up to that degree of intensity at
which the last dollar's worth of cost will barely repay itself.
That is, not only is there a margin of cultivation as to
acres — in other words, a last acre which it pays to culti
vate — but there is also a margin of cultivation for every
acre, good or bad, i.e., the last degree of effort or cost
which it pays to put forth on that acre. Each acre will
be tilled until this marginal cost of tilling agrees with the
market price as determined by the cost of production on
the most inferior land.

Again, as to the cost of tilling land per acre, this is by
no means a constant quantity for all lands, both good and
poor; nor is it constant even for the same land. The cost
of tilling per acre may be either higher or lower on good
land than on poor land; and, as implied above, the cost
on any land will vary with the price of the product, just
as the product itself varies with the price. The farther
cultivation is extended to poorer and poorer lands or the
more intensively the same land is cultivated, the greater
will be the marginal cost. This is the law of increasing
cost applied to agriculture. It is also often called “the
law of diminishing returns”; for to say that, as cultivation
is either extended or intensified, the cost of producing a
given amount of wheat continually increases is, turned
about, evidently the same thing as to say that the
amount produced at a given cost continually diminishes.
In an absolutely correct theory the numbers expressing
productivity in Figure 46 must be conceived as increas
ing slightly as the margin of cultivation is extended,
and the numbers expressing cost will not be simply a con

SEc. 2)

INCOME FROM CAPITAL

42I

stant $10 per each acre, but will differ among different
kinds of land according as the soil is rocky or not resistant
to the plow and harrow, level or uneven in surface, con
taining obstructions such as trees, or free of obstructions.
Moreover the cost will not be invariable even for a given
land but will increase slightly as the margin is extended.
Again, lands differ so widely as to accessibility that
tenants are reluctant to leave English lands, for instance,
to take up lands in the Mississippi valley. A slight ad
vantage in the latter over the former will not suffice to

produce emigration from the English to the American
lands and to reduce the rents of the former. Only when
the advantage is considerable will emigration ensue. The
readjustments of population are therefore not as delicate
as the readjustments of water between two connecting
reservoirs seeking a common level. They resemble, rather,
the readjustments of a viscous fluid like pitch which re
quires a considerable difference of level before the fluid
will flow at all. The same viscosity applies in a less
degree to the products of lands. These do not compete
on even terms, for some lands are distant and others near

the common market, and some have good and others poor
transportation facilities. These differences are especially
important in the case of bulky products such as hay which,
for the reasons just given, differs very widely in price in
different localities.

While, therefore, the theory of rent as above given is
correct under the ideal conditions assumed, it is not abso
lutely correct under the actual conditions we find in the
world. But the modifications necessary to make the
theory of ground rent true to life are so slight as not
materially to change the practical results. It still remains
substantially true that the rent of any wheat land is equal
to the difference between its productivity and the pro
quctivity of the worst wheat land under cultivation in the
neighborhood.

4.22

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

§ 3. Rent and Interest

(The principles of ground rent apply also to house rent,
piano rent, or rent of any other kind, except that much
greater divergencies from such stereotyped figures as we
gave for ground rent will be necessary in these cases. In
particular, houses, pianos, etc., are not essentially fixed in
quantity, but their quantity will be changed according to
their rent and their price (which is the discounted value of
their rent). The difference, then, between the rent of land
and the rent of other instruments is a difference in the

character of the supply. The supply of land is relatively
fixed; other instruments are reproducible."
It is important to understand this difference and also not
to confuse it with a common fallacy that land rent alone
is truly rent, and house rent and other rent are really
interest. It is easy to see that land rent may be equal to
interest on the capital-value of the land just as truly as
house rent may be equal to the interest on the capital
value of the house.

In that case both are rent and both

are interest; they are simply two different ways of measur

ing the same income-value.

Rent is measured per unit

of physical capital, as for instance per acre; interest is

measured per cent. That is, rent is income considered
in relation to the quantity of the capital yielding it; it is
expressed as so many dollars per acre or per piano or
other rented unit of wealth.

Interest is the same income

considered relatively to the value of the capital yielding
it; it is expressed as so many cents of income on the dol
* This practical difference between ground rent and other rent, such as
house rent, has an important application in taxation.
scope of this book to consider problems of taxation.

It is not within the
In treatises on tax

ation it is shown that a tax on ground rent falls on the landlord and does
not appreciably affect the tenant, because it cannot affect the supply of
land, which is practically fixed by nature; whereas a tax on house rent is
borne partly by the tenant, because it discourages house building and affects

the supply of houses.

7
s

SEc. 4)

INCOME FROM CAPITAL

423

lar of capital, i.e., as a simple percentage, such as five per
Cent.

To illustrate, let us suppose a quantity of land–ten acres
— to have a value of $10oo, and that $50 a year is paid
for its use. This $50 is both rent and interest. It is the
rent on the ten acres and the interest on the $1ooo.

The

rent is $50 per year for Io acres, or $5 per acre per annum.
The interest is $50 per year for $10oo, or five per cent per
annum. In precisely the same way, let us suppose a quan
tity of houses — ten houses – to have a value of $100,000,
and that $5000 a year is paid for their use. This $5000 is
both rent and interest.

It is the rent on ten houses and

the interest on $100,ooo. The rent is $5000 per year for
ten houses, or $500 per house per annum, and the interest
is $5000 per year for $100,000, or five per cent per annum.
The erroneous belief that land bears only rent, and that
other instruments bear only interest, is to a large extent
responsible for the narrow definitions of capital which
are so often given and which are so framed as specifically
to exclude land. A true analysis justifies the usage of
business men who apply the term “rent’’ as freely to in
come from houses as to income from land, and the term

“interest" as freely to income from land as to income from
houses.//

$4. Four Forms of Income: Interest, Rent, Dividends,
and Profits

If now we gather together what was said in regard to
explicit and implicit rent and the relations between rent
and interest, we shall see that there are four chief forms in

which men receive income from capital. These are ordi
narily known as interest, rent, dividends, and profits.
In order to distinguish them clearly, let us suppose four
brothers, each of whom inherits a fortune of $100,ooo.

The

first invests his $100,ooo in a land company in one hun

424

ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. XXIII

dred $10oo bonds at par bearing five per cent interest.
He then receives $5000 a year, which is interest in the narrow
or explicit sense of the term. The next brother invests his
$1oo,ooo in a ranch of a thousand acres, which he rents to
a tenant for $5 an acre. He then receives an income of
$5000 a year, which is rent in the narrow and explicit sense.
The third brother invests his $1oo,ooo in a hundred shares

of stock in a land company, buying them at par, or $10oo
per share. This stock we shall assume yields him five per
cent, and he receives an income of $5000 in dividends (also
called profits). The fourth brother invests his $1oo,ooo in
a ranch of a thousand acres, which he proceeds to operate
himself. Supposing that he succeeds in securing a net
income of $5 per acre, he will be receiving $5000 a year of
profits. Each of these brothers is receiving an income of
$5000 a year from capital in the form of real estate; but
they are all receiving their income under different conditions.
The four types of income may be arranged as follows: —
(1) Interest per cent.
(2) Rent per acre.

(3) Dividends (or profits) per cent.
(4) Profits per acre.

In the upper line, namely for brothers (1) and (3), the in
come is expressed as a percentage of the value of the capital.
In the lower line, namely, for brothers (2) and (4), the in
come is expressed per acre. As we have seen, either ex
pression can be translated into the other.
Again the first column, namely for brothers (1) and
(2), represents the explicit or assured income, while the
second column, namely, for brothers (3) and (4), represents
the implicit or uncertain income. The first two brothers
have an assured or stipulated income of $5000. The last
two have an uncertain or precarious income which, though we
have supposed it to be $5000, may, and probably will, fluc
tuate from time to time.

There is a fundamental difference

between the first two and the last two brothers in regard
to the risk involved. The first two are supposedly relieved

SEc. 4)

INCOME

425

FROM CAPITAL

of risk, some one else assuming the risks of managing the
land of the company or of running the ranch, and guar
anteeing to these brothers a certain stipend of $5000 a
year each. Corresponding to this fundamental difference
in risk is a fundamental difference in variability. The in
comes of the first two brothers are regular; those of the
last two are irregular.

Where there are risks or chances

to be taken there is irregularity of income as a conse
quence.

It is evident that some one must assume these risks.

Uncertainty attaches to the future product because we
can never know absolutely the conditions as to weather,
blight, fire, labor conditions, etc. Nature never offers a
perfectly safe investment. What is called a safe investment
is always in the form of a contract between one man and an
other by which one man takes risks and guarantees another
man against risks. Even then the guarantee is not perfect,
so that the most “gilt-edged security' involves a slight
element of risk, while in many cases little dependence can
be placed upon a guarantee because of the unreliability of
the person making it.
Nevertheless, it remains true in a general way that ex
plicit income promised to the holder of a note or bond is
comparatively certain, while the income to a stockholder is
uncertain. Investors, therefore, are naturally divided into
two groups: those who are unwilling to assume the risks
of business, or bondholders, and those who are willing to
assume these risks, or stockholders.

Most modern enter

prises are financed by both of these two classes of investors,
part, often half, being owned by the bondholders and the
remainder by the stockholders. As we have seen in
the study of capital accounts, the stockholders' share is the
residuum after the value of all other obligations is de
ducted; and this residuum acts as a sort of a buffer or

guarantee that the assets shall cover the liabilities. The
smaller the fractional part assumed by the stockholders, the
.*

426

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

less adequate is this margin or guarantee and the greater
the risk of large losses to the stockholders or even of com
plete bankruptcy. Therefore, in any proper financiering of
an industrial project, care should be taken to provide that
enough of the first cost should be paid by stockholders to
fully guarantee the bonds. Exactly what constitutes a safe
proportion will depend on the particular circumstances of
the business. Experience, however, has determined certain
fairly definite proportions for stocks and bonds of different
enterprises. These should be ascertained by the intending
investor before entering into any particular project.
The question now arises: What determines the rate at
which the risk takers in a business, those who receive

dividends and profits, shall be rewarded? Will all four
brothers normally receive the same income? To this our
answer is, first, that those who assume risk may receive

either a larger or a smaller income than those who do not,
and probably over a long period of time will receive a fluctu
ating instead of a steady income. Probably on the average
the risk takers will receive a larger income than those
guaranteed against risk; for risk is, or should be, regarded
as a burden and will not be undertaken unless the chance

of unusually large returns outweighs the risk of unusually
small ones. The daring spirits who assume the risk of
embarking their capital in ships, railways, and other enter
prises and guarantee to their fellow-investors, the bond
holders, a fixed return, not only deserve, but in general
receive, a higher return. Those who voluntarily assume
risks, as the stockholder, do so not because they like the
chance of taking risks, but because they hope in the long
run to be sufficiently rewarded for so doing. They may,
of course, be disappointed where bad luck has been un
usually persistent or where the investors have been unusu
ally sanguine and lacking in caution.
At the extreme of incaution are the gamblers and reck
less speculators to whom a small chance of great gain out

Sec. 5]

INCOME

FROM CAPITAL

427

weighs a great risk of moderate losses; and where men of
this temperament predominate, as is often true in mining
camps, the average profits or dividends are apt to be less
than the interest and rent which the cautious, conservative
investor receives.

§ 5. Avoidance of Risk
Uncertainty being regarded as an evil by practically all
normal persons, there is a constant effort to avoid or
reduce uncertainties of income. Not only do bondholders
avoid risks by shifting them to other persons, but those
who thus assume risks also strive to reduce them to a mini

mum. This they accomplish in various ways, of which the
following are important: (1) by increasing their knowledge
of the future, (2) by employing safeguards against mis
chances, (3) by insurance, (4) by speculative contracts,
especially “ hedging.” We shall take these up in order.
(1) Risk, being simply an expression for human ignorance,
decreases with the progress of knowledge. The chief lines
of progress in industry at the present time may be said to
be those which tend to lift the veil which hides the future.

Countless trade journals exist principally to enable their
readers to forecast the future more accurately than they
otherwise could. This the journals accomplish by supply
ing data as to past and present conditions, as well as by
instructing their readers in the relations of cause and effect.

Our government weather bureau supplies weather forecasts
which somewhat reduce this form of uncertainty for the
farmers. Government reports of crop conditions and infor
mation as to diseases of plants and animals are more impor
tant influences in the same direction. Again the prediction
as to the amount of ore to be obtained from a mine and

the cost of obtaining it is to-day far less uncertain than ever
before. Whereas formerly the mining prospect consisted
of wild statements of the ore “in sight,” and the time and

428

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

cost required to mine it, to-day the graduate of a mining
school can, through his knowledge of economic geology and
metallurgy, make forecasts with some degree of certainty.
(2) Safeguards of many kinds have been invented to
reduce the risk of shipwreck, fire, explosion, burglary, etc.
A modern ship is built in compartments as a safeguard
against shipwreck; fire escapes are a safeguard against loss
of life by fire; safety valves against explosions; and bur
glar alarms and safety deposit vaults against burglary.
(3) Insurance consists in consolidating risks, i.e., in off
setting one risk by another by consolidating in one insurance
company a large number of chances. Relative certainty
is, as it were, manufactured out of uncertainty. Insurance,
unlike increase of knowledge and safeguards, does not
directly decrease the risks for society as a whole, but by
pooling these risks it has the effect of steadying the income
of individuals and spreading the burden of risk more evenly
over all.

The owner of a house would receive, if it were

not insured, a net annual income of, let us say, $500 until
the house was burned, after which he would suddenly find
himself without any house to have an income from ; whereas
if he insures, he will be receiving annually an income slightly
less than before because of the insurance premium he will
have to pay; but when a fire occurs, he will receive an
indemnity enabling him to restore the house and continue
his income almost unabated. The same method of steady
ing one's income is obtained by marine insurance, steam
boiler insurance, burglar insurance, plate-glass insurance,
live-stock insurance, hail and cyclone insurance, accident and
fidelity insurance, employers' liability insurance, and even
life insurance.

If a wife holds insurance on her husband's

life, she avoids the evil, when widowed, of being left rela
tively destitute; for the insurance provides her with an in
come which is a partial substitute for that formerly received
from her husband. He and she prefer to sacrifice a yearly
premium during his lifetime to avoid the risk of the sudden

SEc. 5]

INCOME FROM CAPITAL

429

complete loss of income to her at his death. In short, the
effect of pooling risks through insurance frees the individual
of the large fluctuations in income which would otherwise
be suffered. The income of society fluctuates less, rela
tively speaking, than that of the individuals composing
society. This is true because the evils which form the
extraordinary catastrophes in individual lives constitute a
regular stream of events in the life of society. Death in a
family is an unusual catastrophe, but the number of deaths
in a community forms a regular and predictable series of
events. To the owner of only a few vessels the shipwreck
of one of them is an extraordinary catastrophe, but the ship
wrecks of the world constitute a regular and predictable
series of events.

The same is true of accidents and mis

chances of all kinds. They are irregular for the indi
vidual and regular for society. When, therefore, society
through insurance companies and otherwise consolidates
these risks, the individual gains an advantage by securing
greater certainty and regularity in his individual income,
even though the average income of the individual is not in
creased at all, in fact is decreased, by the cost of con
ducting the insurance companies.
In this last connection it should be noted that insurance

indirectly leads to the reduction of risk; for insurance com
panies find it to their interest to reduce the risk against which
they insure. Marine insurance companies expect the ships
to secure the installation of safety devices. Fire insurance
companies do likewise, and to-day even life insurance com
panies are beginning to advise their policy holders how to
reduce the chances of death.

In view of all that has been said, it is evident that insurance
is one of the grandest of human devices in the warfare against
risk. As its importance has gradually been appreciated,
its use has been steadily extended, and in some cases, as
in Germany, its employment (in certain cases affecting

workingmen) has been made compulsory.

43o

...

ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. XXIII

(4) It seems at first to be a curious fact that speculation,
although dealing in chances, may be used to reduce chance to
some persons who use it for this purpose. We have already
seen how short selling reduces the risk to the person sold to.
A building contractor when taking a large contract was
asked whether he was not taking a large risk, since he could

not know in advance what the costs would be.

He replied,

“No, I am taking no risks at all except on “labor’; I have

made contracts to be supplied with material when needed
at fixed prices.” In other words, dealers had sold him future
building materials “short.” They had each assumed the
risk of fluctuation in those special materials in which they
dealt, thus relieving the contractor of the necessity of in
forming himself of the special market conditions on stone,
brick, timber, etc.