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New York
All rights reserved

The New York
Public HLAiLbArMary




Set up September, 1910.

Norwood Press
J. S. Oushing Co . - Berwick & Smith 00.
Norwood , Mass ., U .S .A .








Capital and Income .


Chapter III


· ·



· · ·


· ·


. . Chapters I- II




Chapters IV - V


Chapters VI-VII


Rate of Interest .


Chapters VIII-XIV
· · ·


· · ·

General Prices .
Particular Prices .

Chapters XV -XVIII


Chapters XIX -XXII


Sources of Income .




Ownership of Income.



Chapters XXV-XXVI



1. Wealth




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. 54

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. 132




. 152






















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. 225
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. 298




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XX .


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. 317
. 327

, 340
: 358



. 373



. 384



. 412




§ 1. Definition of Economics and of Wealth
ECONOMIC SCIENCE , or, as it is often called, Political Econ
omy or Economics, may be most simply defined as the

Science of Wealth . The purpose of economic science is to

show thenature of wealth ; the relation of wealth to human
wants, and to the satisfaction of those wants ; the forms

of the ownership of wealth ; the method of its accumulation
and dissipation ; the reasons that some people have so much

of it and others so little ; and the principles that regulate
its exchange and the prices which result from


In a word , everything which concerns wealth in its general
sense falls within the scope of economic science.
To most persons the chief interest in the subject lies in
its practical applications to public problems, such as those

connected with the tariff, 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. Before we can treat of economic dis

eases, however, we must first understand the economic
anatomy and physiology of society ; that is, wemust grasp

the general economic principles which these public questions

involve. Hence, the study of economic science must precede
the application of that science to problems of public policy.
In 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, a monometallist or bimetallist, an indi

vidualist or a socialist, or indeed , any other kind of partisan.


Wemust, then, in the first place, distinguish economic

science from its applications to public problems; but, in
the second place, we must likewise distinguish it from its
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. Eco
nomics, it is true, is the theory of business ; and business the

practice of economics. But, though they are not in the
least conflicting, - indeed , to some extent mutually helpful,

- they are nevertheless totally different. Some of the
wildest economic theories have originated among success
ful financiers. Men who have been trained in Wall Street
are often the most sadly in need of elementary instruction
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 prob
blems, 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 desirability.”
Having indicated Wealth as the subject matter of Eco

nomics, the question at once arises : What is Wealth ? By
Wealth (in its most general sense) is meant material objects

owned by human beings. Any single such object is an
article of wealth , or an instrument. In common parlance,
1 Every writer may define a term as he pleases, except that he should jus
tify 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 (although

it departs from the practice of some economists) it leads to a consistent and
systematic development of the science.

Some economists add to the definition that an object, to be Wealth ,must


“ wealth ” is often opposed to " poverty," the contrast being
between a large amount of wealth and a small amount; pre

cisely as in common parlance " 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

somedegree of heat, so in economics a poor man is regarded
as having somedegree of wealth .
Wealth , then, includes all those parts of the material
universe that have been appropriated to the uses of man

kind . It does not include the sun , moon, or stars, for no
man owns them . It is confined to this little planet of ours,
and only to certain parts of that ; namely, the appropriated
sections of its surface and the appropriated objects upon it .
§ 2. Distinction between Money and Wealth
One of the first warnings needed by the beginner is that

he avoid the common confusion of wealth with money.
Few persons, to be sure, are so naïve as to imagine that a
millionaire is one who has a million dollars of actual cash

stored away ; but, because money — or some money — is
be useful; thus defining wealth as “ useful material objects owned by

human beings.” But unless a thing is 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 owner

ship ,it need not bementioned separately in our definition . Other writers omit
the idea of ownership and simply define Wealth as “ usefulmaterial objects. "

Butthis definition includes too much. Rain , wind, clouds, theGulf Stream ,
the heavenly bodies, especially the sun , from which we derive light, heat, and
energy, are all useful, but are not appropriated , and so are notwealth as com

monly understood . Even more objectionable are those definitions 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 themselves wealth .
To include wealth , property, and services, all under one term , 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, or benefit , of that wealth .



a kind of wealth , and because the beginner is so accustomed

to measure all kinds of wealth in terms of money, he some
times forgets that not allkindsare money . For an extended

study of money, we are not yet ready, 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 more fully after they have received
a more extended treatment.
First, then , it is sometimes seriously asserted 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 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 agriculture and for manufac
turing ; for in gambling the winnings are precisely equal to
the losses. But as a matter of fact, it is not in order to

obtain money that people engage in trade, but in order to
obtain whatmoney will buy, and that is precisely what both
parties to a normal transaction eventually get.
Again , some persons have tried to prove that the nations
of the earth can never pay off their debts because these
debts amount to more than the existing supply of money.

This fallacy is due to the fact that debts are merely ex
pressed in money. “ If we owe money,” it is argued , “ we
can 't pay more money than there is .”

This 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.
Again , it is sometimes argued that there must be a great

deal of “ water ” in the capitalization of the trusts because
their total capitalization exceeds all themoney in existence.
But we cannot thus infer that the capital of the trusts is so


largely fictitious, for capital and money are by no means the

same thing. A cargo ofmerchandise is capital, but it is not
money .
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 equal the
totalwealth 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 paying his debts . “ I

will give five dollars,” he said , “ to any one who can dis
prove that statement.” When no one accepted the chal

lenge, a wag suggested that itwas because there was but one
chance in twenty of getting the promised five dollars !
The attempt to equalize money and wealth by making
money twenty times as plentiful would , as we shall see later,

prove absolutely futile . Themoment you raised the amount
of money, the money value of all other forms of wealth

would rise in proportion , and there would be the same dis
crepancy as before.

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 the quantity of money is then increased the

wheels of business will stop or slacken. The fact is, how

ever, 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 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 too fast and is having the effect of raising prices .

This writer contends that the panic of 1907 was due to a
scarcity of money, whereas the true explanation lies in the





fact that gold had been pouring outof the mines for so many
years and in such large quantities that men were led to use
it too freely in speculation , and this inflation of enterprise
precipitated an economic crash .
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
recentmeeting 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 . Theworld 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 ofmoney 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 sameexperiment with the sameresults, – no
real increase in wealth , but simply an increase of the amount

ofmoney to be exchanged for wealth .
The idea thatmoney is the essence of wealth gave rise to


a set of doctrines and practices, called Colbertism or Mer
cantilism , 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 regarded 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 advocated the policy now

known as “ protection.” To-day it is generally understood
that, as between individuals, both nations may gain in an
exchange transaction ; but the old idea that a nation may
get rich by selling more than it purchases, 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 rea

sons for a protective tariff, but the old fallacious reason still
appeals to themultitude, who continue to think that by put
ting up a high tariff people are prevented from spending money
to the foreigner and compelled to keep it in this country .

In order to avoid money fallacies of the sort we have re
ferred to , what the student should realize is that no technical
term in economics should be used as a basis 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. “ Mak
ing money,” for instance, is a catch phrase used without any
definition. Properly speaking, nobody can “ make " money
except the man in themint.

The rest of usmay gain wealth ,

but, unless weare counterfeiters,we cannot literally “ make ”

The propositionswhich are true of money we shall

state carefully in due time. Asyet we are not even prepared
to define money.


§ 3. Classification of Wealth

Various kinds of wealth may be distinguished . That
wealth which consists of owned portions of the earth 's sur

face is called land ; fixed structures upon land are called
land improvements , and the two together , since they con

stitute immovable wealth , are called real estate . All wealth
which is movable (except man himself) is called commodi

ties. There remain , then, human beings themselves, —
not only “ slaves " who are wealth owned by other human

beings, but also “ freemen ” who are wealth owned by

It is truethatin ordinary usage freemen are not counted as
wealth . And it mustbeadmitted that, ifthey arewealth, they

are wealth of a very peculiar sort; first,because they arenot,
like ordinary wealth , bought and sold ; secondly, because

theowner usually estimates his own value much more highly
than does any one else ; and thirdly , because the owner
coincides with the thing owned . However, it is perfectly
logical to make our definition of wealth broad enough to

include human beings.'
* In order to concede as much as possible to popular usage, the following
supplementary definition is framed : Wealth (in its narrower sense) consists

of “ material objects owned by human beings and external to the
owners." This definition obviously includes slaves butnot freemen . It corre
sponds closely to the popular use of the term , but it is more difficult of applica

tion than the wider definition ; for it makes an arbitrary line of demarcation
between freemen and slaves,when , in fact, there are several intermediate forms,
such as vassals, indentured servants, long- time apprentices, and men held in
peonage. A man bound out to service for thirty years is almost indistinguish
able 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 extentand 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 .

The two concepts just mentioned , " wealth in its broad sense " and " wealth
in its narrow sense,” need cause no confusion . When thesimple term “ wealth "
is used , the broad meaning will be understood, and any propositions which


There are of course many admissible ways of classifying
wealth . That which follows seeks to exhibit the principal

groups into which wealth most naturally falls."
Productive land

Ways of transit

Building land

Real Estate

Land improve-


on highways




Raw materials



Finished products Consabl
Dur e
Human being

| Free

It scarcely needs to be stated that these groups are not
always absolutely distinct. Like all classes of concrete
things, they merge imperceptibly into each other. For

this reason the classification is of little importance in scien
tific study, except as giving a bird's-eye view of the field of
economic science.
$ 4 . Measurement of Weath

Having seen what wealth is and what it is not, and having
classified it roughly, we shall next examine separately its
hold true of wealth in this meaning will necessarily hold true of wealth
in the narrow meaning. Whenever there is occasion to restrict the term ,

we shall make use of the phrase, “ wealth in its narrow sense.”
" The student need not attempt to learn this classification outright. He
should simply become familiar with its chief divisions, studying its details
merely as illustrative. It is also advisable that he construct other classifi

cations, of which many are possible.



two attributes, materiality and appropriation , devoting the
remainder of this chapter to the first of these .

The materiality of wealth is chiefly important as provid
ing a basis for the physicalmeasurement ofwealth . 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 have been handed down to us, such as the
pound avoirdupois , the kilogram , etc.

In England , besides

the avoirdupois pound and the Troy pound, and the apothe
cary 's weight, 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 the past change from silver to

gold money. In the United States a dollar of “ standard
gold ,” or gold which is % fine, is a unit of weight, employed
for measuring gold coin .

It is equivalent to 25.8 grains, or

to 2008 of a pound avoirdupois, since there are 7000 grains
in a pound avoirdupois . We can scarcely put too much
emphasis on the fact that the pound sterling and the dollar

are units of weight. As units of “ value,” we need not yet
trouble ourselves about them .
For many articles it is not so convenient to measure by
weight units as to measure by space units, whether of volume,

of area, or of length. Thus we have, for volume, milk
measured by the quart , wheat by the bushel, wood by the

cord, and gas by the cubic foot ; for areas, we have lumber
sold by the square foot, and land by the acre. For length ,

we have rope, wire, ribbons, and cloth measured in feet and

Many articles are already in the form of more or less

definite units.' In these cases the measure of their quantity
is thenumber of such units. For instance, eggs or oranges

are measured by their number expressed in dozens. Simi
larly, 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 “ num

ber " is by no means peculiar to such cases. All measure
ment implies an abstract number , as well as a concrete unit.

The only peculiarity of measurement “ by number ” is that
the unit, instead of being one which is applied from the
outside, as by the yardstick , is one in which the things meas

ured happen to be already divided.

The English pound avoirdupois is the weight of a part
icular piece of platinum kept in London . A great many
copies of it have been tested by balance, so that they weigh
almost exactly the same as that pound ; but there is, prop

erly speaking, only one standard pound and that is the
one in London . So also the kilogram is another piece of

metal kept in Paris. These units, like all units, are arbi
trary. The definition of an English yard , for instance, is
simply an imaginary line drawn between two small dots on
gold plugs in a particular brass rod in London .
Having such definitely specified units of measure and a
knowledge of the number of times that unit is contained in

any given wealth , the amount of that wealth is fully ex
pressed . This assumes that the given wealth is homogeneous,
so that all parts of it are measurable in the same unit. If
different qualities have to be distinguished , the amount of

each quality requires separate measurement. But the ex
istence of a gradation in quality, such as is usually applied

to real estate, makes it very difficult to measure wealth in
physical units . A tract of land of 100 acres may consist of

many different qualities of land, and to include all these as
merely so many acres is a misleading measurement: Or,

sometimes there is only one article of the particular kind in
existence, in which the element of comparison is left out of

themeasurement. There is but one Battery Park , oneWhite
House, one Koh -i-noor diamond , one Rhynd -papyrus.
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 may be necessary to enumerate the
particular attributes of the wealth under consideration , or

enough of these attributes to distinguish that species of
wealth from others with which it might be confused.


it is often necessary to specify what “ grade ” or “ brand ”
is meant, as “ grade A ,” “ Eagle brand ,” “ Lackawanna,”
etc. Sometimes the special variety is denoted by a
“ trademark ” or “ hall-mark .” It is in this way that the
attributes of particular kinds of wealth enter into the
consideration of economic science, and not, as some have
erroneously supposed , as themselves constituting separate

“ immaterial” sorts of wealth . “ Fertility ” is not wealth ,
though “ fertile land ” is wealth. · The “ skill ” of a me

chanic is not wealth, though the skillfulmechanic is wealth .
§ 5. Value and Price

We have considered articles of wealth as measured sep
arately . Each kind has its own special unit, as pounds,
gallons, or yards. But it is convenient also to measure the

combined value of aggregations of wealth.

This term in

troduces the principle of exchange. So much mystery has

surrounded “ value ” that we cannotbe too careful to obtain
a correct and clear idea of it at the outset. In the explana

tion 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. Wemust

begin , therefore, 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 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 . The distinction between change of owner

ship and change of position is often overlooked. Exports
and imports, for instance, mean change of place ; whereas
international trade means changes of ownership. Some
wealth may be exported , therefore, without being trans

ferred, as when an American going abroad takes his effects
with him . On the other hand , wealth may be transferred
without being exported , as when, for example, American
railroads are transferred in part to foreign ownership ,
though they cannot be exported . Yet we say that exports

and imports must balance each other when we really mean
that international trade must balance.
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. Vol- 2
untary transfers 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.
Exchange, then , means the mutual and voluntary transfer

of wealth between two owners, each transfer being in considera
tion of the other. When a certain quantity of wealth of one
kind is exchanged for a certain quantity ofwealth of another
kind , we may divide either of the two quantities by the
other and obtain what is called the price of the latter .

Thus if 200 bushels of wheat are exchanged for 100 ounces

of silver , theprice of the wheat is 200 or ounce of silver
per bushel. Contrariwise, the price of silver in terms of
wheat is 400 or 2 bushels per ounce. Thus there are always
two prices in any exchange. Practically , however, we
usually speak only of one, viz . the price in terms of money,

obtained by dividing the units of money by the units of the
commodity .



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

changed , some kinds of wealth are more acceptable in
exchange than others. Money primarily means wealth
which is generally acceptable in exchange . And here for the
first time we reach a definition of money.

In other words,

the fundamental quality of money is 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, a sale for the man who receives it. Originally, all
exchange was barter, but to -daymost exchange is, as we all
know , purchase and sale .

· 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 some

times 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,
and theonly prices are those bid and asked . For many com

modities the trade journals report, preferably, the prices of
actual sale ; but if there has been no sale, 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 could or should bring. Appraising or guessing
at prices is often very difficult. It frequently has to be em
ployed, however, by the government, for 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

purpose or another, a price of some sort must be set. The
purpose evidently makes a great difference 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 possible purchaser would prob

ably give. And these prices may be all 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 borrow money
on it from a pawnbroker, the appraisal would have to be

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
enter it, if the truth must be told , at a low price on the tax

list . When a fire loss is adjusted , the two conflicting in
terests, viz . the “ insured " and the “ company,” are usually

represented by two experts who in case of disagreement
call in a third .

Having succeeded in obtaining the price of any kind of
wealth , we may next proceed to compute the value of any
given quantity of it . And the value of a given quantity of

wealth is that quantity multiplied by the price.

Thus, if the

1 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 here called money price and
applied the term “ value " to what is here called price. Other economists
have used the term " price " in the sense of market price, — what an article

actually sells for, — and " value " in the sense ofappraised price or reasonable



price of wheat is

dollars per bushel, then a lot consisting

of 3000 bushels would have a value of 3000 times


or 2000 dollars. In other words, the value of a certain

quantity of one kind of wealth at a given price is the quan
tity 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

following :


44 bu. per pair

Shoes . . . . 1000 pair

. . . . 300 lb .
Dwelling house .
I house
Wheat . . . 100 bu.



bu . per pound

4250 bu .
60 bu.

| 10,000 bu. per house

10 ,000 bu .

I bu. per bushel

100 bu .

In the second column are recorded various quantities of

wealth ,measured each in its own special unit ; in the third
column are the prices of these in terms of wheat ; while in

the last column are their values, also in terms of wheat.
The first and last columns of figures represent two different

ways of measuring wealth . Statistics of wealth , such as
those published monthly by the Department of Commerce,

usually give both “ quantities " and " values.” To trans
late from one to the other we always need a price as a go
It is important not to confuse the columns with one
another. The quantity of beef is totally different from its
value, and each of these is different from its price. The

quantity is here measured in pounds of beef, its value in
bushels of wheat, while its price is measured in bushels per
pound .
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 desirability."



The measurement of wealth in " value ” has one great

advantage over its measurement in “ quantity.” It
translates many kinds of wealth into one kind and thus
enables us to add them all together . This is a very use
ful accomplishment. To add up the second column is
quite impossible, because shoes , pounds of beef, houses, and
bushels of wheat are incommensurable. But the items in
the third column of the inventory, being expressed in a

common unit,may be added together ,despite their otherwise
baffling diversity.
Since prices and values are usually expressed in money,
themost exchangeable kind of wealth , therefore money may
be said to bring uniformity of measurement out of diversity .
In other words it is not only a medium of exchange, but it is
also a measure of value.

Although this reduction to a common measure is a great
practical convenience, we must not imagine that it gives

what may be called “ the true measure " 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 onemonth

was $ 12 ,000, and in a later month , $ 15,000, from which fact
we might infer that 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 2100 , showing a

decrease. Likewise, the figures for imports of coffee in
these periods show a decline in dollars , despite an increase

in pounds. It is conceivable that the quantity of every
article might decrease, and yet, if the prices increased suffi
ciently, there would be an apparent increase of wealth when
there really was nothing of the kind . Such is apt to be the

case in times of an inflation of the currency.
Even when we are confessedly trying to measure the
value of wealth and not its quantity, it is difficult or im
possible to find a right way.

Imports into the United

States from Mexico in one year were worth 28 millions



of American gold dollars, and ten years later , their value
was 40 millions, - - an increase in value of 42 per cent; but

these very sameimports measured in Mexican silver dollars
were 41 millions in the first year and 90 millions in the
second , - an increase in value of nearly 120 per cent.
These increases do not agree ; yet the American merchant
reckons value oneway,and theMexican merchant, the other.
In a sense both are right ; that is to say, both are true

statements 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 measured also in iron , copper, coal, cotton ,
or any other article, we should have many other different
“ values,” no two of which would necessarily agree. “ The
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 use such values for comparing different groups
of wealth , except under certain conditions, and to a limited

To compare the wealth values of distant places or

times, — as America and China, Ancient Rome and Modern
Italy, or Carnegie and Croesus, — will inevitably give
conflicting and unsatisfactory results.

§ 6 . 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 attained is exaggerated . Even in the

measurement of themere 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. In modern

times the first source of error — the unit - - is practically


eliminated. Our units of weight and measure are stand
ardized 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 measure
ment. Different towns have their sealers of weights and
measures , to prevent error through ignorance or fraud .
But this fortunate condition of affairs did not always exist.

The Egyptians are said to have been unable to test their

units of length to less than 1 foot in 350. The Roman
weights were only true to i pound in 50 . And when we go

back to primitive units , we find that they were very rough
indeed. A yard was probably originally the length around
the waist, which naturally was apt to fluctuate 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 considerably heavier than the other.

The heavier

were used for buying and the lighter for selling ! Such tam
pering with weights and measures is now almost unheard of.

To-day the chief 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 potatoesmeasured correctly within five per cent,
we are fortunate . Wholesale transactions are more accu
rate. Probably the greatest degree of accuracy ever at
tained in commercial measurements is on the mint scales

employed by the federal government in Philadelphia and

San Francisco. These scales weigh accurately to within
about one part in ten million .
Besides these two sources of error in the measurement of
mere quantity, when we proceed from quantity of wealth 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 inaccu

racy ; but the price at which we estimate 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 the 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

towns,where sales are infrequent, the appraisement becomes

merely a rough guess. Again , in the country districts,while
farms in the settled parts of Iowa and Texas can be ap
praised 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 ques
tion is scarcely conceivable, an appraisement is almost out
of the question . To estimate the value of Yellowstone Park

is impossible, unless we allow ourselves an enormous range.
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 atmy valuation and sell him at his, I'd get
rich .” It would be erroneous, however , to conclude, as,
somewriters have done, that because we cannot value them
accurately, public parks or freemen cannot be called wealth .'
1.When the slaves in the South became freemen , they ceased to be ap
praised 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 them
selves, and their consequent omission 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 .


$ 1. The Nature of Property

OUR definition of wealth restricts it to concrete material
objects. According to the definition , wealth has two attri

butes : 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 the “ benefits ” of wealth . To own

a loaf of bread means nothing more or less than to have the
right 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 real
objects for which wealth and property exist are the benefits
which they confer.

If some onewere to give you a thousand

dollars on condition that you neither spend them nor give

them away,or if some one gave you a house on condition that
you never use it, sell it, rent it, or give it away, you would be
justified in refusing it as worthless.

Benefits are also called the uses or services or work of
wealth . The last two terms are generally employed when
the wealth referred to is human beings. Sometimes these
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 . When a loom changes yarn into cloth , the trans

formation is a desirable 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 conferred by a fence around a farm
consist in preventing the cattle from roaming away. The

dikes in Holland confer the benefit of keeping out the ocean .
Thebenefits conferred by a diamond necklace consist in its
sparkle and the satisfied vanity of the wearer.
To be desirable an article must confer benefits 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 serviceable to the
owner of the factory , it is for him a benefit.
Benefits may be measured just as wealth may be meas
ured , although the units of measurement are of course not

the same. We measure some benefits by number , — as

when we count the strokes of a printing press. Wemeasure
other benefits by time, — as when we reckon a laborer 's
work by thenumber of hours or days that he is engaged in it.

Somebenefits of wealth wemeasure by the wealth which it
produces, — as when the work of a coal miner is measured

by the amount of coalhemines, or when the use of a loom is
measured by the number of yards of cloth it weaves.

When we have measured the benefits of wealth , we may
apply to them the sameconcepts of transfer, exchange, price,

and value which, in the last chapter, we applied to wealth .
We have seen that wealth may be exchanged. The same
is true of the benefits of wealth . But when the benefits of
wealth are exchanged , there is really no new kind of exchange
1 Benefits (or uses) or services must not be confused with the utility (or
desirability ) of those benefits. The benefits are desirable events ; the
utility is the desirability of those events. “ Desirability ” is very im
portant in economics , but does not concern us until Chapter XVI.



taking place. For to exchange wealth is really to exchange
the benefits of wealth. Under the term “ wealth " we really
take account of the benefits of wealth . Thewealth was the
thing explicitly mentioned and measured, but its benefits
were included by implication .
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 , tomake happen what hedesires to

happen, and to prevent from happening what he does not
desire to happen .

But often wealth can work no benefit

without entailing somecost ; that is, preventing what is desir
able or occasioning what is undesirable. Whatever wealth
brings about to the pleasure of the owner is a benefit ; what

ever it brings about to his displeasure is a cost. He assumes
the costs only as a means of securing the benefits .

As most roses have thorns, so almost every beneficial
article has its costs .

The benefits from a farmer's land are

measured by the crops which that land produces ; the costs
it imposes aremeasured by the labor, trouble, and expense
of getting the crops.
The costs ofwealth may, of course , bemeasured , just as its

benefits are measured , — by number, by time, or other
appropriate units .
§ 2.

Rights to Benefits of Wealth

We have said that to own wealth means to have the right

to its benefits. Wehave seen what is meant by “ benefits ”
and have next to examine what is meant by “ right.”

Rights, in the most general sense, are the liberty , under
the sanction of the law and society, to enjoy the benefits and
assume the burdens of wealth. Lawyers generally distin
guish between property rights and personal rights , but to the
economist all rights are proprietary. We have already

defined wealth in its broad sense as inclusive of persons.
Consequently personal rights are but rights to personal








wealth, -- just as other rights are rights to other wealth .
Logical convenience is therefore served by comprising under

the general term of property rights all rights whatsoever.
Every right, then, is a right to the benefits from wealth ,
whether persons or things. For instance , the right to life,
liberty, and the pursuit of happiness ; or the right of a hus
band over a wife or of a wife over a husband ; or the rights of

parents over children or of children over parents , — all
these may be regarded as property rights in the broadest

sense. It is not often, however, that personal rights will
need our attention . It is only as property in human beings

enters into commerce that such rights obtrude themselves.
When wives were bought and sold , they were thought of as
wealth ; and the rights of husbands were thought of as

property .
The benefits to which a right in wealth entitles its pro
prietor require time for their occurrence and are 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 ” must therefore

be added to our definition ; so that it shall read : Property

is the right to future benefits of wealth . But even yet we

are not quite done with our definition . For 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. Wemust therefore add to
our definition the idea of uncertainty . The definition will
now read : Property is the right to the chance of future benefits
of wealth . 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
“ in fee simple.” If he has a right to only some of the
benefits 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 in partnership , each is a part owner ;
each has an 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 de
scribes each brother's share as an “ undivided half interest."
Property may be measured just as wealth and benefits

may be measured . For instance, the quantity of property
in the form of railroad stock is measured by the number of

shares held. 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 the benefits of wealth . And

just as the exchange of wealth was a disguised exchange of
the benefits of wealth , so the exchange of services of wealth
is a disguised exchange of property rights to these benefits.

In the lastanalysis, then , the only thing that iseverexchanged
is property. It is only for the sake of brevity and simplicity
thatwe ever speak in any other terms. It would evidently
be pedantic for a man selling wheat to insist always that he

was not selling “ wheat,” but only the “ right to possible
future benefits from wheat.”

§ 3. 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 costs. Wealth being the means, and
property the right, to those future benefits (and costs) ,wealth

and property may be said to be coextensive. There cannot
be wealth without property , nor property without wealth .

This follows from the definitions given . Wealth was defined
as something owned ; this implies property . Property was


defined as the right to wealth ; this implies wealth . In
specific cases we can readily see the correspondence. In
fact, in cases where wealth is owned “ in fee simple ” or com

pletely , the correspondence is altogether too clear ; so clear
that in ordinary parlance the two terms, wealth and prop

erty, becomeconfused , 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 completely lose sight of

the 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 still
further separated from the thing to which the rights relate, —

so far 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 you examine it, you

will find that the wealth of the entire community is behind
this property ; for it is out of this wealth , by means of taxa
tion , that the bond must be paid . For cities, in fact, 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 realwealth behind the city bonds to make

their ultimate payment secure.
§ 4. How to find the Wealth underlying Property
While it is sometimes difficult to discover the wealth be
hind a given property right, the difficulties may easily be

removed by following a few simple guides, of which the fol
lowing are examples : -



(a ) The first guide is this: Always look for the benefit
which the given property confers ; and when your eye is
fixed on those benefits, look around for the means by which
those benefits are produced . Benefits do not come of them

selves ; they always require actual, tangible , concrete, physi
cal means, - either persons or things. The means may not
be the same as the cause. For instance, a man living in
northern latitudes owns a house that has a southern exposure
and therefore a great deal of sunlight. The benefits from
that location , therefore, consist partly in abundant sunshine.
Now , the land is the means of securing that sunshine,

although the sun is the cause. Wealth , though it may not
always be the cause, is always the means of benefits. Take
as another example of property, a street railway franchise .

If a city sells a franchise permitting a company to build
and operate a railway through its streets , — what has

the city sold ?

Is it a right that has no wealth behind it?

No; for there are benefits to be gained by the possession of
the franchise - the sale of transportation ; and

are physical means to those benefits — the streets.



city streets are therefore the wealth behind the franchise
which the city gives or sells. It gives or sells a right to use
the streets .

(b) A second guide lies in the fact that one property
right often overlaps another. For instance, a mill is owned
in shares : a railway company owns some of those shares;
a bank owns some of the railway shares ; and John Smith
owns someof the bank shares . It is evident that John Smith

has a claim upon the mill, although only distantly, i.e.
through several intermediate layers of property rights .
Such secondary relations between wealth and property

occur when property is held in trust. At common law , the
trustee is the legal owner; but the law of equity recognizes
the fact that the beneficiary is the true owner. That is, he
has a claim against the trustee ; it is only for his benefit that

the trustee holds the right to the wealth.

Through the rights


of the trustee, therefore , thebeneficiary has an indirect but
secure right to the benefits of thewealth .
(c) A third guide is based on the fact that the correspond
ence between property and wealth is a contemporaneous corre
spondence . That is to say , existing property rights are

rights to the use of existing wealth , so that existing wealth
always underlies existing property rights. Next year' s
fruit crop may be sold in advance. The buyer then has the

right to next year's fruit, but this is really a right to, or in , the

present fruit trees, expected to bear the fruit. Likewise
the right to next year's wheat is a right to, or in , the present

farm , farmer, and farm implements. The right to receive a
chair or table yet unmade is the right to,or in , the present
person , tools, and other wealth of the carpenter, by which

that chair or table is to be secured . It would seem at first
that “ credit ” forms an exception , for the right of a creditor

is a present right to a future payment. But it is impossible
to have a right to any future benefit which is not also a right
to some present wealth as a means of securing that future

benefit. To own a note falling due next year is a part right
in the person and other “ assets ” of the promissor, and ceases
to have value as soon as he ceases to be “ good for it.” It
is true that the courts do not restrict a debtor in the disposi
tion of his possessions prior to the maturity of a note.

Hemay elect to squander his resources. Such destruction of
the present means of providing for future payment carries

with it the impairment or destruction of the value of the note.
No future benefits whatever can be owned in the present

except as claims on certain requisites of their production that
are already in existence. We cannot own next year's goods
suspended in mid -air, as it were, any more than we can fly

a kite without a cord . There must always be some present
means of controlling the future.
And not only is every right to a future benefit a claim on

present wealth , but conversely , as already set forth in our
definition of wealth , every claim on presentwealth is a right



to a future benefit . Owning rights to " futures ” is therefore
not an exceptional but rather the typical case. As we have

seen , all wealth is the existingmeans toward future benefits ,
and all property consists of present rights to some of those

future benefits. It is only through future benefits that
wealth and property are bound together at all. The se
quence of ideas is : present wealth , future benefits, present
rights to future benefits and therefore to the present wealth
which is to yield future benefits. Property is thus always
a present right to the chance of future benefits from present
wealth .

(d ) Our fourth guide for finding the wealth underlying
property is as follows: In cases of the partial ownership of
wealth, we should remember that the aggregate of all partial
rights constitutes the total ownership. Each partial right is a

right to a part of the total future benefits. These benefits
may be cut up among separate owners in different ways .
But the total ownership of the wealth is always the aggregate

of the rights to the entire stream of future benefits. The
character and size of this stream of benefits may of course
differ according to the differentmethodsby which ownership
is parceled out. But this fact does not invalidate the prin

ciple that the total ownership is the combination of all the
partial rights.
The future benefits flowing from wealth may be compared
to a pennant attached to a flagstaff, - a long streamer

stretching out into the future. Some of the possible ways
in which the present ownership of these pennants may be
subdivided is indicated in Figure 1, which contains three

diagrams. The first represents the stream of benefits 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 there
fore divided, so to speak, longitudinally into two parts.
But if the house is rented, the division of benefits between



the tenant and the landlord is transverse, as shown in the

middle diagram . The tenant has all the benefits of the
house for a certain time, after which the landlord has all
the future benefits.

The third diagram shows another way in which the benefits
may be divided . This is by carving out a particular part of


these benefits in the
future. It may then
be said that the bene
fits are cut up both

longitudinally and
transversely . For in
stance, a patron of the




House pays for the
use of a “ box " for

next winter and all
the benefits which go
with it. He owns
certain future benefits

from that Opera
House. He does not
own the whole Opera


House, yet he partly

Fig . 1.

owns it, because he

owns part of the uses
or benefits to be derived from it. The part he owns (the

benefits of the box for next winter) may be represented
by a small rectangle cut out of the entire stream of benefits

from the theater . When a promise is made and a man sells

this promise for presentmoney, he has cut out some part of
the benefits which in the future will emanate from his person

and his other wealth .
It is plain , then, that the succession of benefits emanating
from any article of wealth may be cut up longitudinally , or
transversely , or by cutting out a certain part.



In common speech, the minor rights to wealth are not or

dinarily dignified as rights of ownership . Thus, a tenant's
right in the dwelling he occupies is sharply distinguished from
the right of the owner . Yet , strictly speaking, every right
to use wealth , however insignificant, is a part ownership .
When an owner of land wishes to sell an unencumbered title,
he finds it necessary to extinguish all outstanding leases, or

claimsfor future benefits, often at considerable cost. It is
the total ownership which he professes to sell and the total

ownership always includes the ownership which the tenant

Applying the above rules there can be no difficulty in
discovering for each property right some underlying wealth
in conformity with the general principle that wealth and

property are coextensive.

$ 5. Practical Problems of Property
Since wealth and property are inseparable, economics
might be called the science ofproperty as well as the science
of wealth . When we treat of the welfare of a community,
we think rather of wealth than of property . When we

treat of the welfare of an individual, we think rather of
property than ofwealth .

The fact that wealth and property

are coextensive should be emphasized 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 legislatures understood this
principle , there would be less of the iniquitous double taxation
that is the bane of present systems of State and local taxa

tion . Such unjust taxation is illustrated by the case of the
Massachusetts factory owner who decided to transfer his

property to a stock company ofwhich he himself should hold
all the stock . Previously he paid taxes only on the factory

itself ; but when the company ” was formed , the tax collec
tor 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 is
taxable " personal property.” Thus the owner was taxed
both on the stock which represented the factory and on the

factory itself. Such instances of double taxation are quite
common in the United States though they are not all so
self-evident as this .

Many of themost important problems of economic policy

are problems of the form of ownership of wealth . The
great slavery question turned upon the problem whether one

man should be owned by another, or whether he should own
himself. It was partly a question whether one man could
steal another man away from Africa, and partly a question

whether any man could sell himself. Those questions have
been settled in the negative, and it is now regarded as bad
public policy for oneman to own another in fee simple . Yet
we do own partial rights in others . In fact it is very difficult

to find a man so free that someone hasnot a claim upon him .
These partial rights are, of course, very different in their
practical effects from perpetual ownership .

Another property problem , and one somewhat similar,

is that of perpetual franchises. Is it good public policy to
grant to a street railway company in perpetuity the rights
to use a city 's streets ? Or ought we to fix a time limit, say
fifty years, after which the rights revert to the city ?


kindred question has been raised by Henry George and
others 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 abusing that right, obstructing

others, and neglecting the opportunities which it affords?
Should the government step in and lease the land for limited


This question is now being discussed with ref

erence 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 ofmodern
England and Ireland .
The right to bequeath property is also a prime source of
trouble .

The right to dispose of property by will has not

always been recognized. It was developed by the Romans,
from whose system of law weborrowed it . Even now it is a

limited right, and its exercise differs with law and custom .
These differences are responsible, for instance, for peasant
proprietorship in France and primogeniture in England.

The right has, indeed , been limited so as to prevent the per
petual tying up of an estate by a testator. Its further
limitation will probably be one of the problems of the
An even broader question of the samesort is the question

of socialism . Shall we continue what is called private
property , except in the things that we wear and eat, and
possibly the houses in which we live? That is, shall we
allow our railways and our factories to be owned by private

individuals ? Or shall they be owned by the community
at large so that wemay 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 .

$ 6. 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: fee simple,
stocks, bonds, notes , leases, partnership rights, and con





Fee Simple



Dry Goods



Yielding crops Right to all use Deed
of farm for

Yielding profits One partner's Articles of
from sale
“ undivided " I agreement
one-third in


Joint Slock Railway
Street Fran Street

Yielding profits The shares of Stock

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


Right to run


Lease or Hire Dwelling

Use of same for Right of tenant Lease
for shelter, etc. till fixed date
Right of land
lord thereafter
Railway Ticket Railway
Transportation Right to speci- Ticket
fied trip
Payment of “ in - Right to same Bond certif
Railway Bond Railway
terest ” and and contin cate
“ principal ” | gent right to
Personal Note | All the posses- Payments
Right to same Note
and in de
sions of the
fault thereof ,


right to collat
eral security
General wealth Refraining from Rightto compel Charter
of community doing similar same
(persons in - business
Streets, public Uses of same Right to walk Official re
over and corded plats,
parks and
otherwise use old grants,


§ 1. Capital and Income
In the foregoing chapters we have set forth several funda

mental concepts of economic science , - wealth , property ,
benefits , price, and value. We have seen that wealth con

sists of material appropriated objects , and that property
consists of rights in these objects ; thatwealth in its broadest

sense includes human beings, and property in its broadest
sense includes all rights whatsoever ; that benefits are the
desirable occurrences which happen through wealth ; that

prices are the ratios of exchange between quantities of wealth ,
property, or benefits ; and that value is price multiplied by

quantity. These concepts are the chief tools needed in eco
nomic study.
Little has yet been said about the relation of these various

magnitudes to time — that great “ independent variable ”
of human experience. When we speak of a certain quantity

of wealth , wemay refer either ( 1) to a quantity existing at a
particular instantof time, or ( 2) to a quantity produced, con
sumed , exchanged , or transported during a particular period

of time. The first is a stock ofwealth ; the second is a flow of

wealth. A stock is fully specified by one magnitude only ,
namely , its amount. But a flow requires two , — the amount

ofwhat flows and the duration of its flow . From these two
we derive a third, namely , the rate of flow , or the quotientof
the number representing the amount divided by the number
representing the duration .

The rate of flow is often more

important than the amount of flow . We care less to know



the aggregate wages of a workman during his lifetime than
his rate of wages during various periods of his life . The

most important purpose of this distinction between a stock
and a flow is to differentiate between capital and income.

Capital is a stock, and incomea flow . This, however, is not
the only difference between capital and income.

There is

another, equally important; namely , that capital is wealth ,
and income is the benefit of wealth . Wehave, therefore, the
following definitions : A stock of wealth existing at a given

instant of time is called capital.

A flow of benefits through

a period of time is called income. Adwelling house now exist

ing is capital; the shelter or the rent it affords is its income.
The railways of the country are capital; their benefits (in
the form of transportation ) are the income they yield .

§ 2 . Senses of the Term “ Capital ”
We have defined capital as a quantity ofwealth 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 of rapid consumption . It would

disclose , not the annual procession of such goods, but the
members of that procession that had not yet been transmuted

in form or had not yet passed off the stage of existence, how
ever swiftly they might be moving across it.

It would show

trainloads of meat, eggs, and milk in transit, cargoes of

fish , spices, and sugar, as well as the contents of private
pantries , 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.
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.



Not only is a stock ofwealth called capital, but a stock of

property is also called capital. The two may be distin
guished as capital-wealth and capital-property . Again , the
value of either is called capital; and this third kind of capital
may be distinguished as capital-value.

A capital account is a statement of the amount and value

of the property 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 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 are all

his property rights, irrespective of his liabilities. The assets
include both the property which makes good the liabilities,

and the property, if any, in excess of the liabilities. They
also include, if exhaustively considered , the person of the

owner himself, if that owner is a real person and not an
artificial person, such as a corporation .
The owner may be either such a physical human being, or
it may be an abstract entity in which a collection of human
beings is interested , such as an association , a joint stock

company, a corporation, or 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 of
either individual is the net capital, or capital-balance indi

cated in the account of such individual.
The items in a capital account are constantly changing,
and their values also ; so that when , after one statement of

assets and liabilities is drawn up, and another is constructed ,
say a year later, the balancing item , or net capital,may have
changed considerably .

However, bookkeepers are accus

tomed to keep the “ capital ” item intact from the beginning
of their account, and to characterize any increase of it as

“ surplus ” or “ undivided profits.”

There are several

reasons for this bookkeeping policy. In the first place,








the less often the bookkeeper's entries are altered, the sim

pler the bookkeeping. Again , by stating separately the
original capital and its later increase, the books show at a
glance what the history of the company has been as to the
accumulations of capital. Finally, in the case of joint stock

companies, the capital is represented by stock certificates, the
engraved “ face value ” of which cannot conveniently be
altered to keep pace with changes in real value.


quently , it is customary for bookkeepers to maintain the
book value if the " capital” is equal to the face value of the
certificates. But this bookkeeping policy does not alter
the fact that at a given instant the owner's capital consists

of the entire excess of his assets over his liabilities, including
the accumulated surplus and undivided profits.
The following two balance sheets show the accumulation

of that part of capital which bookkeepers separate from the

capital account and call “ surplus."
JANUARY 1, 1910


Plant . . . . . . $ 200,000

Debts . . . . . $ 100,000
Capital (owed to the
stockholders) . . 100,000

$ 200,000

$ 200,000

JANUARY 1, 1911
Plant, etc . . . . . $ 246,324


. . . . . $ 100 ,000

Capital . . . . .
Surplus . . . . .

$ 246,324

100 ,000
46 ,324

$ 246,324

But not only is the book item , “ capital,” maintained in
tact as long as possible , but often the surplus also is put
in round numbers and kept at the same figure for several
successive reports. That is , the smaller fluctuations are



registered in a third item , called “ undivided profits.” The
distinction between surplus and undivided profits is thus
merely one of degree. The three items — capital, surplus,
and undivided profits — together make up the total present

net capital. Of this, “ capital ” represents the original
capital, “ 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, that is , to become divided profits, although this
may also happen to the surplus, or even in certain cases to the
capital itself.

Wesee ,then , that the capital of a company, firm ,or person,
is to be understood in two senses : first , as the item entered
by the bookkeeper under that head , — the original capital;

and secondly , this sum plus surplus and undivided profits,
the true net capital at the instant under consideration .

Inasmuch as the stock certificates were issued at the for

mation of the company, and cannot be perpetually changed ,
they ordinarily correspond to the original capital instead of

the present capital. Recapitalization may be effected , how
ever, by recalling the stock certificates and issuing new ones.

In this way the nominal or book value may be either de
creased or increased . It is sometimes scaled down because of
shrinking assets, and sometimes increased because of new

subscriptions or expanding assets. If, for instance, the
original capital was $ 100 ,000 , and the present capital (in

cluding the surplus and undivided profits) is $ 200,000 ,
it would be possible , in order that the total certificates out

standing might become $ 200 ,000 , and the surplus and un
divided profits be enrolled as capital, to issue stock certifi
cates free to each stockholder. Such an issue of stock is
called a stock dividend . Ordinarily , however, the stock

certificates remain as originally, and merely increase in

Thus, if the present capital is $ 200,000, whereas

the original capital and the outstanding certificates amount

to only $ 100 ,000, the “ market value ” of the shares will be








double the face value ; for the stockholders own a
total of $ 200 ,000 , represented by certificates whose “ face

value ” 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 discrepan
cies in the results . For instance, a national bank of New

York reported a total capital, surplus, and undivided
profits of $ 1,295,952.59, of which the original capital was

only $ 300,000 . We should expect, therefore, that the
stock certificates, amounting to $ 300 ,000 , would be worth

$ 1,295,952.59, or, in other words, that each $ 100 of stock
certificates would be worth $ 432.

however, was about $ 700 .

The actual selling price,

The discrepancy between $ 432

and $ 700 is due to the fact that there are two estimates of

the capitalized value of earning power , — one that of the
bookkeeper, which is seldom revised and usually conserva
tive, 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 undervalued the assets
of the bank , and even omitted some valuable assets alto

gether, such as “ good will.”

The object of a conservative

business man in keeping his books is not to obtain mathe

matical accuracy, but to make so conservative a valuation as
to be well within the market.
Of the two valuations of the capital of a company,

the bookkeeper 's and themarket's,the latter is apt to be the
truer of the two, although it must be remembered that each

of them is merely an appraisement. The ordinary book
keeper's figures , which have so imposing an appearance of
accuracy, are in reality, and often of necessity , very wide of
the mark .



$ 4. Case of Decreasing Capital-balance
Wehave 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 books will be as follows:


. . . . $ 200 ,000 .00

Miscellaneous .

101,256 .42


. . . . $ 150,000 .00

Capital . . . .

100,000 .00

Surplus . . . .

50,000 .00

Undivided profits

1 ,256.42

$ 301,256.42

$ 301,256.42


Plant . . . . . $ 160 ,000 .00
Miscellaneous . . 101,256 .42

Debts . . . . $ 150 ,000 .00
100 ,000 .00
Capital . . . .
Surplus . . . .
10 ,000 .00

Undivided profits
$ 261,256.42

$ 261,256.42

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 capitalitself 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 required by law in many cases,as in that of insurance

companies. Dishonest concerns, however , often conceal

their true condition by the reverse process of exaggerat
ing the value of the assets. Sometimes this is done system
atically, as in the case of stock - jobbing concerns. The

sums intrusted to unscrupulous promoters by confiding
stockholders are often invested in unwise or fraudulentways .

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, 000 purchases

land of friends at a fancy price, collusively providing that
the proceeds be returned in large part to the promoter. In
such a case the books of the bubble concern will show the

following figures :


Land . . . . . . $ 100 ,000

Debts . . . . . . $ 50 ,000

Capital . : : . : 50,000
$ 100,000

$ 100 ,000

But if the land is worth, say only $60,000, these accounts
should read :



. . . . . $ 60 ,000

Debts . . . . . . $ 50,000
Capital . . . . . 10,000



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

the promoter.
This is an example of what, in commercial slang, is called
“ stock watering," which may be defined as the issue of
stock without a corresponding increase in actual capital



value. It is sometimes said that there is no wrong in stock
watering, so long as it is fully known. This is much like
saying that to lie is not wrong provided everybody knows

you are lying. Stock watering usually represents an inten
tion 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 knowledge of the

proposed stock watering, and the bond buyer is injured if
the watering of the stock, having given him a false idea of
theactual 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 . In the course of its fluctuations it may some

times shrink to zero . If it shrinks below zero , we have
“ insolvency,” — the condition in which assets fall short of
liabilities. 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 the assets, and which
the merchant or company has agreed to keep intact at all

The fortunes of business will naturally cause the

whole volumeof assets to vary in value, but all this “ slack "
ought properly to be taken up or given out by the capital,
surplus, and undivided profits .

A man 's capital thus acts as

a buffer to keep the liabilities 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
ness reasonably safe will differ with circumstances. A
capital-balance equal to 5 per cent of the liabilities may ,

in one kind of business, such as the business of a mortgage



company, be perfectly adequate, whereas 50 per centmay be

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

wise , depends on the character of the liabilities.
The risk of insolvency is the chance that the assets may
shrink below the liabilities. 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 shipwreck .

A wise merchant, however ,will not only avoid insolvency ,
but also insufficiency of cash . He will not only keep his
assets 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 to cancel each claim at the time and in the

manner agreed upon .
From this pointof view there are three chief formsofassets ,
— already touched upon in Chapter 1, — cash assets, quick
assets , and slow assets. A cash asset is property 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, call loans, short-time loans, and

other marketable securities. 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 railway stock or bonds,

when he has contracted for payment in money, the debtor
must maneuver so as to keep on hand a sufficient quantity

of quick assets and of cash assets to enable him to meet his



obligations when they are due. A large part of the skill of a
business man consists in marshaling his assets so that he
always has enough cash , and quick assets to provide for im

pending debts, while maintaining at the same time enough
slow assets to insure a satisfactory 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 bankruptmay be discharged ,
free from further liability .

Since the liabilities of one man are also the assets of an
other, when one man fails and is able to pay only fifty cents

on the dollar, the unlucky man who is his creditor, — who
has his 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 somebig firm , involving a shrinkage in
the assets of others .

This indicates why assets oughtusually

to be undervalued . A man who is in debt has no right to

exaggerate his means of payment.

A conservative and

honest businessman will therefore always undervalue rather

than overvalue his assets, in order to be fair to his creditors.

$ 6 . Two Methods of combining Capital Accounts
We have seen how the capital account of each person in a
community is formed. We are, however, more interested

in the bookkeeping of society at large than in the book
keeping of the individuals composing it. Our next task ,

therefore, is to express the total capital of any community.
This is the sum of the capital of its members, that is , all the
assets less all the liabilities . There are two chief ways of
combining these plus and minus items in order to obtain the

total for society at large.


The simplest is to obtain first the net capital balance of

each person by subtracting the value of his liabilities from
that ofhis assets, and then to add these net capitals together,
as the capital of society . This is the method of balances.

We balance the books of each individual. But we may add
and subtract the items of assets and liabilities in many other

ways. One way which takes account of thenetwork ofdebts
and credits between individuals is to couple each liability

with its equal and opposite asset, existing in another indivi
dual's accountand cancel these twoagainst each other. This
is called themethod of couples. Wecouple itemsin different
accounts . This 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. It follows that every
negative term in one balance sheet may be canceled 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
persons, say X , Y , and Z :

Z 's note


. . . . $ 30 , 000 A

Residence . . . .
Railroad shares .

70 ,000
20 ,000
$ 120 ,000

Mortgage held by Y
(Capital balance

$ 50,000 b

70 ,000 )

$ 120,000



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

. . 20 ,000
. . 10,000

Debt to Z . . . . $40,000 C
(Capital balance . . 40,000 )





Y 's debt . . . $ 40,000 C

. .

. .

50 ,000

Railroad bonds ,


Debt to X

. . . $ 30,000 a

(Capital balance .

80 ,000 )

$ 110 ,000

$ 110 ,000

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. Themethod
of couples thus consists in omitting from society's balance
sheet these pairs of items, and entering only those which
remain uncanceled . These, in the present case, are all

The results of summing up the capital accounts by the
two methods are shown in the following tables : -


X ' s capital
Y 's capital

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

Z 's capital

. . .


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

. . . . . .


Railroad shares . . .
Railroad bonds . . .

30, 000
20 ,000


$ 190,000

$ 190,000

The totals are the same by both methods, but themethod
of balances shows the share of this total capital which is
owned by each individual, while themethod of couples shows

portions ascribable to each different capital-good .

§ 7. Real and Fictitious Persons
It is well to note here the distinction between the account
ing of real persons and of fictitiouspersons (such as corpora

tions). For a real person , 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 to be
regarded as a liability, but as a balance or difference be

tween the liabilities and the assets. For a fictitious person ,
on the other hand ( a corporation or partnership ), the lia

bilities are always exactly equal to the assets ; for the balanc
ing item called capital is as truly an obligation (from the

fictitious person to the real stockholders) as any of the other
liabilities. A fictitious person , in fact, is a mere bookkeep
ing dummy, holding certain assets and owing all of them out

again to real persons, including the stockholders. Book
keepers, it is true, apply the samemethods in both cases,
but they do so by regarding the account even of a real person

as relating to a fictitious entity for bookkeeping purposes.
For bookkeeping purposes, one's business self and one's

real self are separated . Thus, if X 'sbusiness shows a balance
in X 's favor of $ 10,000, he enters this as a liability item in

his business accounts and considers his “ business " as owing
him this sum . There is no objection to such a procedure.

But wemust remember that when we say that X 's “ busi
ness ” owes X $ 10,000 , we imply that the real X in his own
accounts holds a claim of that amount against his “ business.”
In other words, we are compelled , in order to be consistent,
to open a separate account for X as an individual, and carry
forward the $ 10 ,000 balance from the debit side of his busi
ness accounts to the credit side of his personal accounts ,
thus : -



Miscellaneous . . . $ 50 ,000

Due to others . . . $40,000
Due to X . . . . .

$ 50 ,000

Due from “ X 's busi
ness ”

. . . . .

$ 10,000


$ 50 ,000



But in the second account there is no counterbalancing lia
bility . For realpersons, then , in the last analysis, – that is,
as represented by “ X 's self,” — the value of assets and that
of liabilities are not equal. If they were, the addition of

their balance sheets would yield zero for society.
$ 8. Ultimate Result of Method of Couples
With this preliminary explanation , let us now introduce
into our addition the capital accounts of the railroad whose

stocks and bonds are 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:

Railway . . . .


$ 50,000

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

(held by X ) $20,000
(held by Y ) $ 10,000
$ 50,000

30 , 000

$ 50,000

Now if we combine this balance sheet with the preceding ,
we shall see that its inclusion does not affect the results
which were obtained by the method of balances 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 . . . . . . . .

Railroad Co.'s capital balance . . . .

$ 70 ,000
40 ,000

00 ,000
$ 190,000

When we apply the method of couples, however , we find
that the inclusion of the railway company's capital account



will affect the items in the final sum . The stocks and bonds,
as assets of X , Y , and Z , will now pair off with the corre
sponding liabilities of the railroad company, and their place

will be taken by the concrete railroad itself, as follows:
• • .
Personal effects . . . .
Farm . . . . . . .
Railway . . . . . .





$ 70, 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 merely use “ residence.”

The property no longer veils the wealth beneath it, and the
inventory , which before was called an inventory of property
capital, is now also an inventory ofwealth -capital.

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. These assets
which have no counterparts are what we have called complete
rights to wealth , or “ fees simple ” ; those assets which do

have counterparts are the partial rights to wealth . The
reason is that every article of concrete wealth is to be re
garded as owned in “ fee simple ” by some one, even if we
have to set up a fictitious person or dummy for that very

purpose. Hence, every part-right to such an article
of concrete wealth will necessarily appear as a liabil
ity on the opposite side of the fictitious person 's account.

Thus, if two brothers own a farm in equal shares, the shares
will appear as assets in the brothers’ individual accounts ; but



since the farm as a whole is regarded as owned by the partner
ship person called “ Smith Brothers,” the balance sheet of

this fictitious person will show as assets the farm itself,
and as liabilities the “ undivided half interest ” of each

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 formed 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, persons themselves,

and other possessions not ordinarily formally accounted for
in practice, – it is evident that we shall obtain, by the

method ofbalances, a complete accountof 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 , build
ings , and other land improvements, commodities, and real
persons. In other words, we arrive again at the proposition
of Chapter II, that wealth underlies and corresponds to
property .

$ 9. Confusions to be Avoided
Among part-right in real wealth is “ credit.” There has
been much discussion asto the nature of credit ; whether, in
particular, credit is to be regarded as capital. It has been

claimed that from the merchant's point of view credit is
capital because it enables a business man to enlarge his busi



ness. But this view entails double counting. Wehave seen
from our study of capital accounts how to avoid such double

counting. That part of a man 's so -called capital which is
borrowed cannot enter his books as his capital at all, being
but a manifestation of the fact that the total capital of the
community is owned in part by others. Indeed , the phenom

enon of credit means nothing more or less than a specific
form of divided ownership of wealth . Credit merely en
ables one man temporarily to control more wealth or prop

erty than he owns — that is, some part of the wealth or
property of others .
It is therefore a cardinal error to regard credit as in
creasing of the capital of the debtor. Indirectly , credit

may result in an increase of society's capital, by stimulating
tradeand production ,as well as by getting themanagement of
capital into the right hands and its ownership into themost

effective form . In these ways the earth is made to yield up
more wealth or greater benefits from the samewealth , - in
either case entailing an increase of “ capital,” — i.e. “ capital

wealth ” or “ capital-value” ; but the amount of any such
increase of capital thus indirectly produced bears no neces

sary relation to the amount of the creditwhich facilitated its
production . If capital is increased, the credit does not
constitute the increase, butmerely represents a part ownership
in the final total, after all the increments have been included .
A great dealof confusion in legislation and discussion could

be avoided if the twomethods of combining capital accounts
were distinguished and their interrelations recognized . In

taxation, the two methods are often confused. A chief
problem of efficient taxation is how to tax all property once,
and none of it more than once. There are two solutions:

One is to tax the amount owned by each real person in a list

which expresses themethod of balances; this method seeks
out the real owners or part-owners ofwealth . The other is to
tax the actual concrete wealth in a list which expresses the

method of couples; this method seeks out the real wealth


owned. At present the two aremuch 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 sufficiently included 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 observed, for where
one system is applied the other cannot also be applied with

out double taxation.





$ 1. Concepts of Income and Outgo
The income from any particular instrument has been de
fined as the flow of benefits from that instrument. These

benefits may sometimes consist of money payments ; but
it is important to avoid the mistaken notion that they con

sist always of money payments. Income is the flow of
whatever benefits accrue from any instrument, whether these
benefits happen to be in the form of money or not. A self

supporting farmer, for instance, may not receive or expend
a single dollar from one year's end to the other, yet he has

an income. He gets a living — the most important kind
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 hoisting

is its income. Human beings do work ; their work is an

of society 's income, as are all the operations of

industry and all the transactions of commerce. When axes
fell trees and sawmills turn them

into lumber, these

changes constitute the income flowing from the agencies
which produce them . When a manufacturing plant con

verts raw materials into food or into fabrics or into imple

ments, these changes constitute the gross income produced
by the plant. The warmth and shelter that a house pro
vides for its occupants go to make up the income furnished

by the house . What we call agriculture,mining, commerce,
and domestic operations are large and important classes of
income, yielded by similar agencies.



Income, being a flow of benefits, implies a stock or fund

of instruments which produces the flow . This stock of
instruments is what we have already designated as “ cap

It has already been noted that income differs from cap
ital in two respects. In the first place, it is a flow relating
to a stated period, whereas capital is a fund relating to a
given instant. In the second place, it consists of intangible )
benefits, whereas capital consists of (tangible ) instruments ;

not farms, therefore, nor houses , nor food , nor railroads, nor
artesian wells , nor goods of any sort can ever constitute

income. Income consists rather in the yielding of crops
by the farm ; the warming and sheltering of people by the

houses ; the nourishing of people by the food ; the trans

porting of passengers and freight by the railroads; the rais
ing of water by the wells; and benefits of any sort by goods
of any sort.

Although income consists partly of other benefits than
money receipts, all income, like all capital, may be trans

lated into terms of money. And to income as to capital

may be applied the concepts of price and value.
So much for gross income, the positive side of the income
account. But just as in our capital account we found a

negative side — comprising 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 of an instrument hasbeen already defined as the oppo
site of a benefit of an instrument. It is an undesirable event
occasioned by the instrument. Labor, trouble, expense, and
sacrifice of all sorts are entailed by wealth and are counted
among its costs.

An instrumentseldom confers benefits with

out 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, insuring it, and
paying taxes upon it.

A saddle horse yields income to the

owner when it gives him a pleasure ride, butit requires feeding


and stabling and shoeing, — thenegative side of the account,
constituting the outgo or flow of costs occasioned by thehorse.

A farm produces benefits in yielding crops ; but it requires
fertilizing, seed planting, and tilling, all of which are costs
occasioned by the farm . A railroad produces benefits called
transportation - hauling passengers and commodities ;but it

requires an expenditure ofmoney, it burns coal, it demands
labor ; and these are the outgo, or the negative side of its
Costs, too ,may bemeasured in money just as incomemay

be measured in money ; and some costs consist in the actual
expenditure of money, just as some benefits consist in the

receipt of money. Neither consists of actual money . We

must therefore distinguish carefully three money items:
money on hand at an instant of time, which is an example
of capital ; money received during a period of time, which is

an example of income (from whatever instrument is the
means of bringing the money in ) ; and money expended

during a period of time, which is an example of outgo ( on
the part of whatever instrument occasioned the expense.)
In general, the costs of a given item of capital are out

weighed by its benefits. For if it should yield more costs
than benefits, it would be thrown away, thereupon ceasing
to be wealth according to 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 are never voluntarily assumed except in the hope
of benefits which will make them worth while .

The total

gross income, i.e. the value of the benefits of wealth minus
the total outgo, i.e. the value of its costs , constitute net

income. Thus, just as net capital is found by subtracting

the liabilities 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, however, are attributable to a definite



capital source. In income-accounting the benefits or in

come-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 cap
ital 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 defini
tions to income accounts. Webegin by imagining a certain

“ house and lot ” as one composite instrument, and shall
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 incomemay be
measured in money, although in the case of occupancy by

the owner this measurement requires a special appraise
ment. The house , let us suppose, was built many years
ago , and is now nearly worn out. It yields an incomeworth

$ 1000 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 " :

Use of house and lot



Repairs . . . . . . $ 200
Taxes . . . . . . .
Insurance . . . . . .

$ 1000

$ 400

The net income is therefore $ 600 .

Next year the house is found to have rotten beams, 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 house .
Wehave, then, the following account :



Expense of building

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

house . . . . . $ 10,000
Taxes . . . . . .

Net outgo . . . . .

$ 10 , 100
$ 9, 500

During this year, then , the house causes a net outgo of
$ 9500. All costs are “ necessary evils ” ; they lead to good ,
though not good themselves ; and this cost of constructing

the house was incurred only for the sake of resulting future
benefits. The adverse balance it creates is only temporary
and will be more than made up in the years which follow .

For the year 1912 we have the following : INCOME AccounT FOR HOUSE AND LOT DURING YEAR 1912



. . . . . . . $ 1200

$ 1200

Repairs . . . . . . $ 50
Taxes . . . . . . . 150



Net income. . . . . $ 1000

These figures remain about the same for forty-nine years,
and give $ 49,000 net income during that time, canceling
the excess in cost for 1911 ($9500) and leaving a large mar
gin 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.

It will be observed that the cost ofreconstructing the house
was entered in the accounts in exactly the same way as re

pairs or other “ current ” costs. This procedure may seem

objectionable on the ground that reconstruction is not a part
of “ running expenses ” but of " capital cost," and should
therefore belong not to the income account but to the cap
italaccount. It is true that the value of the new house must
be entered on the capital-balance sheet, but the cost of pro

ducing it belongs properly to the income account. The
former relates to an instant of time (which may be any
instant from the timethe house is begun till the time when
it ceases to exist ) ; the latter 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) .
A house is quite distinct from the series of sacrifices by which

it was built, although the confusion between the two is
natural in view of the bookkeeping practice of entering cap
ital 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.
Yet we instinctively object to entering the cost of building

the house in its income-and-outgo account; and we express
this objection by calling this cost a “ capital cost," rather
than a part of running expenses . By so classing it wemean
that it does not recur, or, at any rate, recurs only at long

intervals. On this basis many persons hold that income
and outgo should be confined to “ regular ” items ; and this

mistaken view seems plausible because in actual practice
an extraordinary expense in a given year, like the cost of

constructing a house , does not usually reduce the owner's
net income for that year by that amount. Hewill generally

contrive to avoid such a result by offsetting this extraordi








nary expense of the house by a corresponding extraordinary
income from someother source, such as a depreciation fund,
and other sources to be mentioned later.

A depreciation

fund may have been created by setting aside annually
throughout the existence of the house a small deposit suffi
cient to rebuild the house when it is worn out. The great

outgo for rebuilding is offset by taking out an equally great
income from thedepreciation fund, and the total net income
from the “ house and lot ” and the depreciation fund com

bined reveals no radical variation .

The depreciation fund

equalizes the flow of net income from all the property which
the individual owns. But it does not prevent, it merely

offsets the large negative balance in the income account of
source , — the house and lot, - therefore, the net income is
evidently $ 1000 a year for each of the forty -nine years ,
and $9500 for the fiftieth year.

§ 3. Devices for making IncomeRegular
Disturbance of income due to building the house may be

avoided , not only by a depreciation fund, but by other
devices ; for instance, by paying for the house in install
ments ; by borrowing money to defray the cost, and mort

gaging the house ; or by selling other property . Another
method of steadying income — and one which ought to set
at rest any further doubt as to the propriety of the present
method of accounting - is employed by all accountants
when the same owner possesses so many of the articles in

question that the reconstruction of one or another of them
must occur at short intervals . 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 difference will be his net
income, which will be a fairly regular amount year after

Any large group of wealth involves the same principle.
Professor Clark of Columbia University 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 water
fall or fund remains about 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 , the

stock of cash . This will furnish an opportunity to illustrate
anew some of the principles of bookkeeping which we have

just discussed. What puzzles the novice in bookkeeping
is the manner of debiting and crediting a cash drawer. At

first this may seem to be the opposite of what should be

To understand the practice of accountants in this

particular is to go a long way toward understanding the
main principles of bookkeeping. It will help us to under
stand it ifwe liken a cash drawer to a gold mine. Wecredit
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 something into it. All the
payments which we have to make to the drawer are a costof
that drawer to us, whereas all the payments that we make
by the drawer are the benefits which it produces for us.

What net benefit, then , does the cash drawer yield in the



long run ? Very little. 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
accustomed to think of money receipts and expenditures,
not with reference to the stock of cash into or out ofwhich

they are paid , but with respect to someother item of wealth
on account of which the payments are made.

If a lodging

house keeper receives $ 10 from a lodger , she finds it hard

to debit $ 10 to “ cash . ”

She thinks of the $ 10 as income ;

and it is incomewith respect to her lodging house, for the

latter has yielded it to her . Her stock of cash, however ,
has not yielded it to her. On the contrary , it has taken it
from her . Later on it will yield it back , and at that time

should be credited .

The income from a man's property should be put down
in his income accounts separately for each item of capital

he owns, and opposite every such article of capital should
be put down a credit and debit. Not only should we include
both positive and negative income, but we should include

both positive and negative items of capital. The negative
items 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 per

son will not. Wehave seen , in the case of fictitious persons,
that there is no net capital because the liabilities always
equal the assets; for what is called the capital of a “ com

pany ” really means the capital of its stockholders. As


there is no net capital because the “ company ” owes it all
to the stockholders, so there is no net income, because the
“ company ” pays its all to the stockholders.

The following is an imaginary income account of a rail
road company :


By passenger and
freight service . $ 1, 246, 147

To operating expenses $800,000

To interest to bond

. .

100 ,000

. .

To dividends to stock

. . . .

200 ,000

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

treasury . . :
$ 1,246, 147



The passenger and freight service yields $ 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 of operating
expenses — $ 800,000 ; interest to bondholders , $ 100 ,000 ;

dividends to stockholders , $ 200,000 . The words by and to
are usual in income accounts. The receipts are benefits ,
and come by virtue of the services designated , and 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. Therefore the two sides
of the account balance, and there is no net income at all.

§ 5. Omissions and Errors in Practice
Practically , however, it is not convenient to put 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 put in
his own person , and yet in his income accounthe will put in

themoney he earns or the work that he does . That is, work
and wages are put in the income accounts , but the corre
sponding items which do this work or earn these wages are
not put in the capital accounts. The correspondence be
tween the two accounts is therefore covered up . On the

other hand , a man never 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.
Adam Smith , the great classical economist, fell into error

when he said that a dwelling yields no income,but is a source
of expense. Evidently he had in mind only those costs and

benefits which come in the form of money payments. We
certainly get no money benefits by living in our house, while
we do suffer a money cost to run it. So far as money re

ceipts 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. The absurdity of not count
ing the shelter of a house as income is particularly apparent
if we note that Adam Smith , like all other economists, in
cludes under income the rent or money income that the

owner gets from a house which is rented. They would


have said that a man who enjoys shelter gets no income, but
if he gets paid for the shelter enjoyed by another man , he

does get income. This results in 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 can furnish
a complete picture of income only when two conditions

exist ; namely , that all the income is in the form ofmoney ,
and all the outgo is for personal satisfaction . Under these

conditions the cash drawer and the cash account is a kind
of money meter of income.

These conditions are approxi

mately fulfilled when people live in a city and do not own
their own houses or furniture. Such people get practically

all of their income from their salaries, dividends, and inter
est,all in the form of money receipts. This money is spent
for benefits, food, clothing, theater going, etc . These
operations are essentially all. To be sure, the cash drawer

(or bank account) intervenes between the money-income
on the one hand — the receipts of salaries , dividends, and

interest — and the final form into which these are converted
by expenditure on the other hand ; but the bank or cash

drawer intervenes only as a cogwheel intervenes to transmit
motion from one part of a machine to another.

In strict

accounting , the bank or drawer should be debited with all
the money flowing into it from salaries , stocks, and bonds

and credited with the expenditures. But these opposite
sums approximately offset and so cancel each other .

The only method, then , of constructing income and outgo
accounts which shall be correct and which can serve as a
basis for economic analysis is the method already indicated

- the method by which are recorded , for each article of



capital, 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 enjoy
able to anybody ; sometimes they consist of merely pro
ductive operations, and sometimes of truly enjoyable
elements . All these elements should be entered in the

accounts on the same footing ; but we shall see that after

being thus entered they may be so combined that all except
the “ enjoyable " elements will cancel among themselves.


$ i. “ 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
society there are two ways, corresponding to the two ways
of reckoning society 's capital ; i.e. the method of balances

and themethod of couples. The method of balances is very
easy to understand. All that is necessary is to make up an
incomeaccount for any given period for each instrument or
each owner so as to include all possible income or outgo in

the society under consideration and, taking from each in
dividual account the net balance, add these net results to
gether. The result is the total income of society . Its con
stituent parts are the net incomes from each instrument or
owner in society .

The “ method of couples " is somewhatmore difficult to
follow . But it is also more important. Just as the same
item in capital accounts is both asset and liability , according
to the point of view , and is therefore self-canceling, so 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 should we call rebuilding 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 depends upon which of two accounts
we are considering. When a carpenter with his plane, ham

mer, 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 certainly perform a service or benefit, but the house
does not. Considered as occasioned by the house, the re

pairs are costs. The house absorbs or soaks up these costs,
promising to compensate 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 nec
essary 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 between two
instruments or groups of instruments.

An interaction , then , is a benefit or service of the acting
instrument, and a cost or disservice 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 by referring it to the desire of the owner. Since the
house owner desires that the house should not occasion re

pairs, these repairs are costs of the house ; and since the

tool owner desires that the tools should occasion repairs ,
such repairs are the benefits of 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 is credited with it as a

benefit and B is debited with it as a cost. These two items
of credit and debit are equal and simultaneous.
Interactions involving this mutual cancellation constitute
the great majority of the elements which enter into income

and outgo accounts.


The only benefits which are not

merely the positive side of such canceling interactions are
satisfactions — desirable conscious experiences — often mis

called “ consumption ” ; and the only costs which are not the
negative side of such canceling interactions are “ labor and

trouble.” 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. Between them is a
connective chain of repoductive processes and commercial
transactions, every link ofwhich hastwo sides, a positive side

of benefits or services and a negative side of costs, always
§ 2.

Interactions which change the Form or Position of

Wealth (Production and Transportation )
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 , transpor
tation , and transfer or exchange.

These we shall take up

in order, and show how each is an interaction, two-faced.
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 of wealth , or changes in its form , is meant the

changes of relative position of its parts. Weaving, for
instance, is the transformation of yarn into cloth by a re
arrangement in the relative position of the warp and woof.

Spinning, likewise, consists of moving, stretching, and
twisting fibers into yarn ; sewing, of 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-all manufacture and all agriculture — consist simply of a
series of transformations of wealth , each transformation








two-faced . On the part of the transformed instrument or
instruments the transformation is a cost ; on the part of the

transforming instrument or instruments it is a benefit. 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, or when a loom produces cloth out of yarn ,
or when land renders a service in producing wheat.

The principle is not altered when the interaction consists
not in producing a change but in preventing one. A ware

house renders its service asmeans 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 thepart of thewarehouse it is an item of income.
Nor is the principle altered when there are, as is indeed
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 costdebited to the land
on the one hand, and at the same time a service credited to

the group of capital 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 thebread and credited to the cook ,
the range, the flour, and the fuel, of which the last two are
consumed as soon as they perform their services. Agents

which disappear in the transformation , but reappear in whole

or in part in the product, are called “ raw materials.” The
production of cloth from yarn is a transformation effected
by meansnot 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
as cost this consumption of raw material — yarn ; and



this consumption of yarn, on the part of the yarn itself, is
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 products, always outgo and
not income.

In this way,when an article passes through various stages
of production , the designation of these stages is often an ar

bitrary matter. A " sapling " grows into a “ tree” . We
may, if we choose, consider the sapling as one category and
the tree as another.

In this case the “ sapling ” yields a

benefit the moment it becomes a " tree " ; but no effect on
social income is produced , because, if we credit the sap

ling with the value of the tree, we must debit the tree
with the cost of the sapling. Likewise we may arbitrarily
designate the moment when a “ calf ” becomes a “ cow ,"
or when “ new " wine becomes “ old ,” without disturbing the
income amounts of society ; for such events are always two
faced and cancel themselves out in the total. Wemay, in
fact,mark any stage whatever in the course of production by
an arbitrary line, and regard the passage across this line as

a service on the part of the capital on one side of the line —
the earlier side — and a cost on the part of the capital on the
other side.

A closely related class of interactions is transportation, or
changes in the position of wealth . It is a very slight dis
tinction which separates this class from the preceding class .
Transforming or producing wealth consists of changing the

position of its parts as related to each other ; transporting
wealth consists of 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 organ

ized library is to make a whole out of parts. The distinction
between transformation and transportation is thus merely
one of convenience. Many writers prefer to include them

both under “ production.” Weprefer to includethem under
the less ambiguous and more inclusive head of “ interac

tions,” and our objecthere is not to emphasize their difference

but their similarity . The same principle of equal and oppo
site services applies to both. The following are examples of
transportation : When merchandise is transmitted from one
warehouse to another , the first warehouse is credited with

the change and the second debited . The warehouse 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 in his cash drawer

will, if he keeps separate accounts for the two, credit the
vault and debit the till. When wheat is imported from

Canada, that nation is credited, and the United States is
debited, with the value of the wheat. As in the case of
continuous productive processes, so in the case of continuous

transportations, we may divide up transportation districts

by arbitrary lines, and consider the passage of any articles
across those lines as interactions.
§ 3. 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.
Transfers usually occur in pairs , and involve two objects

transferred in opposite directionsbetween two owners.


double transfer we have called an exchange. Since an ex
change 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 cannot of itself contribute


anything to the total income of society. When, for instance,
a bookseller sells a book , he credits his stock with the fact
that it has brought in money, and the customer debits his

library to the same amount.

These two items constitute the transfer between the stock
of books of the dealer and the stock ofbooks of the customer.
The remaining two items constitute a transfer between the

stocks of cash of the twomen ; the dealer debits his “ cash ”
and the customer credits his.
When , therefore , an article of wealth changes hands,

whether it be money or something else, it occasions an ele
ment of income to the seller and an element of outgo to the

purchaser, and therefore no income at all to society.


effect of canceling these items -- the credit item of the seller

and the debit item of the purchaser - is to free the income
account of that article from all entanglements with exchange,

to wipe out all money-income, and to leave exposed to view
the “ natural ” incomeof the 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 pre

paratory service ,a credit item to the book dealer and a debit
item to thebuyer. 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 ; and to him 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 .

The 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. This shelter alone remains as the income from
the house after the rent transaction is canceled out between

the two parties concerned . The shelter-income is the es
sential and abiding item , and without it there could be no
rent- income to the landlord .








Again , 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 railway
simply as a money maker ; but to the shippers and passen
gers this same money is an expense , and exactly offsets the
railway's money earnings. Of the three items — money-in
comeof the road , money-outgo of its patrons, and transpor

tation — the first two mutually cancel and leave only the
third , transportation , as the real contribution of the railway
to the sum total of income.
Wesee, then , that themethod of couples , applied to buyer
and seller, denudes all capital of its so -called “ money -in
come,” and lays bare the only income it can naturally pro
duce. We see that capital is not a money -making machine,

but that its income to society is simply its services of

production, transportation , and gratification. The income
from the farm is the yielding of its crops ; from the mine,
the production of its ore ; from the factory, its transforma

tion of raw into finished products ; from commercial capital,

its passage of goods from producer to consumer; from
articles in consumers' hands, their enjoyment or so-called
“ consumption."

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. For manufacturers,
merchants , and other business men , almost every outgo is an

expense, i.e. consists of a money payment. 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 othermanufacturer ; the rent
is received by the landlord ; the interest charges by the



$ 4. Accounts illustrative of so -called Production
Not only do exchange transactions completely cancel

themselves out in reckoning total income, 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 trans
portations 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 outgo side of the social
balance sheet.

In order to show the effect of canceling out the equal
and opposite items entering into every interaction through
out all productive processes, let us observe the various
stages of production which begin with the forest above re
ferred to . The product of the forest, its gross income, is the
series of events called the turning out of logs. This log pro
duction 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 they next pass . As the sawmill turns its logs into
lumber , the lumber yard is debited with the production of
lumber , and the sawmill is credited with its share in this

transformation. Intermediate categories may, of course,
be created , and wemay follow , in like manner, the further
transformation , transportation , and exchange to the end of
the stages of production , — or rather , to the ends ; for these

stages split up and form several streams flowing in differ
ent directions. To follow only one 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 converts the cloth into suits for his cus
tomers ; and his customers receive and wear those suits .

In this series , all the intermediate services cancel out in
“ couples " and leave as the only uncanceled element, or







final fringe of services, the use of clothes in the consumers ' ,

Should we stop our accounts, however, at earlier points
in the series, the uncanceled fringe atwhich we should find
ourselves would be not consumers' services, but the positive
side of some intermediate service or interaction whose nega

tive side would not appear, as it would belong to a later stage
in the series.

These facts 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 :


Production of logs . . . . $50,000


The gross income from the logging camp, considered by
itself, and without any deductions for expenses, is here seen
to consist in the production of $ 50,000 worth of logs. If,
however ,we combine the logging camp with the sawmill,we
shall have accounts like the following, in which , to avoid

irrelevant complications, no account is taken of any expenses
which do not happen to be interactions between the groups

of capital considered :



Logging camp . . . Yielding logs to saw
mill . . . $ 50 ,000
Sawmill . . . . . Yielding lumber to

Receiving logs from

lumber yard $60,000 camp . . $ 50,000
In this case , canceling the two log items, we have left only

the lumber item ; i.e. the income from the combined logging



camp and sawmill consists only of the production of lumber,
its 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 in another,
- a fact which would be particularly evident in case the

logging camp and sawmill were combined under the same

Extending the same principles to the entire series, we
have the accounts as given in the table on the next page.

In this table we may successively cancel each pair of items
constituting an interaction . An item on the left is the posi
tive side of an interaction of which the item on the right in
the line next below is the negative side.

Thus, 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 lines next below , respectively . If we stop after the
first two cancellations, using only the first three lines of the

table , we shall find that the net income from logging camp,
sawmill, and lumber yard consists only of the production of
retail lumber, $ 70 ,000 ; it does not include either the trans

fer of logs or the transfer of wholesale lumber. In like
manner, if we proceed one stage further , that is, if we stop
our cancellations at the end of the first four 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 actualaccounts 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 negative side of interactions ; and if we were to intro

duce their respective mates, the opposite aspects of the same
transactions respectively, it would be necessary to include

the accounts of still other instruments. If weshould 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 apply .

§ 5. Preliminary Results of combining these Income
The table given will throw light on the question : Of what
does income consist ? This question is not a thoroughly defi
nite one. But if we ask instead : Of what does the income

from a particular group of capital consist ? we shall make the
question definite. Whether the production of logs is in
come or not depends upon the point of view . It is income
from the first link of capital in our series (the logging camp) ;
it is not income from the first two links combined, for in the
second link it occurs as outgo. 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

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 disap
pears by being joined to the next partof the economic fabric,
and another still more remote fringe appears . The question
then arises : When is the economic fabric complete, and has

it any final outer fringe?

But the answer to this question

must be postponed .
Contrasting the method of couples with the method of
balances,wemay 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 ex
hibiting the amount of income contributed from each capital
source. The two methods, as applied to the example just

given, are as follows:






$ 50 ,000

Logging camp . . . . . $ 50 ,000

Sawmill . . . . . . . 60,000
Lumber yard . . . . .

70 ,000

Warehouse . . . . . .

80 ,000

Stock of cloth in warehouse 90,000
Stock of cloth of tailor . . 100,000
Stock of clothes ofcustomers 110,000

$ 50,000
70 ,000
90 ,000


10 ,000
10 ,000
10 ,000
10 ,000

10 ,000
10 ,000
$ 110,000



$ 50,000

70 ,000
80 ,000

$ 50,000
70 ,000

100 ,000

100 ,000


90 ,000

The two methods — balances and couples — show the
same result, but from different points of view . By means
of themethod of balances we are enabled to see what part of
the final net income is contributed by each of the articles in
the group. By means of the method of couples, we are en
abled to see of what the net incomefrom the entire group of
articles consists ; canceling by the oblique lines ,we have left
but one item , $ 110,000, representing the “ wear ” of thesuits.
The two methodsmust not be confused . When we find

by the method of couples that the net income of $ 110 ,000
consists exclusively of the use of suits of clothes , this does

not by anymeans imply that this net income is all of it due



to the stock of clothes. To discover to what it is due re
coursemust be had to the method of balances . We then see

that only $ 10,000 of it is due to the stock of clothes, the re

mainder being due to the other capital instruments in the
table , which made the clothes possible, and most of all
( $50,000 ) to the logging camp. Combining the results of
both methods, we may state that the total net income from
the specific group of instruments consists of $ 110,000 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 . Wehave , as already noted ,omitted for the sake of

simplicity all itemsof costwhich 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 interaction .
The two methods correspond in a general way to the two
methods for canceling liabilities and assets in capital ac

The method of balances gave, it will be remem

bered , the amount of capital belonging to each individual ;
the method of couples showed of what elements the total

capital consists.
$ 6 . 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 following scheme, which shows 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 opposite.


Seller . . . . . .

+ $ 2

- $2


- $ 2

+ $2

. . . . .

The two transfers into which any exchange may be re

solved are represented by the two columns of the table. But
an exchange may also be resolved into two pairs of items

represented by the two horizontal lines of the table . The
items in the same horizontal line record the part taken in the
exchange by one of the two persons participating in it.
Every exchange, then , consists of four items, and may be

resolved either into two transfers (one for each property
exchanged ) or into two transactions (one for each party to
the exchange). The first resolution has been considered ;
we proceed now to the second .

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 paired

are represented by the same letters, the capitals being used
for positive items and the small letters for negative.



Stock of goods ByGoods sold $ 10,000 A To goodsbought $ 5,000 b
Cash . . . . By cash taken out for: To cash received from

Purchases $ 5,000 B

sales . . . $ 10 ,000 a

Profits . $ 2,000 C
Capital Stock

To profits paid $ 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. For simplicity,
it is 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 “ capital stock,"

which is a liability item . 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 that each item is entered

twice, once on each side.

This “ double entry " is a nec

essary feature of the income accounts of fictitious persons,
and has long been observed in practical accounting. It fol

lows that the doubly entered items may be mutually can
celed , A cancels with a ; that is, though the stock of goods
are credited with bringing in $ 10 ,000 ( A ) in cash, the cash
drawer must be debited with the $ 10 ,000 (a ) which it swal
lows up . Likewise the stock of goods costs $ 5000 (6 ), which

must therefore be debited to it ; but the cash drawer has to
supply the $ 5000 , and is therefore credited with 5000 ( B ) ,

so that item B cancels with b . Finally, when the profits are
paid , they also come out of the cash drawer, and the cash

drawer is 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 items cancel each other in pairs .

The two sides of the account of such a fictitious person nec
essarily balance. Even if the company accumulates its

profit instead of paying it to the shareholders, the two sides
still balance ; for, as has been seen , the money thus received
is then debited to the cash account.


$ 7. 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 ofdouble
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, which are much simplified , we have
indicated the like items on opposite sides by like letters, the
positive itemsbeing represented by capitals and the negative

by small letters. We observe that,as in the corporation




Stocksand bondsReceipt of money from
Money expended
stocks and bonds $ 2000 A for stocks and
bonds . $ 500 d
Lease right ,

Shelter . . . . $ 100 (B] Money rent paid



$ 100 e

Food . . . . Use of food . . . $ 150 (C]Money cost of
food . . $ 150 ſ

“ Cash " . . . Paid out ior bonds $ 500 D Receipt ofmoney
from stocks and
bonds . $ 2000 a
Paid out for rent . $ 100 E Receipt of money
for work done
. . .

Paid out for food . $ 150 F
Self . . . . . Receipt ofmoney for work

. . . . $ 2000 G

Uncanceled items : Shelter( B ]. . $ 100
Use of food (C) $ 150

$ 2000 g



accounts, many of the items will “ pair.” But, unlike cor
poration accounts, the present accounts contain a residue of
items which will not pair .

The letters representing these

unpaired items are designated 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 in
come which does not appear elsewhere as outgo .

When studying the accounts of instruments, 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
of outer fringe in studying the accounts of persons, provided

they are real persons. This outer fringe consists of the final
benefits of their instruments.

All other items are merely

interactions preparatory to such final benefits , and pass

from one category of capital to another. Thus the income
from investments, being deposited in bank , is outgo with
respect to the bank account; the bank account yields in
come by paying for stocks and bonds, food , etc., but in each
case the same item enters as outgo with respect to these or

other categories of capital.

In all these cases the individual

receives no incomewhich is not at the same time outgo . It

is only as he consumes the food , wears the clothes, or uses
the furniture, that he receives income. And these final
benefits are, of course, the end and goal of all the preceding

economic processes and activities.
$ 8. Final Enjoyable Income
The stage at which we have just left incomemay be called

the stage of final objective services .

In other words, it is

the stage at which the wealth of the objective world at last

acts upon the physical person of the recipient. This final

objective incomeis that ofwhich the economist is usually in
search , and is that which the ordinary statistics of working
men's expenditures represent. It is clear from whathas been



said , that in the finalnet income which we derive from wealth
all interactions between different articles of wealth drop
out, — all the transformations of production , such as the

operations of mining, agriculture, and industry, all the
operations of transportation , and all business transactions

or exchanges. 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 itemswhich survive are the final personal uses of
wealth . Let us call these the last benefits outside ourselves .
Examples of such benefits are benefits of nourishment, bene

fits of housing and warming, benefits of clothing, benefits of
personal attendance.
But the economist, in his analysis, must not stop here —
outside ourselves . There is one step more before the pro
cess is complete. Indeed , no benefits outside ourselves

are of significance to us except as they lead to satisfactions,
and these can only exist within our minds.
Now these final benefits come to our minds through our
bodies . No agent outside the body can yield them . All

that persons or things outside of man can do is to stimulate
his bodily organism . What are called benefits of amuse
ment or instruction cannot amuse or instruct the mind save

through bodily agencies. An “ instructive book ," for in
stance, is powerless to instruct. It can render its benefit

simply and solely by reflecting light into the eye of the
reader . It is necessary that these stimuli on the optic nerve

should be transmitted through the nervous system and
brain before any mental instruction takes place. So a piano

can of itself produce no sensations of tone. It merely pro

duces vibrations outside ourselves which , through the ear and
auditory nerve, ultimately result in sensations within us.
All sound, sight, taste, smell, touch , come about through

reactions of the nervous system to stimuli. We must ,
therefore , to make our accounts complete and final, include
the debits and credits of our own persons. When we do so,



we immediately see that, just as the credits of the logging
camp are the debits to the sawmill, so the credits of our outer
possessions are really the debits of our bodies . A man who
receives a Turkish bath must credit the bath to the water,
towels, attendants, and other coöperating agencies by which

he gets it, buthe must debit his body with the bath as one of
the costs his body occasions him . The bath is simply an
interaction , between the towels , etc., and his body. Like
all interactions, their purpose is that later theremay be ex

perienced pleasant sensations or the avoidance of unpleasant

ones, in this case the exhilaration and enjoyment of good
health . Similarly , the use of clothing and shelter leads ul

timately to the prevention of the sensation of cold , but their
immediate service is simply to hinder the dissipation of heat

from the body. They are costs of the body, just as the care
and protection of a horse are costs of the horse .
Likewise medicine is a cost to the body. Its services are

(or are supposed to be) the repairing of the body, and,
although credited to the medicine, should be debited to the
body, just as the services of a carpenter are credited to him
butdebited to the house which he mends. The “ consump

tion ,” or use of food , though it is a service of the food , is a

disservice of the body ; for food stands in the same relation
to the body as fuel to a furnace or repairs to a house . The
final income consists of the subjective satisfaction of the
appetite and the other satisfactions which the taking of

food enables the body to yield to the mind. These include
not simply the immediate gratification of the palate ,but the
promotion of pleasant sensations or the avoidance of un
pleasant ones later on . In other words, the consumption
of food , by preserving health and maintaining life , enables

the body to yield better and longer-continued service to the
mind in future years, just as the repairs on a house enable it

to yield shelter a long time after the repairs are made.
These and other illustrations will show that, if we include
the body as a transforming instrument,while wemust credit


with their respective services all these outside agencies, such
as food, clothing, dwellings, furniture , ornaments, and other
articles which , as it were, bombard a man 's sensory system ,

we must at the same timedebit the body with these same
items. The benefits or services of food , clothing, houses,
still lie outside ourselves. But when they come to be
actually used to satisfy wants , they are translated, as it
were, into subjective benefits ; i.e. into something inside

the human mind. After this point, income can be expressed

only in terms of human consciousness, having passed the
threshold of the outside, objective world .
The only surviving credit items, after these equal debits
and credits are canceled , are the resulting final satisfactions

in the mind. In other words, in order that the external
world should become effective to man, the human body
must be considered to be the last transforming instrument.

Just as there is a gradual transformation of services through
the farm , flour mill, and bakery , so is there a final trans

formation within thehuman body itself. It is a sort of fac
tory, the products of which are the only final uncanceled

income of the consumer. In a complete view of productive
processes, the human machine is no more to be left out of
consideration than machines which handle the wheat in its

prior stages.
All objective income is then entirely erased or negatived
as soon as we apply our accounting to the body of the recip

ient. The benefits of which that income consists empty
out, as it were, into the human body, but the ultimate result

is not actually felt until it appears in the stream of con
Final income, then , is simply the stream of consciousness

of any human being. All his conscious life, from his birth
to his death , constitutes his subjective income. Sensa

tions, thoughts, feelings, volitions — in fact, all mental
events -- are a part of this income stream . All conscious ex

periences which are desirable are positive items of income;


they are final benefits. All which are undesirable are nega
tive items; they are costs.
When we say that mental satisfactions are the goal of all

economic processes, we mean that they are the object at

which men aim . In the deeper economy of theuniverse
these satisfactionsmay, in turn, be the beginning of more
important chains of events. But economic analysis ends
with the motives which actually sway men 's actions, not
with ultimate consequences of their acts. The satisfaction
of the desire for food should lead to the preservation of the

individual, but it may lead to the impairment of his health .
The satisfaction of the sexual appetite should lead to the
preservation of the race, but it may lead to its degradation .
Nature , or natural selection , seems to have implanted many

appetites merely as baits to serve ulterior purposes. But to
the individual the satisfaction of these appetites may be the
farthest end he individually has in view . Whatever is the
ultimate end in view for the satisfaction of the individual's

desires is then “ final ” only so far as our present analysis
is concerned .

Wehave now reached a convenient place in which to em
phasize 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 themethod of couples, that every item
of cost outside ourselves 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 income to the miller. To society as a whole it is
not cost nor benefit, but a mere interaction . Similarly of
wages ; the employer counts his pay roll as cost of produc

tion , but the laborer counts it as earnings. To society as a
whole , wages are neither cost nor benefit.

In the last analysis payments of wages, interest, rent, or
any other payments from onemember of society to another

' must not be thought of as costs to society as a whole. This







fact should now be clear; yet it is commonly overlooked .
When people talk of the cost of producing coal or wheat,
they usually think of money payments .

The only ultimate

item of cost is labor cost, or if the term “ labor " be not suf
ficiently broad, labor, anxiety, trouble, annoyance, and all
the other mental experiences of an undesirable nature which

are undergone in order that mental experiences of an agree
able nature may be secured. Perhaps the best term to com

prise the undesirable feelings undergone for the sake of gain
ing desirable feelings later on is the term “ efforts."


conclude, therefore, that in the last analysis income consists
of satisfactions and outgo of efforts to secure satisfactions.
Between efforts and satisfactions may intervene innumer
able interactions, but they all must cancel out in the end.

They are merely the machinery connecting the efforts and
satisfactions. At bottom , economics treats simply of ef
forts and satisfactions.

This is evident of an isolated

individual like Robinson Crusoe, who handles no money ;
but it is equally true of themost highly organized society,
though obscured by the fact that each member of such a
society talks and thinks in terms of money.




§ 1.

The Link between Capital and Income

We have now learned what capital and income are and
how each is measured . Wehave 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 -in
come, but that it consists simply of the 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 themethod 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 owner or to a
particular instrument. Themethod 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, and that, as to income, every interaction is at
once a benefit and a cost.

We observed that the method of couples, fully carried
out, reveals wherein capital and income ultimately consist.



This method , applied to capital, gradually obliterates all
partial rights , such as stocks and bonds, and exposes to
view the concrete capital-wealth of a community .


same method applied to income obliterates the “ interac

tions ” such as money payments between persons, and ex
poses to view an uncanceled outer fringe of benefits and
costs . If themethod is continued further, it leaves simply

the final benefits of the wealth outside of ourselves poured ,
so to speak, into the human organism ; while, if themethod
be pushed to the utmost limits, so as to include this organ

ism itself within the accounts considered , it leaves simply the
pleasant and unpleasant experiences ofhuman consciousness ,

the satisfactions and the efforts of life.
We have seen that capital and income are in many re

spects analogous, and are strictly correlative; that all
capital yields income and that all income flows from capital
- at least when the term “ capital ” is used in its broadest

sense, which includes 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 pass from capital to in
comeor from income to capital? The bridge or link between
them is the rate of interest.

The rate of interest is the ratio

between incomeand capital, both the income and the capital
being expressed in money value. More specifically, the rate
of interest is the ratio found by dividing the rate of flow of a
uniform perpetual stream of income measured in terms of
money by the capital which such a stream is worth also measured

in terms of money. Business men sometimes call the rate of
interest the “ price of capital ” or the “ price of ready
money.” Suppose , for instance, that any capital worth

$ 10 ,000 to-day will secure a perpetual annual incomeworth
$400 per year; then the rate of interest is said to be 4 per

It will be observed that the preceding definition of inter
est involves the idea of perpetual income. Another defini




tion may be found without involving that idea. The rate

of interest may be defined as the premium on money in
hand at one date in terms ofmoney to be in hand one year

later . Present and future money never exchange at par.
One hundred dollars to-day is always worth more than
$ 100 due oneyear hence. If, then , $ 100 to -day will exchange

for $ 104 one year hence, the premium — or rate of interest is 4 per cent. That is , the price of to-day 's money in next
year's money is 4 per cent above par ; for 104 / 100 exceeds

100 / 100 by 4 / 100.
We have, then, two definitions of the rate of interest ,

viz . “ the price of capital in terms of income ” and “ the
premium on present money over money due one year

But the two definitions are quite consistent, and either
may be converted into the other. The rates of interest in
the two senses are, in fact, equal, unless one of them be sup
posed to change from year to year. For instance, if a man

borrows $ 100 to-day and agrees to pay it back in one year
with interest at 4 per cent, wemay conceive of him as selling
a perpetual income of $ 4 a year for $ 100 — that is , giving

4 per cent interest in the “ price " sense — 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 — that is , an exchange at 4 per cent interest

in the “ premium " sense. Hereafter, therefore, we shall

not attempt to distinguish between the two definitions of
the rate of interest.

Bymeans of the rate of interest we can evidently trans
late, as it were, presentmoney value into equivalent future

money value, or future money value into its equivalent pres
ent money value.

Thus, if we know that the rate of inter

est is 4 per cent,we can find how much $ 1000 to-day is worth
next year or the year after and also how much $ 1000 due
next year or the year after is worth to -day. To translate



any present value into next year's value, wemultiply by the
factor 1.04 ; to translate any next year's value into this
year's value, we divide by this factor 1.04. This operation
is what we learned in our school arithmetics as “ discount

ing.” The rate of interest is thus a link between 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 , is a species of
price , but a very different species from any prices mentioned
in previous chapters. We have seen that the price ofwheat

enabled us to translate any given number of bushels of wheat
into so many dollars' worth of wheat, and the prices of
other goods , to translate, in like manner, their respective
quantities into their money equivalents. Any price thus
serves as a bridge or link between the quantity of any good
and its value.

By means of prices we could convert a miscellaneous
assortment 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 pass from one time to another . By means, how
ever, of that unique price called the rate of interest, we may
convert the money values found for one time into their eqiu

valent at another time. The rate of interest is thus the

hitherto missing link necessary for reckoningmoney equiva
lence universally .
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 just as we have taken other

prices ready-made. In the preceding chapters we have
seen how to form capital accounts and income accounts by

assuming the prices necessary in each case to turn quanti
ties into money values. We are now ready to show the rela



tions between these two sets of accounts by assuming a rate
of interest 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 all wealth is money.

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 ofmoney invested ,
and from it I get $ 500 of money each year as interest,"
implying a rate of interest of 5 per cent, he will be forced to
admit that he hasn 't really got $ 10,000 of money at all, and

perhaps even that the $ 500 of money interest which he says

he gets each year isnot at first in money form . Hemay then
attempt to correct his statement by substituting the follow
ing : “ I have put my $ 10,000 of money into a farm ,and each

year I get $500 by selling the crops.”

This form of state

ment brings to light two other things than money, viz . a
farm and its crops. But even this form is in error, for it

still seems to imply that there is somewhere some money
($ 10,000) in the farm , and that thismoney in the farm yields
some other money ($ 500 ) each year.

The true form


statement is simply that the man has a farm which yields
crops, and that both of these are worth , or their value may

be measured in terms of, money, the farm being worth

$ 10 ,000 and the crop $500. Money need not enter at all
except as a matter of bookkeeping. Hence, if we are care
ful, we will avoid thinking and speaking of a fund of $ 10,000

producing an interest of $ 500, but will instead think and
speak of actual capital, such as farms, factories, railways, or

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



the interest from $ 10,000 worth of capital is $500 worth of
benefits, the interest is this $ 500 worth of benefits, but the

rate of interest is 5 per cent. Interest and the rate of inter
est are as distinct as value and price and in the sameway.

The rate of interest, then , is a sort of universal timeprice
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 or present 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 ofproblems 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
this is true.

Income in its original state is derived from

capital in its original state. But the value of income is not

derived from the value of capital. On the contrary, the value
of the capital is derived from the value of the income.


not until we know how much income an item of capital will

bring us can we set any valuation on that capital at all.
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 two bits of data : (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

With these data he may derive the value of any capital
from the value of its incomeby means of the connecting link
between them called the rate of interest. This derivation

of capital-value from income-value is called “ capitalizing,”
or, more generally, “ discounting,” income.

$ 3.

The Discount Curve

Let us assume that the expected income is foreknown with
certainty, and that the rate of interest is also known. With

these provisos,when we know the incomethat will be yielded
by any article of wealth or item of property , 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 in
come accrues continuously or discontinuously ; whether it
is uniform or fluctuating ; whether the installments of it are

few or infinite in number.
We begin by considering the simplest case, namely, that
in which the future income consists of a single item accruing

at a definite instant of 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 $ 104, the present value of this

right, if the rate of interest is 4 per cent,will be $ 100. Or if,
by virtue of the property, he is to receive a benefit worth $ 1

one year hence, its present value (interest being at 4 per
cent) is found, as we have seen , by dividing the $ 1 by the
factor 1 .04.

Theresult is $ 1 / 1.04 or $ 0 .962; if the value to

which the right entitles the owner is any other amount than
$ 1, its present value is simply that other amount divided







by 1.04. Thus the present value of $ 432 due in one year
is $ 432 / 1.04, which is $ 415.38.
Conversely, $ 1 to-day is the present value of $ 1.04 a

year hence ; and $ 1.04 a year hence will then be the present
value of $ 1.082 two years hence. This is by compound
interest. The $ 1 .04 due at the end of the first year, when
multiplied by the factor 1.04, gives $ 1.082 as its equivalent
at the end of the second year. The $ 1.082 is therefore the

equivalent of, and is called the " amount ” of $ 1 at the end
of two years , just as $ 1.04 is the “ amount ” of $ 1 in one
year. Thus $ 1 in the hand to-day is worth $ 1 .082 in the

bush two years hence and, since the sameratio applies to all
other sums, if weknow the value ofany sum two years hence,

but not its present value,wemay find the latter by simple
proportion . Thus let $ 1 be the future value two years hence
of a present unknown sum x .

Then we have the following

proportion : as this presentsum x is to its future amount $ 1,
so is the present sum $ 1 to its future amount $ 1.082.


the proportion,we find that x is $.924 ,which therefore is the
present value of $ 1 due two years hence . The same prin
ciples apply to three ormore years.
Wemay illustrate this process by a diagram ,much in the

sameway as geography is illustrated by a map. In Figure 2
is a curve, A , A ', A ” , A '" , etc. The latitudes of these points,
or their vertical distances above the base line, represent the
values of capital as determined at given instants of time,

and the longitudes or horizontal distances between them
represent the intervals of time between those instants.
Thus, let the point B represent the present instant, and let
the longitude interval, BB' represent a year. Using the

same intervals for successive years,we have AB representing
any present capital, say $ 1, A ' B ' representing its equiva
lent next year, say $ 1.04, A " B " , the equivalent two years
hence, and so on. We see that A ' B ' is what we have called

the “ amount ” of AB put out at interest for one year, and
A " B " is the “ amount ” of the same, compounded for two




years. Conversely, AB represents the present value or
discounted value of any one altitude on the curve, say
A ' B ', as well as of any other such as A " B " or A ' B '" .
The latitude ofany point on the curve may thus be regarded

either 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 BB "" is any length of time, say i
years, we may either say that A " B " is the future



FIG . 2.

" amount ” of the present AB, or that the present A B is the

“ present value ” of the future sum , A " B " ). The line


not only ascends but at an accelerating rate — i.e . it

does not ascend in a straight line, but gradually bends up
ward , forming a curve which in economics is called the

“ discount curve.” This curve, if prolonged to the left,
will, of course, never reach the bottom line. It keeps
becoming flatter and flatter so that its distance above the
line can never become zero .
Curves sometimes puzzle beginners, but they are very im
portant in economics, and make 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.



The discount curve is a tool by which we can interpret
the relations between incomeand capital.
§ 4. Application to valuing 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 always 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
construction , is the present value of what it will bring when

completed, 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 its probable price when finished and
sold, less the discounted value of the costs of construction

and selling which still remain. 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 Liver

pool is worth the discounted value of what it will fetch in
Liverpool, less the discounted value of the cost of carrying

it there. Other classical examples are wine, the value of
which is the presentworth of what it will be when “ mellow "
and ready for consumption ; and young forests, which are
worth the discounted value of the lumber they will ulti
mately 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 incomeby discount curves in exactly the sameway




that we can treat one such item . This fact is shown in
Figure 3. Suppose that a represents the present point of
time, and A the point of timein the future at which the last

benefit occurs. The diagram refers to any instrument of

capital, such as a house, or any property right, such as a
bond. In either case the capital every season yields so many

dollars' worth of benefits or income. This income is repre
sented by the short, heavy vertical lines drawn on the verti

cals . In the particular case here represented we have three

The capital yields about the same amount during

each year of the first stage of four years. After that the



FIG . 3.

yearly income is greater during a second period of five years;
during the third and last period, of six years, it is still
greater. The first period of income is represented by short,
heavy vertical lines drawn upward from the base ; the second
by lines slightly longer, and the third by lines still longer.
We thus have a series of fifteen heavy verticals represent

ing the successive items of income for fifteen years. Our
problem is, on the basis of this series of fifteen lines repre
senting income, to construct a curve representing the value of
the capital. This curve is AO , and must be constructed
backward from A to O . The value of this house or bond
just before it is worn out or paid up is evidently about equal



to the value of the income, then about to be had from the
capital, represented by the last vertical, AB, to the right.

A year earlier than this the capital will be worth the dis
counted value of AB as represented in the height f C of the

discount curve (drawn backward one year from

B ).


is the value just after the item of income fx has been detached .

Its value just before fx was detached was, of course, greater
by fx . This greater value is fD , the difference, CD, being
equal to the benefit fx . Proceeding another year back ,
the value of the capital just after the income at that time is
taken out, is e E , and just before that income is taken out, it is
eF. In this way we may proceed backward year by year.

Each tooth in this broken curve will have a height equal to
the value of the benefits of the capital in the year at the be
ginning of which it stands. We thus construct a broken
line or “ curve,” beginning at the farthest future point and
working backward to the present. This curve represents
the value of the capital at the various points of time prior
to its wearing out. This curve goes up and down. It goes
down suddenly, whenever a benefit is detached , and it goes

up gradually, while remaining future benefits are anticipated
and approaching .

In this curve we have a picture of the history of the value
of the capital it illustrates. Weformed this curvebackward .
But now that it is formed , let us follow it forward . It be
gins with O , rises gradually until the first of its periodic

benefits is realized , such as receiving a rent payment, a
crop , or a coupon . When , let us say, a coupon is cut, the

curve falls by the amount of that coupon . Each coupon
cut off is represented by the heavy vertical line at thebase ;

the fall in the value of the capital, being exactly equal, is
represented by the tooth immediately over said heavy

vertical line. During the ensuing year the capital value

gradually climbs up as the next coupon cutting approaches ,
when it again falls by the amountof that coupon ; and so on ,

always rising up in virtue of anticipation of future income



and falling after each realization . Finally , when the last
coupon is taken out, the value of the capital vanishes alto

gether. The value of the capital fluctuates then , by a
series of teeth .

$ 5 . Valuing a Bond
Let us now apply these principles to the special case of
valuing an ordinary bond, entitling the holder to a series
of equal items of income and also to a larger single sum at

the end. A so -called “ 5 per cent, ten-year, $ 100 bond ”
means the right to receive an annuity of $ 5 a year for ten
years, and in addition , $ 100 at the end of the ten years,
called the “ principal.”

If the rate of interest is 5 per cent, and a man buys
· a bond which entitles him to an annual income of $ 5 a year
for ten years and $ 100 returnable at the end ofthis period, it

is evident that the purchase price of the bond must be $ 100
or “ par.” In this case the $ 5 of annual income is the
interest on the purchase price, and the sum of $ 100 which is
to be received at maturity is equal to the sum originally

invested. Such a bond is called a 5 per cent bond, the an
nual installments of income are called “ interest,” and the
final payment of $ 100 is called “ principal.”

The value of a bond may, of course ,be obtained by means
of discount curves on precisely the same principles as were
explained in relation to Figure 3.

The only difference is in

the size of the various installments of income represented
by the original dark verticals from which the remainder
of the diagram is derived. Figure 4 represents the value
history of a ten -year 5 per cent bond when the rate of in
terest is 5 per cent.

We see that, at the beginning, the value of the bond is
$ 100 or par (represented by AB) ; and that it gradually in
creases in value to $ 105 ( A ' B ') at the end of the year, when

it suddenly falls again to $ 100 (A " B ') in consequence of
the detachment of the first installment of $ 5. During the



next year it repeats the same cycle, and so on for each year
until the ten years are up ,when its value disappears to zero

with the payment of the principal.
But often the bond is not sold at par. If the bond is

sold above par, say at $ 108, the rate of interest realized by
the investor is not 5 per cent at all, but only 4 per cent.




15 15 15 15


15 15


15 _ 15 _ 5

FIG . 4 .

In this case the bond is only nominally a “ 5 per centbond.”
The true rate of interest is that rate of interest which , if
used for discounting all the benefits — the 10 annual items

of $ 5 each and the final item of $ 100 — will give the value
at which the bond was actually bought, above or below par,
as the case may be. Let this true rate of interest be 4 per
cent. The 5 per cent bond is then said to be sold on a 4


per cent basis.



The investor does not make 5 per cent, as

he would , had he bought the bond at $ 100 , but makes only
4 per cent because he bought at $ 108 .
This capital-value ($ 108) of a so -called 5 per cent bond,

sold or valued on a 4 per cent basis, is obtained by reckon





Par Value

15 15




15 15



15 15s

FIG . 5.

, ing at 4 per cent the present values of the ten payments of
$ 5 each and the present value of the final payment of $ 100,
and adding these all together .
In Figure 5 the upper line shows the value-history of the
5 per cent bond sold on a 4 per centbasis, beginning with $ 108
and, after the usual series of gradual rises and sudden falls,
reaching par at the end of ten years and then dropping to


The difference between this curve and that in Figure



4 consists in the fact that the discount curves are all less
steep in the upper curve of Figure 5 than the discount curves

in Figure 4, and is due to the fact that the rate of interest is
now supposed to be only 4 per cent instead of 5 per cent. If
interest is 6 per cent,we shall have the lower of the two curves

in Figure 5 , made up of discountcurves, steeper than those of
Figure 4 . This curve shows that the bond then begins at
$ 93 , reaching $ 100 or par in the ten years, and then drops to

It is worth noting that the final $ 105, although $ 100 of
it is called “ principal,” is really just as truly income from
the bond as all the items called “ interest." The original
investment is the real discounted value of all the expected
receipts; the final “ returned ” principal is simply a part of

the largest of those receipts. The only difference between
this receipt and the other smaller ones is that usually it

is employed differently when received. It is usually “ rein
vested,” that is, exchanged for other long-time securities ,
whereas the smaller items of income, the so -called “ interest,”
are usually “ spent,” i.e. exchanged for articles of shorter
duration, and thereby soon converted into true “ final
income ” or satisfactions. The “ principal ” and “ inter

est,” therefore, while both are income with reference to the
bond considered by itself, are apt to lead to different results
when followed into the final transformations of purchase
and sale which ensue. The principal, though income from
the bond , is outgo for the new investment. The owner is

thus virtually in possession of a perpetual series of payments
of $ 5 a year. It is with a view to such an operation that the
final payment of $ 100 on a bond is instinctively regarded as
on a different footing from the other payments called “ in

terest .”

It is called “ principal," on the theory that it is

to be reinvested in order to continue the perpetual income
of $ 5 . In theory , therefore, it represents capital, whereas
the other payments represent only income. Butwe see now
that both are income received from the bond as a source of



income, although either may, by reinvestment, be put into
capital. That one of them is usually put back into capital,

and the other not, is a matter of subsequent history, and
does not affect the study of the present value of the bond

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. They are also used for solving the con
verse problem , viz . for finding the true rate of interest

“ realized ” when a bond is bought at a given price. The

following is an abridgment of these tables , for (so -called)

3 per cent, 4 per cent, and 5 per cent bonds. The prices of
the bonds in all cases are the prices immediately after an
installment of income.



| 10

20 | 30


I 20


2 .0







4 .5



3 1 5




I 20




2. 9

3 .5


3. 9


3 .9


4 .0
4 .1

4 .2
4 .5

0 .1







I 20




6 .6
7 .7

6.5 | 6.3




§ 6. Capital-value when Alternative Income Streams are
Thus far we have considered the possibility of but one
income stream from any given capital. But it often happens
that, from the same instrument, there is a choice between

several different income streams. Land may be used for
grazing, agriculture , building, or recreation. Tools may be

employed in a variety of ways, and the same is true of in
numerable articles of wealth , particularly when taken in
combination . What, then , determines the value of the

capital? It is obviously not the sum of the discounted
values of the different income streams, but the discounted
value of that one which is chosen in preference to all the
others . What, then , determines the choice of the series of
uses to which any given instrument may be put ? Evi

dently that particular series of uses will be selected which
yields themaximum present value. Thus, if land used for
grazing purposes will yield a net service of $ 1000 a year
forever, and interest is taken at 4 per cent, its value for
grazing purposes is evidently $ 25,000. If, in like manner,
the capital-value for some other use, say, for growing wheat,
is $ 20 ,000, it is clear that the land will be employed for

grazing rather than for growing wheat, and will derive its
value from the grazing use and not from thewheat use.
We conclude, therefore, that the value of any capital
good , either of wealth or of property rights, assuming that

all future income is foreknown, is the discounted value of
the income chosen .
$ 7 . Effect of changing the Rate of Interest
If the rate of interest is changed , the value of all capital
will be changed in the opposite direction .

The amount of

change, however, will be very different with different ar



ticles of capital. Thus, let us suppose five typical articles
as given in the following table : —



$ 1000 per yr. forever


$ 1000 per yr. for 50


$ 100 per yr. for 6 yr.
$ 20 ist yr.; $10 ad

Suit of

Loaf of


(INT. AT 5 % ) (INT. AT 24 % )

Infinite $ 20,000.00 | $ 40,000.00

. . . . . $50,000.00 18,300.00
508 .00


30 .00



. 10

. 10


1 yr. . . . . . .

$ 36 . 50 per yr., for i

· · · · ·

If the value of the benefits derivable from these various
articles continues the same, but the rate of interest is

suddenly cut down from 5 per cent to 24 per cent, there will
result a general increase in the capital-values, but a very

different increase for different articles. Themore enduring
ones will be affected the most . These effects are seen in
the last column 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 60 per cent, i.e. from $ 18 ,300 to $ 28,400 ; the

value of the horse will rise only 10 per cent, i.e . 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 10 cents . Wesee in these five types
of articles that the sensitiveness of capital-value to a
change in the rate of interest is the greater, the more endur
ing the income.


§ 1. Realized and Standard Income

We have seen how the value of capital is derived from
that of income. Wehave also seen that the value of capital
rises in anticipation of incomeand falls with its realization ,

and that the alternate rise and fall may or may not be equal.
If the income taken out is just equal to the appreciation of
the capital, the capital is thereby restored to its original
value. If more than this amount of income be taken

out, the capital will be impaired ; if less, the capital will

When the income taken out is such that the capital left
is neither impaired nor increased , that income is called
standard income, because it affords a convenient standard
with which to compare other incomes. Thus, $ 50 a year is
the standard income from capital worth $ 1000 when the rate
of interest is 5 per cent ; for, since such a capital will in

crease or appreciate $ 50 in the course of a year, and since

just the amount of this appreciation is taken out, the capital
will be left at the beginning of the next year at just the figure
of the year before, $ 1000 . The standard income on any
capital is the interest on that capital ; that is , it is the in

come which will keep the capital value intact.
But the owner of a capital of $ 1000 may take from it each
year either more or less than the standard amount, $ 50 .

The $ 1000 merely means the present value, discounted at
5 per cent, of some income stream ; but this income stream

may take any one of an indefinite number of forms. It may



take the standard form of a perpetual annual incomeof $ 50
a year ; but it may also take the form of an incomewhich is
twice the standard , or $ 100 a year for 14 years , and which
then ceases altogether ; for the discounted value of these
14 sums is $ 1000 . Or it may take the form of an income

which is half the standard , or $ 25 a year for the first 10
years, is then $ 167. 50 a year for 10 years, and which then

ceases ; for , discounted at 5 per cent, this income also will
give a capital of $ 1000 .
There are, then , two kinds of income: first, the so -called
standard income, just described ; second , “ realized ” in
come. Realized income is whatever income is actually

realized – that is, detached from the capital — in any given
case. Standard incomeand realized incomemay, of course,
sometimes be equal.

Of all possible forms of income, then, we take the per
petuity as the standard and compare the others with it . For

instance, the possessor of a property yielding $ 100 a year for
14 years knowsthat he might sell this property for $ 1000 and
reinvest in another property yielding the standard $ 50 a
year forever. Contrasting this standard income of $50 a
year forever which he might receive, with the income of
$ 100 a year for 14 years which he does receive, he finds that

his income exceeds the standard income, so long as it lasts,
by $ 50 a year.

This excess of $ 50 each year involves, how

ever, a reduction of $ 50 each year in the capital-value of
his property.

At the end of the first year the value of his

property will be the discounted value of $ 100 a year for

thirteen (instead of fourteen ) years,which , if interest is still
reckoned at 5 per cent, is $ 950.
The principle is perfectly general, and may be summarized
as follows: ( 1) When a property yields a specified foreknown
income, and is valued by discounting that income according

to a specified rate of interest, if the realized income is equal
to the standard income,the value of the capital will remain
at a uniform level. (2) If realized income exceeds standard



income, the value of the capital will be decreased by the
amount of the excess. (3 ) If realized income is less than

standard income, the value of the capital will be increased
by the deficiency.

Expressed in a single sentence , the general principle
connecting realized and standard income is that they differ
by the appreciation or depreciation of capital. It is thus

possible to describe standard income as realized income
less depreciation of capital, or else as realized income

plus appreciation of capital.
§ 2.


In order that these important relations may be as clear
and vivid as possible , we shall illustrate them

graphically ,

by concrete examples , and by business accounting.

In Figure 3 we saw that the value of the capital at first
increased each year, then remained stationary, and finally
decreased . During the first period, therefore, the realized
income was less than the standard income; during the second

period it was equal, and during the third greater. Let us
look closely at a typical year in each period. During the
first year the capital-value first ascended gradually from
O to N and then dropped suddenly to M . Its whole ascent,

or the appreciation of the capital,was the difference in level
of these two points or wN . Had this amount been de

tached at the end of the year, the capital would have been
broughtback to its original level and the income would have

been standard. But the diagram shows that only NM was
actually taken out. In other words, the realized income
(NM ) was less than the standard income ( Nw ) by an amount
(Mw) which represents the net increase, appreciation , or

savings of capital-value. During the second year, likewise ,
less income is taken out than the year's total increase in

capital-value, leaving a net increase of capital-value. After
a few years, however, the situation changes. From L



the curve rises to K by an amount KJ, and the coupon
cut out (KJ) is in this case just equal to the appreciation ;
that is, the realized income is equal to the standard income,
and capital is restored to its value at the beginning of the
year. In the third case the curve goes up from I to H ,
appreciating by the amount Hz, but the income HG taken
out is in this case greater. The realized income exceeds the
standard, and capital is impaired by the difference (G2).

To illustrate by concrete examples the distinction between

standard and realized income, we use the following six
typical cases.

Forest land




|(INT. AT 5 %



$1000 a yr. for 14
yrs. and then
$3000 a yr. for
ever . . . . $40,000.00

$2000 .00

Farm land

$ 1000 per yr. for
ever . . . . $ 20,000.00



$1000 per yr. for
50 yrs.

. . .

$ 100 per yr. for 6
yrs . . . . .
Suit of clothes $ 20 ist yr.; $ 10


2d yr. . . . .





Loaf of bread $36.50 per yr. for
i day · · · ·


36 ,500

1. The forest land yields $ 1000 the first year on a capital
value of $40,000, from which,on the 5 per centbasis assumed,
the standard incomewould be 5 per cent of$ 40,000 or $ 2000 .

Consequently, the realized income ($ 1000) is less than the
standard income ($ 2000) by $ 1000. Therefore the forest
will appreciate in the year by the excess, $ 2000 – $ 1000 or
$ 1000, and will be worth $ 41,000 at the end of the year. It

will continue to appreciate for 14 years, after which it will be



worth $60, 000, after which its realized income ($ 3000 ) will
be equal to the standard income.

2. The farm land yielding $ 1000 a year in perpetuity is
worth $20,000, and continues to be worth that amount each
succeeding year.

The realized income of $ 1000 is always

the standard income from $ 20,000 .

3 . The house yields a realized incomeof $ 1000 on a capital

value the first year of only $ 18 ,300 . The standard income
from $ 18, 300 would be only 5 per cent of 18 ,300 or $ 915 .
The consequence is an excess of realized over standard in
come of $ 1000 – $ 915 or $85, and a corresponding fall of
$85 in the value of the capital. That is, the house depre
ciates 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 50 years.
4 . The horse also depreciates, and very fast.

Its owner

realized from the horse an income of $ 100 on a capital- value
of $ 508 , from which the standard income would be only
$ 25.40 . The difference between the realized and standard

income is $ 100 - $ 25.40 or $ 74.60, and the horse will lose
that much in value in the year.
5 . The suit of clothes yields an income the first year of
$ 20 on a capital of $ 28 , from which the standard incomewould
be only $ 1.40 . It therefore depreciates by the difference,

$ 20 – 1.40 or $ 18.60 .
6 . The loaf of bread yields for one day only at the rate of
$ 36 .50 a yearor 10 cents a day on a capital-value of 10 cents, the
standard income of which amounts to practically zero.

Consequently , the loaf depreciates in a day by the difference
between 10 cents and zero or 10 cents ; that is, loses its value
entirely .

In all cases the standard incomeis 5 per cent of the capital
value, while the realized incomemay be a higher or a lower
percentage. Expressed in percentages, the actual rate of
value return (i.e. ratio of realized income to capital) on the
forest land is 2. 5 per cent ; on the farm land, 5 per cent ;



house, 5.4 per cent ; horse, 19.6 per cent ; clothes, 71.4 per
cent ; and bread , 36 ,500 per cent.

The more rapidly the

income is taken out the greater the rate of value return

realized, but (if that rate exceeds 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; the clothes
yield a rate over 14 times the rate of interest, but last only

2 years, while the bread yields a rate almost inconceivably
great, but lasts only a day. 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 (so long as the realized
rate of value return remains less than the rate of interest)

also increases in value.
The various cases supposed may also be illustrated by the

dividendsdeclared by a joint stock company. If a company
declares dividends of 5 per cent (on the true value of its

capital reckoned on a 5 per cent basis), these dividends will
be standard incomeof the capital because they will leave it
intact. If the dividends are less than 5 per cent, capitalwill

be accumulated ; i.e. a “ surplus " will be added to the

original capital. If the dividends are greater than 5 per
cent, the capital or surplus previously 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 with intention to

deceive as to the ability to pay dividends. It is, however ,
not always of such a character. Someland-selling companies

in the West distribute dividends far above the standard,

every one understanding that, by the nature of the business,
the assets are to diminish with each sale . The same is
true to some extent of mining companies. The dividends
are big , but they are not supposed to keep on forever.

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 .
We have already seen that every item in an income
account represents the income or outgo from some item


the capital account. That is, the income account consists
merely in a statement of the income and outgo from each

item of asset or liability, including that class of assets and
liabilities which are alike claims and obligations, such as

leases and employees' contracts. If the income for each
item remains steady or standard , the relation between the
capital and income accounts is very simple.

In such a case

( supposing the rate of interest to be 5 per cent), eachitem in
the capitalaccount will constantly stand at twenty times the
amount of the corresponding item in the income account.
Rightly interpreted , the capital account merely represents
as a whole the capitalization of expected items in the income
account; and the fluctuations of the capital account corre

spond with the deviations from the standard income in the
items of the income account.

$ 3. Confusions to be Avoided
With all the preceding explanations and illustrations the
distinction between realized and standard income should
be clear. Standard income is the incomewhich ought to be
taken out in order to maintain capital intact, neither im

paired nor increased. Realized income is the income which
really is taken out. The one income is only an ideal, the
other, real. The realized is equal to the actual drop in the
curve of Figure 3 ; the standard is what that drop would need

to be in order to equal the previous gradual rise.
Of these two concepts, realized income is by far the more
fundamental. Everything else grows out of realized income



— the value of the capital and therefore the value of the
interest upon that capital, which is the standard income, as
we have seen. We cannot, as would at first seem possible,
begin with capital-value and derive the actual income from

it ; nor can we begin with standard income, for standard
income presupposes somecapital-value for which it is stand
ard . That is, standard income depends on capital-value,
and capital-value depends on realized income. The order of
dependence then is realized income, capital-value, standard

income. All three of these concepts must be carefully
distinguished .

It is not uncommon to confuse them .


illustrative table 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.
Bread has practically thesame 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

10 cents which is the value of the use of the bread , and which
is, therefore, income, and the 10 cents which is the value of

the bread itself, and which is , therefore, capital. There is
almost as much danger of such confusion in the case of
clothing ; for there is only a slight difference between the
$ 30 which is the value of the use of the suit, and is therefore
income, and the $ 28 which is the value of the suit , and is

therefore capital. As we pass to the more enduring articles,
there emerges so wide a difference between the value of the
use of an instrument and the value of the instrument itself,
that there is no difficulty in distinguishing between them .

But if the distinction is valid in one case , 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 shel

ter is worth $ 1000 a year for 50 years (or $ 50,000 in all),
whereas the house itself is the discounted value of all

this $ 50,000, or $ 18,300. We should find no greater diffi
culty in distinguishing between the use of the clothes



and the clothes nor between the use of the bread and the

The more rapidly any capital yields up its benefits , i.e .

the greater the rate at which its realized income is taken out,
themore the danger of confusing the capital with the income

it yields.
Again , the confusion between realized and standard income
is fostered by the very effort of bookkeepers to make the two
identical. To do so may be said to be thebookkeeper's ideal.

Wehave shown the tendency to confuse three concepts, —
standard income, realized income, and capital-value. We

have also dealt with a fourth concept, which must not be
confused with the other three, viz . savings. Savings in its
broadest sense includes more than simply saved money.
It includes all the net increase in capital-value after all in
come has been detached . It is the net appreciation or the
difference (Mw in Figure 3 ) between the total appreciation

of capital or standard income (Nw ) and the realized income
(MN) . Savings are therefore still a part of capital.


are the part of capital saved from being taken out for income.

They are not a part of realized income. The individual is
always struggling between saving more capital and realizing
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 when , and only when , money is drawn out

of it. It occasions outgo when , and only when ,money is
put into it.

If the depositor merely lets his deposit accu

mulate , he derives no income and suffers no outgo. There
is no effect on income.

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, wemust, to be consistent, also accept
the fiction that he redeposits it and so cancels the receipt.
If the teller hands over the interest across the counter, the



depositor's account certainly yields up “ income” to him ,
but if he hands it back , the account occasions “ outgo , ”
and the net result is simply a cancellation . This procedure
reveals clearly the fact that the accumulation is not income.

We have seen that net appreciation or savings are not
income, but additions to capital. Likewise, net deprecia
tion or “ wear and tear ” are not outgo, but subtractions from

capital. Almost every article except land ultimately de
preciates in value owing to the fact that the services left

for it to render gradually diminish in number and value.
The approaching cessation of services may be due to physi

cal wear, 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 never
theless last only a limited period . On the Atlantic coast
the fishermen sometimes construct temporary platforms
which are pretty sure to disappear in the September gales.
It is evident that without any physical deterioration the

value of such property must nevertheless decrease rapidly
as the end of the fishing season approaches . In like manner
the “ World 's Fair " buildings at St. Louis depreciated ,

during the brief period of the fair, from $ 15 ,000,000, which
was first paid for their construction , to $ 386 ,000, for which

they were sold after they had served the purpose for which
they were built. 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 meta

phorical sense. Even when there is actual physical dete

rioration, this deterioration acts upon the value only in so
far as it decreases or terminates the flow of income, and not

simply because of a physical change in the capital which
bears the income.

There are then four concepts which wemust keep distinct,
viz : -

Realized income.

Capital-value (the discounted value of expected realized
income) .



Standard income (the interest on capital-value) .
Savings ( the deficiency of realized compared with standard

income) ; and its opposite , “ wear and tear ” (the excess of
realized compared with standard income) .
These are given in the order of dependence on realized

$ 4 . Standardizing Income

Various devices have been made to make realized income
standard , or, as we may express it, to standardize income.

The method of the depreciation fund has already been men
tioned under income accounts . By it, an irregular income

is converted into a regular 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 $ 1000 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 depre
ciation of his house. This, in the first year, is $ 85, aswe have
seen . At the end of 50 years his depreciation fund is large

enough to rebuild the house. Although the house by itself
does not yield him a standard income ($ 915), but $ 1000 a

year for 50 years, yet the house and the depreciation fund
taken together yield him the standard $915 in perpetuity ,
or as long as he keeps up the system .
In this way, any instrument may be made to yield a
standard income, not by itself, but conjointly with a depre

ciation fund. The latter is often forgotten. Only by ac
tually paying into this fund can realized income be stand

ardized . Merely to reckon what the depreciation is will
not make the income standard . Reckoning depreciation is
as poor a substitute for providing a fund to meet deprecia
tion as Beau Brummel' s keeping a dinner hour was a sub

stitute for a dinner . Of course, depreciation payments
only standardize or change the time-shape of one man 's



income at the expense of some other man 's income. That
is , every addition 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 and pay back $ 18,300 at
the end of 50 years.

To society as a whole such purely shifting devices are
inapplicable, for society can find no outside party on whom

to shift the fluctuations. There is, however, a method by
which society 's income may be more or less standardized ;
namely, by assorting and combining the various instruments

of capital wealth so that the various income streamsmay
be mutually compensatory. For instance, suppose a com

munity owns an iron mine and a young forest. In the iron
mine it has a form of property which for a time probably
yields more than the standard income. Every bucketful of
ore reduces the amount which theminecan yield in the future.
After it is exhausted , there will be no further returns. The
capital-value of the mine will therefore continue to depre
ciate. On the other hand, the forest land, which is covered

with young saplings, will not begin to yield much income

for many years. The income from this capital is therefore
temporarily below the standard . A community which
owns both mine and timber land will consequently find that

the increase and decrease will tend to offset each other, so

that its income will be more nearly standard than if it
merely possessed either one without the other.
The last-named method may sometimes be applied even
to a case of private enterprise ; for instance, in the case of
capital which consists of a large number of instruments at
different stages of production or consumption . If a weaving

mill is equipped with 20 loomsof the samedegree ofwear, the

value of this plant will evidently diminish, and a deprecia
tion fund may be necessary . But if the 20 looms are evenly
distributed throughout the different stages of wear, and if
we assume that one loom wears out each year, no deprecia



tion 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 constant level.
$ 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 discounted is only imperfectly foreknown. The
capital-value is the discounted value of the future expected

income, with all the risks of loss or chances of gain included

in present 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 factory which

was taken for illustration was supposed to yield definite
future income which could be counted upon , precisely as
interest on a bond may be counted on by the bondholder.
But, as every enterprise offers chances both of gain and loss,
we cannot close our discussion of capitalizing income with

out some account of how these chances affect thematter .
It has been explained that capital-value increases with
the approach of an anticipated installment of income, and
diminishes as that installment is reached and passed . These
changes in capital-value take place when the future income

is regarded as certain . The introduction of the element of
chance will bring other and even more important changes in

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 detachment of
income. Few , if any, future events are entirely free from

uncertainty. In fact, property, by its very definition , is
simply the right to the chance of future benefits. A mine



owner takes his chances as to what themine 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 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 serviceable. Even what are
called “ gilt -edged ” securities are not entirely free from risk .

Strictly speaking, therefore, every owner of property is a
risk taker.
$ 6. Five Methods of avoiding Risk
Business men try not only to estimate the risks which they
must encounter and to adjust their accounts accordingly ,
but they also endeavor to avoid these risks so far as possible,
viz.: –

(a ) By increasing guaranties for the performance of

(6 ) By increasing safeguards against incurring losses .

(c) By increasing foresight and thereby diminishing the
(d ) By insurance, that is, by consolidating risks.

(e) By throwing risks into the hands of a special class
of speculators.
These will be considered in order.
(a ) The Method of Guaranties. In spite of the fact that

the ownership of capital necessarily involves risk , since the
income from it can only be estimated , never precisely fore
known, it is nevertheless possible , by a division of the
ownership of capital-wealth , for one class of property

holders to assume the burden of risks and to guarantee to
another class a fixed income. This is the primary reason
for the separation of securities into two great classes, called
stocks and bonds. In any large enterprise the stockholders

take the risks, and by so doing guarantee to the bondholders


a fixed income. As was remarked in a previous chapter,
the capital stock acts as a buffer between the liabilities and
the assets , which amounts to saying that it guarantees a
fixed income to the holders of the various liabilities .


dent Hadley has emphasized the fact that a bondholder
“ commutes ” the precarious income of an enterprise into a
fixed annuity , and that the system by which one class re
ceives “ interest ” and another “ profits ” has its origin in

the desire of oneclass to avoid , and thewillingness of another
to assume, risks.
(6) The Method of Safeguards. The method of guaran
ties is really a method of shifting risks rather than of avoiding
them . The second method — that of safeguards — aims
to reduce the risk . Some safeguards are themselves articles
of wealth existing simply for the sake of meeting sudden

unforeseen emergencies . This is true, for instance, of fire
engines, fire extinguishers, safety valves, safety appliances

on railways, burglar alarms, safety deposit vaults , etc.
To a large extent this risk -meeting function applies to almost
every stock or store of wealth. Food in a pantry usually
exists beyond certain wants in order to provide for uncertain

wants, and when sources of supply are distant, such stores
of food need to be large. Especially is this true in the case

ofarmies . Again , a factory will usually have a large reserve
stock , both of raw materials and finished products , in order

to meet unexpected demands. In like manner , jobbers,
wholesalers, and retailers maintain a sufficient stock of goods
to meet not only the foreseen, but some of the unforeseen
demands of their customers.

The function of speculators

in grain or other commodities consists largely in conserving
the stock of a community as a safeguard against future

scarcity . Almost all of what is called the reserve of a bank
is used as a safety fund to meet the unforeseen demands of

note holders and depositors , and , in particular, to meet a

“ run ” on the bank . These reserves often remain as idle
as a fire extinguisher for years or even decades. It is said



that there are bars of precious metals in the Bank of Eng
land which have lain there undisturbed for two centuries.

A large part of the cash carried by an ordinary individual is

quite analogous to a bank reserve, being held to meet special
emergencies. Some individuals even keep in a separate
pocket a special gold piece, lest some day they should be

come “ stranded .” It may be said that this risk -meeting
function of pocket cash is the chief compensation for the
so-called “ loss of interest ” on the money thus carried .
The convenience and security obtained by having an ade
quate supply is a species of income replacing the income

which might be earned were the sum invested .
(c) The Method of increasing Knowledge . The third
method of reducing risks is by increasing knowledge. Risk
is nothing but an expression of ignorance, and decreases with

the progress of knowledge . It may be said that the chief
progress now being made industrially consists in lifting the
veil which hides the future. Countless trade journals

have theirmain reason for existence in enabling their readers
better to forecast the future, by supplying them with data

as to past and present conditions, as well as by instructing
them in the relations of cause and effect . Government
reports of crops, technical schools, and agricultural colleges ,
all tend in the same direction . Whereas formerly the mine

prospector could only guess wildly at the ore “ in sight ”
and the time and cost required to mine it , the graduate of a

mining school is now able , through knowledge of geology
and metallurgy, to bring these forecasts into some degree
of scientific accuracy. And whereas until recently farming
was one of the most uncertain of occupations, it is to -day —

thanks to modern scientific agriculture — almost if not
quite as amenable to prediction as industry or commerce.

(d) The Method of Insurance. We come now to that im
portantmeans of avoiding and shifting risks called insurance.

Insurance involves the offsetting of one risk by another ;
that is, the consolidation in an insurance company of a



large number of chances whereby relative certainty is, as it
were, manufactured out of uncertainty.

One effect of insurance on the individual is to steady the
income from his property .

The owner of a house would

receive, if it were not insured , let us say, a net annual in
come, after providing for depreciation , of 5 per cent on

$10,000, or $500 a year until the house was burned , after
which he would receive nothing ; whereas, if he insures, he
receives this $ 500 income less his premium up to the date of
the fire, and afterward the income from the indemnity paid

him by the company.
The same principles apply to other forms of insurance, -

such as marine insurance, which , by consolidating in an
insurance company the risk on a large number of vessels,

reduces for the individual even the perils of the sea to rela
tive certainty and regularity ; or steam boiler insurance,

which in a similar manner treats the risks of explosion ;
or plate- glass insurance, burglar insurance, live stock in

surance, hail and cyclone insurance, fidelity insurance, acci
dent insurance, employer's liability insurance, and, above
all, life insurance. The last-named form of insurance, like
the others, tends to steady the income of the beneficiary .

If a wife holds insurance on her husband's life, the conse
quence is that, although what he gives her during his life is
somewhat diminished , her income will not suddenly cease
at his death .

The tendency of insurance here, as elsewhere,

is to make regularity out of irregularity, relative certainty
out of relative uncertainty ; and where, under the form of

insurance contracts, the opposite result follows, the case is
not one of true insurance, but tends to become one of

gambling. Thus, if a person insures the life of some one
in whom he has no financial interest, he is merely gambling

on that person's life. Some years ago in Michigan there
was an abuse of this type, called “ graveyard insurance .”

Speculators went through the form of insuring the lives of
certain old persons, — in other words, of betting on their



deaths, a procedure not only vicious as gambling, but calcu
lated also to lead to crime. The same considerations apply to

fire insurance,where a person insures a building in which he is
not financially interested , or over insures one in which he is.
(e) Shifting Risks to Speculators . Dangers of Imitative

Speculation . Where risks cannot be reduced to a statistical
basis, and therefore cannot be insured against, recourse is

often had to the shifting of the risks into the hands of those

who are willing to take them . Such persons are called
speculators . A speculator is usually one in whom caution is

not so pronounced as in the ordinary individual. In ex
treme cases he tends to become a simple gambler.


distinction between a speculator and a gambler, however , is
usually fairly well marked.

A gambler seeks and makes

risks which it is not necessary to assume, whereas the specu
lator merely assumes those risks of business which must
fall somewhere. A speculator is also usually fitted for his
work by special knowledge, so that the risk to him , owing to
superior foresight, is at the outset less than it would be to

others . The common indiscriminate prejudice against all
speculation is unjust and unfortunate ; for, were there no
speculators , the same risks would have to be borne by those

less fitted to bear them . The chief evils of speculation flow
from the participation of the generalpublic, which lacks the
specialknowledge, and which enters the market in a purely
gambling spirit. In addition to suffering the usual evil
consequences of gambling, they produce evil consequences
for the non-participating public by increasing instead of
decreasing the fluctuations in the values of the products or

property in which they speculate.
The evils of speculation are particularly acute when, as
generally happens with the investing public, the forecasts
are not made independently . Were it true that each
individual speculator made up his mind without consultation

with others as to the future course of events, the errors of
somewould probably be offset by those of others. But, as a



matter of fact, themistakes of the common herd are usually

in the same direction . Like sheep , they tend to follow the

same leader. We see , then , that where speculation is imita
tive, it is in the end injurious — alike to those who engage in it

and to the public which pays or receives the artificialprices
thus created . Where, on the other hand , speculation is based

on independentknowledge, it is usually of great utility . It
operates both to reduce risk by means of utilizing the special

knowledge of speculators,and also to shift risk from those who
lack this knowledge to those who possess it.

The normal

consequence is that speculative property will gravitate into
the hands of those most able to forecast its true income.

Modern production has been called capitalistic specula
tive production , owing to the fact that it is managed by
“ captains of industry," who are specially fitted at once to
forecast and to mold the future within the special realms
in which they operate. The industries of transportation

and manufacturing particularly are under the lead of an
educated and trained speculative class, whose function it is

to assume for themselves themain risks, and leave the ordi
nary investor, who is not so equipped , to coöperate as a

mere “ lender ” or silent partner . Yet it often happens
that these “ captains ” betray the confidence placed in them ,

and continue to throw theburden of risk on those whom they

pretend to shield.

§ 6 . Review
The preceding chapters are intended to give a definite
picture of the mass of capital and its benefits to man . In
such a picture we see man standing in the midst of a physical
universe ; the events of this universe affect his life favorably
or unfavorably . Over many of these events he can exercise
no control or selection ; they constitute his natural environ

ment. 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 constitute 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 consist, first, of the
appropriated parts of the surface of the earth, of the build
ings and structures attached to the soil, and of the movable

objects or “ commodities ” which man possesses and stores
up ; and secondly , of the human beings themselves, for
these, though they are also the abode of the owners of
wealth, are themselves owned objects.
This mass of instruments serves man 's purpose in so fars a

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

hismore immediate enjoyments — such , for instance, as food,
clothing, books, ornaments — he is enabled to consummate

the objects 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 lux
uries, or the amusements of life . In these and other ways
the stock of wealth will modify the course of natural events

in ways more or less agreeable to the owner. These desir
able changes in the stream of events which occur by means of
wealth constitute the benefits ofwealth . But these benefits
are obtained by dint of certain costs . In the last analysis

costs are simply human efforts, and benefitsaresimply human



satisfactions ; but the interval between efforts and satisfac
tions 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 in one aspect and a cost in another.
Their values are, at bottom , merely the discounted values of

the future benefits (less costs) to which they lead .
The whole economic structure therefore — all that is
represented in capital and income accounts -— rests on two
ultimate elements , viz . efforts and satisfactions.

These enter

our accounts , transformed simply by being multiplied or
divided by 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 of interactions, efforts , and satis
factions), and then the capital accounts (containing the dis

counted values of the items in the income accounts) .
To recapitulate in a few words the nature of capital and

income, wemay say that those parts of the material universe
which at any timeare under the dominion ofman , constitute

his capital-wealth ; its ownership , his capital-property ; its
value, his capital-value. Capital implies anticipated in
come, which consists of a stream of benefits 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 present. In other

words, the value of capital is the discounted value of the
expected income. The fluctuations of this capital-value
will, chance aside, be equal and opposite to the divergencies
of “ realized income ” from “ standard income " ; whereas,
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.


§ 1. Introductory
We have now finished the first great division of our sub
ject, — Economic Accounting. Wehave gained a picture of

wealth, property, benefits, costs, capital, and income. Our
study has so far consisted in pointing out the fundamental

relations between these various concepts, and particularly
between capital and income.

All of these relations find expression through the medium
of prices. By prices, as we have seen , a miscellaneous col

lection 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 aremosaics of hetero

geneous elements fitted together by 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 wemust consequently now

take up the second part of our task , which consists in dis
covering the principles that determine prices.
. If one were to ask how the price of wheat is determined ,
the immediate answer would probably be : By supply and

demand . This answer, though correct so far as it goes , is
lamentably 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 science 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 interest ?

Supply and

demand. What determines the distribution of wealth ?
Supply and demand ." In every instance the answer is
right, but it explains nothing. Wemust discover the forces

which determine supply and demand. In so doing we shall
learn that to determine the price even of one simple com
modity, like wheat, involves practically all the principles of
economic science. We are not yet ready to undertake the

full study of the supply and demand of any article. For the
present we shall concern ourselves only with 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 10 cents a pound for sugar ?

That depends on whether or not he wants the sugar more
than something else purchasable with the 10 cents . The
man , in other words, balances in his mind the sugar and the

money, — the latter standing in his mind for any other thing

he could spend it for. If the purchasing power of money is
high , he will bemore reluctant to part with a given amount
for a given quantity of sugar than if it is low . The seller, on
the other hand , is more ready to take money when it has a

high than when it has a low purchasing power. Hence, if in
a given yearmoney has a high purchasing power, the price of

sugar willbe lower than ifmoney has a low purchasing power.



The price of any particular article will be low if money has a

high purchasing power ; that is, if the prices of articles in gen
eral 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 ocean .

The phrases “ the purchasing power ofmoney ” 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 .

If the

first is doubled , the second is halved , and vice versa .
It is possible to study the general level of prices independ

ently of particular prices, just as it is possible to study the
general tides of the ocean independently of its particular

waves. 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 ofmoney.
Therefore, before we attempt to explain even the demand
and the supply of wheat, we shall undertake 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 eco

nomics ,who is exceedingly prone to misunderstand its func
tions. At the beginning of this book we pointed out someof
the supposed functionsofmoney that do not belong to it . We

are now in a position to ask : What are the real functions of
money ?

§ 2. The Nature of Money
Wedefinemoney aswhat is generally acceptable in exchange
for goods. The facility with which itmay be thus exchanged,
or its general acceptability , is its distinguishing characteris


This general acceptability may be reënforced by law ,

themoney thus becoming what is known as “ legal tender " ;
but such reënforcement is not essential. All that is necessary



in order that any good may be money is that general accept

ability attach to it. On the frontier, without any legal sanc
tion ,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 these things come into use as
money ? If we consider, for instance, the tobacco money of
the Virginia colony before metallic money came in from

Europe, it is not difficult to see how (in all probability ) it
first becamemoney. When a man in Virginia had a par
ticular commodity to sell, say a piece of land, and he looked
about for a purchaser, hemay have found a man who wanted
that piece of land and sought to make a trade with him . He

found this man willing, let us suppose, to take that piece of
land in exchange for cattle, slaves , tobacco, jewelry , musical
instruments, etc., or for collections of various articles, but he
wanted none of these things. Under these circumstances,

wemay suppose the proposed purchaser of the land to have
said , “ I have a lot of tobacco, which I will give you for the

land,” and the landowner to have replied , “ I do not smoke ;
I do not want the tobacco.” We may then suppose the
purchaser to have said , “ But tobacco is easily salable ;
many people want it ; it is so easy to carry and to keep that

you will find no difficulty in disposing of it ; will you not take
it temporarily , and instead of smoking it yourself, find some

body to take it in trade.” Whereupon the landowner sells
his land for the tobacco - not in order to use it himself, but
in order to sell it to some smoker. When , however, he sets
about finding the smokers in the community , he may have

some difficulty in disposing of his tobacco, just as did the pre
vious owner of the tobacco. But he can then follow the ex

ample of the previous owner, that is, find somebody who has
the things that he wants , and whom he can induce to take

the tobacco temporarily . In this way the tobacco may pass
through many hands, in each of which it rests only tempor

arily before it is passed on. Gradually , in this manner, it



becomes customary to take tobacco just for the purpose of

passing it on, and not for the purpose of smoking it ; and
after a time it is even prepared in a way not adapted to
smoking, but convenient for passing on . At last everybody

takes the tobacco simply because he expects others to take
it ; everybody gets it only to get rid of it. It is then said to
circulate as a medium of exchange.
It was doubtless in some such way that gold came into

use as money . Gold is easily transportable and durable .
People who did not want it for ornaments took it to sell to
people who did want it for ornaments , and after a while

it came to be coined for the purpose of being handed on.
At first a number of different things were used for money ;
but finally it was found that one thing was much more con
venient than the others, and it became the money par ex
cellence of the community.

Tobacco acquired this function

in Virginia ; gold possesses it to-day, having survived the

competitive process by which a great many other kinds of
money were tried out and found less suited to the purpose.

There are various degrees of exchangeability which must
be transcended beforewe arrive at realmoney . Of all forms

of property, one of the least exchangeable is real estate .
Only in case some person happens to be found who wants it
can a piece of real estate be traded . A mortgage on real

estate is one degree more exchangeable. Yet even a mort
gage is less exchangeable than a well-known and safe cor

poration security ; and a corporation security is less ex
changeable than a government bond. In fact, persons not

infrequently buy government bonds as merely temporary

investments, intending to sell them again as soon as per
manent investments yielding better interest are obtainable .
One degree more exchangeable than a government bond is a

bill of exchange; one degree more exchangeable than a bill
of exchange is a sight draft; while a check is almost as ex

changeable 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 thosemeans of exchangewhich either are money

or most nearly approximate it, we shall find that money
itselfbelongs to a general class of property rights which we
may call “ circulating media .” A circulating medium in
cludes any type of property right which , whether generally

acceptable or not, does actually, for its chief purpose and
use, serve as a means of exchange.

Circulating media are of two chief classes : (1) money ;
(2) bank deposits, which will be treated fully in the next

chapter. By means of checks, bank deposits serve as a
means of payment in exchange for other goods.

A check is

the “ certificate ” or evidence of the transfer of bank de
posits . 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 exchange.
But while a bank deposit (transferrable 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 distinc
tion between what is money and what is not. True, the
line is delicately drawn , especially when we come to such
checks as cashier's checks or certified checks.
latter are almost identical with bank notes.

For the
Each is a

demand liability on a bank , and each confers on the holder

the right to draw money. Yet while a note is generally ac
ceptable in exchange, a check is only specially acceptable,
i.e. only by the consent of the payee. Real money-rights

are what a payee accepts without question , either because
he is induced to do so by “ legal tender ” laws or because he

is induced to do so by a well established custom .
Of real money there are two kinds : primary and fiduci

ary. Money is called primary if it is a commodity which
has just as much value in some use other than money as it
has in monetary Primary money has its full value



independently of any other wealth . Fiduciary money, on
the other hand , is money the value of which depends partly
or wholly on the confidence that the owner can exchange
it for other goods, e .g. for primary money at a bank or gov
ernment office or at any rate for discharge of debts or pur
chase of goods of merchants .

The chief example of primary

money is gold coin . The chief example of fiduciary money
is bank notes . The qualities of primary money which make
for exchangeability are numerous. Themost important are
portability , durability, and divisibility.

The chief quality

of fiduciary money, which makes it exchangeable , is its re
deemability in primary money, or its imposed character of

legal tender.
Bank notes and all other fiduciary money, as well as bank

deposits, circulate by certificates often called “ tokens.”
“ Token ” coins are included in this description . The
value of these tokens, apart from the rights they convey, is

Thus the value of a silver dollar, as wealth , is only

about forty cents; that is all that the actual silver in it is
worth . Its value as property, however, is one hundred

cents ; for its holder has a legal right to use it in paying a
debt to that amount, and a customary right to so use it in
payment for goods. Likewise, the property value of a fifty
cent piece, a quarter, a ten - cent piece , a five-cent piece, or a
one-cent piece is considerably greater than its value as
wealth . The value of a paper dollar as wealth — for instance,

a treasury note or silver certificate — is almost nothing. It
is worth just its value as paper, and no more. But its value

as property is a hundred cents, that is, the equivalent of
one gold dollar. It represents to that extent a claim of
the holder on the wealth of the community .
Figure 6 indicates the classification of all circulating

media in the United States. It shows that the total amount
of circulating media is about 8 ) billions, of which about 7

billions are bank deposits subject to check, and 11 billions,
money ; and that of this 1.7 billions of money 1 billion are



fiduciary money and only about } a billion primary
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




FIG . 6 .

the United States, the only primary money is gold coin .
The fiduciary money includes (1) token coins, viz . silver

dollars, fractional silver, and minor coins (“ nickels " and
cents) ; (2) paper money, viz .: (a) certificates for gold and
silver ; and (b ) promissory notes, whether of the United
States government (“ greenbacks ” ), or of the national
banks (“ bank notes ” ).



Checks aside, wemay 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 makes up what we
call the circulation of money .

The circulation of money

signifies , therefore, the aggregate amount of its transfers
against goods. All money available for circulation , i.e .
all money except what is in the banks' and United States

government's vaults, is called money in circulation .

§ 3 . The Equation of Exchange, Arithmetically
The price levelmay be said to depend on only three sets of
causes : (1) the quantity of money in circulation ; ( 2) its
“ efficiency ” or velocity of circulation (or the average
number of times a year money is exchanged for goods) ; and

( 3) the volume of trade (or amount of goods bought by
money) . The “ quantity theory ” has often been incor

rectly formulated , but it is correct in the sense that the level
of prices varies directly with the quantity of money in cir

culation, provided the velocity of circulation of that money
and the volume of trade which it is obliged to perform are
not changed .

This will bemademore clear 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 to
gether the equations of exchange for all individual trans
actions. Suppose, for instance, that a person buys to pounds

of sugar at 7 cents per pound.

This is an exchange trans

action , in which 10 pounds of sugar have been regarded as

equal to 70 cents , and this fact may be expressed thus:
70 cents = 10 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.
During this period , however, the same money may serve,

and usually does serve, for several transactions. For that
reason the money side of the equation does not represent

the total amount ofmoney in circulation . For instance, the
same 70 cents may figure in 10 different transactions during
the period under study, and thus perform the work , so to
speak , of $ 7 used but once. The equation has a goods side

and a money side. Themoney side is the total money paid ,
and may be considered as the product of the quantity of
money multiplied by its rapidity of circulation . The goods
side is made up of quantities of goods multiplied by their

respective prices.
Let us begin with the money side. If the number of dol
lars in a country is 5 ,000,000, and the velocity of circulation
is twenty times per year, then the total amount of money
changing hands during any year is 5,000 ,000 times twenty
or $ 100 ,000 ,000 .

Since the money side of the equation of exchange is

$ 100,000,000, the goods side must be the same. For if
$ 100 ,000,000 has been spent for goods in the course of the
year, then $ 100,000,000 worth of goodsmust 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 actually exchanged, let us assume for
the present that there are only three kinds of goods, –

bread , coal, and cloth ; and that thesales are :
200,000,000 loaves of bread at $ . 10 a loaf,

10 ,000 ,000 tons of coal
30 ,000 ,000 yards of cloth

at 5 .00 a ton , and
at 1.00 a yard.

The value of these transactions is evidently $ 100,000,000, –
i.e . $20 ,000 ,000 worth of bread plus $ 50 ,000,000 worth of

coal plus $ 30 ,000,000 worth of cloth . The equation of ex



change therefore (remember that the money side consisted
of $5,000,000 exchanged 20 times) is as follows :
$ 5 ,000, 000 X 20 times a year =

200,000,000 loaves X $ . 10 a loaf +
10,000,000 tons X 5.00 a ton +
30,000,000 yards X 1.00 a yard.
This equation on the money side contains two magnitudes ,
viz . : ( 1 ) the quantity of money and ( 2 ) its velocity of circu

lation ; and, on the goods side, two groups of magnitudes in
two columns, viz . : ( 1) the quantities of goods exchanged
(loaves , tons, yards), and ( 2 ) the prices of these goods. The
equation shows that these four sets ofmagnitudes are mutu

ally related . The prices, for instance, bear a relation to the
three other sets of magnitudes , quantity of money , rapidity

of circulation , and quantities of goods exchanged . Conse
quently these prices must, as a whole, vary proportionally

with the quantity of money and with its velocity of circula
tion , and inversely with the quantities 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 it would be
quite impossible for prices to remain unchanged.


money side would now be $ 10 ,000,000 X 20 times a year or
$ 200 ,000 ,000 ; whereas, if prices should not change, the

goods would remain $ 100 ,000 ,000 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 nec
essarily sold by another, but the total value of goods sold

must equal the total amount of money exchanged. There
fore, 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 uneven rise in 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 ,000 X 20 times a year =

200 ,000 ,000 loaves X $ .20 per loaf +
10 ,000 ,000 tons X 10 .00 per ton +

30 ,000,000 yards X

2.00 per yard.

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 totalmoney 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 goodsmultiplied by their prices, it followsthat 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 these other factors — quantity of goods and
velocity of circulation -- affect prices ,and in a very similar

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
become —

$ 5,000,000 X 40 times a year =

200,000,000 loaves X $
10,000 ,000 tons


20 a loaf +
10 .00 a ton +

30,000,000 yards x 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 (not double but) halve the height of the price level, pro

vided the quantity of money and its velocity of circulation

remain the same. Under these circumstances the equation
will become:
$ 5 ,000 ,000 X 20 times a year =

400,000 ,000 loaves X $ .05 a loaft
20 ,000,000 tons


2.50 a ton +

60,000,000 yards x .50 a yard ,
or else it will assume a form in which someof the prices are
more than halved , and othersless than halved , so as to pre
serve the equation .
Finally , if there is a simultaneous change in two or all of

the three influences, i.e . quantity of money, velocity of cir
culation , and quantities of goods exchanged , the price level

will be a compound or resultant of these various influences.

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 undis

turbed . Likewise it will be undisturbed if the quantity of
money is doubled and the quantity of goods is doubled ,

while the velocity of circulation remains the same. To dou
ble the quantity of money, therefore, is not always to double
prices. We must distinctly recognize that the quantity of
money is only one of three factors, all equally important as
determinants of 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 . Such a representation is em
bodied in Figure 7 . This represents a mechanical balance



in equilibrium , the two sides of which symbolize respectively

the money side and the goods side of the equation of ex
change. The weight at the left, symbolized by a purse,
represents themoney in circulation ; the “ arm ” or distance
from the fulcrum at which this weight (purse ) is hung repre

sents the efficiency of this money , or its velocity of circula
tion ; and the product of the weight by its “ arm ,” i known
in mechanics as the moment of rotation , represents the

money side of the equation of exchange ; that is, the

total circulation or value of exchange work done. In


Fig . 7.

accordance with the mechanical principles of a balance

this is equal to , or balanced by, corresponding magnitudes
on the opposite side. On that side are three weights : bread ,
coal, and cloth , symbolized respectively by a loaf, a coal

scuttle, and a roll of cloth . The arm , or distance of each
from the fulcrum , represents its price . In order that the
lever arms 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 those of cloth from
yards to feet, and consequently to enlarge correspondingly
the numbers of units : the measure of coal changing from
10,000 ,000 tons to 200,000 ,000 hundredweights , and that of

the cloth from 30,000,000 yards to 90,000,000 feet. The
price of coal in the new unit per hundredweight becomes
25 cents, and that of cloth in feet becomes 33 } cents. If,

now , we assume that the velocity of circulation of money
remains the same (that is , that the left arm does not either
1No necessary relation need exist between the units of length employed
for measuring the arms to the right and those to the left.



lengthen or shorten ), and that the trade remains the same

(that is, that the weights at the right do not either increase
or decrease), then it follows that the increase of the money

at the left will require a lengthening of one or more of the
arms at the right, representing prices, and that if these
prices increase uniformly , they will increase in the same
ratio as the increase in money ; and that, if they do not in
crease uniformly , somewill increase more and some less than

this ratio, maintaining an average.
Likewise it is evident that if the velocity of circulation

ofmoney increases, i.e. if the arm at the left lengthens and if



Fig . 8.

themoney in circulation and the trade (the various weights)
remain the same, there must be an increase in prices (length
ening of the arms at the right).

Again , if there is an increase in the volume of trade (rep
resented by an increase in weights at the right), and if the

velocity of circulation ofmoney (left arm ) and the quantity
of money (left weight) remain the same, there must be a

decrease in prices (right arms).
In general, any change in the four sets of magnitudes 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 me
chanical representation by hanging all the right-hand weights
at one average point, so that the arm shall represent the

average prices. This arm is a “ weighted average ” of the



three original arms, the weights being literally the weights
hanging at the right.
This averaging of prices is represented in Figure 8, which

visualizes the fact that the average price of goods (right
arm ) varies directly with the quantity ofmoney (leftweight),
and directly with its velocity of circulation (left arm ), and
inversely with the volume of trade (right weight).
$ 5.

The Equation of Exchange Algebraically Expressed

To put these relations in general terms, we may use an
algebraic formula : p" Q" +
etc .

+ + +

MV = P Q +
p '& +

The quantity of money in circulation we call M , and the
velocity of circulation , V . Then MV equals the amount of
money expended for goods during the year. On the other
side, p is the price of any good , and Q its quantity ; the
price of another, and

its quantity , and so on . If in this

equation M is doubled (and V and the Q 's remain un
changed ), 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

PQ - a price multiplied by a quantity bought.

It is customary in mathematics to abbreviate a sum of
terms (all of which are of the same form ) by using “ E ” 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 equation of ex
changemay now be written very simply :
MV = Ep



Wemay, if we wish, further simplify the right side in the
form PT where P is a weighted average of all the p 's , and

T is the sum of allthe Q ’s. P then represents in one magni
tude the levelof prices,and T represents in onemagnitude the
volume of trade. This simplification is the algebraic inter
pretation of the mechanical illustration given in Figure 8 ,

where all the goods, instead of being hung separately , as in

Figure 7 ,were combined and hung at an average point repre
senting 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 is themost impor
tant. 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 ofmoney ” is meant the number of dollars (or other
given monetary units ) in circulation .

This number may be

changed in several ways, of which the following three are
most important.

They serve to bring home to us the con

clusions we have reached and to reveal the fundamental
peculiarity ofmoney on which they rest.

As a first illustration, let us suppose the government to
double the denominationsof allmoney ; that is, let us suppose
that what has been hitherto a half dollar is henceforth called
a dollar, and that what has hitherto been a dollar is hence

forth called two dollars. Evidently the number of “ dol

lars ” 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 though no such law were passed. But he
will, in each case, be paying twice as many “ dollars.”




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 .
Thus we see how the nominal quantity of money affects
price levels .

A second illustration is found in a debased currency. Sup
pose a government cuts each dollar in two, coining the halves

into new “ dollars ” ; 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 recoinage is an immaterial circumstance, unless it be

carried so far as to make counting difficult and thus to inter
fere 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
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 number of

actual pieces of money of each kind was unchanged , but their
denominationswere 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
redoubling the paper money .

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 possessor of the

original. Wemust 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 increase will escape. But



if the quantity of money is 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 samedenominations. 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 doub
ling of coins must have the same effect as the 50 per cent

debasement, i.e. the effect of doubling prices.
The force of the third illustration becomes even more
evident if, in accordance with Ricardo's presentation,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 illustra
tion , and removing the only point of distinction between
the two. This “ seigniorage ” abstracted will not affect the
value of the coins, so long as their number remains un

changed . In short, the quantity theory asserts that (pro
vided velocity of circulation and volume of trade are un

changed) if we increase the number of dollars, whether by
renaming coins, or by debasing coins, or by increasing coin

age, or by any other means, prices will be increased in the
sameproportion. 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 explains

the peculiar manner in which its purchasing power is re
lated to other goods. Sugar, for instance, has a specific

desirability dependent on its quantity in pounds. Money
has no such quality. The value of sugar depends on its

actual quantity . If the quantity of sugar is changed from
1,000 ,000 pounds to 1,000,000 hundredweight, it does not
follow that a hundredweight will have the value previously

possessed by a pound. But if money in circulation is

changed from 1,000,000 units of one weight to 1,000 ,000



units of another weight, the value of each unit will remain
unchanged .
The quantity theory ofmoney thus rests , ultimately, on a

peculiarity which money alone of all goods possesses , —
the fact that it has no power to satisfy human wants except

a power to purchase things which do have such power.




§ 1.

The Mystery of Circulating Credit

We are now ready to explain the nature of bank deposit
currency, or circulating credit. Credit, in general, is the

claim of a creditor against a debtor. Bank deposits subject
to check are the claims of the creditors of a bank against the
bank , 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.”
But as the first step we must enlarge upon our analysis of
circulating media by adding a discussion of bank checks, by
means of which credit is put into effect. Bank checks, then ,
are merely certificates of rights to draw bank deposits or
to transfer them . The checks are not currency. It is the

bank deposits themselves, or credit balances on the books of
the banks, that constitute the real currency. Nor are these

deposits actual money. They are not money, because they
are not generally acceptable ; they always require the special
consent of the payee. But they are currency, because their

chief purpose and use is to act as a medium of exchange.
Closely analogous to checksare post office orders, and money
orders issued by express companies. They are distinguish
able only by two facts : that they are not issued by ordinary
banks, and that they originate in special deposits of money

or the equivalent of money. 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 third 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 econo

mists, 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 founda
tion in actual wealth at all, but is a kind of unreal and in

flated bubble with a precarious if not wholly illegitimate
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 depositsmay in substance be taken as true also of bank
notes . The chief difference is a formal one, the notes cir

culating from hand to hand ,while the deposit currency cir
culates only by means of special 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 actualmoney . The original bank of Amsterdam
was somewhat like thebank 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 $ 100,000 owed to
depositors, as follows : –


. . . . . $ 100 ,000 Due depositors . . $ 100,000
The right-hand side of the statement is, of course, made
up of the amounts owed to individual depositors. Assum
ing that there is owed to A $ 10,000 , to B $ 10 ,000, and to all

others $ 80,000,wemay write the bank statementas follows :

Gold . . . . . . $ 100,000

Due depositor A . . $ 10 ,000
Due depositor B . .
Due other depositors

$ 100,000

$ 100,000



Now assume that A wishes to pay B $ 1000 . A could go to
the bank with B , present certificates or checks for $ 1000 ,
obtain the gold , and hand it over to B , who might then re
deposit 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 $ 1000. 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 statementwould then read :


Gold . . . . . . $ 100,000

$ 100,000

Due depositor A . . $ 9 ,000
Due depositor B . .
Dueother depositors .
$ 100,000

Thus the certificates, or checks, would circulate in place of
cash among the various depositors in the bank . What really
changes ownership , or “ circulates,” in such cases is the right

to draw money. The check ismerely the evidenceof this right
and of the transfer of this right from one person to another .

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 money ” by lending at

interest some of the gold on deposit. This could not offend
the depositors. These do not expect or desire to get back
the identical gold they have 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 , butmerely of a defi

nite 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 its cash . This is usually done in exchange for promis
sory notes of the borrowers. Now a loan is really a sale , the

quid pro quo being the 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 money for

promises, and its books will then read :


Gold . . . . . . $ 50,000

Due depositor A

. . $ 9 ,000

Promissory notes . .

Due depositor B

. .

50 ,000

Due other depositors



$ 100,000
$100 ,000
It will be noted that now the gold in bank is only $ 50 ,000 ,

while the total deposits are still $ 100 ,000 . 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 good is on deposit behind each loan ,
but not necessarily money .
Next, suppose that the borrowers become, in a sense, de
positors also, by redepositing the $ 50 ,000 of cash which they
borrowed , in return for the right to draw out the same on
demand . 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 enlarged by $ 50,000, and its

obligations (or credit extended ) will be equally enlarged ;
and the balance sheet will become: ASSETS


Gold . . . . . . $ 100 ,000
Promissory notes . .

Due depositor A
Due depositor B

. . $ 9,000

Due old depositors .
Due new depositors,
i.e. the borrowers .

$ 150 ,000

50 ,000

$ 150 ,000







Now what happened in each case was this : 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 promissory note
and the depositor a right to draw . Evidently, therefore ,
the same result would have followed if each borrower had
merely handed in his promissory note and received , in ex

change, a right to draw . As this operation most frequently
puzzles the beginner in the study of banking, we repeat the

tables representing the conditions before and after these

“ loans,” i.e. these exchanges of promissory notes for present
rights to draw .


Gold . . . . . . $ 100,000

Due depositors

. . $ 100,000


Gold . . . . .
Promissory notes . .

$ 100,000 Due depositors


$ 150,000


Clearly , therefore, the intermediation of the money in
this case is a needless complication , though itmay 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 ; in exchange for the gold it gives a
right to draw . In exchange for the promises itmay give or lend — either a right to draw , or gold — the same that
was deposited by another customer. Even when the bor

rower has deposited only a promise , by fiction he is still held
to have deposited money ; and like the original cash deposi
tors, he is given the right to make out checks. The total
value of rights to draw , in whichever way arising, is termed

deposits. Banksmore often lend rights to draw (or deposit

rights) than actual cash, partly because of the greater con
venience to borrowers, and partly because the banks wish



to keep their cash reserves large, in order to meet large or
unexpected demands.

It is true that if a bank loans money,

part of the money so loaned will be redeposited by the per
sons 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 cash .
Besides lending deposit rights, banks may also lend their

own notes — called “ bank notes.” And the principle
governing bank notes is much the same as the principle
governing deposit rights . The holder simply gets a pocket

ful of bank notes instead of a bank account. In either case
the bank mustkeep itself ready to pay the holder, — to “ re
deem its notes,” — as well as pay its depositors , on demand,
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 .


customer's note bears interest, but is payable only at a defi

nite date . Assuming that the bank issues $50,000 of notes,
the balance sheet will now become: LIABILITIES



. . . . :

Loans due the bank .

$ 100,000
$ 200 ,000

Due depositors


Due note holders . .

$ 150,000
50 ,000

$ 200,000

We repeat, then , that by means of credit, the deposits of
a bank may exceed its cash. There would be nothingmysteri

ous or obscure about this fact, nor about credit in general, if
people could be induced not to think of banking operations
as money operations. To so represent them ismetaphorical

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
And yet , the same principles of property which apply to

bank deposits also apply to bank notes. There is wealth
somewhere behind the mutual promises, though in different
degrees of accessibility.

The note holder's promise is se

cured by his assets ; and the bank 's promise is secured by
the bank 's assets .

The note holder has “ swapped ” less

known credit for better-known credit.

The accounts as they

now stand include the chief features of an ordinary modern
bank, - a so- called “ bank of deposit, issue, and discount.”

§ 2. The Basis of circulating 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.”


cannot be too strongly emphasized that, in any balance

sheet, the value of the liabilities rests on that of the

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 behind some of the notes or deposit-liabilities there is
nothing . 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 the true value of the
liabilities (“ bad debts ” ) will only equal the true value of
the assets behind them .



These assets , as already indicated , are largely the notes
of merchants, although, so far as the theory of banking is
concerned , they might be any property whatever. If they
consisted in the ownership of real estate or other wealth in

" fee simple," so that the tangible wealth which property
always represents were clearly evident, all mystery would

disappear. But the effect would not be different. Instead
of taking grain , machines , or steel ingots on deposit, in ex
change for the money 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 in either case the

excess of liabilities is balanced by the possession of other
assets than cash . In other words, the assets of the bank

are the liabilities of business men .

The ultimate basis of

the entire credit structure is kept out of sight, but the basis

exists . Indeed , wemay say that banking in a sense causes
this visible , tangible wealth to circulate. If the acres of a
landowner, or the iron stoves of a stove dealer cannot cir
culate in literally the same way that gold dollars circulate,

yet the landowner or stove dealermay 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 dol
lars .

Through banking, he who possesses wealth difficult

to exchange can create a circulating medium . He has only

to give his note , forwhich ,of course, his property is liable, to
a bank , get in return the right to draw , and lo ! his compara

tively unexchangeable wealth becomes liquid currency.
To put it crudely , banking is a device for coining into dollars
land , stoves, and other wealth that is not otherwise generally
exchangeable .

It is interesting to observe that the formation of the great
modern “ trusts ” has given a considerable impetus to de
posit currency ; for the securities of large corporations are



more easily used as a basis for bank loans than the stocks and

bonds of small corporations or than partnership rights.
Webegan 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 it reaches 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 and its
cash depositors , risks which the depositors would be unwill
ing to assume. Tomeet this situation , the responsibility and

expense of running the bank is taken by a third class of
people, — stockholders , — who are willing to assume the
augmented risk for the sake of the chance of profit. Stock
holders , in order to guarantee the depositors against loss ,
put in some cash of their own. Their contract is, in effect,

to make good any loss to depositors. Let us suppose that

the stockholders put in $ 50,000, — $40,000 in cash and
$ 10,000 in the purchase of a bank building. The accounts
now stand :


Cash . . . . . . $ 140,000
. . . . . . 100 ,000
Building . . . . .

Due depositors

. . $ 150,000

Due note holders , .

50 ,000

Due stockholders , .

50, 000


$ 250,000

§ 3. Banking Limitations
We have seen that the assetsmust be adequate to meet

the liabilities. We now observe 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 quickly available
property (cash or credit ) in place of the slower property of
its depositors, it fails of its purpose when it is caught with
insufficient cash . Yet it “ makes money ” partly by tying up
its quick property , i.e. lending it out where it is less acces

sible. Its problem in policy is to tie up enough to increase
its property, but not to tie up so much as to get tied up it

self. 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 limits,
however, imposed by prudence and sound economic policy,
on both these processes. Insolvency and insufficiency of
cash must both be avoided . Insolvency is that condition
which threatens when loans are extended with insufficient


Insufficiency of cash is that condition which

threatens when loans are extended unduly relatively 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 at all. Insufficiency of cash is
reached when , although the bank 's total assets are 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 less the ratio of the value of the stockholders' inter

ests to the value of liabilities to others, the greater is the risk
of insolvency ; 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 was a reserve of $ 140,000 of
cash , and $ 200 ,000 of demand liabilities (deposits and notes) .

The managers of the bank may think this reserve of $ 140,000

unnecessarily large or the loans unnecessarily small. They
may then increase their loans (extended to customers in the

form of cash, notes, or deposit accounts) until the cash re
serve is reduced , say to $40,000 , and the liabilities due de

positors and note holders increased to $ 300,000 . If, under
these circumstances, 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 behind the $ 50 ,000 demanded ; but the understand
ing was that depositors and note holders should be paid in
money and on demand. Were this not a stipulation of the
deposit contract, 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 con
dition 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. To keep its depositors in single file is partof
its policy . The paradox of a panic is well expressed by the
case of theman 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 timewanted 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 by
alternately selling securities for cash and loaning cash on

securities .

The more the loans in proportion 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. Thụs, by alternately rais
ing and lowering the rate of interest, a bank keeps its loans

within the sum which the reserve can support, but en
deavors to keep them (for the sake of profit) as high as the
reserve will allow .

The amount of reserve itself, however , must be propor
tioned to liabilities . If the sums owed to individual de
positors are large, relatively to the total liabilities, the re
serve should be proportionately large, since the action of a
small number of depositors can deplete it rapidly . The

reserve in a large city with great bank 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 ratios are often im
posed by law . National banks in the United States, for
instance, are required to keep a reserve for their deposits ,
varying according as they are or are not situated in certain
cities designated by law as “ reserve " cities, i.e. cities where
national banks hold deposits of banks elsewhere. These
reserves are all in defense of deposits . In defense of notes,

on the other hand , no cash reserve is required, — that is, of
national banks. True, the same economic principles apply
to both bank notes and deposits, but the law treats them
differently . The government chooses to undertake to re
deem the national bank notes on demand.
This legal regulation of banking reserves, however, is not

a necessary nor a normal development of banking. Banking
may exist without government regulations at all.



$ 4 . The Total Currency and its Circulation
The study of banking operations, then , discloses two
species of currency : one, bank notes, belonging to the
category of money ; and the other, deposits , belonging

outside of that category, but constituting an excellent sub
stitute. 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. And by the use of these , there are six pos

sible 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 .

As to the other four, the first and third have been previously
explained as “ money changing ” and “ barter ” respec

tively .

The second and fourth are banking transactions :

the second being such operations as the selling of drafts for

checks or the mutual cancellation of bank clearings; and
the fourth being such operations as the depositing or with
drawing 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. Weshall 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 'V '. The equation of
exchange, therefore, becomes

MV + M ' V ' = EpQ.
Let us again represent the equation of exchange by means
of a mechanical picture. In Figure 9 , trade, as before, is

represented on the right by the weight of a miscellaneous
assortment of goods ; and their average price by the dis

tance to the right from the fulcrum , or the length of the
arm on which this weight hangs. Again at the left,


Fig . 9.

money (M ) is represented by a weight in the form of a purse,
and its velocity of circulation ( V ) by its arm ; but now we
have a new weight at the left, in the form of a bank book , to

represent the bank deposits (M ') . The velocity of circula
tion ( V ) of these bank deposits is represented by its dis
tance from the fulcrum or the arm at which the book hangs.

Thismechanism makes clear the fact that the average price
(right arm ) increases with the increase ofmoney or bank de
posits and with the velocities of their circulation , and de

creases with the increase in the volume of trade.
Recurring to the left side of the equation of exchange,
orMV + M 'V ', we see that in a community without bank
deposits the equation reduces simply to MV, the formula of
Chapter VIII; for in such a community the term M ' V '

$ 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 dif
ficult and complicated . It has even been argued that this

interposition of circulating credit breaks whatever connec
tion theremay be between prices and the quantity ofmoney .
This would be true if circulating credit were independent of
money . But the fact is, as we have seen , that the quantity

of circulating credit, M ', tends to hold a definite relation to
M , the quantity 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
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 equilibrium
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 con
stantly 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. But for both these depositors
the bank acts as intermediary.
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 developed

the business of a community , the more prevalent the use of
checks. Where business is conducted on a large scale, mer
chants habitually transact their larger operations with each .
other by means of checks, and their smaller transactions 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 convenient,
and therefore more money is used in proportion to the

amount of business done. Again , the wealthier the mem
bers of the community, themore 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 thecountry as a whole , means that by

convenience a rough ratio is fixed between M and M '.


that ratio is disturbed temporarily , there will come into play

a tendency to restore it. Individuals will deposit surplus
cash , or they will cash surplus deposits.

Hence, both money in circulation (as just shown) 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
fixed ratio to each other. As to the adjustment or ratio

of bank reserves to bank deposits, this evidently varies for
different banks. In the United States a reserve is required
by law , and the ratio insisted on differs according as the



banks are ordinary national banks, national banks in reserve

cities, or in central reserve cities, state banks, private
banks, or trust companies. But even were there no legal
requirement, experience would doubtless dictate differently
the average size of deposit accounts for different banks ac

cording to the general character and amount of their busi
ness. For every bank there is a normal ratio , and hence for
a whole community there is also a normal ratio , — an aver
age of the ratios for the different banks.

$ 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 aremoney ; and bank deposits ( or rights to draw )
— which are not money.

(2) A bank check is merely a certificate of a right to
draw .

( 3) Behind the claims of depositors and note holders
stands 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

(6 ) Six sorts of exchange exist among three classes of

goods,money, deposits , and other goods. Of these six sorts
of exchange, the most important for our present purposes

are the exchanges of money and deposits against goods.
(7) The equation of money circulation extended so as to
make it include bank deposits reads thus : MV + M ' V ' =

EpQ .



(8) The relation of bank deposits (M ') to the quantity of
money (M ) has already been discussed , and we have seen
that there must exist between bank deposits and money a

normal ratio ; 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 available currency shall be

apportioned between deposits and money in a certain more
or less definite, even though elastic, ratio .


§ 1. The Tardiness of Interest Adjustment to Price
In the last chapter it was shown that the quantity of

bank deposits normally maintains a definite ratio to the
quantity of money in circulation and to the amount of bank
reserves. As long as this normal relation holds, the exist
ence of bank deposits merely magnifies the effect on the
level of prices produced by the quantity of money in cir

culation and does not in the least distort that effect .
Moreover, changes in velocity or trade will have the same
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 .
Weare now ready to study theseperiods of transition. The
change which constitutes a transition may be a change in the
quantity of money, or in any other factor of the equation of
exchange, or in all. Usually all are involved , but the chief
factor which we shall select for study (together with its

effects on the other factors) is quantity of money. If the

quantity of money were suddenly doubled, the effect of the
change would not be the same at first as later. The ultimate
effect is, as we have seen , to double prices ; but before this
happens, the prices oscillate up and down . In this chap
ter we shall consider the temporary effects during the period of
transition separately from the permanent or ultimate effects

which were considered in the last chapter. These perma
nent or ultimate effects follow after a new equilibrium is es

tablished, — if, indeed , such a condition as equilibrium may



ever be said to be established . Whatwe are concerned with
in this chapter is the temporary effects, i.e. those in the
transition period .
The transition periods may be characterized either by
rising prices or by falling prices. Rising prices must be
clearly distinguished from high prices, and falling from low .
With stationary levels, high or low , we have in this chapter
nothing to do. Our concern is with rising or falling prices .
Rising prices mark the transition between a low and a high
level of prices, just as a hill marks the transition between flat

lowlands and flat highlands. Since the study of these ac
clivities and declivities is bound up with that of the adjust
ment of interest rates, our first task is to present a brief

statement regarding the effects of rising and falling prices
on the rate of interest. Indeed , the chief object of this
chapter is to show that the peculiar behavior of the rate of
interest during transition periods is largely responsible for

the crises and depressions in which price movements end .

It must be borne in mind that although business loans are
made in the form of money, yet whenever a man borrows
money hedoes not do this in order to hoard themoney, but to
purchase goods with it. To all intents and purposes, there

fore , when A borrows one hundred dollars from B in order
to purchase , say , one hundred unitsof a given commodity at
one dollar per unit, it may be said that B is virtually lending

A one hundred units of that commodity. And if at the end
of a year A returns one hundred dollars to B , but the price
of the commodity has meanwhile advanced , then B has lost
a fraction of the purchasing power originally loaned to A .

For even though A should happen to return to B the iden
tical coins in which the loan wasmade, these coins represent
somewhat less than the original quantity of purchasable
commodities. Bearing this in mind in our investigation of

interest rates, let us suppose that prices are rising at the
rate of 3 per cent each year. It is plain that theman who
lends $ 100 at the beginning of the year,must, in order to get



5 per cent interest in purchasing power, receive back both
$ 103 (then the equivalent of the $ 100 lent) plus 5 per cent of

this, or a total of $ 108.15. That is, in order to get 5 per cent
interest in actual purchasing power, he must receive a little
more than 8 per cent interest in money. The 3 per cent rise

of prices thus adds approximately 3 per cent to the rate of
interest . Rising prices, therefore, in order that the relations
between creditor and debtor shallbe the same during the rise
as before and after, require higher money interest than sta
tionary prices require. Not only will lenders demand higher

interest in terms of money, but borrowers can afford to pay
it ; and to some extent competition will gradually force
them to do so . Yet we are so accustomed in our business

dealings to consider money as the one thing stable , – to
think of a “ dollar as a dollar ” regardless of the passage of

time, — that we reluctantly yield to this process of read
justment, thus rendering it very slow and imperfect. When
prices are rising at the rate of 3 per cent a year, and the

normal rate of interest, i.e. the rate which would exist were
prices stationary, is 5 per cent, the actual rate, though it
ought (in order to make up for the rising prices) to be 8 . 15
per cent, will not ordinarily reach that figure ; but it may

reach , say, 6 per cent, and later, 7 per cent. This inadequacy
and tardiness of adjustment, is fostered, moreover, by law
and custom , which arbitrarily tend to keep down the rate
of interest, even though , at the prevailing rate, the demand

for money exceeds the supply . A similar inadequacy of
adjustment is observed when prices are falling. Suppose

that, by the end of a year, $ 97 will buy as much as $ 100 at
the beginning.

In that case the lender, in order to get back

a purchasing power equivalent to his principal and 5 per

cent interest, should get, not $ 105, but only $97 + 5 per
cent of $ 97 or $ 101.85.

Thus the rate of interest in money

should in this case be 1.85 per cent or less than 2 per cent.

In other words, the 3 per cent fall of prices should reduce the

rate of interest by approximately 3 per cent. But as a



matter of fact, such a perfect adjustment is seldom reached ,

and money interest keeps far above 2 per cent for a consider
able time.

§ 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 will cause a rise in prices.

The rate of interest

will not respond immediately. As prices rise, profits of busi
ness men measured in money will rise also , even if the costs of
business rise in the same proportion . Thus, if a man who
sold $ 10 ,000 of goods at a cost of $ 6000 , thus clearing $ 4000 ,

can get double prices at double cost, his profit will be double
also ,being $ 20 ,000 – $ 12,000 ,which is $ 8000 . Ofcourse such

a rise of prices is purely nominal, as itmerely keepspace with
the rise in price level. The business man gains no advan
tage, for his larger money profits will buy no more than his
former smaller money profits bought. But if among his

costs is interest, and this cost does not rise, the profits will
rise faster than prices. Consequently , he will find himself

making greater profits than usual, and be encouraged to
expand his business by increasing his borrowings.


borrowings are mostly in the form of short -time loans by

banks; and, as we have seen , short-time loans are in the
form of 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. Hence prices, which
were already
dy strip itit ststill
e alto
ill ffur
onts, to inthe
, who wertend
ther, enabling borrowers, who were already increasing their
profits, to increase them still further. Borrowing, already
stimulated, is stimulated still further ; more loans are
demanded , and although nominal interest may be forced up



somewhat, still it keeps lagging below the normal level,
Yet nominally , the rate of interest has increased ; and hence

the lenders too, including banks, are led to becomemore

Led by the higher nominal rates into the

belief that fairly high interest is being realized, they extend
their loans, and with the resulting expansion of bank loans,
deposit currency ( 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, but we
have chosen for illustration an increase in the amount of
gold .)

2. The rate of interest rises, but not sufficiently .
3. Enterpriser-borrowers, encouraged by large profits,

expand their loans.
4. Deposit currency (M ') expands relatively to money

(M ).
5 . 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
interest rate lags behind its normal figure.
§ 3 . How a Rise of Prices culminates in a Crisis

The expansion in deposit gurrency indicated in this cycle
of events abnormally increases the ratio of M ' to M .

This, however, is not the only disturbance caused by the
increase in M . There are disturbances in the Q 's, in V , and
in V'. These will be taken up in order. Trade (the Q's)
will be stimulated by the easy terms for loans.

This effect is

always noted during rising prices, and people note approv
ingly that “ business is good ” and “ times are booming."
Such statements represent the point of view of the ordinary



business man who is an “ enterpriser -borrower .” They do
not represent the sentiments of the creditor, the salaried
man , or the laborer, most of whom are silent but long -suffer
ing — paying higher prices but not getting proportionally
higher incomes.
The increase in business on the one hand and the increase
in deposits on the other hand do not exactly offset each
other, as experience abundantly proves . The increase in
deposits will outweigh the increase in trade. This becomes
evident when we consider that the added deposits found
their origin in loans that were intended to finance new opera

tions. Usually the added trade for which the deposit was
created requires the expenditure of that deposit only once.

But the deposit once created is apt to last a long time. After
it is spent by the men who created it, it goes to swell the de
posit accounts of others. It is like new gold coin which , after
the gold miner has once put it into circulation , continues in

circulation indefinitely .

The gold miner may expend it for

mining expenses which help to make a demand for the new

coins it brings into circulation , but the new gold will be used

more than once ; and for all uses beyond the first, no new
transactions have been especially created for its continued

Thenew deposit currency likewise, when once

originated by the loan for new business , does not thereafter
find enough “ new work ” to do to keep it busy.

That is ,

the new deposit currency ( M ') adds more to the left side of
the equation than the trade which gave it birth adds to
the right side. Consequently, the net effect is to increase
the price level.

We next observe that the rise in prices — fall in the pur

chasing power of money — will accelerate the circulation of
money. We all hasten to get rid of any commodity which ,
like ripe fruit, is spoiling on our hands. Money is no excep

tion. When it is depreciating, holders will get rid of it as
fast as possible .

As they view it, their motive is to buy

goods which appreciate in terms of money. The inevitable



result is that these goods rise in price still further.


series of changes, then , initiated by rising prices, expressed
more fully than before, is as follows : 1. Prices rise.

2. Velocities of circulation (V and V') increase ; the rate
of interest rises, but not sufficiently .

3 . Loans expand and the Q 's increase.

4 . Deposit currency (M ) expands relatively to money
(M ) .
5 . Prices continue to rise ; that is, phenomenon No. I is

repeated .
Then No. 2 is repeated , and so on .

It will be noticed that these changes now involve all mag
nitudes in the equation of exchange.

They are temporary

changes, pertaining only to the transition period . They are
like temporary increases in power and readjustments in the
position of an automobile climbing a hill.

Evidently the expansion coming from this cycle of causes
cannot proceed forever. It must ultimately spend itself.
The check upon its continued operation lies in the rate
of interest. It was the tardiness of the rise in interest

that was responsible for the abnormal condition . But the
rise in interest, though belated , is progressive, and , as soon as
it overtakes the rate of rise in prices, the whole situation is

changed . If prices are rising at the rate of 2 per cent per
annum , the boom will continue only until interest becomes

2 per cent higher. It then offsets the rate of rise in prices.
The banks are forced in self -defense to raise interest because

they cannot stand so abnormal an expansion of loans rel
atively to reserves . As soon as the interest rate becomes
adjusted , borrowers can no longer hope to make great profits,
and the demand for loans ceases to expand .

There are also other forces resisting further expansion of
deposit currency and tending to contraction . But those

above mentioned are the most important.
With the rise of interest, those who have counted on re



newing their loans at the former rates and for the former

amounts are unable to do so . Some of them are destined to
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 sus
picion, 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 . Being short of

reserves the banks have to curtail their loans. It is then
that the rate of interest rises to a panic figure. Those who
are caught must have currency to liquidate their obligations,
and to get it are willing to pay high interest. Some of them

are destined to become bankrupt, and, with their failure,
the demand for loans is correspondingly reduced .


culmination of an upward price movement is what is called
a crisis, — a condition characterized by bankruptcies , and

the bankruptcies being due to a lack of cash when it is most
needed .

accued .

Then a curious thing happens : borrowers , unable to get
easy loans, blame the high rate of interest for conditions
which were really due to the fact that the previous rate of
interest was not high enough. Had the previous rate been

high enough, they never would have overinvested.
§ 4. Completion of the Credit Cycle
The contraction of loans and deposits, and the decrease in
velocities, prevent a further rise of prices and tend toward a

fall. The crest of the wave is reached and a reaction sets in .

Since prices have stopped rising, the rate of interest, which
has risen to compensate the rise of prices, should fall again .
But, just as at first it was slow to rise, so now it is slow to fall.

In fact, it tends for a time to rise still further. Even when
interest begins to fall, it falls slowly, and failures continue
to occur. Borrowers now find that interest, though nomi






nally low , is still hard to meet. Bank loans tend to be low , 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 to pay back what

they have borrowed . Owing to this tardiness of the interest
rate to fall to a lower and a normal level, the sequence of

events is now the opposite of what it was before : –
1. Prices fall.

2 . The rate of interest falls, but not sufficiently.
3. Enterpriser-borrowers , discouraged by small profits,
contract their borrowings.

4 . Deposit currency (M ') contracts relatively to money
(M ).

5. 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 rate of in
terest lags behind. 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.”
During this depression velocities ( V and V ') are abnor
· mally low . People are less hasty to spend money or check

when the dollars they represent are rising in purchasins
power. Also trade (the Q ’s) declines. A statement includ
ing these factors is :
1. Prices fall.

2 . Velocities of circulation ( V and V ') fall; the rate of
interest falls , but not sufficiently .

3. Loans and the Q 's decrease .
4 . Deposit currency (M ) contracts relatively to money
(M ).
5 . Prices continue to fall ; that is, phenomenon No. I is

repeated .



Then No. 2 is repeated, and so on .
The contraction brought about by this cycle of causes be
comes self-limiting as soon as the rate of interest overtakes
the rate of fall in prices. After a time, normal conditions

begin to return . The weakest producers have been forced
out, or have at least been prevented from expanding 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. Bor

rowing and carrying on business becomes profitable ; loans

are again demanded ; prices again begin to rise, and there
occurs a repetition of the upward movement already de
scribed .

The upward and downward movements taken together

constitute a complete credit cycle,which resembles the for
ward and backward movements of a pendulum .
We have considered the rise, culmination , fall, and re

covery of prices.

These changes are abnormal oscilla

tions, due to some initial disturbance. In most cases the
time occupied by the swing of the commercial pendulum to

and fro is about ten years. While the pendulum is continu
ally seeking a stable position , practically there is almost
always some occurrence to prevent perfect equilibrium .
Oscillations are set up which , though tending to be self

corrective, are continually perpetuated by fresh disturb

The factors in the equation of exchange are there

fore 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 en

counters causes which accentuate the oscillation .


§ 1. Influences which Conditions of Production 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 ofmoney and
of deposits .

These are the only influences which can di

rectly affect the level of prices. Any other influences on
prices must act through these three. There are myriads of
such influences (outside of the equation of exchange) that
affect prices through the medium of these three. It is our

purpose in this chapter to note the chief among them , ex
cepting 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.


conditions which determine the extent of trade are numer
ous and technical.
follows: –

The most important may be classified as

1. Conditions affecting producers.
(a ) Geographical differences in natural resources.
(6 ) 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.


3 . Conditions connecting producers and consumers.

(a ) Facilities for transportation .
(6 ) Relative freedom of trade.
(c) Character ofmonetary and banking systems.
(d ) Business confidence.

1 . (a ) It is evident that if all localitieswere exactly alike
in their natural resources and in other comparative costs of
production , no trade would be set up between them . It is
equally true that the greater the difference in the costs of
production of different articles in different localities , the

more likely is there to be trade between them , and the greater

the amount of that trade. Primitive trade had its raison
d 'être in the fact that the regions of this earth are unlike in

their products. The traders were travelers between distant
countries. Changes in commercial geography still produce

changes in the distribution and volume of trade.

The ex

haustion of the gold and silver mines in Nevada and of lum

ber in Michigan have tended to reduce the volume of trade
of these regions, both external and internal. Contrariwise ,

cattle raising in Texas, the production of coal in Pennsyl
vania , of oranges in Florida , and of apples in Oregon , has

increased the volume of trade for these communities re

spectively .
1. (6) Equally obvious is the influence of the division of

labor, i.e. the differentiation of productive activity among
men . Division of labor is based in part on difference in

comparative costs as between men, — corresponding to
geographic differences as between countries. These two
combined lead to local differentiation of labor, making, for

example, the town of Sheffield famous for cutlery, Dresden

for china, Venice for glass, Patterson for silks, and Pittsburg
for steel.

1. (c) Besides localand personal differentiation , the state
of knowledge of production will stimulate trade. The mines
of Africa and Australia were left unworked for centuries by



ignorant natives, but were opened by white men possessing
a knowledge ofmetallurgy . Vast coal fields in China await

development, largely for lack of knowledge of how to ex
tract and market the coal. Egypt awaits the advent of
scientific agriculture to usher in trade expansion . Nowa

days, trade schools in Germany, England, and the United
States are increasing and diffusing knowledge of productive

1. (d ) Butknowledge, to be of use,must be applied ; and
its application usually requires the aid of capital. The
greater and the more productive the stock of capital

in any community, the more goods it can put into
the channels of trade. A mill will make a town a center
of trade. Docks, elevators , warehouses, and railway ter

minals, help to transform

a harbor into a port of

commerce .

Since increase in trade tends to decrease the general level
of prices ; anything which tends to increase trade likewise

tends to decrease the general level of prices. We conclude,
therefore, that among the causes tending to decrease prices
are: increasing geographical or personal specialization ;
improved productive technique ; and the accumulation of

2. (a ) Turning to the consumer 's side, it is evident that
their wants change from time to time. This is true even

of so -called natural wants, but more conspicuously true of
acquired or artificial wants.
Wants are, as it were, the mainsprings of economic activ

ity 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, by leading to an increase in
trade, tends to lower the price level.



§ 2 . Influence of Conditions connecting Producers and
Consumers on Trade and therefore on Prices

3 . (a ) Anything which facilitates intercourse tends to
increase trade. Anything that interferes with intercourse

tends to decrease trade. First of all should be mentioned
the mechanical facilities for transport. 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 to increase trade and therefore to decrease

3 . (6 ) Trade barriers are not only physical but legal. A
tariff between countries has the same influence in decreasing
trade as a chain ofmountains.

The freer the trade, the more

of it there will be. In 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 United States and other countries
there is a high protective tariff. The very fact of increasing
facilities for transportation, 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 andmake
countries more alike as well as less productive, they also tend

to decrease the amounts of goods which can be exchanged.
The ultimate effect is thus to raise prices.
3. (c) The developmentof efficient monetary and banking

systems tends to increase trade. There have been times in
the history of the world when the money was in so uncertain
a state that people hesitated to makemany 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 sta
bility of banks, they will hestitate to use deposits and

3. (d) Confidence , not only in banks in particular but
in business contracts in general, is truly said to be “ the soul
of trade.” Without confidence there cannot be a great

volume of contracts. Anything that tends to increase this
confidence tends to increase 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 investments they may make will be taken from
them .

Wesee, then , that prices will tend to fall through an in
crease 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 business

The external trade ofany country is intimately connected
with its internal trade. An increase of the former may cause
an increase in the latter. Industry planted in any locality
for the purpose of trading with distant localities will bring

with it all kinds of supplementary commerce , so that the
locality will become a market for many sorts of goods.
Through the various causes mentioned, trade has been

increasing for centuries ; and the history of civilization is
largely the history of increasing trade. The discovery of
new lands, the specialization of their products, division of
labor, invention , and the improvement of industrial tech
nique, the accumulation of capital, increased complexity of

human wants, cheapened transportation and communication ,
development of better monetary and banking systems, and

greater confidence , have, in spite of higher tariff walls,
worked toward lower price levels ; and the future promises

a still further expansion of trade.



$ 3 . Influence of Individual Habits on Velocities of
Circulation and therefore on Prices
Our next task is to consider those causes outside of the
equation of exchange that affect the velocities of circulation
of money and of deposits .

For the most part, the causes

affecting one of these also affect the other. These causes
may be classified as follows:

Habits of the individual.
(a ) As to thrift and hoarding.
(6 ) As to book credit.

(c ) As to the use of checks.
2 . Systems of payments in the community .
(a) As to frequency of receipts and of disbursements.
(6 ) As to regularity of receipts and of disbursements.
(c) As to correspondence between times and amounts
of receipts and of disbursements.
3 . General causes.

( a) Density of population .
(b) Rapidity of transportation .
1 . (a ) Taking these up in order, we may first consider
what influence thrift has on the velocity of circulation .
Velocity of money is the same thing as the rate of turnover of
money. It was found by dividing the total payments ef

fected by money in a year by the amount of money in circu
lation in that year. It depends upon the rates of turnover

of the individuals which compose the society. This velocity
of circulation or rapidity of turnover of money is the greater
for each individual the more he spends with a given average
amount of cash on hand or the less average cash he keeps
for a given yearly expenditure.

Great is the velocity of

circulation of a spendthriſt. He tends to be “ short ” of





funds — to have a small average balance on hand. But his
thrifty neighbor takes care to provide himself with cash
enough to meet all contingencies. The latter tends to hoard
and lay by his money,and will therefore have a slower velocity
of circulation . 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. Oftentimes
in a certain university town the banks either refuse to take

deposits from students of spending habits because the aver

age balances of the latter are so low , or insist on a special
stipulation that the balances shall never fall below one hun
dred dollars .

Hoarded money is sometimes said to be withdrawn from
circulation . This is only another way of saying that hoard
ing tends to decrease the velocity of circulation .
A man who is thrifty is usually to some extent a hoarder

either of money or of bank deposits . Laborers who save
keep their savings, usually in the form of money, until
enough is accumulated to be deposited in a savings bank .

Those who have bank accounts will likewise accumulate
considerable deposits when preparing to make an invest

ment. Banks whose depositors are “ rapidly making
money ” and periodically investing the same, have, it is
said , less active accounts than banks whose depositors “ live
up to their incomes.”
1. (b) The habit of " charging,” or 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 credit, requires that money shall be kept

on hand in advance of purchases. Evidently, ifmoneymust
be provided in advance, itmust be provided in larger quan
tities 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. Moreover, this money
need not lie long in his pocket. Immediately it 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 successive daysat least asmuch as $ 7, $ 6 , $ 5 , $ 4 , $ 3 ,
$ 2 , and $ 1 , at which time another $ 7 comes in .

This makes

an average of at least $ 4 . But if he can charge everything,
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, the average ofwhich
is only $ 1.
Through book credit, therefore, the average amount of
money or bank deposits which each person must keep at

hand to meet a given expenditure ismade less. This means
that the rate of turnover is increased .
1. (c) The habit of using checks, rather than money, will
also affect the velocity of circulation , because a depositor's

surplusmoney will immediately 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 thus 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 de
posits may, by adjusting the two, prevent either from being
idle .

We see, then , that these habits — spendthrift habits, the

habit of charging, and the habit of using checks — all tend



to raise the level ofprices through their effects on the velocity

of circulation, of money, or of deposits. It is believed that
these habits (except probably the first) have been increasing
rapidly during modern times.
$ 4 . Influence of Systems of Payments on Velocities of
Circulation and therefore on Prices

2. (a ) Themore frequently money or checks are received
and disbursed, 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 ve
locity 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 on hand will be a little over half of

$ 7 , or about $ 4 . This makes his rate of turnover nearly
twice a week . Under monthly payments , the laborer who

receives and spends an average of $ 1 a day will have to

spread the $ 30 evenly over the following 30 days. If, at the
next pay day, he comes out empty -handed, his average

money during the month has been $ 15. This makes his
turnover nearly twice a month . Thus the rate of turnover
is more rapid under weekly than under monthly payments.

The same result would hold if we assumed that, instead of
ending the cycle empty-handed , he ended it with a given

fraction - say half — of his wages unspent. Under weekly

payments, he would begin with $ 10. 50 , and end with $ 3.50,
averaging about $ 7. Under monthly payments he would
thus begin with an average of $45, and end with $ 15, aver
aging about $ 30. In the former case his average velocity of
circulation would be once a week , and in the latter once a

month. The turnover would still be about four times as
rapid under weekly as under monthly payments . Thus,
if the distribution of expenditure over the two cycles should



have exactly the same “ time shape ” (distribution in
time), weekly payments would accelerate the velocity of
circulation in the same ratio which a month bears to a week .
As a matter of history, however, we cannot be sure whether
the substitution of weekly payments has increased the

rapidity of circulation of money among workingmen four
fold , because the change in another element, book credit,
would be likely to cause a somewhat compensatory decrease .
Book credit is more likely to be used under monthly than

under weekly payments . Where this book -credit habit or
habit of “ charging ” is prevalent, the great bulk of money

is spent on pay day. It is probable that the substitution of
weekly for monthly payments , when it has taken place, has

enabled many workingmen , who formerly found it necessary
to trade on credit, to make their own payments in cash , thus
decreasing the velocity of turnover of money .

Frequency of disbursements evidently has an effect simi
lar to the effect of frequency of receipts; i.e . it tends to
accelerate the velocity of turnover, or circulation .

2 . (6 ) Regularity of payment also facilitates the turn

over. 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 therefore con

clude that regularity of receipts and of payments tends to
increase velocity of circulation .

2. (c) Next, consider the synchronizing of receipts and
disbursements, i.e. making payments at the same intervals
as obtaining receipts. It is manifestly a great convenience
to the spender of money or of deposits, if dealers to whom




he is in debtwill allow him to postpone payment until hehas
received his money or his check .

This arrangement obvi

ates the necessity of keeping much money or deposits on
hand, and therefore increases their velocity of circulation .
Where payments such as rent, interest , insurance, and taxes ,

occur at periods irrespective of the times ofreceipts ofmoney,
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, have tended
to increase prices by an increasing velocity of circulation .

The change from monthly to weekly payments of workmen
has been progressing rapidly, and in many states has been

made mandatory by law . So far as these factors have oper
ated , therefore, there has been a tendency for prices to rise .

§ 5. Influence of General Causes on Velocities of Circu
lation and Indirectly on Price Levels
3 . (a ) The more densely populated a locality , the more
rapid will be the velocity of circulation , because therewill be
readier access to people from whom money is received or to

whom it is paid . In the country, although there are no
statistics, 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

Pierre des Essars has worked out the velocity of cir

culation 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.

3. (6 ) Again , the more extensive and the speedier the

transportation facilities, in general the more rapid the circu



lation 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.


telegraph has increased the velocity of circulation of de
posits , since these can now be transferred thousands of miles
in a few minutes. 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 transportation have tended to increase prices by increas

ing velocities .

$ 7. 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."

It goes without saying that a banking system must

be devised and developed before it can be used . The in

vention of banking has made deposit currency possible, and
its adoption has undoubtedly led to a great rise of prices.
( 2) “ 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 in money and not by
check .

The ultimate effect of this practice, therefore, is to

increase the ratio of check payments to cash payments and
the ratio of deposits to money carried , 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 .



§ 1. Influence of “ The Balance of Trade ” on the
Quantity of Money
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

reserved for separate treatment in this chapter the outside
influences that affect the quantity of money (M ).
The chief of these may be classified as follows :
1 . Influences operating through the exportation and im

portation of money.
2. Influences operating through the melting or minting

3. Influences operating through the production and con
sumption of money metals.
4 . Influences produced by prevailing monetary and bank
ing systems.

1. The first to be considered is the influence of foreign
trade. Hitherto we have confined our studies of price level
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 problemsofmoney and
of the price level an international character .

If all coun

tries had their own irredeemable papermoney, and nomoney
that was acceptable elsewhere, there could be no interna

tional adjustment of monetary matters . Price levels in
different countries would have no intimate connection .



Indeed , to some extent the connection is actually broken
between existing countries which have different metallic
standards, — for example , between a gold -basis and a

silver -basis country, — although through their non -monetary
uses the two metals are still somewhat bound together,

as any two substitutes, or partial substitutes, are bound
together . 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 Switzerland depends largely upon the
price level in other countries. Gold , which is the basic or
full weight money in most civilized nations, is constantly
traveling from one country or community to another .

When a single small country is under consideration, it is
therefore preferable to say that the quantity of money in
that country is determined by the universal price level,
rather than to say that its level of prices is determined by
the quantity of money within its borders. An individual

country bears the same relation to theworld that a lagoon
bears to the ocean .

The level of the ocean depends, of

course, upon the quantity of water in it. But when we
speak of the lagoon we reverse the statement, and say
that the quantity of water in it depends 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

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 non-monetary uses. We shall likewise , for the
present, omit consideration of the production of money
through mining .

Let us, then , consider the causes that determine the quan

tity 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 , Connec
ticut becomes a good place to buy from , but a poor
place to sell to. But if outsiders buy of Connecticut, they

will have to bring money to buy with. There will, there
fore, 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 to and a poor one to buy from . But if outsiders sell

to Connecticut, they will receive money in exchange. There
is then a tendency 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 towards places where it is low . 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 any
other currency than money ; as we have seen , in the long
run deposit currency will maintain a definite ratio to money .

But it must not be inferred that the prices of various arti
cles, or even the general level of prices, will becomeprecisely
the same in all countries. Distance, ignorance as to where
the best markets are to be found, tariffs, and costs of trans

portation , 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 cover the cost of transportation .
Practically 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

theUnited States to England, but not from England to the



United States. It is produced in the United States, and
tends to be cheaper here . Large exportations raise its price
in America toward the price in England , but it will usually
keep below that price by the cost of transportation . Other
commodities that are cheap to transport will be sent in

either direction , according to market conditions.
But, although international and interlocal trade will

never bring about exact uniformity of price levels, it will
produce an adjustment of these levels toward uniformity by
regulating, in the manner already described , the distribu
tion of money. If one commodity enters into international
trade, it will suffice to act as a regulator of money dis

tribution ; for, in return for that commodity, money may
flow , and as the price level rises or falls , the quantity of that

commodity sold may be correspondingly adjusted . In or
dinary intercourse between nations, even when a deliberate

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.
It follows that nowadays international and interlocal
trade is constantly regulating price levels throughout the
world .
Wemust not leave this subject without emphasizing the

effects of a tariff on the purchasing power of money. When
a country adopts a tariff, the tendency is for the level of

prices to rise. A tariff obviously raises the prices of the
“ protected ” goods. But it does more than that — it tends

also to raise the prices of unprotected goods. Thus, the
tariff first causes a decrease in imports.

Though in the

long run this decrease in imports will lead to a correspond
ing decrease in exports , yet at first there will be no such

adjustment. The foreigner will, for a time, continue to
buy from the protected country almost as much as before.




This will result temporarily in an excess of that country's

exports over its imports , or a so -called " favorable " bal
ance of trade, and a consequent inflow of money .


inflow will eventually raise the prices not alone of pro

tected 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.

Although the “ favorable balance ” of trade created by a
tariff is temporary, it leaves behind a permanent increase 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 tempor

ary stimulus not only to protected industries but to trade in
general, which is really simply a stimulus of money inflation .
Our present interest in international trade, however, is
mainly directed to its effects on international price levels .

Except for the export or import of money to adjust the
price levels, international trade is at bottom merely an

interchange of goods. The “ goods ” entering into inter
national trade include not only the visible exports and im

ports , but also securities, services of carrying vessels con

ducting the trade, and in fact any wealth , property , or serv
ices exchanged.
We have shown how the international and interlocal equi
librium of prices may be disturbed by differential changes
only in the quantity of money. But it may be disturbed
by differential changes also in the volume of bank deposits ;

or in the velocity of circulation of money ; or in the veloc
ity of circulation of bank deposits ; or in the volume of
trade. And whatever may be the source of the difference
in price levels, equilibrium will eventually be restored

through an international or interlocal redistribution of
money and goods brought about by international and inter

local trade. Other elements in the equation of exchange
than money and commodities can not be transported from

one place to another.


§ 2.


Influence of melting and minting on the Quantity
of Money

We have seen how M in the equation of exchange is
affected by the import or export of money. Considered
with reference to the M in any one of them , 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 any equation of

exchange for a particular country but outside those for the
whole world . Besides the monetary inflow and outflow
through import and export, there is an inflow and outflow
through minting and melting.

In other words, not only

do the stocks ofmoney 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
or silver , — usually plays the part of primary money, and
this metalhas two uses, – a monetary use and a commodity


That is to say, gold or silver 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 . Now gold money, for example ,
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 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 will determine the direction of the flow . Since
100 ounces of gold , i'o fine, can be transformed into $ 1860,
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, no matter how slight the difference may

be, the users of gold who require bullion - notably jewel
ers — will save this difference by melting gold coin into
bullion . Contrariwise , if the price of bullion is less than

the value of gold coin , the owners of bullion will save the
difference by taking bullion to the mint and having it
coined into gold dollars, instead of selling it in the bullion

market. 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 bul

lion and raising the value of gold as money ; thereby
lowering the price level and restoring the equality between
bullion and money . The effect of minting bullion into coin
is by the opposite process to bring the value of gold as coin
and the value of gold as bullion again into equilibrium .
Where 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 ofmetallurgy, both melt
ing and minting may be performed so inexpensively and so
quickly that there is practically no cost and no delay in
volved .

In fact, there are few instances of more exact

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 misunder



stand the significance of the fact that an ounce of gold
always costs about $ 18 .60 in the United States or £3, 175.,

and 103 d . 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
dollars, or that a gold eagle is worth a fixed number of

Except, then , for extremely slight and temporary fluc
tuations, gold bullion and gold money must always have the

same value. Therefore in the following discussion respect
ing the more considerable fluctuations affecting both , we

shall speak of both interchangeably as “ the value of gold .”
§ 3. Influence of the Production and Consumption of
Money Metals on the Quantity of Money
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 of the output of themines —
which constantly tends to add to the existing stocks both
of bullion and coin . The consumption of gold consists of
the use of bullion in the arts by being wrought up into

jewelry, gilding, etc., and of losses by abrasion , shipwreck ,
etc. If we consider the amount of gold coin and bullion as

a reservoir, production would be the inflow (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 grown obsolete, illustrated

by the business of producing gold bullion by burning old
picture frames .



We shall consider first the inflow or production, and after
ward the outflow or consumption . The regulator of the
inflow (which practically means the production of gold

from themines) is its estimated cost of production. Where
ever the estimated cost of producing a dollar of gold is less
than the existing value of a dollar in gold, it will normally

be produced . Wherever the cost of production exceeds the
existing value of a dollar, gold will normally not be pro

duced. In the former case the production of gold is profit
able ; in the latter it is unprofitable .
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, or of any supposed “ absolute ” standard of value.

In gold -standard countries gold miners do actually reckon
the cost of producing gold in terms of gold . From


standpoint it is a needless complication to translate the
cost of production and the value of the product into some

other standard than gold . They are interested in the re
lation between the two, and this relation will not be affected
by the standard .

To illustrate how the producer bf gold measures every
thing in gold , suppose that the price level rises . He will then
have to pay more dollars for wages, machinery , fuel, etc .,
while the prices obtained for his product (expressed in those
same dollars) will, as always, remain unchanged . Con
versely, a fall in the price level will lower his cost of pro

duction (measured in dollars), while the price of his product
will still remain the same.

Thus wehave a constant number

expressing the price of gold product and a variable number
expressing its cost of production . 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.
Of course the comparison is the same, whether we use
gold or other commodities as our criterion . In the one



view , a rise of prices means a rise in the gold miner's cost
of production ; in the other it means a fall in the price

(purchasing power) of his product. 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. The cost of
production in either case is compared with the purchasing

power of gold . If this purchasing power is above the cost
of production in any mine, it will pay to work that mine.

If the purchasing power of gold is lower than the cost of
production of any mine, it will not pay to work that mine.

Thus the production of gold increases or decreases with an
increase or decrease in the purchasing power of money .

So much for the inflow of gold and the conditions regu
lating it. We turn next to outflow or consumption of gold .
This has two aspects , viz . consumption in the arts and con
sumption formonetary purposes.

If objects made of gold are cheap, — that is, if the prices
of other things are relatively high , — then the relative

cheapness of the gold objects will lead to an increase in
their use. Or, expressing the matter in terms of money
prices, when people find prices of everything else higher and
their own incomes likewise higher , while gold watches and
gold ornaments generally remain at their old level, they can

afford to buy more gold watches and ornaments .
These are instances of the consumption of gold in the
form of commodities .

The consumption of gold as coin is

a matter of abrasion, of waste and wear. It changes with

the changes in the amount of gold in use and in its rapidity
of exchange.

The important result is that an increase in

the price (purchasing power) of a gold dollar encourages
the production of gold and discourages its consumption
just as an increase in the price of any other commodity

encourages its production and discourages its consumption .

A decrease, of course , acts in the opposite way. The pur



chasing 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.
§ 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 consump

tion or “ outflow ” (into the arts and by destruction and
loss) ; and (3) the “ stock " or reservoir of gold (whether
coin or bullion ) which receives the inflow and suffers the



outflow . The relations among these three sets of magni

FIG . 10.

tudes can be set forth by means of a mechanical illustration ,
given in Figure 10. This represents two connected reser

voirs of water,Go and G . The contents of the first reser
voir represent the stock of gold bullion , and the contents

of the second the stock of gold money . Since purchasing
power increases with scarcity, the distance from the top of
the cisterns, 00 to the surface of the liquid is taken to
represent the purchasing power of gold over other goods.

A lowering of the level of the liquid in Gm indicates an in



crease in the purchasing power of money , since we measure
this purchasing power downward from the line 00 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 . We
shall now explain the shapes of these cisterns.

The shape

of the cistern Gm must be such as will make the distance of
the liquid surface below 00 decrease 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 Gm doubles , the distance of the

surface from the line 00 should decrease by one half. In
the same way for gold bullion , the shape of the cistern must
be such as willmake the distance of the liquid surface below

00 decrease with an increase of the liquid in the same way
as the value of gold bullion decreases with the stock of gold
bullion. The shapes of the two cisterns need not, and
ordinarily will not, be the same.
Both reservoirs have inlets and outlets. Let us con

sider these in connection with the bullion reservoir (G ) .

Here each inlet represents a particular mine supplying bul
lion , and each outlet represents a particular use in the arts
consuming gold bullion . Each mine and each use has its
own distance from 00. There are, therefore, three sets
of distance from 00 : the inlet distances, the liquid surface

distance, and the outlet distances. Each inlet distance
represents the cost of production , measured in goods for
each mine ; each outlet distance represents the value of
gold in each particular use in goods.

The surface distance,

as we have already explained , represents the value of bul

lion, likewisemeasured in goods, - in other words, its pur
chasing power.



It is evident that among these three sets of levels there
will be discrepancies. These discrepancies serve to interpret

the relative state of things as among mines, bullion , and

uses of gold at any given moment, and will determine the
various flows — in and out. If an inlet at a given mo
ment be above the surface-level, i.e. at a less distance

from 00 , the interpretation is that the cost of produc
tion is less than the purchasing 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 00 is as small

as the inlet -distance — i.e. until the purchasing power ofbul
lion is as small as the cost ofproduction . Atthis point there
is no longer any profit in mining. So much for inlets ; now
let us consider outlets . If an outlet at a .given moment be

below the surface-level, - i.e. ata greater distance from 00 ,
the interpretation is that the value of gold in that par
ticular use is greater than the purchasing power of bullion .

Hence gold bullion will flow into these uses where its worth
is greater than 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 , there
fore,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 outlets .
We turn now to the money reservoir (Gm) .

The outlets

from this reservoir represent the consumption of gold coins
by loss and abrasion . These increase with increase of the
stock of coins. The fact that gold has the same value
either as bullion or as coin , because of the interflow between

them , is interpreted in the diagram by connecting the



bullion and coin reservoirs, in consequence of which both
will (like water ) have the same level. The surface of the
liquid will in both cases be the same distance below the line
00 , and this distance represents the value of gold . Should
the inflow at any time exceed the outflow , the result will

necessarily be an increase in the stock of gold in existence.
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 pendu
lum swinging back and forth through a position of equi

librium , 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 vari
ables involved in the problem under discussion . It does
not of itself constitute an argument, or add any new ele

ment; nor should one pretend that it includes explicitly all
the factors which need to be considered . But it does enable
us to grasp the chief factors involved in determining 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 or im
proved methods of working old ones , — due, let us sup
pose, to the discovery of new mines, — this may be
represented by an increase in the number or size of the
inlets into the G , reservoir ; the result will evidently be an
increase of “ inflow ” into the bullion reservoir , and from

that into the currency reservoir, a consequent gradual fill



ing up of both , and therefore a decrease in the purchasing
power of money. This process will be checked finally by
the increase in consumption . And when production and

consumption become equal, an equilibrium will be estab
lished . An exhaustion of gold mines obviously would

operate 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 ofGy.

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 connection between the currency reservoir and the
bullion reservoir is closed by a valve so that gold cannot flow

from bullion into money (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. Whatever

increasemay take place in the production of gold will then
tend only to fill the bullion reservoir and decrease the dis
tance of the surface from the line 00 , i.e. lower the value

of gold bullion .

The surface of the liquid in the money

reservoir will not be brought nearer 00 . It may even be
lowered farther away. In other words, the purchasing
power of money will be entirely independent of the value
of the bullion out of which it was first made.

We have now discussed all but one of the outside influ
ences upon the equation of exchange. That one is the
character of themonetary and banking system which affects
the quantity of money and deposits .

This we reserve for

special discussion in the following two chapters . Mean
while wemay here summarize such of those influences dis



cussed in this and the preceding chapter as operate in more

than one way. Consider, for instance , technical knowledge
and invention , which affect the equation of exchange by in

creasing trade. So far as these increase trade, the tendency
is to decrease prices ; but so far as they develop metallurgy

and the other arts tending to increase the production and
easy transportation of the precious metals, they tend to in

crease prices . So far as they make the transportation and
transfer 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 likewise tend to increase prices, both
by increasing deposit currency (M ') and by increasing the
velocity of circulation 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 .

Finally, so far as per capita trade is increased through
this or any other cause , there is a tendency to increase the
velocity of circulation of money. What the net effect may

be during any given period will depend on the predominant
direction in which the arts are developed .

It is also noteworthy that almost all of the influences
affecting 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

volumeof trade ; but this is largely neutralized by increased
velocities due to the increased trade itself, and by the pro

gressive increase and concentration of population , which

helped to bring about the increase of trade.


§ 1. Gresham 's Law
Thus far we have considered the influences that deter
mine the purchasing power of money when the money in
circulation is all of one kind .

The illustration given in the

previous chapter shows how the money mechanism operates
when a single metal is used as the primary money and is
freely minted and melted . We have now to consider the
monetary systems in which more than onemetal enjoys this

status, beginning with the most familiar system , — that of
bimetallism .
One of the first difficulties in the early history of money
was that of keeping two (or more) metals in circulation .

One of the two would become cheaper than the other, and
the cheaper would drive out the dearer .

To this tendency has been given the nameof “ Gresham 's
Law ” in honor of Sir Thomas Gresham , a financial adviser
of Queen Elizabeth of England. It was he who propounded

it in the middle of the sixteenth century. But 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 !” .

Gresham 's Law is ordinarily stated in the form , “ Bad

money drives out good money,” for it was usually observed



that the badly worn , defaced , light-weight, “ clipped ,"
“ sweated,” and otherwise deteriorated money tended to
drive out the full-weight, freshly minted coins. This formu
lation , however, is not accurate. It is not true that “ bad ”

coins, e.g. worn , bent, defaced , or even clipped coins will
drive out other money just because of their worn , bent,

defaced, or clipped condition. Accurately stated , the law
is simply this : Cheap money will drive out dear money. The
reason why, of two moneys, the cheaper 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 re

ceives it. When any one has the choice of paying his debts

in either of two moneys, motives of economy will prompt
him to use the cheaper. If the initiative and choice lay
principally with the person who receives instead of the per
son who pays themoney, the opposite would hold true. The

dearer or “ good ” money would then drive out the cheaper

or " bad ” money. It is because the debtor exercises the
choice that the cheaper money tends to continue in circu

lation . What 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

cause , where foreign trade is involved, it is the foreigner who
receives the money rather than ourselves who give it that

dictates what kind of money shall be accepted. He will
take only the best, because our legal-tender laws do not
bind him .

Gresham 's Law applies not only to two rival moneys of
the same metal — it applies to all moneys that circulate
concurrently . Until “ milling ” the edges of coins was
invented , and a " limit of tolerance ” of themint (deviation
from the standard weight) 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 customary or legal limits
of tolerance, however , — that is, as long as the cheaper

money retains the “ money ” power, -- it will still drive
out the dearer.
§ 2 . When Bimetallism Fails
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

formulate 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 .

In order to understand fully the influence of any monetary
system on the purchasing power of money, we must first
understand how the system works. It has been denied that

bimetallism ever did work or can be made to work, because
the cheaper metal will drive out the dearer. Our first task

is to show , quite irrespective of its desirability, that bi

can and does “ work ” under certain circum

stances , but not under others. To make clear when it will
work and when it will not work, we shall continue to em
ploy the mechanical illustration of the last chapter, in
which the amount of gold bullion is represented by the con
tents of reservoir Go (Figs. II, 12). Here, as before, we

represent the purchasing power or value of gold by the dis
tance of the water level below the zero level 00 . Now , 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 , a step at a

time, elaborate that figure. First,as in Figure 11 a, weadd
a reservoir for silver bullion ( S ), a reservoir of somewhat



different shape and size from Gs. This reservoir might be
used to show the relation between the value or purchasing
power of silver and its quantity in the arts and as bullion .
Here, then , are three reservoirs. At first the silver one is

entirely isolated ; but after a while we shall connect it

with themiddle one. For the present let us suppose that
the middle one, which containsmoney, is entirely filled with

gold money only (Fig . 11 a ), 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 we
have 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
So with the money reservoir, that is, we introduce bimet
allism . Under bimetallism , governments open their mints
to the free coinage of both metals at a fixed ratio , i.e . a fixed

ratio between the said metals. For instance, if a silver
dollar contains 16 grains of silver for every grain of gold
in a gold dollar, the ratio is said to be 16 to 1. Under this
system , the debtor has the option , unless otherwise bound

by his 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 un

limited legal tender of each metal at that ratio . These new
conditions are represented in Figure

b (and later, Fig . 12b) ,

where a pipe gives silver an opening into themoney or cen
tral reservoir .
What we are about to represent is not the relations be

tween mines, bullion, and arts, but the relations between
bullion (two kinds) and coins. We may therefore disre
gard for the present all inlets and outlets except the con

nections between the bullion reservoirs and coin reservoir.
Now in these reservoirs the surface-distances below 00

represent, as we have said , purchasing power. Purchasing



power ofwhat? Of gold and of silver, yes ; but each unit
of silver (say each drop of silver water, whether as money




or as bullion) contains 16 times as many grains as each unit
of gold (say drop of gold water, whether as money or as
bullion ). We all know , of course, that a silver dollar is
much larger than a gold dollar. But for the sake of our


FIG . 11.

mechanical representation we may disregard this differ
ence, and regard a drop of gold (whether money or bullion )
as occupying equal space with a drop of silver (money or
bullion ). That is, a unit of water represents a dollar of
gold or a dollar of silver. All we wish to represent is the

relative purchasing power of corresponding units.
The waters representing gold and silver money are sepa
rated by a movable film ff. In Figure ir a this film is at



the extreme right, in Figure 11b, at the extreme left, in Fig
ure 12 a , again at the right, and in Figure 12 b , midway. The
a figures represent conditions before the mints are opened
to silver.

The b figures represent conditions after they

have been opened and Gresham 's law has operated .


just previous to the introduction of bimetallism , the silver

level is below the gold level, the statute introducing bi
metallism will be inoperative, i.e. the silver bullion will not

flow into themoney reservoir ; but if,as in Figure 11a or 12a
the silver level is higher, then as soon as the mints are open
to silver, it will flow into circulation . Being at first cheaper
than gold , it will push out the gold .

This expulsion of gold

may be complete, as shown in Figure iib, or only partial,
as shown in Figure 12 b .

The expulsion will continue just

as long as there is a premium on gold ; that is, as long as
the silver level in the bullion reservoir is above the gold

level in the money reservoir ; i.e . as long as silver bullion
is cheaper than gold money .

Let mm , as shown in Figure ii a , be the mean level ;
that is , a level such that the volume x above it equals the
combined vacant volumes y and z below it. This line mm
remains the mean level, whatever may be the distribution

of the contents among the three reservoirs . As soon as
the connecting pipe is inserted , silver will flow into the

money reservoir and , in accordance with Gresham 's Law ,
will displace gold.
Here we have to distinguish two cases : ( 1) when the sil
ver x above the mean line mm exceeds the contents of the

money reservoir below this line; (2) when x is less than said
lower contents. In the first case, it is evident that silver will

sweep gold wholly out of circulation ,as shown in Figure 11b
where the film ff has moved from the extreme right to the
extreme left. The contents of silver in the bullion reser

voir are less than before, and the contents of gold in the
bullion reservoir greater than before.

But this redistribution is only the first effect of opening



the mints to silver. The balance between production and
consumption has been upset both for gold and for silver.

The increased value of silver (lowered level in So) has
stimulated production , bringing into operation silver mines

(uncovered inlets at right) ; and, on the other hand , the
decreased value of gold (raised level in Gy) has discouraged

gold production , shutting off gold mines (covered inlets at
left ).

Like alterations are effected in the outflows, i.e.

the consumption , waste, and absorption of each metal.
The result is that the levels resulting from the first redis
tribution will not necessarily be permanent. Under the
influence of production and consumption, they may, and
under ordinary conditions will, recede somewhat toward
their original respective positions.

$ 3. When Bimetallism Succeeds
So much for the first case ,where x is larger than the con
tents of the money reservoir below mm .

In the second

case, x is supposed to be smaller than the contents of the

money reservoir below mm ; that is, there is not enough
silver to push all the gold out of circulation . Under these

circumstances the opening of the pipe — the opening of the
mints to silver — will bring the whole system of liquids
to the common level mm . In other words, the premium
on gold bullion will disappear (Fig . 12 b ), and its purchas
ing power and the purchasing power of silver bullion will
be a mean between their original purchasing powers, this
mean being the distance of themean line mm below 00 . In
other words, bimetallism succeeds in this case. That is, it
will establish and maintain an equality for a time between

the gold and silver dollars in the money reservoir.
The equilibrium we have found is a mere equalization
of levels produced by a redistribution of the existing stocks
of gold and silver among the various reservoirs.

It will be

disturbed as soon as these stocks are disturbed . A per



manent equilibrium requires that the stocks shall remain
the same — requires, in other words, an equality between

production and consumption for each metal. After the

inrush of silver, from the silver bullion to the money reser
voir, it is evident that the production and consumption of

gold need no longer be equal to each other, nor need the







A .

(6 )

Fig . 12.

production and consumption of silver be equal to each other.
The same stimulation of silver production and discourage
ment of gold production will occur that occurred in the
first case. The result may be that, after all, silver will, in
the end, entirely displace gold , or again it may not. If a
position of the film be found at which the production and

consumption of gold are equal to each other, and the pro



duction and consumption of silver are likewise equal to

each other , there will be equilibrium . This equilibrium
may be upset later and the film driven to the right or the
left as new gold or silver is discovered and flows into the
system of reservoirs from one side or the other. But bi
metallism will continue to keep gold and silver dollars
equivalent until the film happens sometime to be driven
to either extreme position . Such a fate is in the end alto

gether probable.

Then the two kinds of dollars diverge in

value and only the cheaper metal remains as money.

§ 4.

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 results when , in
a system of straight bimetallism , before either metal can

wholly expel the other , the mint is closed to one of them , but
the coinage that has been accomplished up to date not
recalled . Suppose silver to be the metal thus excluded , —
as in France and the United States. Any money already

coined in that metal and in circulation is kept in circula
tion 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 difference in value between

silver bullion and silver coin, the silver coin being over
valued . This situation is represented in Figure 13. Here
the pipe connection between the money reservoir and the

silver -bullion reservoir has been , as it were, cut off — or,
let us say, stopped by a valvewhich refuses passage of silver
into the money reservoir,but does not prevent passage from
the money reservoir to the bullion reservoir ; for no law

ever can preventthemelting down of silver coins into bullion.
Newly mined silver cannot now becomemoney , and thus



lower the purchasing power of the money. On the other

hand, new supplies of gold continue to affect the value of
the currency, as before, not only of the gold but also of

the concurrently circulating overvalued silver. If more
gold should flow into themoney 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
long, however, as the currency level is below the silver level,
the passage in that direction (i.e. melting) is still free. So






& Sm

FIG. 13.

i.e. so long as the coined silver is worth more than the un
coined, there will be no flow of silver in either direction .
The legal prohibition prevents the flow in one direction , and
the laws of relative levels prevent its flow in the other.
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
constituentmaterial. 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
the coined value of which is greater than the value of its

limited in quantity, its value will ordinarily be equal to

that of its legal equivalent in gold. If its quantity in
creases indefinitely, it will gradually push out all the gold








and entirely fill the money reservoir , just as silver would
do under genuine bimetallism if produced in sufficiently
large amounts. Credit money and credit in the form of
bank deposits have this effect. To the extent that they are
used , they lessen the demand for gold , decrease its value 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 the 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 sup
posed it is not of sufficient quantity to do. The parity

between silver coin and gold coin , under the “ limping "
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 usu
ally sufficient to maintain parity despite irredeemability .
This is not always true, however ; for if the people should

lose confidence in some form of irredeemable paper or token
money, even though it were not overissued , it would de

preciate and be nearly as cheap as money is in the raw state.
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 what
ever money is a customary or legal tender, may then take
a hand and insist on “ contracting out ” theoffending stand
ard . That is, he may insist on making contracts in terms
of the better metal, — gold , for instance, — and thus con
tribute to the further downfall in value of the depreciated
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
sion of the field .

But though such a result — a condition of irredeemable
paper money as the sole currency - is possible, it has never
proved desirable. On the contrary, irredeemability is a
constant temptation to abuse, and this fact alone causes

business distrust and discourages long-time contracts and
enterprises. Irredeemable paper money has almost in
variably proved a curse to the country employing it . While ,

therefore, redeemability is not absolutely essential to pro
duce parity of value with the primary money, it is prac
tically 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 and a continuing
danger .

§ 5. The “ Limping ” Standard in the United States
Among the nations which now have the limping standard

is the United States. In 1792, Congress adopted complete
bimetallism . Full legal- tender quality was given to both
gold and silver coins ; both were to be coined freely and
without limit at the ratio of 15 ounces of silver to i of gold .

This coinage ratio was soon found to be below the bullion

or market ratio ; it overvalued silver, as money, and con
sequently gold (which was, as bullion , the dearer or better
money) tended to leave the country, so that although nomin

ally bimetallic, the country came actually to a silver basis .
Influenced partly by the desire to bring gold back into

circulation , and partly also perhaps by the supposed dis
coveries of gold in the South, Congress passed acts in 1834
and 1837 establishing the ratio of “ 16 to 1,” — or, more
exactly, 16 .002 to 1 in 1834, and 15.998 to 1 in 1837. Whereas
silver money had been overvalued by the previous laws, by

these new laws gold money was overvalued. That is, the



commercial ratio continued to be near 151 to 1, while the
monetary ratio was slightly greater.

This remained the

case up to 1850 ; consequently , in accordance with Gresham 's
Law , gold money, now the cheaper, drove out silver money ,

and the United States became a gold -standard country .
In 1853 , to prevent the exportation of our subsidiary silver

coins their weight was reduced .
The United States continued to be a gold -using country
until the period of the Civil War, during which “ green
backs, ” or United States notes , were issued in considerable

excess. Again Gresham 's Law came into operation . Gold
was in turn driven from the currency, and the United States

came to a paper standard. For some years after the close
of the war the country remained on a paper standard , little

gold being in circulation , except on the Pacific coast , and
notmuch silver anywhere.
In 1873 Congress passed a law (called by bimetallists
the “ Crime of '73 ') by which the standard silver dollar
was entirely omitted from the list of authorized coins. Of

course this could not have had any immediate effect on the

flow of gold and silver, because the country was at the time
on a paper basis . But when specie payments (i.e. gold and

silver payments) were resumed in 1879, this repeal of the
free coinage of silver brought the country to a gold standard ,

not to a silver one. Had it not been for the law of 1873, the

United States, when it returned in 1879 to a metallic basis,
would have been a silver country with a standard consid
erably below the gold standard it actually reached. Our
monetary problems would then have been very different
from what they actually became.

The greenbacks, however, were not all canceled . By
the express provision of a law passed in 1878 nearly

$ 347,000,000 of the “ greenbacks ” were retained in cir
culation , and have been in circulation ever since. They
have been kept at par with gold because : (1 ) they are
limited in amount ; (2 ) they are redeemable in gold on de






mand ; (3) they are receivable for taxes and are legal tender .
But in returning to a gold basis, we reintroduced the silver

dollar in a minor rôle . Although the free coinage of silver
was not resumed , the advocates of silver, through the

“ Bland -Allison Act ” of 1878 and the “ Sherman Act ” of

1890 which replaced it, succeeded in pledging the govern
ment to the purchase of large, but not unlimited , amounts
of silver and the coinage of a large, but not unlimited ,
number of silver dollars. The Bland-Allison Act required
the Secretary of the Treasury to purchase every month

from $ 2,000,000 to $ 4,000 ,000 worth of silver and to coin
it into standard silver dollars. The Sherman Act required
the purchase, every month , of 4,500,000 ounces of silver.
Under these acts 554,000 ,000 silver dollars were coined ,
although less than 20 per cent of them have ever been put

in actual circulation. Silver certificates redeemable in silver
dollars on demand, and, for a time, treasury notes , have
circulated in the place of this immense mass of silver ; the
silver dollars (and therefore the silver certificates) maintain
their value on a parity with gold primarily because they

are limited in supply . Also in practice, though not by any
compulsion of law , they are redeemed on demand in any

form of money desired, including gold . No law directly
provides for the redemption of silver certificates in gold ,
but it is made the duty of the Secretary of the Treasury to
take such measures as will maintain their parity with gold .

In 1893 the Sherman Act was repealed, and in 1900 a law
was passed specifically declaring that the United States
shall be on a gold basis.

$ 6 . Our Present Monetary System
The system of the limping standard, now obtaining in the
United States, logically forms a connecting link between
complete bimetallism and those " composite ” systems by
which 'any number of different kinds of money may be



simultaneously kept in circulation . The manner in which
most modern civilized states have solved the problem of
concurrent circulation has been to use gold as a standard ,

and to use silver , nickel, and copper chiefly as subsidiary
money, limited in quantity, with , in most cases, limited
amounts of paper money, the latter being usually redeem
able . The possible variations of this composite system are

unlimited . In the United States at present we have a sys
tem which is very complicated and objectionable in many

of its features — especially (as we shall presently see) in
its lack of elasticity. Gold is the standard and is freely
coined .

A limited number of silver dollars , worth , money

wise, more than double their value bullion -wise , are the
heritage of former bimetallic laws rendered inoperative by

the paper money of the Civil War and expressly repealed
in 1873. The two unfortunate attempts of 1878 and 1890
to return halfway to bimetallism by the purchase of silver

– attempts discontinued in 1893 — have greatly swollen
the volume of coined silver.

The attempt to force silver

dollars into circulation was not acceptable to the business

world , and Congress therefore issued two formsof paper to
take their place . The chief form is the “ silver certificate."
For each silver certificate a silver dollar is kept in the

vaults of the United States government.
The absurdity of the situation consists in the fiction
that somehow the silver keeps paper at par with gold .


paper would keep its parity with gold just as well if there
were no 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 frac
tion of a cent,will not avail in the least to make the paper

worth a whole dollar. A pillar which only reaches half
way to the ceiling cannot hold the ceiling up any more than
a pillar an inch high .

The paper representatives of silver might always con



tinue to circulate as well as they do now , even if the “ sil

ver behind them ” were non -existent, except that the
absurdity of the situation would then be so apparent that
they would probably be retired . Whether the half-billion
dollars of new currency, which came into circulation with

the Bland and Sherman Acts, are of silver, overvalued to
the extent of 50 per cent, or of paper, overvalued to the
extent of 100 per cent, does not really affect the principle

of the limping standard which keeps silver dollars at par
with gold .

The idle silver in the treasury vaults repre

sents mere waste, a subsidy given by the government to
encourage silver mining. Its only real effect to -day is to
mislead the public into the belief that in someway it keeps

or helps to keep silver certificates at par with gold ; whereas,
it is kept at par simply by its limited amount. It cannot

fall below par withoutdisplacing gold , and it cannot displace
gold because there is not enough of it.

Another and equally useless anomaly is the existing vol
ume of “ greenbacks.”

These are United States govern

ment notes. Under the law of 1875, the greenbacks were
by 1879 retired in sufficient numbers to restore parity with

gold ; but by a counterlaw of 1878, 347,000,000 of them were
kept in circulation and are in circulation now . As soon as
redeemed, they must be reissued ; they cannot be retired .

These are a fixed ingredient in our money pot pourri, neither
expansive nor shrinkable .

It is absurd to redeem but not

retire – in fact, almost a contradiction in terms.

This ab

surdity has at times seriously embarrassed the government.

The next feature of our currency to be considered is the
bank note. Although the National Banks acts wiped out

the old , ill-assorted state bank notes by taxing them out of
existence, and supplied us with a better and uniform sys

tem of national bank notes, it tied these notes up with the
war debt, and they have remained so tied ever since, in

spite of the fact that the advantages of the connection have
long been terminated and the disadvantages have grown



acute. National bank notes cannot legally be issued in
excess of the government debt, however urgent the need

for them ; nor can the government pay its debt without
thereby compelling national banks to cancel their notes .
The result is an inelastic currency which , instead of adjust

ing itself to the seasonal fluctuations in trade, and thus
mitigating the ensuing variations in the price level, remains
a hard and solid mass to which the other elements in the
equation of exchange must adapt themselves .

It is clear that the elements of our currency just enu
merated (except gold ) are inelastic, i.e. practically fixed
in quantity . The remaining elements, namely, fractional
and minor coins, are the only ones besides gold which ,

as regards their proportion to other money, are adjustable
to changing conditions. The government certificates of
deposit of gold and currency are not adjustable, because

they are scarcely independent features, being simply con
venient receipts for deposits of gold or of greenbacks.

In the United States, then , we have a currency system
in which gold , the basis of it all, constitutes directly , or by
means of gold certificates, about one third of the totalmone

tary circulation , and in which the remainder consists almost
wholly of elements which are inelastic and almost unchange

able . Consequently , to meet any modification in other
factors of the equation of exchange, — such , for instance,

as trade, — the gold in circulation must bear the burden .
But any modification of the gold in circulation can cause

only one third as great a proportionate change in the total
money in circulation , and almost all the burden of adjust

ing the quantity of money to the other changes in the equa
tion of exchange is thrown on gold . As gold requires time

for minting or transportation , the adjustment is slow and
clumsy as compared with the prompt issue or retirement

of bank notes practiced in other countries. The seasonal
changes in the purchasing power of money , as well as the

changes connected with crises and credit cycles , are there
fore greatly and unnecessarily aggravated.


§ 1. Can “ Other Things remain Equal? ”
THE chief purpose of the last 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, prices , we saw to be con
nected by an equation called the equation of exchange,
MV + M ' V ' = EpQ . 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 transportation .

The velocities of circulation will be in

creased , and therefore the price level increased correspond
ingly by improvident habits ; by the use of book credit;
and by rapid transportation .

The quantity of money will

be increased , and therefore the price level increased cor
respondingly 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 in
creased , and therefore the price level increased correspond

ingly by extension of the banking system and by the 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 thenumber

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 feas
ible nor profitable to catalogue them . The value of our
analysis consists rather in simplifying the problem by set
ting 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 therefore the introduction of deposits does
not disturb the relations we found to hold true before.
That is, it is still true that ( 1) prices vary directly as the

quantity of money, provided the volume of trade and the
velocities of circulation remain unchanged ; ( 2) that prices
vary directly as the velocities of circulation (if these veloci
ties vary together), provided the quantity of money and the

volume of trade remain unchanged ; and (3) that prices
vary inversely as the volume of trade, provided the quan

tity of money - and therefore deposits — and their veloci
ties remain unchanged.
But the question now arises, can the factors here sup

posed to “ remain unchanged ” actually do so ? To this
we answer, “ Yes, with one exception.” A change in the
volume of trade ( in a certain case now to be explained ) may

affect, besides prices, the velocities of circulation so that
the supposition that these velocities “ remain unchanged "
becomes untrue.

The case in which 'a change in trade effects

changes in velocities of circulation is this : when the change
in trade more than keeps pace with the changes in popu



lation so that it involves a change in per capita trade. At
a given price level, the greater the per capita expenditure,

the more rapid the individual turnover. The rich have a
higher rate of turnover than the poor. They spend money
faster , not only absolutely , but relatively , to the money they
keep on hand . Statistics collected at Yale University of
several hundred cases of individual turnover show that.
The man who spends much , though he needs to carry more

money than the man who spends little, does not need to

carry as much in proportion to his expenditure. This is
what we should expect ; since, in general, the larger any

operation , the more economically it can be managed.
Wemay therefore infer that, if a nation grows richer per
capita , the velocity of circulation of money will increase.

This proposition , of course, has no reference to nominal
increase of expenditure. As wehave seen , a doubling of all
prices, wages, and salaries would not affect anybody's rate

of turnover ofmoney, except nominally . Each payer would
need to make exactly twice the expenditure for the same
actual result and to keep on hand exactly twice the money

in order to meet the same contingencies in the same way .
The real expenditure of a person , on the other hand, is
measured by the comparative quantity of things bought, not

by their value in money. We conclude, therefore, that a
change in the volume of trade, when it affects the per capita
trade, affects velocity of circulation as well, i.e. real
velocity . It is, in fact , another name for the volume of
trade of that person.
We find, then , that an increase in trade, unlike an in
crease in currency or in velocities, has other effects than
simply on prices ; for, in fact, it increases the magnitudes
on the opposite side of the equation . But with the excep

tion above named, and apart from transition periods, the
proportions already stated still hold true.

In particular,

a change in the quantity of money causes an exactly pro
portional change in prices.



The “ quantity theory ” does not claim that while the
quantity of money in circulation (M ) is increased , other

causesmay not at the same time affect M ', V , V ', and the
Q's, and thusaggravate or neutralize the effect of M on the
p's. But these are not the effects of M . So far as M by
itself is concerned, its effect is only on the p 's and is strictly
proportional 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 quiescent and allow the

effect on the p's of an increase in M to be seen separately
from all other effects. 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 inter
fere with the truth of the quantity theory ; that variations

in money ( M ) produce, normally , proportional changes in

We have now finished with the principles determining

the purchasing power of money. By the aid of these
principles 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 .
up in later chapters.

The others we hope to clear

§ 2. An Index Number of Prices

We have been studying the causes determining the pur
chasing power ofmoney or, its reciprocal, the level of prices.

Hitherto we havenot defined exactly what a “ generallevel ”
of prices may mean. There was no need of such a defini
tion so long aswe assumed,aswe 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 , othersmust rise more.

If some rise too much, others must rise less. The case is
further complicated by the fact that some prices cannot
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 custom . 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 more predominantly the price of



the article depends upon the gold as one of its raw materi
als , the narrower is the range of variation .
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 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 ( as we have before emphasized)
these prices 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 movement
in prices as a uniform movement for all bees 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 generalmovement of a swarm of
bees because the individual bees have different movements.
Besides these 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

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 suppos
ing such uniform changes, we must now proceed to the

problem of developing some convenient method of averag

ing these two groups of un -uniform


changes . We must

formulate two composite or average magnitudes : the price
level and the volume of trade.

It is desired , then , in the equation of exchange, to convert
the right side, Epe , into the form PT, T , measuring the vol

ume of trade, and P expressing the price level at which this
trade is carried on .

This P is what we shall call an “ index

number," or average.

These magnitudes , price level ( P )

(the index number of prices in general) and volume of trade

( T ) need now to be more precisely formulated.
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 aremeasured 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 commodity , we should
have a very arbitrary summation . 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 goods, not the unit in which it is commonly
sold , but the amount which constitutes a “ dollar's worth "
at some particular 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. Any other year, the average price (i.e , the average
of the prices of the newly chosen units which in the base
year were worth a dollar) will be the index number repre
senting the price level, while the number of such units will
be the volume of trade.

Introducing, then , our newly found magnitudes P and T
into the equation of exchange, it assumes the form

MV + M ' V ' = PT,



and its right member is the product of the index number P

(or average of prices ) multiplied by ( the volume of trade)
T (or sum total of units sold ).
This completes all we need say of the theory of index

numbers, or average prices. In actually averaging the price ,
say in 1910 , of various articles ( the prices of those amounts

which were a dollar'sworth in ,say, 1900) wemust, of course,
take due account of the relative importance of these various

articles .

The prices of wheat or iron are to be given more

weight in constructing our average than those of tooth

picks or eyeglasses, for the trade in wheat or iron is far
more important than the trade in toothpicks or eyeglasses.

There are various ways of giving the proper “ weight” to
different articles , but the results differ so little from each

other that it is not worth our while to consider them .
$ 3 . 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 prac

tical 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 suf
ficient, however , to show that the general trend of prices
during the last ten centuries has usually been upward . We

may say that prices are now about ten times as high as a
thousand years ago, and that they are from four to six

times as high as in the period between A.D . 1200 and A.D .
1500 . And since the last -named date also , or since shortly

after the discovery of America, prices have almost steadily
risen .

The successive opening of mines has been largely

responsible for this rise.
From this telescopic view of the past we turn to what
be called by contrast a microscopic view of the present.
We shall confine ourselves to the events of the last odo
and a half in the United States.



For the years 1896 – 1909 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 mag
nitudes for the fourteen hyears
o all presented
p mentioned iare
sc a . by the equat

in Figure 14. In this diagram the equation of exchange
for each year is represented by the mechanical balance
described in a previous chapter .

We note that every factor has greatly increased in the
fourteen years considered . The quantity of money in

circulation (M , represented by the purse) has nearly
doubled ; bank deposits subject to check (M ', represented

by the bank book ) have more than doubled ; the volume
of trade ( T , represented by the weight at the right) has
doubled ; the velocity of circulation of money ( V , repre
sented by the “ arm ” of the purse , or its distance from the
fulcrum ) has increased slightly , and the velocity of circu
lation of bank deposits ( V"", represented by the “ arm ”
of the bank book) has increased considerably . As the
net result of these changes, the index number of prices ( P ,
or the “ arm ” of the weight at the right) has increased
about two thirds. The price level of 1909 is taken as 100
per cent. On this scale the price level of 1896 is 60 per
cent, and that of the other years, as indicated . The volume

of trade is represented as the number of “ dollars ' worth
in 1909.” Thus the actual value of trade in 1909 was
$ 387,000, 000,000 worth , or over a billion a day.

The trade

in 1896 was $ 191,000,000,000 worth , reckoned, of course ,
at the prices of 1909, not at the prices of 1896 . At the
prices of 1896 the value of the trade in 1896 was only
$ 115,000,000,000. This is PT , i.e. $ 191,000,000,000 X 60
per cent.

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, prices have been rising



because of the extraordinary rise in gold production and
consequent increase in money media of all kinds.
The gold of South Africa, combined with the gold from
the rich mines of Cripple Creek and other parts of the

Rocky Mountain Plateau, and reënforced by gold from the
Klondike, has caused , and is still causing, a rapid rise of

The history of prices has in substance been a race between

the increase in media of exchange (M and M ') and the in
crease in trade ( T ), while we assume that the velocities of
circulation have changed in a much less degree. Some
times 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

The most careful review of present gold-mining condi
tions suggests the probability of a continuance of gold
inflation for a generation or more. De Launay, an excel
lent authority, says, “ For at least thirty years we may
count on an output of gold higher than , or at least compar

able to , that of the last few years.”

This gold will come

the United States, Alaska, Mexico , the Transvaal,

and other parts of ‘Africa and Australia , and later from
Columbia, 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 expansion
will keep ahead of trade expansion . That for many years,
however , gold will outrun trade seems probable , for the

reason that there is no immediate prospect of a reduction

in the percentage growth of the gold stock nor an increase
in the percentage growth of trade. Not only do mining
engineers report untold workable deposits in outlying
regions ( for instance, a full billion of dollars in one region



of Columbia alone), but any long look ahead must reckon
with possible and probable cheapening of the processes 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 improvements in the future whereby still
lower grades may be worked , or possibly the sea compelled
to give up its gold .

Like the surface of the continents, the

waters of the sea contain 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 not be secured, or at least, may be secured but gradu

It is unfortunate that the purchasing power of money
should be always at the mercy of every chance in gold
mining. There are few businesses 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 shall be. The prob
lem of making the purchasing power of money stable so
that a dollar may be a 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 at
tention .

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 received very little attention .


scheme has been suggested which , although it allows the
present fluctuations to continue, aims to avoid the evils
which these fluctuations cause. This is to permit long- time
contracts to be corrected from time to time, according to

changes in the purchasing power of money as shown by an

official index number of prices. Under this plan if a man
borrowed $ 1000 in 1910, and prices rose 10 % in a year, he

would have to repay as his principal in 1911 not simply
$ 1000 but 10 % more than $ 1000. His interest payments
would be corrected in the same way .
As the consideration of these schemes belongs to applied
economics, we shall not discuss them here.


§ 1. Individual Prices presuppose a Price Level

We have completed our study of the purchasing power of
money ,which , as we have seen, is really a study of price
levels. Our next topic will be individual prices. It has
already been shown 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 con
sidering individual prices.
Before proceeding to the causes determining individual
prices, it will be advisable to explain more fully the propo

sition 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 the purchas
ing power ofmoney is great, itwill seem precious in his mind ,
and he will be .nore 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 pur
chaser 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 helpless in a foreign country when he is told
the price of sugar or of any other article in terms of un
familiar 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 a

pound of sugar until he knowshow the purchasing power of

that unit compares , for instance,with that of a cent or with
that of a dollar. Theremust thus always be in theminds of
those who use money some idea of its purchasing power.

The sellers and buyers of sugar express the amounts they
are willing to supply or to demand in terms of money , and
money means to them merely purchasing 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, provided a price level is first assumed . This proviso
needs emphasis because it is so often overlooked .


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 measure the figures in the fore

§ 2.

A Market and Competition

The terms “ supply ” and “ demand," say, of sugar, thus
imply a concealed reference to the purchasing power ofmoney,
i.e. to prices in general as well as to the price of sugar in par
ticular. 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. We are ready to leave these general rela
tions 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 commodity or good is any assemblage
of buyers and sellers of that commodity or good.


buyers and sellers may be, and usually are, physically near

each other ,as on the New York Stock Exchange, or they
may bemerely connected by telegraph , telephone, or other

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 present or on the floor of the ex

change, but the members outside and their numerous cus

tomers in and out of the city. It is in the market that
questions of supply and demand which we are about to dis

cuss work themselves 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 compe

tition , that is, we shall assume that each man who offers
to buy or sell does so independently of every one else . Thus,

if self- interest leads him to do so, a buyer will bid a higher
price than 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 .
But until these independent bids meet , there will be no
When there is a perfect competition , there is only one price

for all buyers and all sellers . This is evident; for if there
were more than one, no buyers would buy at the higher

prices which had first been asked (and so these must there
fore fall), and no seller would sell at the lower prices which

had been bidden (and so these must therefore rise).


watchfulness of one competitor toward the other eliminates

differences in price ; even if not all buyers and sellers were
careful to note slight differences in price, the more watchful

would bring about the same result by becoming “ specula


They would buy at the lowest prices and sell at

the highest.

Their buying would raise the lowest prices

and their selling would lower the highest.



In these ways differences in prices are reduced or entirely
eliminated. It is true that in practice there remain slight

differences in price, even in the same or closely associated
markets. This fact simply means that competition is often

imperfect. In our discussion we shall not take account of
those cases, but consider only the simple case where com

petition is perfect.
§ 3. Demand and Supply Schedules

The terms “ supply ” and “ demand ” have a definite and
technicalmeaning in economics , and the reader should note
the following definitions carefully.
In any market there is a different demand for sugar at
different prices. Wemay 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 amountwhich 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 ,

900 pounds a week. If the price falls to 7 cents, the demand
would increase, say, to 940 pounds. If the price falls to 6

cents,the demand would rise , say,to 1000 pounds,and so on .
The supply of sugar,we shall suppose , changes in theopposite

way. At 8 cents itmay be 1100 pounds. At 7 cents, 1050,
at 6 cents, 1000, etc. The following table shows these
figures and others, and constitutes what are called " sched

ules” 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 smallest price at which a given quantity will
be taken . When the relationship between the two columns
is expressed in the last of these two ways, it is more con

venient to place thesecond column first,and the first, second ;
but their order is immaterial. It is their relation to each
other which constitutes the demand schedule .

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, de
mand increases, and the supply decreases until, when the
price reaches 6 cents, the supply and demand are equal.
For prices lower than 6 cents we find the reverse condi

tion, demand exceeding supply .
If the foregoing figures represent the demand and supply
schedules showing the amounts that buyers are willing to

pay and sellers to give at different prices, it is clear that
there is only one price that will make supply and demand

That price is 6 cents , and that is the price that

supply and demand will finally fix . The price cannot really
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 (1100)
would exceed the demand (900 ) by 200 pounds. Those
wishing to sell this extra amount would then be unable
to do so except by offering at a lower price, and their

competition would drive the price down . On the other
hand, if the price were 4 cents, the demand (1250) would
exceed the supply (750) by 500 pounds, and those demand



ing this extra amount would be unable to get it except 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.


amounts supplied and demanded at the market price are
called the amountmarketed , i.e. the amount actually bought
by buyers and sold by sellers .

§ 4. Demand and Supply Curves
The relations discussed can be seen more clearly by
means of a diagram . In Figure 15 is represented the de

mand for sugar at different

As in previous diagrams,

- D

the two axes OX and OY are
drawn simply for reference,
like the equator and


Greenwich meridian in a map.
( 900 )

The intersection () of the two
axes is called the “ origin ."
The diagram is a “ map " of
demand on which the “ lati

FIG . 15.

tude,” or the distance above
the line O X , represents any price ; and the “ longitude,” the

distance to the right of the line O Y, represents the amount
demanded at that price. Let us, for instance, represent an

assumed price, say 8 cents, by measuring off the “ latitude "
O Y from the origin 0 . The demand at this price of 8 cents,

which we have seen to be 900 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 at



that price (900 pounds). It will be seen that the “ latitude "
is simply the elevation above the base axis O X , whether we
measure this “ latitude " by the line Oy or by Dx. Likewise

the “ longitude ” is simply the distance of D to the right of
the axis O Y , whether this distance bemeasured by yD or by
Ox. Having found one point, the “ longitude ” and “ lati
tude ” of which represent price and the demand at that
price, we may find in like manner other points, the “ lati

tudes ” and “ longitudes ” of which will represent other par
ticular prices and the corresponding demands. Several
such points are indicated on the diagram . It will be seen
that the lower in the diagram the points, the farther they
will be to the right. This represents the fact that the lower
the price, the greater the demand . Wemay 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 “ latitude "

and “ longitude " of each of its points represent respectively

a particular price and the particular demand corresponding
to that price.

Thus a demand curve is a graphic picture

of a demand schedule.


In precisely the same way
we may treat supply . In
Figure 16 let us represent any

Wooj - - - - - -

particular price, say 8 cents ,
by the “ latitude ” Oy and
the supply corresponding to
(1100 )


- --

its “ latitude " (Oy or XS)


this price (1100 pounds) by
the “ longitude " ys. Thus
we locate a point S such that o

FIG . 16.

represents a particular price, and the " longitude ” (yS or
Ox) represents the supply at that particular price. In like

manner wemay locate other points,the " latitudes ” ofwhich
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 .

In Figure 17 are drawn both the supply and 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, but

that there is only one price

at which supply and de


romand are equal. We can
see this clearly in Figure
17, for there is only one

8 point ( P ) in which the two
FIG . 17.
curves intersect.
" latitude " of the intersection (P ) of the curves DD and
SS' represents the market price. The “ longitude " of P

represents the amountmarketed ,which is at once the sup
ply 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 dis
tance 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 pl s'" , leaving an
excess of demand over supply of D ' S '' , which 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 intersect, is
the only real point the latitude of which represents the

market price and the longitude the actual amounts bid and
sold. All the other points in the two curves are hypotheti
cal, 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 descend

at different rates. Those which descend very rapidly rep
resent necessities, for the rapid descent means that it re
quires a great fall of price to materially affect demand .
The demand for necessities such as salt does not change
greatly, whether the price changes much or little .

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 de
mand. 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 , those ascending speedily being commodities the sup
ply of which cannot expand very much , even with a great
increase in price. At the opposite extreme are the supply

curves which ascend very slightly, being those of commodi
ties the supply of which can be greatly increased by even a
small increase in price.


Most of the articles produced in extractive industries
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 materially affect the output of coal
mines, but it requires only a slight rise in price of manu

factured products to lead to an enormous increase in the



§ 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 de

mand ” or “ increase of sup
ply.” These phrases are
often used loosely , without

realization that they are am
biguous. Increase of de
mand , for instance, may
mean one of two things . It
may mean a shifting of the
X market point from one posi

FIG. 18.
tion A to another position B,
farther to the right, on the same demand curve (Fig . 18 ),
or again it may mean a shifting of the entire demand curve

from the position A to the position B , farther to the
right, (Fig . 19).
Both of these meanings are admissible, but they are en

tirely distinct. In the same way, “ increase of supply '
may mean one of two things,
either a shifting of the mar


ket point A to another posi
tion B , farther to the right,
on the same supply curve , as
in Figure 20 , or a shifting of
the entire supply curve from
the position A to the position

B farther to the right, as in
Figure 21. Wesee, therefore ,
that an “ increase of supply
or demand ” maymean either

Fig . 19.

a change of the point on the same curve or a change of
the curve itself. To distinguish their two meanings we
shall call the first an increase in the point sense and the



second an increase in the curve sense. We shall find that
the curve sense is the more important and fundamental.
It will be seen that an increase of demand in the point
sense is nothing else than
an increase of supply in the

curve sense ; for we have
already made it clear that

there is only one point
which is the intersection

of the two curves, and that
this point cannot be shifted

to the right from A to B on
the demand curve unless

the supply curvehas shifted on
FIG . 20.
so as to change the inter
section . Such a shifting is seen in Figure 22. Here the
demand has increased in the point sense, having changed
from A to B on the same demand curve, but it has done
so only because the supply has increased in the curve sense,

having shifted from the position of the unbroken supply
curve to the position of the dotted curve.
Again , to say that supply
has increased in the point

sense is the same thing as
to say that the demand has

increased in the curve sense.
This is shown in Figure 23,
where the point A on the
supply curve has shifted to
B on the same curve, be
cause the demand curve had


shifted from the unbroken
FIG . 21.

to the dotted position .

We should , therefore , be careful to know when we speak
of a change in demand or supply whether wemean that the

change is in the point sense or in the curve sense. Itseems



odd at first to think that the 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 sup
ply, it means the samething
as when another speaks of
an increase of demand.

To illustrate the two

meanings, let us suppose
that the demand curve con
sidered is the demand curve

8 for automobiles, and that,
given thesameprices,people
would demand automobiles now no more and no less than
Fig . 22.

they did a few years ago , but that the condition of the
supply has changed , so 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 shifted to the
right. Therefore two things Y
have happened on the de
mand side. The price has
fallen , and as a conse
quence of that fall of price
the number of automobiles
demanded has increased .
Demand in the point sense
has increased. But de
mand in the curve sense

has not changed at all. O
FIG . 23.

People are just as willing as
before to take an automobile at $ 4000, but they are willing

to take more automobiles at present low prices than they

were willing to take at former high prices. What have
changed are the conditions of supply .





On the other hand , we might take as our illustration an
article of luxury.

In the last 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 de
mand curve has shifted ; the demand for works of art has

increased in the curve sense. Consequently , the supply has
increased in the point sense ; namely, on account of the
greater demand the price has risen, and thereforeowners and

makers of works of art have offered more for sale. Increase
of demand in the curve sense brings about increase of
supply in the point sense, and vice versa . An increase in
the supply of automobiles in the curve sense brought about
an increase in the demand for automobiles in the point sense,
while an increase in the demand for works of art in the curve
sense brought about an increase in the supply of works of

art in the point sense. In either case the ultimate change
is in a 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 “ increase of
supply " or “ increase of demand ” only in the sense of shift
ing to the right the supply or demand curve.
When we shift demand or supply curves , the effect on the
intersection , that is , on the market price and the amount
marketed , will depend greatly on the character of the
curves, whether, for instance, one or both of them ascends
rapidly or slowly . It will be instructive for the student

to draw on paper various pairs of intersecting curves where
one is nearly horizontal or both are, and where one is nearly
vertical or both are, and to observe the various effects
thus 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 constantly shift
ing, with the result that their point of intersection is con



stantly 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

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 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 more abundant

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 in a future chapter.)
One cause of shifting demand and supply curves men
tioned in a general way at the beginning of this chapter

may be especially emphasized . 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 50
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, 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 is, in fact , the case . As soon as
the half dollar became a dollar, the price in “ dollars ” at



which any given amount of sugar, such as Ox (in Fig . 24) , is
demanded , will evidently be doubled , becoming xB, which
is twice xA . If previously

people were willing to take
Ox at one price, they are now

willing to take it at double
thatprice,because 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
tsvice as high as before.
In the same way and for

FIG. 24.

the same reasons, those who

have sugar to sell will require twice as high a price as before
for a given amount ; so that, as indicated in Figure 25 ,
each point, such as A , in the supply curve, will be shifted
to twice as high an elevation above the base, OX .
When the two curves thus shifted are drawn on the same

axes (see Fig . 26), it is evident that the new point of inter
section, B , will be vertically

over the old point of inter

section , A .

The price of market sugar
is therefore doubled , though
the amount marketed is un

changed . Simply the doubl

ing of the general price level
carries with it a doubling in
the price of sugar. Practi

cally, of course, it takes time
FIG . 25 .

to change a price level, and

while the supply and demand

curves for sugаr may change for many other reasons than
the doubling in general price level, so far as this cause ,



taken by itself, affects the price of sugar, it doubles it.
Our analysis of demand and supply curves then brings us
back to the point already made, that the price of any one
good like sugar depends partly on the general level of prices ,
or the purchasing power ofmoney .
We can now see more clearly than before the shallowness
of the idea that the supply and demand of each individual
commodity fixes its price independently of other commodi

ties. According to this view , the general price level is re

garded as the effect of innumerable individual pairs of supply

and demand curves, each
pair being supposed to com
pletely determine someone
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 one of the causes
affecting thesupply and de
mand of sugar in relation

* to money, for we have seen
FIG . 26 .
that , as the price level rises
or falls, the price of sugar rises, and falls, correspondingly .
We end this chapter, therefore, with the statement with

which we began , namely, that it is important to distinguish

between the influences determining the general price level
and the influences determining an individual price. The
price level is determined by a comparatively simple mech
anism , that of the equation of exchange. It is the result of
the quantity of money and deposits , the velocities of their

circulation and the volume of trade. The general price
level then helps to fix individual prices,although not inter
fering with relative variations among them , just as the gen
eral level of the ocean helps fix the level of individualwaves
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 (or fall) in the general

price level is one of the many causes raising (or lowering)
the demand and supply curves of sugar.



§ 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. Both market price and quan
tity marketed are determined by the intersection of the sup
ply and demand curves. But the supply and demand curves

are not the ultimate influences determining prices. They
are only the proximate influences. Beneath and behind
them lie influences more remote and more fundamental. In
this chapter we shall consider those remoter influences so
far as they have to do with the demand side of the market.
Our problem , therefore, is to analyze the demand curve
into its ultimate elements. In the preceding chapter the

demand schedule or curve was considered as a cause. In
this chapter it is considered as an effect of antecedent

In the first place, the demand schedule or curve is for the
community as a whole ; and this community consists of a
large number of individuals, each of whom contributes his
share to the formation of the total demand. In fact, the
total demand at any price is merely the sum of the in
dividual demands at that price. For instance, let the fol
lowing table represent the demand schedules for coal of

Individual No. I and Individual No. II at prices of from
$ 12 to $2 per ton :



No. I




No. II


(6 )

(a + b)

The last column gives the sum of the demands of these

two individuals. If we should extend such a table to in
clude the demand of all the individuals in the community ,

wewould obtain the total demands in the community. The
total demand schedule is thus found to be merely the sum

of the individual demand schedules found by adding to
gether all the individual amounts demanded 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 . Y
In Figure 27 let the curve

didi represent the demand
curve for Individual No. I,
and ded , the demand curve

,da id : 10

for Individual No. II.
At a given price, Oy, the

demands of these two indi

viduals are respectively ydı
and ydą. The sum of these
two demands is represented

yD . Thuswe add the longi

FIG . 27.



tudes of the two individual demand curves together to get
the longitude of the combined curve DD'. If, instead of
two individual demand curves, we should have all the

demand curves for all the individuals in the market, and
should add together, as already indicated , the longitudes
corresponding to given latitudes , that is, the demands cor
responding to given prices, we should thereby obtain the
total demand curve as employed in the previous chapter.

To see more clearly the relations which the price bears
to the individual,and to the total,curves of demand,wehave

drawn in Figure 28 an indi

vidual demand curve dd',
the totaldemand curve DD ,
and the total supply curve
SS . The intersection of
the last two determines the

market price Px (or OP', or
px') , and this price deter
mines for the individual the
amount P'p (or Ox') which
that price.
Although , for the market as

i hou take
. he twill
gh supplat
FIG . 28.

a whole , supply andthdemand
us fixed ,
fixes the price Px , for the individual, this price, thus
in turn fixes the amount demanded .

§ 2 . Marginal Desirability
We have now found that back of the demand curve in
any market lie the individual demand curves of all the
people who compose that market. The next step is to find
what causes lie back of the individual demand schedule.

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 of Individual No. I. It is true that a man may



have a strong desire for something without having any

demand for it. But this is simply because he desires still
more the money he would have to spend for it. Every pur
chaser of goods balances two desires, the desire for the goods
and the desire for the money they would cost . On the rela
tive strength of these desires depends the price he is willing

to pay. We have, therefore, to investigate these two de
sires, the one for goods, the other for money . We shall

begin with the desire for the goods. The quality of an
article by virtue of which it is desired may be called its
desirability . The term “ desirability ” is identical with
what is usually called “ utility ” in textbooks. “ Desira

bility ” is preferred here as a better term to express the idea
intended. If there exists a keen desire to purchase a cer
tain piece of land , we say that the land is especially desir

able. So, also ,with sugar or any other commodity or bene
fit that is desirable. The desirability, then , of any particular
goods, at any particular time, to any particular individual,
under any particular conditions, is the strength or intensity
of his desire for those goods at that time and under those con

The desirability of any particular goods may relate to the
whole or to any part of a quantity of goods. The desira
bility of the entire quantity is called the total desirability ;

the desirability of one unit more or less of that quantity is
called the marginal desirability . In economic science we
have to do more with marginal than with total desirability,

and it is therefore important that the concept of marginal
desirability should be thoroughly understood.
The marginal desirability of any good is the desirability of
one unit more or less of it. If a person possesses ten chairs,
their marginal desirability is the difference, in his mind,
between the desirability of having ten chairs and the de

sirability of having nine chairs; that is, it is the desirability

which would be sacrificed by losing one chair. Or, what is
almost the same thing,the marginal desirability ofthe group



of ten chairs is the desirability of one chair more; that is,
the difference in desirability between eleven chairs and ten .
Whether the marginal desirability is taken as referring to

one unit more or to one unit less is usually of so little im
portance as not to require separate designations to distin
guish them , and in case the good is one which admits of in
definite subdivision , as flour, wheat, coal, etc., the two tend
to coalesce as the size of the unit is reduced .

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 indi
vidual may be meant the marginal desirability of the par

ticular 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 hav

ing fourteen tons. Again , if a person is consuming in his
household fifteen tons of coal a year, its marginal desira
bility at any instant is the desirability of the fifteenth ton ,

or the sacrifice which would be occasioned were he to re
duce his yearly consumption from

fifteen tons to fourteen .

It is therefore necessary in each case to specify the particular
quantity of goods referred to.

Undesirability is the opposite of desirability. Often
wemay express the same idea in terms of either word . For
instance, it does not matter whether we speak of the de

sirability of keeping money, or the undesirability of losing it.
The first principle 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 . Each unit in addition is less
desirable than the preceding unit.

The marginal desira

bility of sugar to the householder consuming five pounds




weekly is greater than the marginal desirability to the
same householder if six pounds are consumed , and is succes

sively diminished as each successive pound is added to his
or her consumption .

It is well to remember that when the term “ successively ”

is here used, it is metaphorically and not literally used .
That is, the succession to which it refers is not a succession
in fact, but a succession in thought. That is, we are con
sidering the consumer of sugar under a series of different
hypotheses which we examine successively. Webegin with

the hypothesis of a weekly consumption of five pounds, and
take up successively the hypotheses of six pounds, seven

pounds, eight pounds, etc. The desirability of the " last "
or “ marginal ” pound in this series is what we consider
the marginal desirability, but the “ last ” pound refers to
the one considered last in ourmental review , and not the one
acquired last by the consumer . Marginal desirability is

usually expressed as the desirability of " the last ” unit.
But by the “ last ” unit — say , the tenth chair — is not

meant any particular chair of the ten , but merely the dif
ference between having nine chairs and ten chairs .


fact needs to be emphasized, in view of frequent confusion

on the subject occasioned by too loose an employment of
the words “ last ” and “ successive."

The total desirability of any quantity of goods is the
sum of the desirabilities of the successive units . The total
desirability of the ten chairs , for instance, is found by

adding together ( 1) the desirability of having only one
chair ; (2 ) the desirability of having a second chair ; (3 )
of a third ; (4 ) of a fourth , etc., until ten chairs have been
considered .
In exactly the same way wemay define themarginal de
sirability of money. The marginal desirability of money
at any particular time, to any particular individual, under

any particular conditions, has the same sort of meaning as
the marginal desirability of any other good . It is therefore



the strength or intensity of a man's desire for the addi
tional dollar, or what amounts to the same thing , his reluct

ance to part with it. Briefly , the marginal desirability of
money is the desirability of a dollar. Whenever he thinks

of making a purchase, this desire comes into play, and the
question of whether or not to buy is determined by his

judgment as to whether or not themarginal desirability of
the goods exceeds or not the marginal desirability of the
price in money required to secure those goods.

§ 3. Individual Demands derived from Marginal De
It is on such comparison of the marginal desirabilities of

goods and money that the demand curve of each individual
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) . We are to show that the price Indi
vidual I is willing to pay is simply the ratio between two
marginal desirabilities, that of coal and that of money.

If he thinks that one ton of coal is a dozen times as de

sirable to him as a dollar, he will evidently bewilling 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 will
ing to buy just one ton . A second ton will be worth, in his
estimation , somewhat less, 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 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. Likewise, 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.
In each case the highest price he is willing to pay for a
given quantity is measured by the ratio of desirability of the

last ton of that quantity to the desirability of a dollar. The
consequent derivation of prices from desirabilities is sum
marized in the following table :





(a )


Aun d



(a + b)

$ 12

As indicated , the last column is found by taking the ratio
of the figures in the first to those in the second ; i.e. dividing
(a ) by (6). 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 meas
uring desirability the marginal desirability of money of

Individual I. We thus derive the individual's demand
schedule from his schedules or desirabilities , which was our

object. The resulting demand schedule is the fourth col
umn considered 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 samething, the largest quantities of coal he
is willing to take at stated prices. As shown in the last

chapter, it does not matter which way the relation is ex

In the preceding table the numbers expressing desira



bilities and the numbers expressing price are the same be
cause we took themarginal desirability ofmoney as our unit

of desirability . It is sometimes said that price is merely
the expression of marginal desirability ; i.e. that the price
column merely duplicates the desirability column. But

if we suppose another individual (No. II) 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

high , in comparing the two men we shall have to use the
same unit of desirability , viz . the marginal desirability of

money of Individual No. I. For Individual No. II the
desirability ofmoney is two such units. The result is the

(a )






(a + b )


mA enoW



following table for Individual No. II :

The first ton has a desirability of 12 units just as did the
first ton for Individual I, but the desirability of a dollar to
Individual II is twice as great as that to Individual I, i.e.

as two units of desirability. Hence the first ton , instead of
being twelve times as desirable as a dollar, is only six times

as desirable. Therefore he is willing to pay only up to $6 for
it. The second ton ,which has a desirability of ten units , is
five times as desirable as a dollar, and he is therefore willing
to pay only up to $ 5 a ton for two tons. The price he is

willing to pay for three tons is measured by the number of
times the marginal desirability of money ( 2) is contained in



the marginal desirability of the third ton of coal (8 ), which
is four times — making the price $ 4 . Likewise he is willing

to pay 6 • 2, or $ 3 a ton for four tons, and so on. Thus,
just as in the case of Individual I, the prices in the last

column are found by dividing the figures in the second col
umn by those in the third . But in this case the figures in
the last column are not identical with those in the second

column, but are only half as great. Thus, the higher the
marginal desirability of money, the lower the price which

buyers are willing to give.
We see, then, that the two individuals, though they have
precisely the same desires for coal, have very different de

mands for coal. If the price of coal is $ 5 a ton , Individual I
will buy up to the fifth ton , for when he reaches the fifth

ton , and not before , his marginal desirability of coal (5 )
will be just five times as desirable as a dollar (1 ). But at
this same price of $ 5 , Individual II will only buy up to two

tons, for in his case $ 5 is the point at which the marginal

desirability of coal ( 10 ) is five times the marginal desira
bility 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 II, have a relatively high marginal
desirability ofmoney .
It is easy to express these samerelations by curves. The
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 29 the curve dd ' is the desirability curve of coal

for Individual No. I ; i.e. it represents the desirability for
him of each successive ton on coal as given in the preceding
table .

Thus the latitude or height (12) of d represents the desir

ability 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 (5) of which represents the desirability
of the fifth ton . The de
sirability of the fifth ton is

called the “ marginal desir
ability ” of five tons, the
desirability of the fourth
the marginal desirability of
four tons, etc. The lati

tude or height of each of

the points from d to ď
represents themarginal de


FIG. 29 .


sirability of the amount of
coal corresponding to the
6 & longitude of that point.
The heights of the points

which form a horizontal row one unit above the base repre
sent themarginal desirability ofmoney. From the heights

of these two sets of points, — the upper ones representing
the marginal desirability of coal and the lower ones repre
senting the marginal desirability of money, — by simple
division of the numbers indicated, we derive the demand
curve for Individual No. I. As the divisor is in this case
unity, this demand curve Y
so derived will coincide
with the curve dd'. Hence

dd' 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 30 represents the
corresponding curves for In


- - -

dividual No. II, for whom ,
by hypothesis, there are
precisely the samemarginal



FIG . 30.






desirabilities of coal, but for whom the marginal desirability
of money is twice as great.

The upper points r to prepre

sent the marginal desirability of coal, and are at the same
heights as the upper points d to d ' in Figure 29. The lower

points in Figure 30,however,are now two units high instead
of one. Hence, when we divide the numbers 12 , etc., for

py by the number 2 , we shall get as our demand curve a
curve dd', which , unlike the demand curve for Individual I,

will not coincide with rr', but will be everywhere only half

as high .
Wesee, then ,how to derive an individual demand schedule
(or curve) by dividing, so to speak , one desirability schedule
(or curve) by another . The resulting demand schedule (or
curve) of coal will coincide with the schedule (or curve) of
marginal desirability of coal if the marginal desirability of
money be taken as the unit. Otherwise the demand sched

ule (or curve) will have its figures all standing in a given
ratio to those of the schedule (or curve) of marginal desir
ability of coal.

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 effect of innumerable in
dividual demand curves ; and finally , that each of these
individual demand curves is in turn the effect of two de

sirability curves for the given individual.

These desira

bility curves are the ultimate curves lying back of demand .
This is all true on the assumption that the marginal de
sirability of money for each individual remains constant, as
represented in our tables or curves, being always i for In
dividual I and always 2 for Individual II. In other words,
we have assumed that the marginal desirability of money is

not appreciably affected by a large or small purchase of coal.
Of course a purchase might bemade so large or at so high
a price that the marginal desirability of money would be

appreciably affected . Theoretically , the marginal desira



bility 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 expenditure on
any one thing, such as coal, requires so small a drain on
the total power to spend that the marginal desirability of
money is not very different whether a man buys no coal at

all or all he can afford .

Consequently for the same indi

vidual, the desirability of a dollar may be regarded as a
constant quantity represented, as in Figures 29 and 30 , by

the heights of a horizontal row of points .
§ 4 . Relation of Market Price to Desirability

We shall now show that themarket price of coal, although
it is itself the ratio between two physical things, — the
ratio of a quantity of money to a quantity of coal, — is,
nevertheless, 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
vidualdemander of coalcan, of course , determine themarket
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 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 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
This principle that the market price of any good is equal

to the ratio between its marginal desirability and the mar



ginal desirability of money is so important that it will be
advisable to restate it in as many formsas possible .
Wemay state the stopping point of each purchaser in

any one of the following ways :
1. Each purchaser buys until the ratio between the de
sirability of the marginal unit and the desirability of the

dollar is reduced
to equality
y thethedesprice
irah .
o equauntil
fosuced tbuys
the desirability of the mar
ginal unit is reduced to equality with the desirability of the

money spent for them .
3. Each purchaser buys until his marginal gain (of
desirability ) is reduced to nothing.

4 . Each purchaser buys until he makes his gain (or sur
plus desirability) a maximum .
The last two may require further explanation .

Evidently it is the samething to say that a purchaser stops
buying when the desirability of the last ton is equal to the

desirability of the money paid for it, 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 purchaser
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 or

his surplus desirability is the difference between the total de
sirability 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 I, as
his schedule (or curve) shows, buys 5 tons, the total desir
ability 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 + 10 + 8 + 6

+ 5 ; 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 ex
cess of the total over the sacrificed desirability, or 41 – 25



= 16 units. Now this gain of 16 consists of a diminishing
gain on successive tons. On the first ton the gain is the
difference between 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 10 – 5 = 5

units ; on the third, 8 – 5 = 3 units ;on the fourth , 6 – 5
= 1 unit ; and on the fifth, 5 – 5 or zero. Hestops his pur
chase at this point, for if he should extend it farther , 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 II, who can only afford to buy
2 tons, the total desirability is 12 + 10 = 22 units of
desirability ; 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 desira
bility is 22 — 20 or 2 units. This gain is all on the first ton , as
the second is only just worth its cost.
Individual I thus gains more than Individual II, though

both gain something.
Still another method of stating the principle is that each
buys so as to make the greatest possible gain of 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 7 + 5 + 3 + ito or 16 units. Had he stopped
buying at the third ton , his gain would have been i unit

less or 15 units. On the other hand, if he had bought 6
tons, he would have lost i unit on the sixth ton , which
would have reduced his gain from 16 to 15. Thus by stop
ping 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 normally 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 thetwo



parties cheats the other, but normal 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 respon
sible for attempts to regulate prices in the Middle Ages, to
make the price “ just ” and prevent one party gaining at

the expense of the other ; it was also largely responsible
for the sentiment in favor of encouraging the export trade
but discouraging 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 ,although
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.
The idea of total desirability, as contrasted with marginal

desirability , will serve to explain the old paradox that the
most desirable things are not the highest in price. Nothing is

so indispensable to us all as the air we breathe, yet its price
is zero.

The reason is now clear. Air is so abundant that

the marginal desirability of air — the desirability of one

additional cubic foot — is nothing at all, although the total
desirability of air is great. An example of the opposite
kind is found in jewelry . As compared with air, gold ear

rings have far less total desirability but far more marginal

As the price depends on the marginal desira

bility, and has no reference to total desirability , we have no
difficulty in reconciling the fact that earrings are worth more

than air with the fact that air ismore desirable than earrings.

§ 5 . Importance of the Marginal Desirability of Money
The student will have noticed that themoney 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 desirability schedules (and curves) of Individuals I and

II, themarginal desirability of any individual is a divisor to
be divided into the marginal desirability of coal to give the
price the individual is willing to pay for coal. Therefore
to halve this divisor for each individual will result in doub

ling 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 . Consequently the same is true of the

total demand schedule (or curve). This is merely restating
what has been said before, except that 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) between different people according
to differences in wealth and needs, and (2) between different
times or countries according to differences in price level.

(1) As to corrections between different people, if a mil
lionaire's wife pays $ 10 ,000 for a brooch , while her poor
neighbor pays $ 10 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 dollar more
than a thousand times as highly as the richer woman, it is
altogether probable that the gown is of more importance
to the poor woman than the brooch is to the rich one. Yet
in money the brooch is worth a thousand times the gown.

From the fact that the richer an individual is, the less his
or her marginal desirability of money , it further follows that



the comparative desirability of two fortunes is much less
than their money values would suggest. A man whose
income has increased from $ 1000 to $ 10,000 a year is better
off than when it was $ 1000 a year, but he is not ten times

as well off. The extra $ 9000 may not be worth asmuch as
the original $ 1000 , in which case he is not even twice as well

off. It is stilltruer that a man with a fortune of $ 500,000 ,000
is only slightly better off (if at all) than one with only
$ 1,000,000. Were these facts better appreciated, “ great

riches,” though desirable, would be less dazzling to those
who have never possessed them .

1000 .

FIG . 31.

Figure 31, in which longitude represents income, and
latitude its marginal desirability , expresses the fact that

the marginal desirability of money (assuming a given pur
chasing 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 grow
ing closer and closer to the base ; that is, no matter how rich

a man becomes, an additional dollar will still have some
desirability in his eyes . Man is literally insatiable.



(2) As to corrections between different price levels, we
note that money wages in the United States are higher
than in England ; but it is misleading to make any com

parisons unless we first correct for differences in the price
levels or purchasing power of money . In some occupations
it would seem that the difference in wages only just corre
sponds 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 . He has more money wages ,
but its marginal desirability is so much less that he has

no more desirable food, lodging, or comforts. In general,

however, after all allowances are made for difference in
price levels, the lot of the American workman is usually
better than that of the English .

Desirability is, therefore , a far more fundamental con
cept than mere money value. This could not fail to be
recognized if we had any practical means of measuring
desirability . Unfortunately , as yet, we have no such means.

As money values are usually measurable, we are often com
pelled to make our measurements in money or else make
none at all. This must not, however, mislead us into at

tributing to money measures any greater significance than
they actually possess .


§ 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

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 I and II
(withoutmeaning to imply ,of course , that they are the same
individuals as those called I and II in Chapter XVI).

(a + b)












The last column gives the sum of the figures in the first
two. If we should include in our table all supplies in the
market, we should obtain in this way the total supply sched

ule. The same relations are indicated graphically in Figure
32, where si s', is the supply curve for coal of Individual I,

i.e. a curve such that if the latitude of any point on it rep
resents a given price, the longitude of that point will repre
sent the amount of coal the individual is willing to supply

at that price. Similarly , let
Sg s', be the supply for coal
of Individual II. If, as in
the case of demand curves,
weadd longitudes (e.g. Sy =

szy + sy ), we obtain SS' as
the curve representing the
total supply of both individ
uals .

If in like manner we add

X together all the individual
Fig . 32.

curves of all the individuals

in themarket,weobtain the total supply curve of the market.
Having thus derived the total supply schedule (or curve)

from its constituent individual supply schedules (or curves),
wenext seek , as in the case of demand schedules (or curves),
to derive each individual schedule (or curve) from a pair of
desirability schedules (or curves) .
The following table illustrates such a derivation . The
figures in the last column, found from the other two by
simple division, gives the prices a coal dealer would be will
ing to take in view of the desirability to him of the money
he seeks to get by selling coal and the undesirability of the
trouble and expense involved in getting it. If the 1500th
ton costs him 8 units of desirability , and a dollar repre
sents to him 2 units of desirability , he will evidently be

willing to take $ 4 a ton up to the 1500th ton, and so on
for the other figures in the table.




(a + b)









The same relations may, of course ,be represented graph

ically . In Figure 33, the latitudes of the points on the
line, rr', represent the undesirability per ton of parting with
the coal, and those of the lower line mm ' represent the

desirability per dollar of obtaining money. The result
of dividing the latitudes of

the points of red by those of yl
mm (i.e. 2) gives us the

supply curve ss', the height
of which at different points
will be proportional to
those of the curver!'. The
latitude of the curve ry rep
resents the undesirability
of the efforts and sacrifices
of furnishing each succes

S .
m - . . . . ..





sive unit, or “ marginal 0
FIG . 33.
undesirability ,” and the
latitude of the curve ss' represents this marginal unde
sirability translated into money. This marginal undesira

rability translated into money is usually referred to briefly
as marginal cost of production or simply as marginal cost.

It 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 ofmoney than the buyer, for
the seller as such has more to do with money. Unless he is
a mere workman , the only cost to whom is labor cost, most

of his costs are in the form ofmoney expenses .
§ 2. Principle of Marginal Cost
Hitherto we have treated the marginal desirability curve
for money as a horizontal straight line. This was essentially
true for the purchaser, but for the seller it is untrue.


the purchaser,money performsmany offices besides buying
coal, and its importance for the purchase of coal is not great.

To the coal dealer, however, coal is the only thing he sells
for money. To him , therefore, changes in the amount of
coal sold and the price of coal will make a great difference
to the total amount of money he gets and therefore to 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.
- Consequently , in treating supply, we cannot continue to

assume that the marginal desirability of money remains
constant and can be represented by a horizontal straight

line. Instead, themarginal desirability of money decreases
the greater the sales, and therefore the more money is ob
tained. Consequently the line mm ', representing marginal
desirability of money, should descend to the right as the
sales increase. Moreover , the descent of this curve mm '

will depend on the price, so that we cannot even construct

it until we specify a particular price . In Figure 34 these
facts are taken into account, OP represents the assumed
price , the curve rr , as before, represents marginal unde
sirability of furnishing coal, and the descending curve
mm ' represents the marginal desirability of the money
obtained . We now use these two curves just as we did



those in Figure 33, and obtain the point s, the latitude of
which is the assumed price OP,and the longitude the supply

of the individual at that price. By changing OP and repeat
ing the construction , we can obtain other points than s,
thus constructing the supply curve showing the marginal
cost of supplying different amounts of coal.

In the supply curve, as we have just constructed it, the
price is a minimum relatively to the supply , and the supply

a maximum relatively
to the price ; that is,
the curve shows the
lowest prices at which
given amounts will be
supplied, or the great
est amounts which
will be supplied


given prices .

We see, then , that m .
the totalsupply curve,
analogously to the -0

total demand curve, on1000
may be derived from

1000 1000 * 1000 1000 1000


FIG . 34.

a number of individual supply curves , and that each such
individual supply curve may be derived by assuming suc
cessive prices, and for each price constructing (1) a curve of
marginal undesirability of furnishing the article and ( 2 ) a

descending curve of marginal desirability of money.
The important result is that the market price, as finally
determined by supply and demand , is not only equal to the

marginal desirability of getting coal for each buyer, but
also to the marginal undesirability of furnishing it for each

seller , both the desirabilities and undesirabilities 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 the funda
mental principles which determine the market price of any

particular good .

Market price, then , is such a price as will equalize (in
terms of money ) all marginal desirabilities of buyers and
all marginal undesirabilities of sellers , and at the same time
equalize the total demand of all the buyers with the total

supply of all the sellers. In short, market price results
from the following two principles :
(1 ) The equalization of all marginal desirabilities and
undesirabilities (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, therefore, the great
determinant of market price (in terms of money) is mar

ginal cost (in termsof money ).
The same principle would , of course , apply in termsof any
other good than money or in terms of general purchasing
power. We have already had occasion to anticipate this
principle when considering the production and consumption

of gold and silver. The price or purchasing power of gold ,
we found, depends not only on gold as money, but also on
gold as a commodity. In the latter case its supply and
demand needs to be considered like those of any other com

modity. That is, so far as gold is an individual commodity

like silver or coal, the study of its price or purchasing power
involves the principles which determine an individual price
as well as the principles which determine the general level



of prices. Our present study of individual prices , therefore,
throws light on our previous study of gold .

If the student

will return for a moment to Figures 10 - 13, he will see that
the distance below the line 00 of the highest outlet (in oper

ation) from any bullion reservoir is simply what we would
now call the marginal desirability of gold for use in the
arts (measured in terms of general purchasing power over
goods), and that the distance of the lowest inlet (in oper

ation ) is the marginal cost of production of gold (measured

likewise in terms of general purchasing power over goods).
Wemay 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 (per unit of prod
uct) or of diminishing returns ( per unit of cost ). It applies ,
of course,more generally than simply to gold and silver . We

have taken coal as our typical example. We might have

taken numerous other examples. If the price ofwheat rises,
its marginal cost will rise. Worse lands will be resorted to ,
and lands previously under cultivation will be worked more

intensively until, on all wheat lands the cost (measured in
money) of furnishing an additional bushel will be equal to
the price.
§ 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 .
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 recently
noted , that there is a separate and descending curve of

marginal desirability of money. This fact, when combined
with the ascending curve of desirability of coal, tends to
bend the supply curve upward — sometimes so much as
to cause it to curl back to the left, as in Figure 35. Such a

curve, although it ascends, does not, throughout its course ,

ascend to the right. It applies
especially to the supply of labor.
The meaning of such a supply
curve is that a rise of price does

not always cause an increased
supply . At first it does, but be
yond the point where the curve

begins to curl back a rise of price
evidently results in reducing the
supply .


If we stop to consider the mo
FIG . 35 .

tives of a workingman , we shall

see that this is true of him . If wages are low , a rise in
them will at first stimulate the workman to work longer

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 thereby to stimu

late the production of baskets . Exactly the opposite
result followed. As soon as these workmen were offered

high prices for the baskets , they produced less than before ;

they could now get more money even for doing less work ,
and they didn 't need or want more. Their wants were so
few and simple that their marginal desirability of money

decreased very rapidly with an increased amount of it.



That is, as the price rose from the height of s' to that of s',
the supply decreased from the longitude of s' to the longi

tude of s" . In the same way in the Philippine Islands it

has been found that to raise the wages of workmen some
times resulted in their working less hours in the day and
less days in the year. One Spaniard , in order to keep his

foreman , whom he considered very efficient, gave him a par
ticularly high salary . The plan worked well for a few
months, but at the end of that time the man had accumu
lated so much money that he had little desire for more, and

decided to retire. 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 work the fewest hours and take the longest

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 the curve begins to bend back , i.e . the

less easily is he satisfied with more money. A curious in
stance in the Philippines is that workmen who have a taste

for alcohol are sometimes more useful to their employers
than those who are always sober , because those who want

liquor have a larger range of desires and are therefore apt to
work harder in order to get the drinkables they desire ;

whereas the sober man is contented merely to get enough

food to eat,and will work only just long enough for that pur



pose . A relatively slight rise of wages satisfies his wants
so completely or so nearly completely that he does not
consider any further wages worth the effort.

§ 4 . Downward Supply Curves
The typical supply curve , with which we began , ascends
continually to the right. In the exceptional case just con

sidered , the rightward movement was arrested and turned
into a leftward movement. Our next exceptional case 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 prod
uct. This is due to the fact that, in such cases , the mar
ginal undesirability 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 ofmoney ;
so that the ratio of the one to the other , i.e . the marginal
cost, decreases with an increase of supply.
When marginal cost decreases with an increase of supply ,

the supply schedule (or curve) is no longer the schedule (or
curve) ofmarginal costs, but must be constructed on an en
tirely new principle. The principle that market price is
equal to marginal cost will no longer hold true. Only when
the supply curve ascends will it be 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 are derived
entirely differently . They depend not on marginal cost
at all, but on average cost . The reason is that no seller is
willing 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 3000th
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
without a loss, and if 3000 tonswere sold at that price there

would be a loss on every ton except the last. Rather than
sell 3000 tons or any less number at $ 5 a ton , the dealer
would choose to sell none at all. Contrast this result with

that which obtains in the case of an ascending curve. In
this case the cost of supplying the 3000th ton was $ 5, but
the cost of all preceding tons was less than $ 5 , so that in

stead of a loss there was a profit on each of these preceding
tons. Not only could he afford at $ 5 to sell 3000, but this
amount gives him the maximum profit — more, for instance,
than if he should sell 2000 or 4000 tons. In order that any
dealer shall sell at all, he must expect to get back at least

the total cost. This means that hemust 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 preced
ing ton , the cost of the last, or marginal cost, is the greatest

cost of all, and therefore exceeds the average cost. Conse
quently the dealer was assured a profit when selling at a
price equal to the marginal cost. Butwhen the cost of each
successive ton is less than that of the preceding ton , the cost
of the last (marginal cost) is the least of all, and therefore is
less than the average cost.

In either case, then, the seller must get back at least the

average cost and also at least the marginal cost. In short,
he must get a price at least as high as the higher of the two.
Whichever 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 individual costs of each separate ton. The simple
average of any specified number of these is the average cost
of that number.

§ 5. Resulting Cutthroat Competition
But, besides the fact that the ascending supply schedules

(or curves) are based on marginal costs, and descending
supply schedules (or 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 themaximum which the seller is willing to offer
at that price,whereas in the second case it is the minimum .

When we consider simply ascending types of supply , we
may express the relation between the price and supply in

two ways, either —
(1) Given the supply , the price is the minimum price at
which that supply will be offered ; or
(2 ) Given the price, the supply is the maximum which will
be offered at that price.

The first of these two propositions still holds true when
the supply descends instead of ascends; but the second
will not hold true until we have changed the word “ maxi
mum ” to “ minimum ." In other words, when , as originally

supposed , the supply ascends, the seller is willing at any
given price to supply a certain maximum amount or less ;
while, when the supply descends, he is willing at any

given price to supply a certain minimum amount or more.
In this respect, then, supply and demand are not an

In the case of demand there were not two classes, one
ascending and the other descending, but only one. In all
cases demand decreases as price increases. Consequently
there were not two ways of stating the 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 the maximum price which can be
gotten for that amount.

Let us then summarize our results, expressing each on
he basis of a given price.
1. At a given price, each buyer is willing to take a certain
maximum amount or less at that price.
2 . At a given price, each seller is willing

(a ) (in case marginal cost increases with an increase
of supply ) to offer a certain maximum amount
or less at that price.

(b) (in case marginal cost decreases with an increase
of supply ) to offer a certain minimum amount
or more at that price.

The contrast between the two types of supply are illus
trated graphically in Figures 36 and 37. Figure 36 illus
trates case a and Figure 37,
case b. 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 will

ing to supply at the price cor
responding to the latitude of

that point. Thus, if we take

any horizontal ' line in the 01
FIG. 36.
shaded area of Figure 36 , its
latitude represents an assumed price, at which the seller is
willing to supply any amount, from nothing at the left end
of the line to the maximum amount at the right end where
the horizontal line is limited by the curve.

Taking any

horizontal line in the shaded area of Figure 37, the seller is
willing to supply any amount from the minimum at the
curve, i.e. at the left end of the line, up to an indefinite
amount at the right.



In the latter case, i.e. when the cost of each additional unit
of product is less than that of the preceding unit, the more
the seller can sell the better he likes it. If he sells only the
minimum , 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.
This fact introduces us
to an unexpected conclu

sion, viz . that if the total
FIG . 37.

supply curve descends, the
price represented at the
intersection of the supply

and demand curves, although it clears themarket, 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 vi
supply curve descends.
Let us consider each case

separately . If the price
(Fig . 38 ) is OP, higher
than the intersection , the

demand exceeds themini

mum supply and stimu

lates each supplier to
furnish more than his min

imum , which , of course,
he is only too glad to do.

Consequently , the supply

FIG . 38 .

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 . Suppose it
is below , as at OP', it will continue to fall. For then even



the minimum supply exceeds the demand,and all who com
pete to supply will be very eager not to be left with unsold
goods on their hands.

A rise of price would , it is true,

remedy the difficulty. But no individual can apply this
remedy, and there is, by hypothesis, no combination .
The individual competitor cannot raise prices without secur
ing the agreement of others ; but to do this would be to create
a combination which is contrary to our present hypothesis
of independent action .

If he should individually raise his

price, he would be committing commercial suicide, for no
people would buy 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. He hopes 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 himself. He therefore offers his wares
at a price below OP'. But, as we have seen , there cannot

be two prices in the samemarket at the same time. Hence
all his competitors must reduce their prices, to his .
Whatever the effect of this action may be on the individual
who first cuts the price, the result on the whole is evidently

to makematters worse ; for, according to conditions shown
in the diagram , the lower the price , themore will the supply
exceed the demand .
Wehave 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, and

the discrepancy between supply and 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 whatever side of the intersection the price

may be. In the case of a descending supply curve, the in
tersection 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 com

petition ceases or the supply curve ceases to descend. If
the supply curve at some point at the right reaches a mini
mum 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 momentbecomes a
monopolist , and the prices will cease falling on that ac

Monopoly 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.
None of the competitors relish the prospectofbeing crowded

out any more than they relish the prospect of continued
cutthroat competition . Whether combination will actu
ally result or not depends on a variety of circumstances.
One or more of the competitors may flatter himself that the

rate war will end in crowding out all others except him ,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. In either
case the result is monopoly .
We find , then , as a result of our study of the supply side
of the market that supply curves sometimes descend , and
that in such cases competition is “ cutthroat ” competition ,

and results 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 usually somewhat imperfect.

The slight under

cutting of price by one grocer will not ruin the trade of
another in another part of the same town for the reason
that the two arenot absolutely in the same market. Each
has a spherewhich the other can only partially reach , partly

because of distance and partly because each has his own
“ custom ,” i.e . the patronage of people who, from habit or


other reasons, would not change grocers merely

because of a slight difference in price.

Thus each is pro

tected by his partial isolation. So that even when supply
curves descend , competition may be so limited as to prevent
any very fierce rate war, the rate war being prevented by

partial or local monopolies among the suppliers in the first
place. A rate war, therefore, is never a permanent or nor
mal condition. If not avoided at first by imperfect com
petition or by partial monopoly , it is avoided eventually

by themonopoly 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


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,

fuel, materials, etc. The only costs hitherto included in
our discussions were running costs.

The fixed costs were

not included because they have no effect on supply schedules
(or curves). Our only purpose now in studying fixed costs is
to show that they do not have any effect on supply , 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 reimbursed
to the owner except as the sale of these said goods may do
so in part or in whole . As we have seen in a previous chap

ter, interest is not a cost to society, for it is merely a payment
from one person to another. To society as a whole the only
cost is the “ sunk ” cost, which , in the last analysis con
sists, 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 —

interest is a cost. If he pays no interest, he must have in
curred the “ sunk ” cost himself, in which case this past
sunk cost replaces the fixed annual cost. In one of the two
ways he must bear the burden of sunk cost. That is, either

hemust have borne it in the past directly , or hemust 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 $ 100,000 is equivalent, if interest is 5 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 some




$ 100 ,000 in a hotel on the top of a mountain . He found

that so few guests wanted to go there that the most he
could earn was only $ 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

$ 100,000. His total building was worth nothing except for
hotel purposes. He could only make the best of his mis
investment and run his hotel for the sake of $ 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 5 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 than
to close out.
In either of these two cases, whether the hotel was built
by the owner out ofhis own purse or out of borrowed money ,
there was a loss equivalent to three fifths of the original

cost,or what amounts to the same thing, the interest thereon .
Yet this cost could not be avoided , whether the hotel busi

ness 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 important to analyze and to understand .

A third hotel keeper made a lucky hit in his $ 100,000 .

He got not only his running expenses and interest on the



$ 100,000, but a handsomeprofit besides. But this fact did
not affect the prices at which he was willing to supply
The point to be emphasized is that in all three cases the
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
ensues,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. Wehave here the same cut
throat competition as when the supply curve descends, ex

cept 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 , i.e.
the existence of fixed costs and the existence of descending
supply . As a matter of fact, these two conditions are often
united .

§ 8. General and Particular Running Costs
The two are not only often associated , but are at bottom
very similar to each other. This may be seen best if we di
vide one of our classes of costs, running costs , into two sub

classes, “ general ” costs and “ particular ” costs. By
general costs, also called “ overhead costs,” are meant costs
which , though they could be gotten rid of if the business

ceased, will not greatly vary whether the business is large



or small. They include the labor of superintendence, sal
aries of the chief officers, rent of rented quarters, interest

on short-time loans for stock carried , etc., power, lighting
and heating, insurance and repairs. By particular costs —
also called ratable or distributive costs — are meant costs
which vary almost or quite in proportion to the amount of

product sold . They include raw materials and cost of ordi
nary 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 grows 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 .

Now the reason that fixed costs were not treated like
general costs , and included in the computation of the

average cost per unit, was because, as we have seen , fixed
costs could make no difference to the price at which the
supplier is willing to supply a given amount, to show
which is the object of the supply schedule (or curve) . The
supplier is not willing to sell at prices below what is neces

sary 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
necessary to cover fixed costs ; for from these there is no

way of escape. He might have escaped them once had he
not made the original investment, but now it is too late.

The difference between fixed and general expenses, then , is
chiefly one of dates. When a man is contemplating build
ing a hotel, and forecasting his possible profits or losses, he
will try to make his 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 cost and supply curves are independent of
fixed costs , the price which results from this supply curve
and the demand curve will be independent also . This con
clusion 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 is not determined by its cost of

production , but by its 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 in

stance, the value of the Panama Canal to -day is dependent
upon its future expected benefits , taken in connection with

the future expected cost of completion. Past elements are
without significance. The future elements being given ,
the value of the canal will be the same whether the past
cost was large or small, or nothing at all. Of course it is

true that the future expected cost for completing the canal
is less than if some of the work had not been already ac
complished, 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 canal.
§ 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 competitors is an important element which must be
reckoned with , while in the case of monopoly this element

is lacking. 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 ab

sent, there being no fear even that high prices will lead to
competition in the future.
Under these circumstances the monopolist will adjust his
price to what he thinks will be the effect on demand . He

will charge “ all the traffic will bear," i.e. will put up his
price to the point which will give him a maximum profit
over cost.

The higher the price, the larger the profit per

unit sold . But the higher the price,the less the demand,
i.e. the sales he can make at that price. If he makes his
price too high, he kills the sales . If he makes it too low , he
kills his profit per unit . By trial and error or by exercise
of his best judgment, 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
often happens, the costs under monopoly are less than the
costs under competition .

In some cases monopoly results

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 giving the ad
vantages in general of large- scale production.
When monopoly price exceeds price under competition ,
there is usually danger that the high price will invite com

petition. 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 . The evils
of high prices are the least of these. There are the evils of

crushing competitors by lowering prices and then raising
them afterward ; the evils of discrimination, or charging
different prices to different persons or localities; and there
are the dangers of political corruption and control. The

reader will have an opportunity in other books to study
these evils and the proposed remedies. He should ,however ,

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 is sometimes an evil, i.e.
when it is of the cutthroat kind, for which some form of
monopoly 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 refrain from

sympathy for

those producers who lose by such competition ,we must not
fail to note that in the end consumers will lose also.


reason is that when cutthroat competition is feared ,
producers will avoid sinking capital in such enterprises .

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 manufacturers dared risk undertaking its manu
facture. Each knew that if it succeeded , competitors would

spring up and rob them of most or all of their 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, precisely
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.
The anti-trust movement does not take these facts into
account, nor does it understand the necessities which have
led to monopoly and that, if we do not allow trade agree
ments, trade is practically impossible to-day .

§ 1. Prices of Competing Articles on the Demand Side

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 of desir
ability which themselves depend on innumerable outside
conditions — included among them being the prices of
other articles besides the particular articles 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 particularly affected by other prices.
It is evident that the price of coal will affect the demand

for coke, for coal and coke are often substitutes, or com
peting articles. Two sorts of wealth are said to be substi
tutes when they fill similar needs.

It follows that the sat

isfaction of these needs by one of the two substitutes not
only reduces its marginal desirability , but affects the mar

ginal desirability of the other in a similar fashion . Conse
quently the marginal desirabilities of the two tend to fall
or rise in unison . Consequently also the prices of the two
tend to fall or rise together . The more 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.
Hitherto we have regarded the schedule (or curve) of

marginal desirability of any article as an ultimate fact or in
our analysis. But behind it lie innumerable determining

causes, and one of the most important is the prices of sub
stitutes available.

There is scarcely an article which does not have its sub
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 — the prices of such substitutes as wheat,
corn , oats , rice, and barley ; of fish , meat, and fowl; of the
various fruits and the various vegetables ; or of clothing

substitutes, such as woolen , cotton, linen , and silk ; or of
ornamental substitutes, such as diamonds, pearls , rubies,
and amethysts. The closest substitutes , though still suffi

ciently distinguishable to prevent their being quite classed
as the same article, are the various “ qualities,” “ grades,” or

“ brands ” of any particular class of articles . There are
many grades of wheat, of sugar, of coffee, of meat, of silk ,
and in fact of almost any class of articles which can be

named. Among different grades the prices are usually so
closely parallel 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 themselves. 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 among them are differences in the quan



tities of benefits which flow from them . In this case the
prices of the goods will evidently be proportioned to the
quantities of benefits they yield . Wheat lands, for in
stance, of different fertility, will be worth prices propor

tioned to the quantities of wheat which they yield .
From what has been said of substitutes, it would evidently
be a mistake to think that the price of each different article

can be determined independently , i.e. without reference to
the prices of other articles .

§ 2 . Prices of Completing Goods on the Demand Side
Substitutes may be called competing articles . We now

consider completing articles . Completing articles are ar
ticles which jointly serve the same want. We have seen
that of two competing articles one is used instead of the
other for a given purpose. But of two completing articles
one is used in conjunction with the other for a given purpose.

Horses and mules are competing instruments for the purpose
of drawing loads.

A horse and a cart are completing instru

ments for the samepurpose . We have seen that the essen
tial attribute of competing articles was 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 completing articles it is the quantities of the articles
which tend to maintain a constant ratio . In the case of

perfect competing articles the ratio of their prices is abso
lutely constant. In the case of perfect completing articles
the ratio of the units used is absolutely constant. Right
and left shoes, for instance, being, practically speaking,

perfect completing articles , the numbers of rights and lefts
keep in a ratio of equality. One-legged people are too few
to seriously modify that relation .

The prices of two com

peting articles tend to move sympathetically , but the prices
of two completing articles tend to move inversely.


horses are abundant and therefore cheap, the tendency is



to make the competing mules cheap also , but to make the
completing 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 as completing are
almost as common as those which relate to each other as

competing. Various articles of food are used in combina
tion , as, for instance, bread and butter , or the elements of
which a sandwich is composed .

A daily diet is usually con

structed with regard to the fitting together of the different

courses served , and of themeals as a whole. Similarly, the
various parts of one's wardrobe are arranged with reference

to each other , and again , a dwelling and its various furnish
ings are mutually adapted . The tables and chairs, crock
ery, knives, and forks, beds and bedding, rugs and wall
paper,are all arranged in relation to each other and to the
house which they furnish .

$ 3. 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 de

mand. 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, for they fulfill dissimilar wants — are to some extent

substitutes 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 . The best example is found in the services of

laborers. The wages, or the prices paid for various kinds
of work , tend to keep pace with each other. Man is so ver
satile a machine that one kind of workman can readily sub



stitute for another. On a pinch, the same man may be
a factory employee, a farm hand , a coachman , carpenter ,

mason , plumber, or clerk . Consequently, these various sorts
of work, though filling very unlike wants on the demand
side, compete on the supply side, and tend to bear similar

If the wages of clerks rise, the wages of carpenters

will rise also , because otherwise many carpenters would
want to become clerks.

The consequence is that wages of

all sorts usually rise or fall together. If labor of all kinds

could be perfectly substituted, 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 “ per

fect mobility of labor," however, never exists. On the
contrary, labor may be classified into several more or less
“ non -competing groups, such as brain work, skilled work ,
and unskilled work .

Two goods complete each other in supply when jointly
they involve the samecost, 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 . Tal
low is a by-product of beef and hides . Other examples

of articles completing each other in supply are mutton and
veal ; 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 theother side of themarket. Consider, for instance,
beef and hides. If the price of beef rises, the amount sup
plied at the higher price will increase . Hence the supply
of hides will be increased at the same time. Consequently
its price will fall.

We see therefore, that two articles may be competing on
the demand side by replacing each other in satisfying the
same desires, or on the supply side by requiring the same
sort of costs ; and also that they may be competing on the
demand side by jointly satisfying the same desire, or on

the supply side by jointly requiring the samecosts.



In all the cases thus far considered , the relationship be

tween 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 .

§ 4. Prices of “ Tandem " Goods
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 “ tandem ”

goods because one follows after the

other. In this respect their relationship differs from the

others discussed. Substitutes are, as it were, " abreast ”
of each other , whereas wool and woolen cloth , for instance,
go tandem . 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 not competing or completing goods on
either side of the market. Their relation consists in the fact
that the producers or sellers of woolen cloth are the con

sumers or buyers of wool. Both the demand and the sup

ply side are involved . They demand wool to supply woolen
cloth .
The prices of tandem

goods 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 sched
ule (or curve) forwool will be higher than otherwise, and as

a consequence the market price of woolwill 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 tandem



articles, and their prices are likely to move in sympathy

with one another; 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 chain
like or serial relationship comprises other elements than raw

materials and finished products.

Thus, steel is related to

the labor and coal consumed in its manufacture in much the

sameway as it is to the iron ore out of which it iswrought.
The price of steel therefore moves in sympathy not only
with the price of iron but with that of the coal and labor
as well as of all the other goods employed in its production .

The series or chain of tandem goods is the chain of produc

tive processes already discussed.
§ 5. Efforts and Satisfactions the Ultimate Factors

This tandem 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, ex
cept 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 dis
entangle 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 innumerable intermediate stages, at each one of

which supply and demand results in a market price, but
each such price represents simply anticipated satisfactions



or efforts translated into money valuations. Any dealer
at intermediate stages , between efforts preceding him and
satisfactions following 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
(or 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 satisfac
tion diminished , as by a change of fashion , he receives the
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 de

pendent on the labor of wheat growing or the satisfaction of
bread eating. 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 eating, 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 busi
ness on either side, and sometimes he does not try to think
beyond what he immediately observes . He is apt to be
content to explain simply one of the two prices which in
terests him in terms of the other . Wholesale merchants
often offer to their customers, the retailers, as an explana

tion 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
pay as much as before, 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.
We see, then , that everything intermediate which hap

pens 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 effort 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 is bor
rowed from efforts and satisfactions.


§ 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 im

plicitly employed, that the prices of most goods are reck
oned. The rate of interest, as previously explained, is it
self a sort of price. 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 , not concerning any one
but 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 realized by an investor who
makes sacrifices at one time for the sake of compensating
benefits at a later time. Implicit interest is also called
profits. If we invest in a bond, for instance, 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 in
stance, if a bond yielding $ 4 a year for 10 years, and then



redeemable for $ 100, sells now for $ 105, we know the rate
of interest realized is not 4 per cent, as it would be if it sold
at par. It is less than 4 per cent — about 3.6 per cent.
The implicit rate of interest werealize on such a bondmay be

found, aswe have already seen , from a mathematical table .
When a man buys stocks instead of bonds, or a house or

a piece of land, the same element of implicit interest enters
into the transaction . He cannot even buy a piano or an

overcoat or a hat without discounting the value of the use
which he expects to get out of it. 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 inter
est, determined ? The problem of interest is one of themost
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 conse

quently it depends upon the quantity of money on themar
ket. In particular, this theory of interest claims that
plentiful money makes the rate of interest low . We com
monly 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 “ themoney market is tight,”
meaning that it is hard to borrow money. Probably the

great majority of unthinking business men believe that in
terest is low when money is plentiful, and high when money

is scarce . 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 .



The fallacy consists in forgetting that plentifulmoney raises
the demand for loans just as much as it raises the supply .
If, for instance, a dealer in pianos wishes to borrow in order
to stock up his store with pianos, supposing that the price
of pianos is $ 200 apiece, and that he wishes to have a
stock of 50 pianos in his salesroom , he evidently will have

to borrow $ 10,000. He goes to the bank and borrows it.
Now , let us suppose that money becomes more abundant.

This man will have an idea that in some way he will 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 money being more abundant will be that prices in gen
eral will rise , and presumably the price of pianos in particu

lar 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 have twice
as much money to conduct the same business. The fact
that the banker has twice as much money to lend is there
fore completely offset by the fact that the borrowers will
want to borrow twice as much .

The consequence is that

doubling the amount of money will not affect the rate of
interest in the least. 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 $ 5 per year by $ 100. 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 ought, instead of decreasing the rate of interest,
to increase it. The truth is, inflation ofmoney works equally
on both sides.

In mechanics 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

asmuch as up. The inflation 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
ofmoney capital in termsofmoney income; or it maymean

the purchasing power ofmoney over other goods. The abun
dance 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 busi
ness men .

One reason for this idea is that bankers look upon money
always 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 re

duce the rate of interest in order to get rid of the reserve.

The banker is constantly watching his reserve, and has to
adjust the rate of interest with respect to this reserve.


only way to get rid of a plethora of money in the reserves is
to lower the rate of interest, and the only way to protect

a depleted reserve is to raise the rate of interest. But the
banker is unconsciously measuring the amount of money in

his bank relatively to the amount of money outside. What
he forgets is that more reserves in his vaults does not neces
sarily mean plentiful money , nor when we have, as at pres

ent, 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. Themoney 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 explained, larger loans. And yet, if for some reason
a due share of themoney does not at first flow into the banks,
the results will be that Banker Smith will have too little
reserve in relation to the greater loans that are now de

manded of him . The consequence, then, will be actually to
raise the rate of interest. When , therefore, the banker
says that more money lowers the rate of interest, he ought
to say , “ When bank reserves get an undue fraction of
money, the rate of interest will be low ; but when an undue
fraction goes into circulation outside of banks, the rate of
interest 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 increase of money
distributes itself between pockets , tills, and bank reserves,
so as not to disturb the normal ratio between them . If this
happens, then the rate of interest will not be affected at all,
which is the normal result.

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 abun
dant. 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 moves with ab

solutely 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 a loan is made just as much as if



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 , and in this case the change in
the inflation may affect the rate of interest during the process

of change. While it is true, as we have just emphasized , that
after inflation has taken place no effect is produced on the

rate of interest, nevertheless , 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 .

Here, again, we encounter one of those transitional effects
already referred to when we were discussing money and

prices . Suppose, for instance, that prices are rising at the
rate of i per cent per annum .

Then , $ 100 lent to -day is

equivalent in purchasing power not to $ 100 repayable next
year, but to $ 101 repayable next year. If prices hadn't

risen, the borrower would have had to pay back as his prin
cipal $ 100, and this would have meant the same amount of

goods as were represented 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, if he gets back as his principal only $100, does not
get back as much purchasing power as he lent, and the bor

rower 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 it easy for the borrower and made
it hard for the lender . During the Civil War the United
States government issued a great many “ greenbacks."


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 were paying back their

loans,and found it very easy . As they said , themortgages
on their farms “ disappeared like smoke.” If they had



borrowed in 1860, say $ 5000 , the $ 5000 they paid back in
1864 really only represented half asmuch purchasing power
over goods, for prices had doubled ; the inflation of the

currency freed them 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 i per cent, then
the principal of the debt ought to be increased about i per
cent in order that there should be exactly the same burden
on the borrower in paying back as there would have been if

prices had not risen . In order to compensate for this rise

of prices, if prices are rising at i per cent per annum , the
borrower ought to pay an extra dollar on each $ 100 bor
rowed ; so that, if the rate of interest were 5 per cent when
prices were low , and will be 5 per cent after prices are high ,

it ought to be about 6 per cent while prices are rising 1 per
cent per year. In that case, a man who has borrowed $ 100
pays back $ 106 , of which $ 101 is the equivalent of the prin

cipal he borrowed . He calls the whole $ 6 interest, so that
the rate of interest expressed in money would be 6 per

cent, in order to be equivalent to 5 per cent when prices
are stationary.

The rise of interest is a sort of compensa

tion for the falling value of the principal; the interest is

increased in order to offset the depreciation in the principal.
If prices are rising 2 per cent per annum , we need to add
2 per cent to the rate of interest, and so on . On the other

hand, if prices are falling, we must reduce the rate of in
terest to offset the appreciation of the principal. If prices
are falling i per cent per annum , the equivalent of a 5 per

cent rate of interest during stationary prices would be about
4 per cent.

This ideal compensation in the rate of interest would
occur if man 's foresight were perfect. If we knew abso
lutely, for instance, that next year's prices were going to
be 2 per cent higher than this year, the rate of interest
would be 2 per cent greater than otherwise. So , also , if we

knew absolutely that all prices would be i per cent less a



year from to -day than to-day , the rate of interest during the

year would be, on that account, i per cent less than other
wise. But we never know the future exactly ; we can only


Consequently lenders and borrowers do not make

perfect compensation . The facts show that the general sen
timent is that prices probably will neither rise nor fall.

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 compensation for the rise ; and
that, on the other hand , when prices are falling, the rate of
interest is usually low , but not as low as it should be to

make a perfect compensation for the fall.
A study of the periods of rising and falling prices in the

United States, England , Germany, France, China, Japan ,
and India verifies these principles. It shows that, in gen
eral, when prices are rising, the rate of interest is high , and

when prices are falling, it is low .
§ 4 . Effect of Unequal Foresight
Another peculiarity of transition periods must be men

tioned. This peculiarity grows out of the fact that differ
ent persons differ greatly in their power to foresee.
general, borrowers foresee better than lenders .


The great

borrowers of to -day are not 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 lender

or bondholder, who are only silent partners in business.
Now , a consequence of the superiority in foresight, of bor
rowers over lenders, is that the borrowers are willing 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 5 per cent, and that prices are rising 2 per cent per annum .
We know that the rate of interest ought to be 7 per cent in
order to make things even ; but let us suppose that the
borrowers foresee that prices are going to rise 2 per cent per
annum ,and they are perfectly willing to pay 7 per cent, where

otherwise they would pay 5 per cent. But the lenders are
not alert enough to see why interest should be more than
5 per cent. The consequence will be that the rate of inter
est will not rise as high as 7 per cent but will be some

thing like 6 per cent.

The consequence of this in turn is

that the borrowers, who are willing to pay 7 per cent to get
the same loans that they used to get at 5 per cent, when

they find that they do not have to pay 7 per cent, but can
get loans at 6 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 6 per cent when they are willing to take 5 per cent.

This 6 per cent is low in the eyes of the borrowers, but high
in the eyes of the lenders. The consequence , therefore, is
an inflation of loans stimulated from both sides of the

In a previous chapter we saw that an increase of loans of
banks makes 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 cir
cular 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


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 precipitating a crisis.

Then we have the back- flow : prices decreasing, interest

falling, and a discouragement of business. This has all
been explained in a previous chapter. What needs empha
sis here is that the essential difficulty in all these changes is
with the rate of interest. The rate of interest is the key



to the situation . Were the rate of interest properly ad

justed , there would be less trouble, if, indeed , there would be
any at all. Crises would be fewer and they would be less

How ,then, can we get a better adjustment of the rate of

One way is to prevent these changes in price

levels as much as possible . This we have already discussed .
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.

§ 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 inflation or contraction of the currency affect
the rate of interest ? Wemust 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: Weshall find that, con
trasted with the supply and demand of goods, which resolves

itself in the last analysis into a comparison between differ
ent marginal desirabilities and undesirabilities , which are

simultaneous, the supply and demand of loans resolves itself
in the last analysis into a comparison between differentmar

ginal desirabilities and undesirabilities, which are not si
multaneous, but are distributed at different points in time.
Before, however, we can fully justify these propositions,
we shallneed to clear the way by removing some of themany
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. Before
most persons have grown old enough to consider the
subject philosophically, they have absorbed, more or less
unconsciously, a number of untenable and conflicting

Next to the money fallacies which were considered in the

last chapter, one of themost persistent fallacies is that “ in
terest is due to the productivity of capital.” If a man who
has never thought on the subject is asked why the rate of
interest is 5 per cent, he will almost invariably answer,

.“ Because 5 per cent is what investments pay.” If you
have $ 100 and invest it, and it yields you 5 per cent a year,
the rate of interest is 5 per cent.

A $ 100,000 mill will pro

duce 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

throughout the whole series of investments. When the rate
of interest is 5 per cent, nothing at first sight seems more

obvious than that it is 5 per cent because capital yields 5
per cent. Since capital is productive, it seems self-evident
that an investment of $ 100 in productive land, machinery ,
or any other form of capital, will receive a rate of interest

proportionate to its productivity . The proposition looks
attractive, but it is superficial. Why is the land worth
$ 100,000 ? Simply because this is the discounted value of
the expected $ 5000 a year. We have seen in previous chap
ters that the value of capital is derived from the value of its

income, not the value of the income from thatof the capital.
Butwhenever we discount income, we have to assume a rate

of interest. One hundred thousand dollars is a capitaliza
tion calculated on the basis of 5 per cent interest.

If we

capitalize $5000 at 5 per cent, and get $ 100 ,000 , we naturally
find that we are getting 5 per cent on the investment We
assumed 5 per cent in the first place. We get out exactly
what we put in ; but if we are not careful, we delude our

selves into thinking that we are getting something we didn 't


put in , and thus imagine that the productivity of wealth
explains the rate of interest.
It is evident that if an orchard of ten acres yields 100
barrels of apples a year, the physical-productivity , 10

barrels per acre, does not of itself give any clew to what
rate of return on its value 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 sense of value return , — which latter is the

important factor in studying the rate of interest.


Instruments -


Value of instruments


Value of benefits

This scheme signifies that (1) any instrument, such , for
instance, as land , railways, factories, dwellings, or food ,
is the means for obtaining benefits of any kind. 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. This final process in

troduces the element of interest . 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 income which produces 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 ex

pected income. And yet business men , although constantly







employing this discount process in specific cases, usually
cherish the illusion that they do so because their capital
value in some vague “ other use ” actually produces interest.

They fail to observe that the principle of discounting the
future is universal, and applies to any investment whatso
ever, and that in such a discount-process there is neces
sarily assumed the very rate of interest we are seeking 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 produc

tivity. If productivity makes interest, then a change in
productivity ought to make a change in interest. Yet, if
an orchard could in some way he made to yield double its
original crop, though the productivity of that capital in

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 calling it a
$ 40 ,000 orchard instead of a $ 20 ,000 orchard ; and the

ratio of the income to the capital-value would then remain

as before, namely , 5 per cent. To raise the rate of interest
by raising the productivity of capital is, therefore, like try
ing to raise one's self by one's boot straps.
Nor can this conclusion be escaped ( as has sometimes

been attempted) by supposing the increasing productivity
to be universal. It has been asserted , in substance, that
though an increase in the productivity of one orchard would
not appreciably affect the total productivity of capital, and
hence would not appreciably affect the rate of interest, yet

if the productivity of all the capital of the world could be
doubled , the rate of interest would be doubled . Now , doub

ling the productivity of the world 's capital would not be
entirely without effect upon the rate of interest ; but the



effect would not be in the simple direct ratio supposed .
Indeed, an increase of the productivity of capital would
probably result in a decrease, instead of an increase , of the
rate of interest. To double the productivity of capital

might more than double the value of the capital; at least
that it would fail to do so has not been shown by the pro
ductivity theorists , much less that capital would remain
unchanged in value. And if it doubled in value, we should
have the same result as before.

§ 2 . The Socialist's Theory

So much for the productivity theory . Wehave next the
socialist's theory. The socialist has the idea that interest
is robbery. He says “ it is allwrong 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
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 ; it is payment which , for some reason never satis
factorily explained, is made to the rich who sit by and do

nothing, while somebody else produces all the tribute that
has to be poured into their laps. 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 held back by somebody who is in a position of

vantage 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 it. The
capitalist, these socialists believe, 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 posit on to rob you ."



The socialist's position involves two propositions : first,
that all income and all capital are practically produced by

labor ; and secondly, that all the 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 socialism . Let it be granted

that practically every instrument of production is produced
by labor ; let it be granted that the capitalist is always liv

ing on the product ofpast 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

the past.
It does not follow that injustice has been done to the
laborer. Let us consider the case of a tree planted with $ 1

worth of labor, and 25 years later worth $ 3 . The socialist
virtually asks, “ Why should not the laborer who planted the

tree receive $ 3 instead of $ 1 for his work ? ”

The answer is

that he may receive it, provided he willwait 25 years for it !

As Böhm -Bawerk 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 en
tire 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 con

trary to be the fact, but it is absurd 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. It is because the laboring man can 't wait that

he is willing to take something less than the whole value,
and it is right that he should do so , because the capitalist
does not like to wait either, and the capitalist is really doing



a favor to the laborer when he pays him in advance for
planting a tree and waits himself 25 years before getting the

product .

§ 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. This preference comes from a
fundamental attribute of human nature. As long as people
like to have things to -day rather than to -morrow , there will
be a rate of interest.
Interest is, as it were, impatience crystallized into a market
rate. The rate of interest is formed out of the various de
grees or rates of impatience in the minds of different people.

The rate of impatience in any individual's mind is his pref
erence for an additionaldollar, 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 to-day's money
over the marginal desirability of next year's money 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 money. If,for instance, in order to get $ 1
to-day he is willing to pay $ 1 .05 next year, then his rate of

impatience is 5 per cent.

The present $ 1 is worth to him

so much that in order to get it he is willing to pay more than

$ 1 in the future for it ; it is because of the willingness to do
this that there is such a thing as the 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 a suit

of clothes or stocks or bonds, or anything else .
But what are these present and future “ goods " which

are thus contrasted ? At first sight it might seem that the



“ goods ” compared may be indiscriminately wealth , prop
erty, or benefits. It is true that present machines are pre
ferred to future machines ; present houses to future houses ;
land possessed to -day to land available next year ; present

food or clothing to future food or clothing ; present stocks
or bonds to future stocks or bonds ; presentmusic to future
music , and so on . These seem a very heterogeneous com
pound by which to explain so homogeneous a thing as interest.
But a slight examination will show that some of these cases

of preference are reducible to others . 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 wewould choose a present fruit tree

rather than a similar fruit tree available in ten years is that
the fruit production of the first will occur earlier than that
of the second .

The reason one prefers 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 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 income; and the earlier the property is
acquired, the earlier will the income accrue, the right to
which constitutes the property in question .
Thus , all rates of impatience resolve themselves into
preference for early income over late income. Moreover,
the preference for present income over future income re
solves itself into the preference for present final income over

future final 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 manu
factured , and the sooner will the clothing made from it be
worn by the consumer.

When, as is usually the case, exchange intervenes between

the weaving and theuse of the clothes, the goalin the process
is somewhat obscured by the fact that the manufacturer
regards his preference for present weaving over future
weaving 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 re
ceived, 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, those who
buy the cloth he manufactures, that base their preference
for present cloth over future cloth 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 enjoyable
income to which the interaction in question is a mere pre
paratory step. 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 satis
factions over future satisfactions.

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 presup

posed. When any other goods than enjoyable income are
considered , their values already imply a rate of interest.
When we say that interest is the premium on the value of








a present house over that of a future house, we are apt to

forget that the value of each house is itself based on a rate
of interest. For, as we have seen , the price of a house is the
discounted value of its future income, and in the process of
discounting there always lurks a rate of interest. The
value of houses will rise or fall as the rate of interest falls or

rises . Hence, when we compare the values of present and
future houses, both terms of the comparison involve the

rate of interest. If, therefore , we undertake to make the
rate of interest depend on the relative preference for present
over future houses, we are making it depend on two ele

ments, in each of which it already enters — present
houses and future houses. The same is true of all capital,
and also of those items of incomewhich we have called inter

actions; for the value of an interaction is the discounted
value of the ultimate income to which that interaction leads.

We could not rest satisfied in the statement that interest is
the premium on the value of present tree planting over
that of future tree planting ; for the value of each tree
planting itself depends on the rate at which the future

income from the tree is discounted . But when present
ultimate income is compared with future ultimate income,

the case is different, for the value of ultimate income in
volves no interest whatever. We see, therefore, that the

reduction of the problem of interest to a comparative value
of present and future enjoyable income avoids the diffi

culty of making interest depend on magnitudes which them
selves depend in turn on interest.

§ 1. Influence which Time- shape of Income exerts on the
Rate of Impatience

Butwehave not yet wholly solved the problem of interest.

It is not enough to know that the more impatient a people
are, the higher will their rate of interest be, and that the
more patient they are, the lower their rate of interest. We
must also know on what causes the rate of impatience de
pends. It depends principally upon the character of one's

enjoyable income. Smith's rate of preference for present
over future satisfactions will depend on the abundance of
his present over his future satisfactions. If the future sat
isfactions that he expects and looks forward to are very great,

and his present satisfactions are very small, he will be im
patient to leave his present scarcity and arrive at the

expected future abundance ; that is, he have a high rate of
preference for present over future satisfactions. This is on
the same principle thatprices are high when goods are scarce .
The preference for present satisfactions is high if present
satisfactions are scarce. Now the rate of preference which
Smith has for present satisfactions over future satisfactions

will depend on his whole future stream of satisfactions, that
is , what we call his final enjoyable income. It will depend
on four characteristics of that income : first, as just said ,

it will depend on the time-shape of the income, — the rela
tive abundance of his present and his future satisfactions ;
second , on the amountof the income, i.e. whether his satisfac
tions are few ormany ; third , on the composition or make-up
of the income, i.e. in what proportions it consists of the








gratifications of the palate, of vanity , clothing, shelter, and

the other elements which make up income; and fourth , on
the uncertainties of the income, i.e . to what extent his sat

isfactions throughout future years can be depended upon .
The rate of impatience of any individual depends, then ,

on the character of his income, i.e . on four characteristics of
its time-shape

income :

its amount

its composition

its uncertainties
This proposition — that the preference of any individual

for present over future income depends upon the nature
of his prospective
enjoyable income —

corresponds to


FIG . 39 .

proposition in the
theory of prices, that themarginal desirability of any article

depends upon the quantity of that article ; both proposi
tions are fundamental

in their respective
We have first to

consider the influence

upon the rate of im
patience, of time
shape of income, i.e.
the distribution of in
come in time. Four

differenttypesof time
shape may be dis
tinguished : uniform
income, consisting of
FIG . 40.

equal yearly items, as
represented in Figure 39 ; increasing income, as repre
sented in Figure 40 ; and decreasing income, as repre



sented in Figure 41. The effect of possessing an
increasing income (Fig. 40 ) is, as we have just seen , to make
the possessor impatient, i.e. to make his preference for
present over future income higher than otherwise ; for it

means that the earlier income is relatively scarce, and
the remoter income, relatively abundant. A man who is

now enjoying an income of only $1000 a year, but expects
in ten years to be enjoying one of $ 10,000 a year, will prize

a dollar to -day far more than a dollar due ten years hence .
He has “ great ex

values the present's



dollars' worth of
satisfaction more



future 's abundant
dollars or dollars '
worth of satisfac

tion. He may, to
satisfy his impa
tience, borrow
money to eke out
this year's income,
Fig . 41.

and make repay
ment by sacrificing from his more abundant income ten
years later.

Reversely , a gradually decreasing income (Fig . 41),
making , as it does, the earlier income relatively abundant,

and the remoter income relatively scarce, tends to reduce
impatience, or the preference for present as compared with

future income. The man with a descending income says,
“ I have all the money I want to -day, and more perhaps,
but next year I shan 't have as much as I want.” He will
therefore strive to save from his present abundance to pro

vide for coming needs.






The extent of these effects will, of course , vary greatly
with different individuals. Corresponding to a given as
cending income, one individual may have a rate of impa
tience of 10 per cent and another only 4 per cent. What we

need here to emphasize is merely that, in the case ofboth of
these individuals, a descending income causes a lower rate
of impatience than an ascending income.
§ 2. Influence of Size and Composition of Income

So much for the time-shape of a man 's income, or its dis
tribution in time. Our next topic is the dependence of
impatience 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
utility 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 the
present is the time to keep to 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 consumption



ten years, because if he put off consuming them , he couldn't
consume them at all ; he would die in the meantime. 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 appreciation of
the future 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 “ sufficientunto the day is the evil thereof."
Weall suffer from lack of perspective,and tend to exaggerate
the needs of the present. But 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 fu
ture, if only the all-absorbing clamor of present necessities

may thus be satisfied .
We see, then , that a low income tends to produce a high
degree of impatience, partly from lack of foresight and self
control, and partly from the thought that provision for the
present is necessary both for itself and for the future as well.

We come next to the influence of the composition of the
income-stream on the rate of impatience of its possessor.
An income worth $ 5000 may, for one individual, comprise
one set of enjoyable services , and for another, an entirely

different set. The inhabitants of one country may have
relatively more house shelter and less food element in their
incomes than those of another. These differences will have
an influence in one direction or the other upon the rate of
impatience. Diminution of any one constituent of income
would have an effect upon rate of impatience similar to the
effect of diminution of income in general. A decrease of

the food element would be felt especially , both because this

element usually forms a considerable part of income and
because it is a primenecessity.





$ 3. Influence of Uncertainties of Income

The next influence on the rate of impatience and there
fore on the rate of interest is risk or uncertainty . Now

uncertainties affect the impatience in several different ways.
In general, risks tend to raise the degree of impatience.
There are four ways in which risk tends to raise , and one in

which it tends to lower, impatience.
First, and most familiar, 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 , that fact will have to be offset
by an increase in the rate of interest, and produces a cor

responding rate of impatience for risky loans.
But even the rate of interest in riskless loans will be raised

by risk in certain ways now to be discussed . The second
way in which risk tends to raise the rate of impatience

is in the risk of life.

It acts like the risk of a loan . You

may tell a man he is perfectly sure of being repaid his loan
fifty years from now . Nevertheless, that will not cause
him to regard the money which will come fifty years hence
as equal in value to the money which he has in his pocket
to -day, because he runs the risk of dying inside of fifty years ;

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. He knows that almost any
day he may be shipwrecked , and the consequence is he

prefers money in his pocket to -day to money next year.
Sailors are proverbial spendthrifts and have a proverbially
high degree of impatience.
The third way in which risk tends to increase impatience
is seen where present income is risky as compared with
future 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.



Fourthly, the risk of income may, instead of applying
especially to remote periods or especially to immediate
periods, apply to all alike. Such a condition largely explains
why salaries and wages are lower than the average earnings
of those who work for themselves. Those who choose salaries

rather than profits are willing to accept a low income in order
to get rid of a precarious 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 impatience, risk , if uniformly

distributed in time, must tend to increase impatience.
These , then , are the 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 where immediately future income 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 scikness he expects to get well and resume 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
compared with the present. His future looks dubious, and

that will cause him to be less impatient, because a risky
future income is equivalent to a small future income, and
we have seen that a small future income tends to lessen
impatience. An income which gets more and more risky

in the future is therefore like an income which gets more
and more small 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 con
nected with distant income is greater than that connected
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 rate 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
increase and in others to decrease the rate of impatience.
There is a common principle , however, in all these cases.

Whether the result is a high or a low rate 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; if the period is the immediate

future , the risk makes for a high appreciation of immediate
income; if the risk is in all periods of time, it acts as a
virtual decrease of income all along the line.
The rate of impatience depends, then , upon the time

shape of an income-stream , its size, its composition , and its
uncertainties .

§ 4. Influence of Differences in Human Nature

It is clear that the rate of impatience which corresponds
to a specific income-stream will not be the same for every

body. One man may have a rate of impatience of 5 per
cent and another a rate of impatience of 10 per cent, although

both have the same income. The difference will be due
to the personal characteristics of the individuals. These

characteristics are chiefly five in number: (1) foresight,
(2) self-control, (3 ) habit, (4 ) expectation of life, (5 ) love
for posterity. We shall take these up in order.

( 1) First , as to foresight. Generally speaking, the

greater the foresight, the less the rate of impatience, and
vice versa . In the case of primitive races and uninstructed



classes of society, the future is seldom considered in its
true proportions. The story is told of a Southern negro
that he would not mend his leaky roof when it was raining,

for fear of getting more wet, nor when it was not raining,
because he did not then need shelter. Among such per
sons the rate of impatience for present gratification is

powerful because their comprehension of the future is weak .
If we compare the Scotch and the Irish , we will find a con

trast in this respect. The Irish , in general, lack foresight
and are improvident, and the Scotch have foresight and are

Consequently the rate of interest is high in

Ireland and low in Scotland .
These differences in degrees of foresight produce cor
responding 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 10 per cent, when the forehanded would
experience a rate of only 5 per cent. In both cases the

rate of impatience will depend on the size of the income.
The lower the income, the higher the rate of impatience
will be. But the particular rates corresponding to a partic
ular income in the two cases will be entirely different.
Therefore the rate of impatience, in general, will be higher

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
foresight. Like those workingmen who cannot carry their

pay home Saturday night, but spend it on the way in a

grogshop, many persons cannot deny themselves any pres
ent indulgence, even when they know definitely what the
consequences will be in the fuutre. Others, on the con








trary, have no difficulty in stinting 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 ac

customed exerts necessarily a powerful influence upon his
valuations and therefore upon his rate of impatience.


influence may be in either direction. A rich man's son who
has been brought up in habits of self-indulgence, when he
finds himself with a smaller income than his father pro
vided him during his formative years, will have a higher
rate of impatience than a man who has the same incomebut
who has climbed up instead of climbed down.
(4 ) The expectation of life will affect a man's rate of im
patience. Wehave already seen this in another connection.
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 ; 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.
If we will take the history of a man 's life , we shall find

that he changes his rate of impatience at successive periods.

A child will have a high rate 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 rate of
impatience , but for a different reason , viz. because he
then expects a large future income. He expects to get on
in the world , and he will have a high rate 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 rate
of impatience, because then the needs of the future rather
than the endowment 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 contrary, he will wonder how he is going to get along
in the future because he will have so many mouths to feed .



He 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 rate of impatience, 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? ”
So there are four periods in the cycle of a man 's life :

( 1) childhood ; (2 ) youngmanhood ; (3 ) the timewhen hehas

a wife and family to look out for and provide for in the
future ; (4 ) and lastly , the time of his lifewhen he again looks
out only for himself and expects to die presently . These,
for different reasons, affect in different ways a man 's rate

of impatience.
(5 ) The fifth circumstance is a love for posterity. Prob

ably themost 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

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 impa
tience 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 didn 't 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 gives them a low rate of impatience: Life

insurance , by training people to look out for posterity, is
acting as one of the most powerful means of lowering the

rate of impatience and therefore the rate of interest. At
present in the United States the insurance on lives amounts
to $ 20,000,000 ,000. This represents, for the most part, an
investment of the present generation for the next. The

investment of this sum springs out of a low rate of impa
tience, and tends to produce a low rate of interest.

Thus we see that men may differ in many ways which
affect the rate of interest and rate of impatience. Wemay
contrast two extreme types of men . Men may have a high

rate under the following conditions : if (irrespective of the

character of their income) they are shortsighted, or are
weak -willed, or have habits of a spendthrift, or look for
ward to a short or uncertain life , or are selfish , and have

no regard for posterity. The opposite characteristics will
lead to a low rate of impatience : foresight, self-control,
habits of thrift, length and certainty of life, and altruism
with respect to posterity.
Then we see that a man 's rate of impatience depends

( 1) upon his income and ( 2) upon his nature. In the table
on page 339 we can contrast the extreme types of income

and the extreme types of human nature, and see how the
rate of impatience will depend upon the various combina
tions involved .

By comparing the types of income and human nature we
find nine compartments in the table. If we compare the

figures in the same vertical column, we see that they grow
less as we descend, expressing the influence of the character

of income. If we compare the figures in the same hori
zontal line, we see that they grow less toward the right,

expressing the influence of human nature. But a man may
have an income-stream of a kind which tends to make a

high rate of impatience, and at the same time a nature of

a kind which tends to make a low rate of impatience . The



result will then be a compromise rate of impatience, say
5 per cent. Or a man may have an income-stream which
tends to make his rate of impatience low , and a nature
which tends to make the rate of impatience high . Thus

5 per cent is found three times in the table forming a diag
onal. The other diagonal shows the contrast between the
extreme where both the character of the incomeand of the
nature of the individual conspire to make a very high rate

of impatience and the opposite extreme where they conspire

to make a very low rate of impatience.



Far-sighted ,


sighted ,



vide for

Of a mixed trolled,
customed to
| Uncertain weak-willed,
Time-shape Composiaccustomedor medium save,
to spend,
ous to pro




Food Precari
Small Increasing scanty ous

20 %



Of a mixed or medium type

10 %



Large Decreasing abun . Assure





§ 1. Equalizing Marginal Rates of Impatience
In the last chapter we saw that the rate of preference for
present over future goods is, in the last analysis , a preference
for present over future income; that this, preference de

pends, for any given individual, upon the character of his
income-stream , - its size, time-shape, composition, and
uncertainties, — and that the nature of this dependence
varies with different individuals .
The question now arises, Will not the rates of impatience
of different individuals be very different, and if so , what
relation do these different rates have to the rate of interest ?
It might seem at first that the rates of impatience would
differ widely , and that the rate of interest must be some
sort of average of their different magnitudes. But this is
incorrect. In a nation of hermits , without any mutual

lending and borrowing, the rate of impatience of individuals
would diverge widely , but there would be no rate of interest.

It is modern society 's habit of borrowing and lending that

tends to bring into equality the rates of impatience in differ
ent minds, and it is only because of the limitations of the
loan market that absolute equality is not reached .
The chief limitation to lending is due to the risk involved ,

and to the difficulty or impossibility of obtaining the secur
ity necessary to eliminate or reduce that risk .

Those who

are most willing to borrow are oftentimes those who are
least able to give security . It will then happen that these

persons, shut off from the loan market, experience a higher
rate of impatience than the rate of interest ruling in that



market. If they can contract loans at all, it will be only
through the pawnshop or other high -rate agencies.
But 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
foreknown income streams, and are free to exchange any
part of them so that present income is exchanged for future
income. We assume, further, that to buy and sell various
parts of one's income-stream (by loans, etc), is the only
method of altering that income-stream . Prior to such
exchange, the income-stream is supposed to be rigid, i.e .
fixed in size, time-shape, and composition . The capital

instruments which the individualpossesses are each supposed
to be capable of only a single definite series of services
contributing to his income-stream .
Under these hypothetical conditions, the rates of impa

tience for different individuals would be perfectly equalized .
Borrowing and lending evidently affect the time-shape of
the incomes of borrower and lender ; and since the time

shape of their incomes affects their rate of impatience, such
a modification of time-shape will react upon and modify
their rate of impatience and bring the market into equi
librium .
For if, for any particular individual, the rate of im
patience differs from the market rate, he will, if he can ,
adjust the time-shape of his income-stream so as to har
monize his rate of impatience with the interest rate. For

instance, those who, for a given income-stream have a rate of
impatience above the market rate, will sell some of their
surplus future income to obtain (i.e. “ borrow ” ) an addition
to their present meager income. This will have the effect
of enhancing the value of the future income and decreasing
that of the present. 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 current rate of interest will borrow up to the

point which will make the two rates equal. Reversely,
those who , with a given income-stream , have a rate of im

patience below the market rate, will sell (i.e . “ lend ” ) some
of their abundant present income to eke out the future, the
effect being to increase their 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 5 per cent, whereas the rate of impatience of a

particular individual is at first 10 per cent. Then , by hy
pothesis, the individual is willing to sacrifice $ 1.10 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 spending only
$ 1.05 of next year. 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 5 per cent when
he is willing to pay 10 per cent. This operation , by in
creasing his present income and decreasing his future, tends

to reduce his rate of impatience from 10 per cent to, say,
8 per cent. Under these circumstances he will borrow

another $ 100 ,being now willing to pay 8 per cent, but having

to pay only 5 per cent. This operation will still further
reduce his rate of impatience. He will continue to borrow
until his rate of impatience has been finally brought down

to 5 per cent. Then for the last or “ marginal ” $ 100, his

rate of impatience will agree with the market rate of inter
est. As in the general theory of prices, this marginal rate ,
5 per cent, being once established , applies indifferently to

all his valuations of present and future income. Every
comparative estimate of present and future which he actu
ally makes must be “ on the margin ” of his income- stream

as actually determined.
In like manner, if another individual, entering the loan

market from the other side, has at first a rate of impatience



of 2 per cent, he will become a lender instead of a borrower.
He will be willing to accept $ 102 of next year's income for
$ 100 of this year's income,but in the market he is able , in
stead of the $ 102, to get $ 105. As he can lend at 5 per cent
when he would gladly do so at 2 per cent, he jumps at the

chance and invests, not one $ 100 only, but another and

another . But his present income, being 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,
which , under the influence of successive additions to the
sums lent, will rise gradually to the level of themarket rate
of interest.

In such an ideal loan market, therefore, where every in
dividual could freely borrow or lend, the rates of impatience
for present over future income for all the different individuals
would 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 42.
It is assumed that his income

stream is an ascending one, as
between this year and next Borrowed-* a!
year, that is, that this year's

income is relatively small and

FIG . 42.

next year's income relatively
large. It may be that this year he is ill, and therefore has

not earned his usual amount of money, and that next year
he expects to get an unusual income from some particular
source. This man will then probably be impatient to get the
large income he anticipates. He does not wish to wait till

next year if he can avoid it. 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 income.

He will borrow , but borrowing changes the time-shape of

zlan 15 , 17 ,31,3 , 5


his income-stream . His original income in the first year is
indicated by the height a, and that next year by the
( greater) height b .

The effect of borrowing will be to

elevate the first line to e' and to depress the second to B'.
These two adjustments will lessen both the scarcity of this
year's income and the abundance of next. This will there
fore modify the time- shape of his income and lessen the valu

ation he puts on a dollar this year as compared with next.
This reduces the premium he puts on this year's dollar, i.e.
his rate of impatience. By increasing his loan he can evi

dently reduce this premium to conform to the rate of in
terest. 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 some

other year or years. In this way he can alter the time-shape
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 inter
est . He began with a rate of impatience greater than the
market rate of interest , but ended in harmony with that rate.
Figure 43 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 ,wemay
Lent of
suppose that he has just received

a small legacy which makes this
year's available income unusually
FIG . 43.

large, while he expects next year

to have an unusually small income. Looking forward to
next year, he sees that it will be hard to get along comfort
ably , while this year he has more than he needs. He there

fore invests some of his present abundance to the extent of
ad' in order to eke out his future scarcity by bb'. He will
do so , however , only provided his rate of impatience for
present over future goods is less than the market rate of

interest, 5 per cent, and he will do so only up to the point
which will bring down his rate of impatience to the level of
this rate of interest.



The two men started out with rates of impatience differ

ent from the market rate of interest . The market rate was
5 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 readjust

ments in the time-shape of their income-streams, they
brought their rates of impatience each into harmony with
the rate of interest and therefore with each other. There
fore, as long as there is a market in which everybody can

borrow or lend at will at 5 per cent, everybody will have at
the margin a rate of impatience of 5 per cent. Nobody
will have a rate of impatience above 5 per cent, because, if

it is at first above it, he 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 samemarginal rates of impatience.
We have seen that different men , even with precisely the
same incomes ,may have different rates of impatience. But

in that case they will not continue to have the same sorts
of income.

§ 2. 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 rate 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 time-shape, composition , or certainty. This
method of modifying one's income-stream , which we shall
call themethod of sale , really includes the former method

of loan ; for a loan contract is at bottom a sale ; that is, it
is the exchange of the right to present or immediately en
suing income for the right to more remote or future income.
A 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 property.

The concept of a loan may therefore now be dispensed
with by beingmerged in that of sale. By selling some prop

erty rights and buying others it is possible to transform
one's income-stream at will, whether in time-shape, com

position , or probability . 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 se
curities , he is providing himself with future money, con
vertible when received into true or enjoyable income. If his
security is a share in a mine, his income-stream is less last

ing, though it may be larger , than if the security is stock
in a railway .

Purchasing the right to remote enjoyable income is called
investing ; to immediate enjoyable income is called spending.

The antithesis between “ spending ” and “ investing ” is
merely the antithesis between immediate and remote in

come. The adjustment between the two determines the
time-shape of one's income-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 individualmay change the conformation

ofhis income-stream precisely as though he were specifically

lending or borrowing. Thus, if a man 's original income



stream is $ 1000 this year and $ 1500 next year, and if, selling
this income- stream , he buys with the proceeds another
yielding $ 1100 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 final one, and $ 105 being the
reverse modification in next year's income.
We may divide society into the spenders and the savers

or investors. Figures 44 and 45 show the contrast between
them .

A spender is a person who chooses to enjoy a
xo '




Fig. 44 .

Fig . 45.

larger income in the present than in the future ; a saver
is a person who chooses to enjoy a smaller income in the
present than in the future. We suppose that the incomes
of the two are at first just the same, but the first man
reacts to his present income-stream differently from the
second man . He is a natural saver, thinks much of his
future needs, and will, we shall suppose, have a rate of

impatience below the rate of interest. He will therefore
take away from his present income a certain amount in
order to add to his future income, and will, as shown in

Figure 44, adjust his income-stream so as to bring the
present income-stream down from a to d' and his future in
come up from b to b'. The secondman is a natural spender,
and although he has the same income to start with , he wants

more immediate income and is willing to sacrifice next year's




income to get it. This means that his rate of impatience
is above the market rate of interest, and therefore he is a
borrower and a spender. He will, then , as shown in Figure

45, add to his present income from a to a', and reduce his
future income from b to b'.

§ 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 should be still borrowing and

lending, but under the name of “ sale ” ; and if “ bonds "
were tabooed , they could merely change the name 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
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 capi
tal 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 such instru

ments as the forest already mentioned.
It was in such a way, as, for instance , by " rent-purchase,”
that the medieval prohibitions of usury were rendered nu
gatory. Practically , at the worst, the effect of restrictive



laws is simply to hamper and make difficult the finer ad

justments of the income-stream , compelling would -be bor
rowers 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 re

strictions, 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 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 appearing therein . Interest is too omni

present a phenomenon to be eradicated by attacking any
particular form ; nor would any one undertake it who per
ceived 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. Inter
est can never disappear until present and future dollars

will exchange at par.

This would imply that human

beings were no longer impatient but considered it no hard
ship to wait indefinitely.

We have supposed each person's income to be “ rigid,”
except as it is modified by borrowing and lending, or buying
and selling . It will, however, make little difference if each

income, instead of being rigid , is more or less flexible to
start with . Often the same article may be used in more

than one way. In such a case the owner merely chooses
the way which gives the capital the highest value.

Since any time- shapemay be transformed into any other,
he need not be deterred from selecting an income because

of its time-shape, butmay choose it exclusively on the basis
of maximum present value.



§ 4. Clearing the Loan Market
Wehave 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 it. For society as a whole, however ,
these rates of impatience determine 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

group forming the market, we know that these marginal
desirabilities and undesirabilities fix the price of coal. In
the sameway , 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
which the whole community may concur in order that
the market of loans may be exactly cleared. Supply and
demand will work this out.

To put thematter in figures : if the rate of interest is set
very high, say 20 per cent, there will be relatively few bor
rowers 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, $ 100,000,000 ; whereas, those
who are willing to add to their present income at the high
price of 20 per cent interest will borrow only , say , $ 1,000 ,000 .

Under such conditions the demand for loans is far short of
the supply , and the rate of interest will therefore go down.
At an interest rate of 10 per cent, the present year's income

offered as loans might be $ 50 ,000,000 , and the amount
which would be taken at that rate only $ 20,000,000. There



is still an excess of supply over demand, and interest must
needs fall further.

At 5 per cent we may suppose the

market cleared , borrowers and lenders being willing to take
or give respectively $ 30 ,000,000. In likemanner 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, having

a high rate of impatience, 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

sellers of property yielding remote income, such as bonds
and stocks. On the other hand , those who — having a low
rate of impatience — 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. 1
The mechanism just described will not only result in a
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 a portion of several years' future incomes . 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 . Historical Illustrations
We have now completed our study of the causes deter
mining the rate of interest. If they are correct, we should

find that the rate of interest is low ( 1) if in general thepeople



are by nature thrifty, farsighted , self-controlled , love 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, 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 the substantial variety .

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

man . 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 perish

able character,built for immediate,not remote,gratifications.
These examples illustrate the effect on the rate of interest
of differences in human nature. We now turn to illustra
tions of differences in the time-shape of 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 , espe



cially where changes have been rapid, as in mining commu

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 15 to 2

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 interest was 24 per

cent per annum .”

After railway connection in 1869, East

ern loans began to flow in .

The decade 1870 - 1880 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 time-shape of their income-streams.


rate of interest consequently dropped from 11 per cent to 6
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 con
tracted at over 50 per cent per annum , and the borrowers

regarded themselves as lucky to get rates so “ low .”
§ 6. 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. It enters

into the price of securities, land, and capital goods gener
ally, as well as into rent, wages, and the value of all “ inter

The rate of interest plays a central rôle in the theory of



prices. It applies to thedetermination of the price of wealth ,
property, and benefits. As was shown in previous chapters ,
the price of any article of wealth or property is equal to the
discounted 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 consequently cause a fall or rise respec

tively in the value of all instruments of wealth . The ex
tent 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 benefitsmay 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 affording
pasture for sheep will depend upon the discounted value of

the benefits of the flock in producing wool. In likemanner,
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 thenext 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 those who wear it — in other words, upon the use
of the clothes.
Thus the final benefits , consisting of the use of the clothes,
will have an influence on the value of all the anterior bene

fits of tailoring, manufacturing cloth, producing wool, and
pasturing sheep, while each of these anterior benefits , when
discounted ,will give the value of the respective capitalwhich
yields them ; 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 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 therefore be most felt
by the links most distant from these final benefits . For
instance, a change in the rate of interest will affect but

slightly the price of making clothing, but it will affect
considerably the price of pasturing sheep .
A study, therefore, of the theory of prices involves (1 ) a
study of the laws which determine the final benefits on

which the prices of anterior interactions depend ; (2) a
study of the prices of these anterior interactions, as de
pendent, through the rate of interest, on the final benefits ;

(3 ) a study of the price of capital instruments 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 regulating the price of final

benefits, is relatively independent of the rate of interest.
The second and third ,which seek to show the dependence on

finalbenefits of the anterior benefits and of the capitals which
bear them , involve and depend upon the rate of interest.
In the theory of prices we found that the ultimate ele
ments supplied and demanded were satisfactions and efforts .

There is involved in each price another special price, viz .

the rate of interest. Without the rate of interest we may
only compare simultaneous satisfactions or efforts. With it

we may compare all that exist. By means of the rate of
interest any future satisfaction or effort is discounted, and

thus translated into terms of present value. It enables us

to pause at every step and appraise the interactions and
capitalwhich anticipate futuresatisfactions . In other words,
by it we capitalize income and form our capital accounts .

Interest, then , is the universal time-price, linking im
pending and remote satisfactions or efforts or both .

It is

literally the previously missing link necessary for a complete

comparison of efforts and satisfactions at all points of time.
The study of the rate of interest , therefore, rounds out
and completes our study of prices.








§ 7. Classification of Price Influences
Wemay now fitly review the theory of prices by enumerat
ing the various possible causes which might decrease the
price of, let us say, pig iron . The price of pig iron may fall
for any one or more of the following reasons :
(1) A rise in the marginal desirability of money due either to
(a) A rise in the purchasing power of money through
I. A decrease in money or deposit currency, or
II. A decrease in their velocities, or

III. An increase in the volumeof trade, or to
(b) An impoverishment or reduction of incomes.
(2) A fall in the marginal desirability of pig iron due either to

(a) An increased amount of pig iron through
I. A decrease in its cost by

1. A saving of waste .
2. A saving of labor.

3. A decrease in the price of iron ore or other
prices entering into its cost.

4 . An increase in the price of by -products .
II. A trade war.

(6) A fall in the marginal desirability of a given amount of pig
iron, through

I. A decrease in the price of iron products through a
decrease in the marginal desirability of the sat
isfactions they yield because of,
1. An increase in their amount.
2 . A change in fashion , etc.

II . An increase in substitutes.
III. A decrease in completing articles.

IV . An increase in the rate of interest through an in
crease in themarginal rates of impatience.
1 . From a change in incomes.

(1) By steepening their time-shape.

(2) By reducing their size.
(3) By increasing their uncertainties .
2. From a change in human nature.

(1) By decreasing foresight.
(2) By decreasing self- control.
(3) By increasing shiftless habits.

(4 ) By decreasing regard for posterity.



Back of these causes lie other causes,multiplying endlessly
as we proceed backward .
But if we trace back all of these causes to their utmost

limits, they will all resolve themselves into changes in the
marginal desirability or undesirability of satisfactions and
of efforts at different points of time and of themarginal rate
of impatience as between any one year and the next.


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 materials for constructing our accounts. This

material consisted of the values of various items, whether
of capital or of income. These values consist in each case
of two factors, the quantity of the goods valued and its
price. Wehave 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 produce ; what determines the quantity of the
wheat fields ; what determines the quantities of the neces

sities, comforts, luxuries, and amusements of life which a
nation or an individual possesses ; what determines the
quantities of human beings on a given area ? Once we can

explain these quantities, we need only multiply by the
prices previously explained , and we have completed our

task of explaining values. We shall then be able to ex
plain -- at least in general terms — why, for instance, the

values of the capital or income in the capital accounts of
some communities or individuals are so great and of others



so little ; why the value of the benefits flowing from one
piece of land is so great, and of another so small, and so
forth .
Our purpose is not so much absolute, as relative, 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 of human beings, per acre of woodland, per loom ,

or per other unit of capital.
Our present search , then , is for relative quantities , or

values. There are two sets of relative quantities, or values,
which are of special importance in our study. One is the

value of income per unit of physical capital which yields it,
and the other is the quantity and value of income and of
capital per human being who owns it.

The first represents

the distribution of income relatively to the agents which
produce it. The second represents the distribution of in
come and of capital among their owners. The study of the

first will occupy our attention in this and the following
chapter .
§ 2 . The Four Ratios of Income to Capital
Our present task , therefore, is to study the ratios of
income to capital. As we learned at the beginning, both
capitaland incomemay bemeasured either in quantity or in
value. The ratio of income to the capital which produces

it takes four different forms, according as the income
and the capital are measured in one or the other of these

two ways.

These four forms of the income-to-capital ratio

are as follows:

( 1) There is the ratio of the quantity income, i.e. of the
benefits per unit of time to the quantity of capital which
yields those benefits. This may be called the physical
productivity of capital. Thus, if 10 acres of land , in a

certain year, yield 60 bushels of wheat, the ratio of income







to capital, or the physical-productivity of this land, is 6
bushels per acre per year. Or if io looms will weave 500
yards of cloth in a day, the ratio of benefits to the quantity
of capital, or the physical-productivity of the looms, is 50

yards per machine per day.
(2) There is the ratio of the value of the benefits to the
quantity of the capital.

This may be called the value- pro

ductivity of capital. Thus, if 10 acres of land yield a net
return worth $ 200 a year, the value-productivity is $20
per acre per year. This is also called the “ rent ” of land.

The same principles apply to the rent of any other article of
capital. Another example of value-productivity is found
in the wages of a laborer.
(3) There is also the ratio of the quantity of benefits to
the value of the capital from which they flow . This may
be called its physical return . Thus, if $ 100 worth of capital
applied to land in the form , say, of agricultural implements
adds i bushel to the yield of the land, the physical return of

this accessory capital is too of a bushel per year per dollar
invested .

(4) There is finally the ratio of the value of benefits to

the value of the capital yielding them . This may be called

the value return . Thus, if a house worth $ 10,000 yields in
any given year a net rent of $ 1000, the value return is 10
per cent per year.
Thus we have four ratios :
1. Quantity of benefits per unit of time
" _= physical-productivity .

quantity of capital
2. Value of benefits per unit of time
ne =_ value-productivity.

quantity of capital
3. Quantity of benefits per unit of wie
time =

physical return .

value of capital
4 . Value of benefits per unit of time
ne = value return .

value of capital



These four magnitudes must be carefully distinguished.

They are measured in totally different units, e.g.
The first, in bushels per acre per year.
The second , in dollars per acre per year.
The third , in bushels per dollar per year.

The fourth , in dollars per dollar per year.
Of these four ratios , the fourth has already been studied
under the subject of the rate of interest .

The third is of

little importance. There are left, therefore, only the first
and second . The first is chiefly a technicalmatter. The
fertility of land , e .g. the number of bushels of wheat, oats ,
or corn per acre in Dakota , the efficiency of machinery,
e.g. the number of yards which a given loom will weave
or the number of cars a given locomotive will carry , the
efficiency of workmen , or the number of yards of trench

they can dig or the number of bricks they can lay. These
are technical facts the study of which would lead us into
the particular details of various sorts of business . In a

sense, these particular studies are included within the
domain of economic science under the special heads of Ag
ricultural Economics , Railway Economics, or Industrial

Efficiency ; but in a book like the present, devoted to a
mere general outline of economic science, we cannot enter

into these details.

Suffice it merely to say, therefore, that

physical productivity depends on two chief factors : the
natural capacities of men , land , and materials ; and the

acquired knowledge, skill, and organization (including divi
sion of labor) by which these natural capacities are utilized .

Discoveries of new natural resources and every invention
of industrial processes add from time to time to physical
productivity . The science of agriculture, for instance, has
been revolutionized in the last few years with the result of

greatly increasing the physical-productivity of land ; and the
inventions for applying mechanical power have multiplied ,
by large factors , the physical-productivity of machinery.



. § 3. Value-productivity in General
Given , then , these technical conditions of natural re

sources and acquired methods of utilizing them , let us pass
at once to what now concerns us, the second of the four
ratios, the value-productivity of capital, or the ratio of the
value of the benefits flowing from any capital to the quan

tity of that capital. The value of the benefits is found by

multiplying their quantity by their price. If we consider
the quantity given by technical conditions and the price
given by the principles already explained, we have only to
multiply the two together in order to obtain the value de
sired , and then we have to divide this value by the quantity

of the capital producing it — likewise supposed for the
present to be given — in order to obtain the value-pro

ductivity desired . Thus, if in any community there are

1000 lodging rooms, the benefits of which have a price of $ 1
per night's lodging, and the total quantity of such benefits in
a year is 300 ,000 night's lodging,then the value-productivity
. $ 1 X 300 ,000
is evidently
or $300 per year per room . In
order to prepare these productivity data for practical appli
cations, we must reduce them to classification. We shall
first classify value-productivities according to whether the
prices they bring are explicitly or implicitly given, explicitly
by actual sale , or implicitly by mere appraisal. The ex

plicit value productivity of an instrument is called , in
economic parlance, hire . Hire may be either rent or wages
according as the hired instrument is or is not a human

being.· The implicit value-productivity of an instrument
is called profits. Each of these catagories of prices — ex

plicit and implicit — may in turn be subdivided accord
ing to the kind of instruments to which they attach whether, for instance, the instruments are human beings or


The result of these two classifications is the following

four classes of value-productivity : -



The value-productivity of a human being, if explicit, is
called “ explicit wages ” or simply “ wages."

The value-productivity of a human being, if implicit, is
called “ implicit wages ” or “ profits produced by men ” or
“ enterprisers ' profits.”
The value-productivity of any other instrument, if ex
plicit, is called “ explicit rent ” or simply “ rent."
The value-productivity of any other instrument, if im

plicit, is called “ implicit rent ” or “ profits of things " or
“ dividends."
Explicit rent and explicit wages are stipulated and cer
tain .

Implicit rent and implicit wages are (as is implied by

their collective term , profits) subject to chance variations.
The man who accepts stated payments for the use of his
instruments for his own services avoids certain risks which

the independent producer (or profit seeker ) assumes. At
the same time this former foregoes certain chances of gain
which fall to the latter.
Thus, profits are “ implicit " wages or rent, and implicit
wages or rent are “ commuted " profits.

$ 4 . The Rent of Land
The remainder of this chapter will be devoted to a study

of the four kinds of productivities just enumerated . We
shall begin with rent - explicit and implicit. A “ rented ”

house bears explicit rent, but even a house lived in by the
owner has an implicit rent, i.e . whatever it would rent for
under assumed conditions. The most common kinds of
instruments which are explicitly rented are real estate,
although many other more or less durable commodities
such as furniture, horses and carriages, telephones, pianos,

typewriters, and even clothing, may sometimes be ex

plicitly rented.
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 .
The rent of land separated 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 discussion .
It underlies, for instance, the proposal called “ the single

tax," i.e. that all taxes be laid on ground rent.
There are two important peculiarities of land which are
shared by very few other instruments. One of these pe

culiarities is that, practically speaking, the land in the
world is fixed in quantity. Except by filling in tidal lands,
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 change the productivity or
quality of it by irrigation , fertilizing, etc., on the one hand ,
or by exhaustion of the soil and other abuses on the other .
These alterations in land are more important than has some

times been recognized , and their importance is increasing.
For the present, however, we shall assume a community
in which the land is fixed , both in quality and quantity,
possessing, as Ricardo expresses it, “ natural and inde

structible powers of the soil.”

For our purpose it is enough

to assume that the land is indestructible .

That it be natural

is a matter of indifference ; precisely the same principles of
valuation apply to land wrested by our ancestors from the

wilderness as to land solely a gift of nature.
The second peculiarity of land is that, though fixed in
quantity, it varies in quality. Land is not a uniform or
homogeneous article , like pig iron or granulated sugar,

but consists of innumerable different grades suitable for
almost innumerable different purposes. The prices of land

have, therefore , a very wide range, and for the most
part follow

the principles of substitutes or competing


It is true that the various lands are not all substitutes .



A city building site is not a substitute for wheat land, nor
is it either a substitute for forest ormineral lands. But here,

again , for the sake of simplicity,we shall assume that all
lands do compete for precisely the same purpose, and differ

only in productivity. Let us say that the product is wheat,
and assume: --





Fig. 46.

1. That the land under consideration is fixed in quantity .
2. That it varies in quality (i.e. productivity) by con
tinuous gradation from very fertile to very infertile lands,

each fixed and invariable as to productivity.
3. That the cost of tilling each acre is likewise fixed and
invariable , say $ 10.

Let us suppose, as represented in Figure 46, an island
fulfilling the two conditions above mentioned . In order








further to simplify the picture, let us suppose the most

fertile land situated in the center capable of producing 25
bushels of wheat per acre per year, and the other lands
arranged around it spiral fashion in the order of descending

productivity . If the population can all be supported on
the 25 -bushel-per -acre land so that no other land is needed

or believed to be needed in the future, no lands except this,
the most fertile, will be used , and none will have value or
yield 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 con
ditions 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 the same for every bushel. Con
sequently 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 the 25

bushels produced on an acre of the first-grade land is only

just equal to the cost of producing wheat there, which , as
$ 10 per acre produces 25 bushels, is 3 or 40 cents a 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. Whatwas 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 marginal cost, but now
the marginal cost is the cost of producing a bushel on the



second -grade land . The value of the 24 bushels produced

on this land will now be equal to the cost of producing 24
bushels on that land, i.e. $ 10. This is 14, or about 42 cents
a bushel.

But since there cannot be two prices for the same
article in the samemarket, the price of the wheat produced

on the first-grade land must be the same. Consequently
the owners of the first-grade land now have a crop worth
more than the cost of producing it,
they choose , obtain a rent for it equal
i bushel per acre ; for a tenant paying
i bushel per acre would have 24 bushels

and can now , if
to the excess, i.e .
the equivalent of
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 appli
cations, and would put up his price.

The market would

be cleared by a rent of 1 bushel per acre. In money this
is 42 cents per acre. If the owner does not rent his land

to another, but enjoys the product himself, he is still said
to obtain 42 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 . 1 . or
431 cents per bushel ; and the rent of the first-grade land
will rise to equal the difference between its productivity

and that of the third -grade land, viz . 2 bushels per acre or
2 X 43

cents = 87 cents per acre. Likewise the second

grade land will now bear a rent equal to its superiority over

the third grade, viz . i bushel per acre or 431 cents .


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 productivity and the pro
ductivity of the worst or marginal land occupied . If, for

instance, the lowest grade of land occupied is that indicated
in the table as having a productivity 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 production on the
worst , or no-rent land, it will now be $ 10 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 X $ 1. 11 or $ 17.76 per acre.
15 X $ 1. 11 or $ 16 .65 per acre .

14 X $ 1. 11 or $ 15.54 per acre.

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,” i.e. it is the last acre whose cultivation

can be made to pay . This marginal land in a sense fixes the
rent of all other land and fixes the price ofwheat. We have

reached , then, two important results true under the condi
tions 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 its
productivity and that of land on the margin of cultiva

tion (i.e. the worst 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 increment in rent,
sometimes called “ the unearned increment,” because it is
due to no labor on his part. The value of land — that is,
the capitalized or discounted rent - will increase with the un

earned increment. 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 exact conditions
are never found .
1. Land is not absolutely fixed in quantity.
2. The productivity of any piece of land is not fixed , but
varies from time to timeboth in kind and in intensity, and
this productivity will vary with the price of 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.
The first consideration is of little practical importance.
The second and third, however , require consideration . The
productivity of land is not solely a matter ofnatural 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 produce
more than 25 bushels as soon as the next grade was in use ;
and the worse the worst grade was, and the higher the price
of wheat, the greater would be the amount grown by those
cultivating the superior grades of land. In other words, a
change in the price of land would not only affect the amount
of land under cultivation , but the amount of cultivation

of each piece of land. The productivity of each acre is not
a constant quantity, but 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,
- i.e., the last acre which it pays to cultivate, — 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.
Each acre will be tilled until this marginal cost of tilling
agrees with the market price.
Moreover, the land may be capable of other uses than



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 differences in qual

ity among lands is merely a matter of the amount of one
product, like wheat.

Finally , as to the cost of tilling land per acre, this is not
a constant quantity for all lands, both good and bad ; nor
is it constant even for the same land . The cost of tilling
may be either higher or lower on good land than on bad
land ; and, as implied above, the cost on any land will vary
with the price just as the product varies with the price,

although in the opposite direction. The higher the price ,
the greater 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 the cost of produc
ing wheat continually increases with the amount produced
is evidently the same thing as to say that the amount of
wheat returned on each dollar of cost continually diminishes.

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 .

In an absolutely correct theory the numbers in

Figure 46 must be conceived as increasing slightly as the
margin of cultivation is extended , and the numbers express
ing cost will not be simply a constant $ 10 per each acre,
but will also increase slightly as the margin is extended .

But these and the other modifications necessary to make
the theory of ground rent true to life are so slight as not

materially to change the practical results.
§ 5 . Rent and Interest

The principles of ground rent apply also to house rent,
piano rent, or any other rent, except that much greater

modifications from such illustrative 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 practical difference between ground rent and other
rent, such as house rent, has an important illustration in

taxation . It is not within the scope of this book to consider
problems of taxation . We can only remark 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 dis
courages house building and affects the supply of houses.
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 under
stand this difference and also not to confuse itwith a common

fallacy that land rent alone is truly rent, and house rent
and other rent is really interest . It is easy to see that land
rent is interest on the capital-value of the land just as truly

as house rent is interest on the capital-value of the house.
Both are rent and both are interest. In fact , rent and
interest are simply two different ways ofmeasuring the same

income value. Rent is value-productivity ; interest is

value-return . We know that the value of income from any
source may be expressed either relatively to quantity or to
the value of that source. Rent is expressed in the first way ;

interest , in the second.

Let us suppose a quantity of land — 10 acres — to have a
value of $ 1000 ,and that $ 50 a year is paid for its use.


$ 50 is both rent and interest . It is the rent on the jo

acres and the interest on the $ 1000 . The rate of rent is $ 50
per year for 10 acres or $ 5 per acre per annum . The rate

of interest is $50 per year for $ 1000 or 5 per cent per annum .
In precisely the same way, let us suppose a quantity of
houses — 10 houses — to have a valueof $ 100 ,000, and that



$ 5000 a year is paid for their use . This $ 5000 is both rent
and interest.

It is the rent on to houses and the interest

on $ 100 ,000 . The rate of rent is $ 5000 per year for 10

houses or $500 per house per annum , and the rate of in
terest is $5000 per year for $ 100,000 or 5 per cent per annum .
The erroneous belief that land bears only rent, and other
instruments bear only interest, is largely responsible for the
narrow definitions of capital so often given and which are

so framed as specifically to exclude land. A true analysis
justifies the usage ofbusiness men who apply the term “ rent”

as freely to houses as to land, and the term “ interest " as
freely to income from land as to income from houses.


§ 1. Similarity of Rent and Wages
TURNING from thehire of things to the hire of persons,we
find a similar but somewhat different problem .

The rate

of hire of human beings is called wages. In case these

wages are very high , and are paid at rather long intervals ,
they are dignified by the name of salaries. But as the dis
tinction between wages and salaries is not based on any
scientific relation , we shall, for convenience, employ simply
the one term “ wages ” to embrace what are ordinarily called

salaries .

Corresponding to the distinction between explicit and
implicit rent, we may distinguish between explicit and im
plicit wages, explicit wages being actual wages paid to the

hired person , called the employee, by the person hiring him ,
called the employer ; and implicit wages being the value

productivity or earnings of a person who does not sell his
services but enjoys them himself. Wemay recapitulate the

various sorts of hire, explicit and implicit, as follows :
Explicit rent is payment for the use of instruments (other
than human beings) which are hired .

Implicit rent is the value of net income from instruments
(other than human beings) which are not hired .
Explicit wages are the payment for the services of human

beings who are hired .
Implicit wages are the net income earned by human

beings who are not hired.
The principles governing the rate of wages are, in a gen



eral way, similar to those governing the rate of rent. The
rate of a man 's wages per unit of time is the product of the

price per piece of the work he turns out multiplied by his
productivity. His productivity depends on technical con
ditions, including especially his size, strength, skill, and
cleverness , while the price per piece of his services depends

upon the general principles of supply and demand as already
stated .
The productivity of any capital, whether human or ex
ternal, will differ with the capital, and there will be differ

ences in productivity or quality. Men differ in quality,
that is, in productive power, as truly as lands or other in

struments differ. Some men have a high degree of earning
power and some have not. Some men can work twice as

fast as others. Some men can do higher grades of work
than others.

The result is that we find men classified as

common manual laborers, skilled manual laborers, common
mental workers, superintending workers, and enterprisers,

or men who take important initiative in conducting indus

Just as we can measure the rent ofany land

by the difference in productivity between that and the low
rent, or no -rent, land , in exactly the same way we can

measure the difference in productivity between men .
There is no grade of workmen called the “ no-wages men ,”

but there would be such a grade if it were customary for
their employer to pay for their cost or support (as the

employer of land pays for its cost), so that only the
excess above this cost were to be called wages. There
are men so incompetent that their net earning power
is practically zero, and they can barely, if at all, earn

enough to support themselves. These incompetents may
be unfortunates, as in the case of invalids and imbeciles ,
or guilty of laziness, as in the case of indolents. But what
ever the cause may be, they correspond in economic analysis
to no-rent land.



§ 2 . Peculiarities of Labor Supply
But owing to the fundamental fact that a laborer, unlike

any other instrument, is owned by himself and not, except
in slavery, by another, there are certain peculiarities of

wages as compared with rent.

These peculiarities lie in

the supply curve. We shall note four such peculiarities.
In the first place, the supply curve of human services
ascends very rapidly and often even “ curls back," as pre
viously explained . This pe
culiarity, as we saw , was due
to the fact that a man 's

desire for more money (mar
ginal desirability of money)
decreases rapidly with an in

crease of his earnings. Be
yond a certain point the more
he is paid , the less he will
work . We may state the
same fact in the reverse di
rection , and say that under o
certain circumstances the less
a man is paid, the harder he will work . The shape of his
supply curve will depend in very large measure on whether

or not he has other sources of income besides his work .

Figure 47 exhibits this fact.
The curve S SS" represents the supply curve of work

for a rich man who has income from other sources than his
work , and the curve s s' s" that for a poor man, who has
to depend on what he can earn .

The rich man will notwork

at all for any wages below a certain price, represented in
the diagram by OS. Any price above this will induce him

to work a little , but if the price exceeds the height of S',
the result will be that he will work less rather than more.

These relations correspond with observed facts. A mil
lionaire will not work for a dollar a day. He may work a







few days in the year for $ 100 a day, and work more days
for $ 500 a day, but $ 1000 a day may lead him to work

fewer days, and devote more time to vacations and to
enjoying his large income.

The poor man will be guided by similar considerations,
but on a smaller scale vertically and a larger one horizon

tally , — if the measure of work in each case is in hours of
work . Having little or no property besides his person , he
cannot afford to be idle. Unemployment for him is seldom

voluntary . So long as he can get a price for his work suffi
cient to keep him out of the poorhouse, he will work for

that price. Thus, the minimum price Os, which is neces
sary to induce him to work rather than become a tramp or

beggar, is almost nothing at all ; and it takes only a rela
tively slight rise in that price to set him working full time.

The height of s' represents the price at which he will work
the greatest number of hours.

Above this he will prefer

slightly shorter hours. As already stated, it is probable
that the eight-hour movement to -day is partly due to the
fact that wages are high enough to enable the laborer to
afford some leisure instead of being so low as to “ keep

his nose close to the grindstone.”
A reduction in wages works in the opposite way, making

workmen willing to work longer hours and for lower wages .
Only when the price falls much below the elbow at s' will
they refuse longer to endure the low wages and long hours.
They will then prefer, if not to starve, to throw themselves
upon the mercy and charity of the community. The
general level of the curve between the elbow s' and the
beginning s represents their minimum

standard of living


which they require if they work at all.

Now , if wages keep high and the workmen have a suffi
ciently low “ rate of impatience " to enable them to accu

mulate savings, they become more “ independent,” which ,
as applied to their supply curves s s' s" means that it
shifts a little toward the rich man 's supply curve s s' s" .



The result is a higher minimum wage necessary to induce
the laborer to work and a lower maximum number of hours
which he is willing to work . The intersection with the de

mand curve will therefore be higher and farther to the left ;
that is, themarket rate of wages will be higher and the hours
worked fewer.
This result is not due to any reduction in the number

of workmen , but simply to a reduction in their desire for
more money. Savings, therefore, making workmen more
independent and less necessitous, will — by lessening their
desire for money — both increase their wages and shorten
their hours.

A second peculiarity in regard to wages is that, except
under slavery, the earnings of a laborer are seldom dis
counted so as to ascertain his capital-value.

The reason for

making an appraisement usually has reference to some pro
posed sale ; and , as working men and women are no longer

for sale, their capital-value is seldom computed . For this
reason, wages, unlike rent, are not often regarded in the
light of interest on the capital-value of the men who earn
them .

A third peculiarity of wages is one already alluded to , viz .
that in practice they are always reckoned as gross and

never as net. This is because the wages are reckoned from
the standpoint of the employer who pays them , and not of
the laborer who receives them . Under slavery the case

was different, and the net income earned by a slave was

computed in the same way as the net income earned by a
horse — by deducting from the value of the work done the
cost of supporting the slave. But under the system of free
labor which now prevails the employer has no such cost.
The laborer assumes his own support,and furnishes only his
work to the employer. Thenet wages of the laborer, if they
are to be computed at all, are to be found by allowing for

the irksomeness of his work i.e . the real costs which he
bears of labor and trouble. At the margin — that is, for



the last unit of work done — this cost is, as we have seen ,
equal to the wages received for it ; but on all earlier units of
work there is a gain of desirability which can be appraised

in money. The net wages thus reckoned will be only a part
of the wages as ordinarily quoted .
When, therefore , we compare the $ 500 a year which a
workman gets by selling his work with the $ 500 a year

which a bondholder gets as interest, we must not forget
that the workman 's $ 500 is really less valuable than the
bondholder 's $ 500, and for two reasons. One is the reason
just given , that the workman 's $ 500 is obtained only by

the sweat of his brow , while the bondholder's is all clear
gain ; the other reason is that the workman 's $ 500 will cease
at his death or disablement, while the bondholder 's goes on

A fourth peculiarity concerning wages is that the supply
of wage earners differs from the supply of any other instru

ment. Except in slavery, workmen are not bred like cattle
on commercial principles. A rise in the price of the serv
ices of a draft horse will increase the demand for draft

horses, and the result will be that both the market price
and the amount supplied at that price will be increased .

Those who supply draft horses will breed them to take

advantage of the higher prices of them and their services.
A rise in the price of human services will not act so simply.
It is true that a rise in wages usually increases the number

ofmarriages and often increases the birth rate ,but such is

not always or necessarily the result ; and even when births
do increase in number, they do not increase to exactly the
same extent as draft horses are bred . It is an excep

tional father who can think or say as did a cynical old farmer
who had raised a large family and thriftily turned their

child labor to early account for his own benefit: “ My
children have been the best crop I ever raised.”


parents view their children not as potential earning power
but as objects of affection , and either do not attempt to



regulate their numbers, or do so with reference to considera
tion for their own or their children 's comfort. The prin
ciples which regulate the number of laborers are part of the

principles regulating population in general, and will be con

sidered in the next chapter.
$ 3. The Demand for Labor
Turning now from the supply to the demand side of the
market, we find that the demand of employers for workmen
is in general quite analogous to their demand for the serv
ices of land or any other productive agent. Sentiment and

humanity have a little influence, but not enough to require
special attention on our part. Wages are paid by the or

dinary employer as the equivalent of the discounted future
benefits which the laborer 's work will bring to him , — the
employer, — and the rate he his willing to pay is equal to

themarginaldesirability ofthe laborer 's servicesmeasured in
money. We wish to emphasize that the employer 's valua

tion is (1)marginal,and (2) discounted. The employer pays
for all his workmen 's services on the basis of the services least

desirable to him , just as the purchaser of coal buys it all on

the basis of the ton least desirable to him ; he watches
the “ marginal ” benefits he gets exactly as does the pur

chaser of coal. At a given rate oi wages he “ buys labor "
up to the point where the last or marginal man's work is

barely worth paying for. This marginal unit of work is
a sort of barometer of wages.

Secondly , wages which the employer pays are the dis

counted value of the future benefits he receives. Thus, the
shepherd hired by the farmer to tend the sheep in the pas
ture renders benefits the value of which to the farmer is
estimated in precisely the same way as the value of the

benefits of the land which he hires. It follows that the
rate of wages is dependent upon the rate of interest.

A rise in the rate of interest will produce a fall in the



rate of wages by lowering the discounted value of the
services of workmen , and therefore lowering the prices
which suppliers are willing to pay . Contrariwise, a fall in

interest produces a rise in wages.
Conformable to the previous reasoning, the dependence of
wages on the rate of interest is the more pronounced , the
more remote are the ultimate benefits to which the work of
the laborer leads. In a community where the workmen are
largely employed in enterprises requiring a long time, such

as digging tunnels and constructing other great engineering
work , the rate of wages will tend to fall appreciably with a

rise in the rate of interest, and to rise appreciably with a
fall in the rate of interest ; whereas in a country where the

laborers are largely engaged in personal service or in other
work which is not far distant from the final goal of enjoy

able benefits, a change in the rate of interest will affect the
rate of wages but slightly.

Moreover, a change in interest will divert laborers from
one employment to another. If interest rises, it will
divert labor from enterprises which require much time and
in which , therefore, the high interest is a serious considera
tion , and turn it into enterprises which yield more immediate

benefits. For example , the higher the rate of interest, the
less relatively will laborers be employed in constructing

great canals and themore relatively will they be employed
as domestic servants, and vice versa .
Wehave now considered wages under ronditions of com

petition . Under competition they are determined — like
any other competitive price — by the familiar principles
of supply and demand . If, instead of competition , we
have conditions of more or less perfect monopoly , the
principles of wage determination will change accordingly

and in the manner previously explained , for monopoly .
If employers form combinations called trusts, or if laborers
form combinations called trades unions, there will be an
effect on the rate of wages. These combinations tend to



render bargaining collective instead of competitive, and the
efforts on the two sides of the market take the form of
struggles called strikes and lockouts. The fuller considera

tion of these subjects belongs to applied economics.
§ 4 . General Influences on Rents and Wages

The sum of all the rents and wages, explicit and implicit,

in any community is, of course , the total income of that
community . An inventory of rent and wages would show

what quota was contributed to this total by human beings,
land , and other instruments . It would be simply a list of

the net incomes from all these. By far the larger part is
contributed by human beings. Professor Nicholson of
Edinburgh has estimated that in England the income earned
by what he calls “ the living capital ” of Great Britain is
five times as great as that earned by the “ dead capital.” In

less wealthy countries the preponderance of man-produced

income is probably still larger. Of the part produced by
“ dead capital ” the larger portion is from land. A state
ment of the parts of total income due to various agents, such
as laborers, land , and other capital which together yield
that income, constitutes the distribution of income rela

tively to the capital which produces it.
It should be noted that though each of the various labor
ers, lands, and other, instruments which jointly produce
income, is credited with a certain part, it could not produce

this part alone, or by itself. The earnings of a railway are

due, for instance, to the joint work of the locomotive, cars,
roadbed , terminals, and employees .

These are not inde

pendent but mutually completing instruments, and their

services are completing services . We impute to each a
certain part , determined according to the principles which

regulate the prices of completing goods.
In a new country the rent of land is apt to be low , but rent

of other things and wages high. For in such a country land



is abundant, but other forms of capital, including laborers,
relatively scarce. As a country grows older and more popu
lous, land rent tends to rise , and other rents and wages to

Progress in scientific knowledge causing an increase in
productivity of land is like the rejuvenation of a country .

Any increase in general productivities, whether of land or
of other agents ofproduction ,has a tendency to make the rate
of wages increase ; for ( 1 ) by increasing the wealth of em

ployers, and thereby diminishing the marginal desirability
of money , there is a tendency to increase their demand for

everything, including the services of workmen ; and (2 ) so
far as workmen themselves are owners of houses, imple
ments , and other instruments of any kind, and thus share in

the increased affluence , the supply of work they offer is
decreased, as we have seen .
Such a result is probably the chief general effect of so -called

labor-saving machinery . It increases the income of other
classes than laborers, and with it their power to buy work of

laborers. The first effect, however, is for the labor-saving
machine to displace laborers, with which , in fact, they are

competing articles, and we have seen that the increase in
one of two competing articles or substitutes tends to lower
the price of the other . The individual laborers thus dis

placed are likely to be injured by the improvement, being
unable to learn another trade without undue loss of time.
It is even conceivable that labor-saving machinery might
become so automatic and so fully a substitute for human
work that there would be no need and no demand for such

work. But such an effect seems very improbable. The
human machine is so much more versatile than other ma
chines, its competing with labor-saving machines is not as
important as its completing them . As a matter of history ,

so -called labor-saving machinery , while it “ saves ” or dis
places laborers from one sort of work, often if not usually
produces new needs for them in another sort of work . If



horses and carriages were introduced into China, they would
largely dispense with theneed of coolies, who now carry pas

sengers in sedan chairs, but theywould call for coachmen and
grooms. When in turn stage coaches give place to railways,

the trade of drivers of stage coaches becomes obsolete, but
the new trades of locomotive engineers, firemen , conductors,

and brakemen are created . In fact , the very names of these
occupations, as of hundreds of others, show that the demand

for these sorts of work arises from the existence of machinery.
In other words, labor-saving machinery, while , as its name

implies , is always a competing article with the human
machine with respect to some of its many -sided capacities,
· usually also is a completing article with respect to some

other capacity ; and we have seen that an increase in the
quantity of one of two completing articles tends to increase
the price of the other .

But while a general increase in the incomes enjoyed by a
community usually tends to increase the rate of wages, an

increased inequality of incomes may have the reverse effect.
At any rate, a decrease in the amount of capital which la
borers own will, as we have already seen , make them willing

to take lower wages than otherwise . In fact, the chief
reason that there exists a wage class is that those consti

tuting it have little or no capital apart from their own per
sons. Wage earners are chiefly " propertyless ” persons,
persons who either never had or inherited any property , or

who lost what they did have, as, for instance through too
high a “ rate of impatience.”

We see, therefore, that the

question of wages depends, among other things,on the dis
tribution of the ownership of wealth . This will be the
subject of the next chapter .


§ 1. The Problems of Opulence and Poverty
In the two preceding chapterswe have considered the dis
tribution of income relatively to the agents or instruments

which produce income. In the present chapter we shall co
nsider the distribution of this same income relatively to

those who own and enjoy it. The two sorts of distribution
are quite different, although there has been a tendency to

confuse them . This was natural, for in the early days of

economics people were classified roughly according to the
sort of instruments they owned . There was the landlord
class, whose chief incomewas ground rent, the non -landed
capitalist ,whose chief income was from other capital than

land , and the laborer, whose chief income was wages . It
was then natural to imagine that the incomes produced by
laborers, by land , and by other capital, were also the in

comes enjoyed by laborers, by landlords, and by other
capitalists. But even were such a classification possible
and duly made, it would still fail to tell us anything what
ever as to how large was the per capita share within each

class, or whether the amounts enjoyed by different individu
als were or were not very unequal.

The best we could say

would be that certain land yields a rent of $ 10 an acre,and
other lands more or less than this ; that certain houses

rent for $ 1000 a year, and others for more or less ; that

money lenders make 5 per cent on their loans ; and that
ordinary wage earners get $ 2 a day. But these data,
however detailed , would not tell us the actual income en

joyed by any single person , except in the case of the laborer,



and then only on the assumption that he derived no income
from any other source than from his work. Furthermore,
to -day there are only small traces left of the old social strati
fication , and correspondingly little excuse for confusing the
distribution of income by the capital which yields it and by

the persons who own it.
But, though the two sorts of distribution are distinct ,
each is needed to understand the other. The last two
chapters were devoted to the first sort of distribution , and

have prepared us for the study of the second sort .
The problem now before us — distribution relatively to

owners — may be described as the problem of the total
income, the average income, and the relative numbers of
people owning incomes of various sizes. The last-named
part of the problem is the problem of grading the population
according to income — the problem of discriminating the
relatively rich and poor. No other problem in economics has
as great a human interest as this ,and yet scarcely any other
problem has received so little scientific study .

Since income necessarily comes from capital, — at any
rate if human beings be included , — the “ distribution ” of
income is likewise the “ distribution ” of capital. Our
problem may therefore be stated either as the problem of
the personal distribution of income or that of the personal

distribution of capital. Still more simply it is the problem
of “ the distribution of wealth .”

For the purpose of comparing the wealth of different
persons or nations, values are more important than quan
tities . If we know that Mr. A 's income is worth $ 1000 a
year and Mr. B 's $ 10 ,000 , wemay say that Mr. B 's income

is ten times Mr. A's in the sense that the elements compos
ing B's income are worth in exchange ten times the elements
composing A 's income; or if we know that X is “ worth ”
(i.e. owns capital worth ) $ 1,000 ,000 and that Y “ is worth "
$ 10,000,000 , we may say in like sense that Y 's capital is
tenfold X 's.



In order to compare the incomes or capitals of widely

distant times or places, a correction may need to be made
for difference in the purchasing power of money, and if the

rate of interest is also different in the two cases, the cor
rection will not necessarily be the same for the capital as

for income. A millionaire worth $ 1 ,000 ,000 in California
half a century ago, the rate of interest being 12 per cent,

commanded an income equivalent to that of a multimil
lionaire to -day, worth $ 3 ,000,000, for the present rate of

interest is only one third as high. Another point of differ
ence between comparisons of capital value and comparisons

of income value lies in the fact that while capitalv alues
differ only in size, income values differ also in time-shape

and certainty. For this reason a man rich in lands from
which there is little immediate income — but only prospects

of income in the distant future — is sometimes called “ land .
poor," having much land but little immediate income.
But when , instead of comparing the wealth of different

persons or nations, we are seeking to compare the absolute
comforts they enjoy, it is more important to consider quan

tities than values . In fact, as noted at the outset of our
study, money valuations are apt to be misleading. A
country where water is scarce will have a higher money

valuation on its water supply than a country where water
is so abundant as to have no price. Thus, a large quantity
of water shows more affluence in the sense of comfort than

does a large value of water.
Practically , however, if we confine our attention to
modern times and conditions in Western Europe and

America, it is true, in a general way, that of two nations
or individuals the one which is richer in capital goods is
richer also in capital-value, in income goods and in income

For simplicity we shall hereafter assume that

these four comparisons are thus similar. We may say
that a man is “ rich " if he has a large amount of capital
goods of various kinds — lands, houses, stocks, bonds, etc . ;



or a large money value of capital goods; or a large amount

of benefits of various kinds — nourishment, clothing, shel
ter , amusements, etc. ; or a large money value of benefits
of these kinds.

A man is “ poor ” if he has small amounts of all these

Of course the two terms “ rich ” and “ poor ” are purely
relative, and represent no deeper scientific meaning. A man

who is rich according to one standard may be poor accord
ing to another. But the two terms are very convenient to
designate relative conditions. Corresponding to the ad

jectives “ rich " and " poor ” are the nouns “ opulence "
and “ poverty.” Our subject, then, in this chapter is com
parative opulence and poverty, both of nations and of


§ 2. National Opulence or Poverty

Wemay divide this subject into two heads : the opulence
or poverty of nations and the opulence or poverty of indi

viduals. First as to the opulence or poverty of nations.
“ Thewealth of nations” is composed of three things, - its
people, its lands, and the capital the people have produced

from the land . These three items of which capital is com
posed are mentioned in order of relative importance.


income earned by the people of a nation always far exceeds

the income earned by all its other wealth . Yet people do
not earn income without at least land . Given laborers
and land, we have the only two real requisites of producing

income. Other capital springs from these two. It is some
times said labor is the father, land the mother, and the
other kinds of capital the children . A nation , then , is the

richer, the larger the number of its inhabitants, the greater
the extent of its territory, and the greater the amount of its

accumulated products.

These three groups or classes of

capital depend each on somewhat different conditions.



The amount of land and its power to produce is largely a
question of natural resources. It may be taken as a given
quantity presented to man by nature. It is now becoming

recognized, however, that land is not so definitely constant
in its power to produce as was once imagined . One of the
most important results of the recent “ conservation move

ment ” in this country is to show conclusively that land is
not altogether a constant source of income, but that it is
possible by the impoverishing and washing away of top soil
to greatly impair or destroy absolutely the productivity of
land ; while on the contrary by proper fertilization , keeping
land fallow , rotation of crops, etc ., it is possible to increase

the efficiency of land just as it is possible to increase the
efficiency of other instruments.
The dominion over land by any given group ofmen may
depend on wresting itby military force from another group.
In fact one of the chief objects of war has been to increase
national wealth by adding to territory. This was a chief
object of the Roman Empire and of the colonial system of

Great Britain . These and other nations have had what is
called “ earth hunger.”

The wealth of the British Empire

to-day lies for the most part outside of the British Isles ;
for England owns India , Canada, Australia , and parts of

Africa. Except for the war of the Revolution, she would
now be owning the territory occupied by the United States.
The number of inhabitants in the nation depends in turn
upon the extent of the territory as also on the past history
of the nation and on other conditions which will be con
sidered later in this chapter . Many nations have sought

to increase their wealth and power by increasing their
population .

In fact, the chief reason for extending a na

tion 's territory has been to fill it with colonists . A country
is usually alarmed at the prospect of a stationary or de
creasing population . France is now trying to conserve its

population , recognizing that national strength for future
wars or for future political position among the nations of



the earth depends largely on the numbers of fighters and
of workers. The productiveness of these people as well as
the productiveness of the lands they keep will depend

largely upon their condition as to vitality and accumulated
We come last to the amount of accumulated products .

This depends on two chief qualities , first those causes like

thrift which we have seen lead to saving, and second inven
tion which has led to the creation of income-producing

§ 3. Per Capita Opulence or Poverty

So much for the conditions determining the opulence of
nations. Wemay pass now to the more important subject
of opulence or poverty of individuals . This subject may

be divided into two parts : the study of average or per
capita wealth ,and the study of its distribution or the rela
tive opulence and poverty among different individuals. By
the per capita wealth of any nation is meant the quotient
found by dividing the total wealth by the number of in

habitants. It is evident that two nations may compare
very differently as to aggregate and as to per capita wealth .

The small countries, Holland and Switzerland , when com
pared with the large countries, India and China , are far

poorer in aggregate wealth, but far richer in per capita
wealth . The per capita wealth in any nation will thus
increase with an increase in the total wealth and decrease
with an increase in population .

With the advent of Democracy in politics has come a
greater emphasis on per capita as compared with aggregate
wealth . Under autocracies the aim was to increase the

wealth of the nation as a whole, partly for the personal
aggrandisement of the autocrat or potentate, who often re
garded himself as a sort of owner of the nation (“ l'etat,

c'est moi " ) , and partly because the sentiment of nationa



greatness was satisfied in this way. Under these con
ditions an increase in population was almost invariably

welcomed and encouraged. But since the individuals of
the nation have become its rulers and, so to speak , share

holders, they have regarded increase of numbers with mixed
feelings ; for while on one hand they welcome an increase
in the total wealth which a greater population brings, they

do not relish a decrease in the per capita wealth which may
ensue. In the Democratic ideal, therefore, an increase of

population is usually welcomed only in a new country where
there is plenty of land, or in a country acquiring colonies to
provide room for a surplus population.
The effect of an increase of national wealth on per capita

wealth will evidently depend upon the ratio between land
and population. In a sparsely settled country an increase
of population will not only increase the aggregate, but the

per capita wealth . When , however, the country is settled

and filled up with population to a certain point, the opposite
becomes true and a fresh increase of population , while
continuing to increase aggregate wealth, will decrease per
capita wealth . This fact sets a sort of elastic limit to an
increase of population . That there must be such a limit

is evident since an indefinite number of people cannot be
supported on one acre of land . We know as a generaliza
tion from ordinary observation that the billion and a half
people now living on this planet could not be supported if

all packed into the state of Rhode Island and dependent on
Rhode Island for sustenance. Per capita poverty would
then be so intense that people would die of actual starva
tion . Long before such a starvation point is reached , every

increase of population beyond a certain point results in an
increased death rate. In fact, statistics show that the
death rate increases as per capita wealth decreases. This
fact is due to the unsanitary conditions which poverty neces

sarily brings, conditions not so much with respect to the
quantity of food as with respect to its quality and with



respect to the quantity and quality of housing and other
comforts and conveniencies of life — and perhaps above

all with respect to conditions of employment, especially

hours of labor. We have, then, ample evidence that when
the ratio of population to land becomes excessive, the
death rate is increased , and consequently a further increase

of population is injurious to the individual.

When population is sparse, the opposite is true. The
history of new countries shows that an increase in popula
tion is a blessing as well individually as collectively .

This law of per capita wealth is chiefly based on the
anterior fact that land is an essential agent in production

and that each successive increase in the productivity of land
is acquired at increasingly great cost — or, expressed other
wise, that with each successive increase in cost, the return

This is the law of diminishing returns in

agriculture. There is then , based on facts, a general law
of per capita wealth in relation to population .

It may be

stated as follows: Given a particular stage of knowledge
and of the arts and of other conditions that determine pro

ductivity, an increase of population first increases and
then decreases the per capita wealth .
§ 4 . Principles of Population

The population of any country may be increased either
by births or immigration and decreased by deaths or emi
gration .

The population in general, as a whole , can be in

creased only by births and decreased by deaths. As we are
more interested in general than in local increases or de

creases in population , we may overlook the questions of
emigration and immigration , assuming for the area under

consideration that they are either absent or balance each

With this proviso , we may say that the population of a
country will decrease if the death rate exceeds the birth rate



and will increase if the birth rate exceeds the death rate.

As we have already stated, the facts show that the death
rate increases with a decrease in per capita wealth . The
birth rate remains to be considered . When Malthus wrote

his famous “ Principle of Population ," it was in general true
that an increase in per capita wealth produced an increase

in the birth rate. To -day this is true only to a certain ex
tent. We shall for the moment, however , assume it to be

universally true. Under these conditions we may say that
an increase in per capita wealth tends to increase the birth
rate and to decrease the death rate, and that a decrease
in per capita wealth tends to increase the death rate and to
decrease the birth rate .
If we assume what history has almost invariably shown
to be the fact, that in a sparsely settled country the birth
rate exceeds the death rate , so that the population tends at

first to increase, we are now in a position to state what will
happen to the population of that country in future genera

tions, quite apart from any increase in immigration . By
hypothesis the population will increase at first and, as at
first each increase in population brings an increase in per
capita wealth , it will continue to increase as long as this
condition continues. But as we have seen , it will ultimately

happen that per capita wealth will cease to increase and will
begin to diminish . It will then happen that the death
rate will increase and the birth rate decrease , so that the
increase of population will be slackened and ultimately

cease altogether. Under these conditions, then , a new
country will be filled with population up to a certain point
at which it will cease . The population is then in a sort of
equilibrium , the birth rate equaling the death rate because
the per capita wealth has been reduced to such a point as
to bring this equilibrium about.
The law of population therefore may be stated as fol

lows : Assuming that in a sparsely settled country the
population will at first increase, and knowing that as the



per capita wealth decreases the death rate will increase, and
the birth rate decrease and therefore the rate of increase

of population slacken and ultimately terminate, we have
an increase of population followed by stationary population ,

the stationary point representing an equality between the
birth rate and death rate because people are either unable

or unwilling to lessen the rate of subsistence thus reached .
This limit on human population is the same limit which
nature sets on animal and plant population . Blades of
grass multiply until they cover the ground on which they

grow . When grass is sown on a grass plot, it multiplies
with great rapidity, but after the whole plot is covered and
there is no room for more, the number of blades remains
nearly stationary. There is a struggle for life constantly
going on and the death rate thus produced is great enough

to balance the birth rate which the capacity of the soil
allows. Out of this struggle for existence among animals
and plants comes what Darwin calls natural “ selection ,"
and it is interesting to know that Darwin 's first idea of such
a struggle came from reading Malthus on Population .

Population is then said to be limited by subsistence.
Since Malthus's day , as a consequence of his doctrines

and advice, there has come into more definite operation
what he called the “ voluntary check ” on population .

While it is still true that among the poor it usually happens
that an increase in per capita wealth tends to increase the
birth rate by encouraging marriages or making them earlier
or increasing the number of children per marriage, it has
become unfortunately true that among the wealthier classes

an increase in wealth tends sometimes in the opposite direc
tion .

Instead of wealth being then thought of as a means

of supporting children, it comes to be thought of as a chief
end in life, and the more of it gained the more ambitious

are its possessors that its enjoyment may not be interfered
with by childbearing, or that it shall not be decreased by

subdivision in the next generation. The result is that the



wealthier classes often have, on the average , smaller families
than the poorer classes. Wemust , therefore,modify the law
of population so as to read that an increase in per capita
wealth instead of tending always to increase the death rate

tends first to increase it and then to decrease it. This wealth
check to population is peculiar. It is quite different from
the poverty check . The poverty check works automati
cally so as to check population when it is too large and not
to check it when it is too small. But the wealth check acts

in the opposite way — or rather it would do so if it were
sufficiently strong and general, which is not yet the case.

Then it would come about that the greater the per capita
wealth the more would population be checked, and as the
check to population usually tends to increase per capita
wealth , this would still further decrease population .


logical result is depopulation or “ race suicide.”

At present however, this wealth check is confined to
certain parts of the population and results , for those parts

only , in “ race suicide.” These parts include particularly
the so-called “ better classes ” of the population . Children
of college graduates are less numerous than the graduates
themselves. Thus , besides depopulation , there is another

danger, degeneration. If the vitality or vital capital is im
paired by a breeding of the worst and a cessation of the

breeding ofthe best, no greater calamity could be imagined .
But while the risk of such a result undoubtedly exists , this

is not immediate, and an increasing realization of its pos
sibility,wemay hope, will lead to someway of counteracting
it. A method of producing the contrary result — namely ,
producing from the best and suppressing from the worst —

has been suggested by Sir Francis Galton under the name of

“ eugenics."
$ 5 . Distribution of Wealth
Having considered aggregate and per capita wealth , we
come finally to the distribution of wealth among different



individuals. Although a whole nation may be rich or poor
relatively to another nation , the widest differences between

nations are small as compared with the differences within
any one nation . Every nation has its extremely poor, its
extremely rich , and its classes in intermediate státes. In

the United States there are many wage earners who can
not earn $ 1 a day and who have no income except what they
earn by labor, while at the opposite extreme are the multi

millionaires who receive incomes of over $ 1,000,000 a month .
What are the reasons for such prodigious inequalities in
the personal distribution of wealth ? Are such inequalities

injurious ? If so , are they preventable ? If so, by what
means ?

These are some of the most burning questions of

the day. Out of them spring many reform movements,
and especially socialism . But these, like other practical
problems, are applications of economic principles, and
cannot be discussed in a book designed to treat only of
economic principles themselves. Suffice it to say that no

proper answer can be made to the last question of how to
cure the unequal distribution of wealth until we have an

swered the first question of what causes this unequal dis
tribution . As often happens, more study has already

been devoted to cure than to diagnosis, and with the usual
ineffective result of quack remedies.

Our present object will be to set forth the causes which
affect the relative personal distribution of wealth . What

ever these causes may be, they are evidently fundamental
and universal; for we find that extremes of poverty and

riches have existed at all times and places. They are men
tioned in the Bible and other histories of peoples in all ages
and stages of civilizations. It is probable that the degree

of inequality differs as between the Oriental civilizations,
like China and India , and the Occidental, like England and
France, and also as between the older nations of western

civilization like Russia and Italy, and the younger, like the
United States and Canada. But the fact and the causes







are nearly the same everywhere. Distribution differs, it
is true, according to political institutions, as, for instance,
between Germany and England.

There is a comparative

absence of extreme poverty in Germany as contrasted with
England and the United States ; and a comparative preva
lence of poverty in Russia and Italy ; and a comparative
frequency of extreme opulence in Holland. Professor Pareto

has found that, as between different countries , for which
statistics are available , and as between various periods of

time, the statistical inequalities in the distribution of wealth
have maintained a remarkable correspondence,more close ,

in fact, than statistics of mortality .
The causes which have produced the present inequalities

of wealth are largely historical, that is, lie in the past. It
usually takes more than one generation to affect greatly the

economic standing of a family . For this reason some people
have foolishly imagined that if to -day we could once correct

the inequalities in wealth handed down to us from the past,
the problem would be solved , and with a new and even start
we would be forever rid of great poverty by the side of great

wealth . We shall soon see, however, that if wealth were
once equally divided , it would not stay so .

The analysis of

what would happen will serve as the best introduction to
our study of distribution .
§ 6 . Equality of Distribution an Unstable Condition
Let us suppose that, through somecommunistic or social

istic law , the wealth in the United States were divided
with substantial equality .

It is proposed to show that

this equality could not long endure. Differences in thirft
alone would reëstablish inequality . We cannot suppose
that human nature could be so changed and become so
uniform that society would not still be divided into “ spend

ers ” and “ savers,” much less that different people would
all spend or all save in exactly the same degree. So long



as there are any differences whatever between people in
regard to their “ rates of impatience ” under like conditions,

there will immediately ensue differences in saving or spend
ing. It requires only a very small degree of saving or spend
ing to lead to comparative opulence or poverty, even in one
generation . It is remarkable how much may be saved in a

lifetime by thrift. Cases are sometimes found of day
laborers who, by saving and putting at interest, accumulate

within a lifetime a small fortune, and in the meantime rear
a family . As Micawber said , a man with an income of one

pound a week will reach poverty if he spends just one penny
more, and reach opulence if he spends just one penny less .
The larger the amounts saved or spent, themore rapidly

is a fortune gained or lost. As we have seen, the process
by which individuals thus gain or lose fortunes by saving
or spending consists , in the last analysis, of an exchange
of present and future income.

If two men have to start

with the same income of $ 1000 a year, but one has a rate of
time-preference above the market rate of interest and the
other has a rate below , the first will continue to get rid of

future income for the sake of its equivalent in immediate
income, and the other to do exactly the opposite. Such

substitutions of immediate for remote, and of remote for
immediate, incomemay take place by means of loans, sales ,

or changed uses of capital. The man with spendthrift ten
dencies will borrow , i.e. pledge future income for the sake of

present income; or he will sell any durable goods which
offer remote income, such as farms or forests , and buy

perishable goods which offer immediate income, such as
champagne, clothing, horses, and carriages ; or he will

change the uses to which he puts his capital, avoiding those
which require improvements, and choosing instead those on
which he can realize quickly , thus letting his property
run down .

The man with saving tendencies , on the other hand , will

lend or invest present income for the sake of future, will








sell perishable and buy durable goods, and will make far
sighted uses of his capital. As we have seen, both men
will pursue their respective policies up to the point where

their marginal rates of impatience harmonize with the rate
of interest .
As we have seen , the rates of impatience among different

individuals are equalized in these ways. In the case of an
individual whose impatience to reduce income is unduly

high, we found that generally he contrives in some way to
modify his income-stream by increasing it in the present at

the expense of the future. We were then intent on study
ing this phenomenon only on the side of income; but the
effect on capital can be easily seen by applying the prin
ciples of Chapter VII. If a modification of the income
stream is such as to make the present rate of realized income
exceed the “ standard ,” capital is being depleted to the ex

tent of the excess , and the person will grow poorer. Indi
viduals of the type of Rip Van Winkle, if in possession of

land and other durable instruments, will sell or mortgage
them in order to secure the means for obtaining enjoyable
services more rapidly. The effect will be, for society as a
whole , that these individuals who have an abnormally low

appreciation of the future and its needs will gradually part
with the more durable instruments, and that these will
tend to gravitate into the hands of those who have the

opposite trait.
The central rôle is thus played by the rates of preference

for present over future incomeand the rate of interest. The
existence of a generalmarket rate of interest to which each
man adjusts his rate of preference supplies an easy highway

for the change in his capital in one direction or the other .
If an individual has spendthrift tendencies, their indulgence
is facilitated by access to a loan market ; and reversely , if
he desires to save, he may do so themore easily if there is a
market for savings. The irregularities in the distribution of
capital are thus due in part to the opportunity to effect



exchanges in the parts of the income-stream located at dif
ferent times. The rate of interest is simply the market
price for such exchanges. By means of this market price,
both those who wish to barter present for future income and

those who wish to do the reverse may satisfy their desires.
The one will gradually increase, and the other gradually

diminish , his capital. Ifall individuals were hermits, it would
be much more difficult either to accumulate or to dissipate
fortunes, and the distribution of wealth would therefore
be much more even . Inequality arises largely from


exchange of income, carrying some individuals toward
wealth and others toward poverty.

In short, the in

equality of wealth is facilitated by the existence of a loan

market. In a sense, then , it is true, as the socialist main
tains, that inequality is due to social arrangements ; but
the arrangements to which it is due are not, as he assumes,
primarily such as take away the opportunity to rise in the
economic scale. On the contrary, they are arrangements

which facilitate both rising and falling, according to the
choice of the individual. The improvident sink like lead
to the bottom . The provident rise to the top.
But thrift, important as it is , is not the only road to

wealth , nor thriftlessness the only road to poverty . Besides
differences in the rates of time-preferences, there are equally
potent differences in ability, industry, luck , and fraud .
By ability is meant one's capacity to earn , by industry the
use of this capacity . Examples of getting rich from ability
and industry are very common . Almost all the rich men

in this country who have made their fortunes have done so,
in part at least , through ability and industry. Often luck
has added greatly . There are many examples of miners
who got rich in Colorado by simply stumbling on a
gold mine. Luck plays a larger rôle in the accumulation
of fortunes than many are inclined to believe. The “ un

earned increment ” is usually a case of luck . Unforeseen
increase in ground rents has often given rise to large for



tunes from time immemorial. It is also unfortunately
true that somemen have really got their start, if not their

larger accumulations, through fraud. This has sometimes
occurred through “ high finance,” which consists very largely
in making contracts with one's self. If a man can own or

control the majority stock in a corporation, and then make
a contract to buy materials of himself at any price he
sets, he naturally can make money .

Also through political

“ graft,” and especially through getting city franchises for
gas and waterworks and street car companies, and through
special tariff legislation , many men have become wealthy .

Poverty, on the other hand, has often resulted not only from
thriftlessness, but from

incompetence, i.e. lack of ability ,

slothfulness (lack of industry), and misfortune or bad luck ,
and from having been defrauded by others.
We conclude, therefore, that equality of wealth is an un
stable condition and , even if once established , would not

endure, because of the unequal forces of thrift, ability,
industry, luck , and fraud .

But inequality once established tends, by inheritance,
to perpetuate itself in future generations. The workman
who accumulates a few thousand dollars from nothing
makes it easier for his children to accumulate more. He
gives them a start or a “ nest egg.” Recently four sons
of a Connecticut farmer met in a family reunion . Many

years ago the father had sent them into the world to make
their fortune, giving each $ 700 to start with . When they
met at the recent family reunion , all were worth thousands.
Hetty Green is an example of a person who inherited a large

fortune and then accumulated , by her low “ rate of impa
tience ” or preference to accumulate for the future rather

than to spend in the present. A fortune of $6 ,000 ,000 was
bequeathed her, and now her fortune is reputed to be worth

$ 100,000,000.
Likewise poverty may be passed down from generation

to generation. A special cause for handing down inequal



ity of fortunes lies in the reduction of the birth rate among

the rich. As we have explained , the tendency to-day is
for the poor to have a high birth rate, and for the rich to
have a low birth rate. There results a tendency toward an
increase in the numbers of the poor and a decrease in the
numbers of the rich . This result tends to exaggerate the
differences in the per capita wealth between the two classes,

for in the upper classes there will be an increasingly larger
share for the few who inherit fortunes, and in the lower
classes there will be an increasingly smaller share for the
many . We see, then , that there is at least a tendency for the

rich to grow richer and the poor to grow poorer. Wemay
even go so far as to say that the richer a man or family

becomes, the easier it is to grow richer , and that the poorer
a family becomes , the more difficult is it to keep from

growing poorer . Large fortunes often grow without effort.
All that is necessary is for their owners to refrain from
squandering. On the other hand, a family once caught in
poverty is aptto be drawn deeper into the mire. Overwork,
anxiety, and unsanitary surroundings bring on disease or

disability, which robs them of what little they once had .
The opportunity of the wealthy is their wealth, and the
curse of the poor is their poverty. “ To him that hath
shall be given , and from him that hath not shall be taken

away even that which he hath .”

§ 7. The Limits of Enrichment and Impoverishment
... Yet there are limits to enrichment and impoverishment.

The ordinary downward limit is reached with the loss of
all capital except the human person itself. When a man has

succeeded in losing all his capital except his own person ,
the process usually comes to an end, because society, in
self-protection , decrees that it shall go no farther.


where there is no such safeguard , the unfortunate victim

may sink into even lower stages of debt servitude, as in the







Malay Archipelago or Russia , and to some extent in Ire

land ; or they may even sell themselves or their families
into slavery . In most countries the poor come to be a large

and permanent as well as a helpless class.

Next, as to the upper limit . We have seen that the
opportunity to increase one's wealth depends upon the

market for present and future goods, that is, the loan
and investment market. A hermit cannot become im
mensely wealthy ; nor can any of the inhabitants of a small
island, if cut off from the rest of the world .

The utmost

that a man in an isolated community can own is the capital
which that community has or can get — its land , dwellings,
means of locomotion , and manufacture, etc .

These are

necessarily limited by the size of the community. As the
market widens, the limits to the growth of large fortunes
widens also . To-day there is no limit to what one man
may accumulate except that he cannot more than “ own
the earth .”

This relationship between the possible size of individual
fortunes and the size of the market to which the owner of
the fortunes has access is important. Practically it means

that in these modern times, when almost the whole world
is one greatmarket, the possibilities of individual fortunes
are greater than ever before . Few people realize this fact ;
for most people imagine that at any time in the world 's
history any fortune " could increase at compound interest."
But a fortune is capital value, and , as we have seen , capital
value has no power to produce income, but, on the contrary,

is merely the discounted value of anticipated income.

The only way a man's fortune can increase at compound
interest is by his constantly reinvesting income as it comes
in ; that is, exchanging it for other and later income at
the discounted values of the latter. But evidently hemust

find sellers of some such other and later income before he
can buy it, and he must find purchasers of the incomewhich
he would fain sell. His income has no power whatever of



itself to create other income. The only way to reinvest

and one
which other
one inin which
his income is to find a market forIn it,chand
for sale.
sale. In short, an extreme upper
and t later income isis for

he ogrowth
to tthe
limi to
of any individual fortune is set by the

scarcity of investments.S .
The common idea that “ money has power to breed
money ” leads to absurdity when applied to compound
interest. Were it true, any person might leave fortunes to

posterity far exceeding the possible wealth which this
earth can hold .

The prodigious figures which result from

reckoning compound interest always surprise those who
make the computation for the first time. One dollar put at

compound interest at 4 per cent would amount in one

century to $ 50 , in a second century to $ 2500, in a third
century to $ 125,000 , in a fourth century to $ 6 ,000 ,000 , in

a fifth century to $ 300,000,000, in a sixth century to 15
billions, in a seventh century to 750 billions, in an eighth
century to 40 trillions, in a ninth to 2 quadrillions, and in a

thousand years to 100 quadrillion dollars. Now the total
capital in the United States is only about 100 billions, and

that in the world at large — even assuming that the per
capita wealth elsewhere is as large as the United States,
which is an absurdly large allowance — would be less than
2 trillions, which is only one fifty -thousandth part of what

we have just calculated as the amount at compound interest
of $ 1 in 1000 years . Yet 1000 years is only half the time
since the Christian era began . In 2000 years the $ 1 would

amount to 100 quadrillion times 100 quadrillion , which is
many, many times as much as a world composed of solid
gold. Needless to say, such a prodigious increase of wealth
could never actually take place, for the simple reason that

this is a finite world . The difficulty lies,not simply in the
reluctance of people to provide for accumulation several

centuries after their death , but also to the fact that large
accumulations would reduce the rate of interest. The
attempt, for instance, to invest trillions every year would



drive up the prices of all investible property, i.e. all capital.
To invest such sums would practically require the pur
chase by the rich man of all existing railways, steamships,
factories, lands, dwellings, etc. But many of the present
owners of these, having already sold a good deal and thus

reduced their rates of impatience to equality with the pre
vailing rate of interest, would not part with more except at

prices so high that the purchaser would make little or no
profit or interest on his investment.

Thus, the approach

toward the limit of investment would reduce the rate of
interest and retard , and finally altogether prevent, further

accumulation .
There are a few examples of long -continued reinvest

ments. Benjamin Franklin at his death, in 1790, left £1000
to the town of Boston and the same sum to Philadelphia ,

with the proviso that it should accumulate for a hundred
years, at the end of which timehe calculated that at 5 per
cent it would amount to £131,000 . In the case of the

Boston gift, it actually amounted, at the end of the cen

tury, to $400 ,000, and has since accumulated to about
$600 ,000. The sum received by the city of Philadelphia
has not increased nearly so fast.
Another interesting case of accumulation is that of the
Lowell Institute in Boston , which was founded by a be
quest of $ 200 ,000 in 1838, with the condition that ro per
cent of the incomefrom it should be reinvested and added to

the principal. A peculiarity of this provision is that it
applies in perpetuity . There is, therefore, theoretically ,
no limit to the future accumulation thus made possible.

The fund,after only 67 years,amounts already to $ 1,100, 200.
§ 8. The Cycle of Wealth
With a world market for investment, we have every pros
pect of a great increase in private fortunes in the next few
centuries. But practically the limit reached in the history



of most large fortunes is only a very small part of the high

limit we have set , that of “ owning the earth.”

There is

usually a reaction against the desire to accumulate. Each

reduction in the rate of interest tends to check the desire
to accumulate. Moreover, this desire soon palls. A

multimillionaire recently left his fortune to accumulate
until 21 years after the death of his youngest heir with the

intention of accumulating by that time the largest fortune
on record . But his heirs much preferred to use it during

their own lifetime, and succeeded in breaking the will.
Even had they not succeeded , those who finally came into

the fortune would probably have begun , at least in a few
generations, to dissipate it .

The effect of great wealth is

to produce habits of spending.
It has already been noted that one's rate of preference

for present over future income, given a certain income
stream , will be high or low according to the past habits of

the individual. If he has been accustomed to simple and
inexpensive ways, he finds it fairly easy to save and ulti

mately accumulate a little property.

The habits of thrift,

being transmitted to the next generation , result in still

further accumulation, until, in the case of some of the de
scendants, affluence or great wealth may result . But if a
man has been brought up in the lap of luxury, he will have a

keener desire for present enjoyment than if he had been
accustomed to the simple living of the poor. The effect
of this factor is that the children of the rich , who have been
accustomed to luxurious living, and who have inherited

only a fraction of their parents' means, will, in attempt
ing to keep up the former pace, be compelled to check
the accumulation and even to start the opposite process
of the dissipation of their family fortune. In the next
generation this reverse movement is likely to gather
headway and to continue until, with the gradual subdivi

sion of the fortune and the increasing reluctance of the

successive generations to curtail their expenses, in the



third and fourth generation there comes a return to actual
poverty .

Wealth is usually inherited in the United States in amounts
equal for all the heirs, so that a fortune of $ 10 ,000,000, for
instance, if left to 10 children , will be divided in amounts of

$ 1 ,000 ,000 apiece . That being the case , the fortune will
reduce itself to į per capita . Now , the children of the
multimillionaire, who dies leaving a fortune of $ 10 ,000,000

to 10 children , each receiving $ 1,000,000, will probably
have handed down to them a taste or habit for spending
which will make them belong to the class of spenders rather
than savers.

They have been brought up in a family which

has spent the income from $ 10 ,000,000 , and each one now
finds that he is left with the income from only $ 1,000,000,

which is far less than he has been accustomed to see used
by his parents .

Trying to keep up the standards of the

family in which he was reared, unless he happens to have
the necessary thrift , ability, industry , luck, or fraud to add

to the $ 1,000,000, the result will be that his fortune will
diminish . One generation after another will reduce the
original fortune to diminishing fragments until there is

nothing of it left. And then the unfavorable effects of
luxury begin . A few years ago an English physician came
to this country who had inherited a large fortune; but
he had also inherited the desire to indulge himself in the

present to the full extent of his capacity. As a result of
this desire, his parents, in leaving their wealth to him , had

left him only the income “ in trust ” (and it is not an
unusual thing in England ,where there are spendthrift sons,
to leave property so that they may be able to use only the
income). Nevertheless, this man contrived , by chattel
mortgages and in other ways, to spend a good deal more

than his standard income, and he was always in debt and

in trouble. The result of such ways is sooner or later what
is called a “ shabby genteel” class. Eventually people in
this class will have to overcome their pride, go to work ,



and become laborers — and often common laborers. Their
wealth-holding ancestry is forgotten .
Thus the limits to the possible growth of large fortunes
set by scarcity of investments is always far higher than
the vast majority of fortunes ever approach . Most for

tunes rise and then fall, the turning point being due to the
abandonment of thrift and the substitution of thriftlessness

which the fortune itself sooner or later engenders. An old
adage has put this observation in the form , “ From shirt

sleeves to shirt sleeves in four generations.”

We have no

inheritors to-day to the fortune of Cræsus, who, in his day,

was supposed to be a wealthier man than Rockefeller, not
only in proportion to the wealth of his time, but absolutely .
A man with a start of that kind ought to have been able to
make the fortune increase rather than decrease with the

future, and yet we know of no heirs to that fortune. To
day we have a large number of wealthy families in this
country, but most of them are only one generation old !
Thus the very rich families, so far from growing rich indefi

nitely , usually do not even continue more than a few genera

tions rich , but grow poor, arriving, too, at the condition of
poverty without the vitality or the character necessary to
retrieve their lost fortunes.

Likewise at the opposite extreme, it does not always hap
pen that the poor grow poorer or even remain poor. Just
as wealth relaxes thrift, poverty stimulates thrift. The
children of the poor often become fired with ambition to

get on in the world simply because they are poor. These
people often rise from the ranks, and rise rapidly . It
should be noted ,however, that unlike thedownward moment
of large fortunes — this upward movement is the exception ,
not the rule. It may be that go per cent of large fortunes
pass their maximim and decline, but only 1 or 2 per cent
of the poor pass their minimum and rise. Many fall into

pauperism or die. The vast majority simply remain poor.
We see , then, that while it is very easy for those who have








once reached the top of the economic strata to stay at the

top , this seldom happens chiefly because of their conver
sion from savers to spenders ; and while reversely it is very

easy for those who once reach the bottom to stay at the
bottom , they do not always do so, chiefly because of their

conversion from spenders to savers.
$ 9. The Actual State of Distribution
The resultant churning up of society neutralizes the
tendency we have mentioned for the rich to grow richer and

the poor to grow poorer and , what is more important, it
prevents — to some extent — the establishment of wealth
castes by changing the personnel of wealth and poverty.
The individuals of society are like goldfish in an aquarium .
Those once started upward continue to ascend for a time,
when they start down again . Those once started down
ward continue to descend until perhaps they reach the
bottom , when they (may) start up again . To complete the

figure, we must suppose the shape of the aquarium to be
like a bell, very small at the top and very large at the bot
tom .

There is room for only a few at the top , and the

struggle of many to get there makes it difficult for any,
while it makes it easy for all to descend .

There is the

most room at the bottom , and consequently there is less
change there than anywhere else. Reversely , at the top
there is most change. The constant changing of position
in this bell jar, while of great moment to the individual,

does not greatly affect the distribution of society as a whole.
There will always be about the same proportion of fish at
each successive stratum . Professor Pareto has, in fact,
represented the distribution of wealth by a bell- shaped

figure which he calls the social pyramid . This is shown in
Figure 48 .

The number of people having an income be

tween Oa and Ob is represented by the volume comprised
in the bell-shaped figure between the plane of a 'a " and the





plane of 6 '8 " . The social pyramid represents the fact that
the larger the size of a fortune the smaller the number of

people who have it . The breadth of the pyramid represents
the number of people who have no capital except their own
persons. As the capital rises in amount, we find we have

fewer and fewer people. We have no exact statistics for
this country, but a rough popular estimate states that
over half of our population have incomes of less than $600 ,
and of the remaining half about half, enjoy incomes between
$600 and $ 1200 , and the other half incomes over $ 1200 .

FIG . 48.

The frequency of changes in fortunes, whether up or

down , will differ greatly in different countries according to
their age, and their laws and customs. Among these fac
tors the laws and customs as to wills is of great importance.

If there is an equal distribution among the children of the
rich , the fortune is pretty sure to run itself out in a few

generations or centuries, but in England this result is

prevented by giving to the oldest son the bulk of the
estate and cutting everybody else off with small stipends.

The idea in this case is to maintain the family dignity and
pride, and the integrity of the large estate . In this country



there are signs that we are gradually changing toward this
English custom by which a rich man , instead of dividing his

fortune evenly , leaves the bulk of it to one of his heirs .
By such a change in the custom of willing property there
will be a new and powerful tendency for existing inequalities

of wealth to be accentuated and perpetuated .
§ 10 .

The Problem of Wills

One of the special problems connected with wills is the

problem of the extent of control a man should be allowed
to exercise after he has died . This problem has frequently
been under discussion . It is sometimes called the problem
of “ the dead hand .” The “ statutes of mortmain ” in
England grew out of this problem ; also the common law
rule that no testator can “ tie up ” his estate beyond " lives
in being " at the time of his death plus 21 years. This rule
applies, however , only to so- called " private ” bequests .
To escape its operation and perpetuate his fortune a rich
man very often leaves it to some “ charitable " foundation .

But as it is ill advised to leave a fortune in the hands of
persons for a number of generations, so it has been found

ill advised to leave fortunes in perpetuity in any shape.
For the result is that after a few generations it is impossible

to carry out the instructions of the donor without doing harm
- however good his intentions. Conditions will have come

about which the donor could not foresee or provide for. In
Norwich , England, for instance, there was left many gene
rations ago a small sum to support a preacher for the Wal
loons, who should utter a sermon in Low Dutch every year

at a certain time. That provision is still carried out,
although there are no longer any Low Dutch in this place.

There is no one to understand the sermon, and yet it is
preached every year. Recently the preacher has learned
a sermon by heart and repeats it every year in order to
receive his remuneration .



A few years ago a lady died in England and left a fortune
to be used for the teaching of the doctrines of Joanna South
gate. This woman died in 1862. Now Joanna Southgate
had had a large religious following in England , but at this
time there was not a single soul in England who believed in
her doctrines. We had the curious spectacle , therefore, of

a fortune being left in the hands of trustees, no one of whom
could be found who believed in these doctrines.

In 1587 a

certain man died leaving to the almshouse of Suffolk some
real estate the income ofwhich was then £113.

The income

at present is £3600 and the trustees do not know what to
do with it .

The result has been to make the almshouse a

mecca for all poor people for miles around and to pauperize
the neighborhood .
The custom of making wills is one that is handed down
to us from the Roman days. There were no laws in an

cient Germany, no laws in the Levitical laws of the Jews,
none among the Hindus, and only slight traces among the
ancient Greeks, regardingwills. When we talk of the sacred

ness of private property and the right to dispose of it by
will, we are merely expressing our loyalty to the particular
custom under which we happen to live.

It may be in the future that a remedy for some of the
present evils connected with the ownership of wealth may

be found by limiting or regulating the inheritance of wealth
as to time or amount ; by inheritance taxes, by limiting

private ownership in certain perpetuities , by substituting
leaseholds for perpetual franchises or for “ fee simples ”
in mineral lands or even in all lands. There is much to be
said on both sides of these proposals, but it is no part of

our present task to enter upon their discussion .


§ 1.

True and Market Worths

AN often -quoted passage from

the Bible states that

“ the love ofmoney is the root of all evil.” Another states,
“ it is easier for a camel to go through the needle's eye
than for a rich man to enter into the kingdom of heaven .”

On the other hand, poverty has always been regarded as
an evil. Agur prayed that he should be given neither
riches nor poverty . This is the theory of the golden mean .

Still another view is that while , absolutely, wealth is good
and the more of it per capita the better, yet its unequal
distribution is an evil. This is the view of the socialists .

In all these views there is some truth . Extreme wealth
and extreme poverty are alike evils , and the disparity be

tween the extremes is also an evil. Moreover , besides these
evils dependent on the quantities of wealth are other evils
dependent on the qualities of wealth . But how can it be

that wealth, which is merely the physical means for satis
fying human wants, can ever do harm ? We have escaped
this question hitherto because we have accepted wealth,
so to speak , at its market valuation .

As was explained at

the outset, prices are determined by the actual desires of
men , and, when seeking to explain prices as they are, it
was no part of our task to inquire as to whether the desires
which explain them are foolish or wise, good or bad , desires.

There was no need to distinguish between the desires which
fix the prices of bibles and those which fix the prices of ob



scene literature. We now propose to go a little deeper
and to point out instances in which desirability is not in
trinsic utility, and in general to point out the various ways
in which market valuations fail to give a true picture of
actual worth .

In the first place, as we have seen , market valuations of
fortunes do not even show their comparative desirabilities
because of the wide differences between the marginal desira

bilities of money of different people . As already pointed
out, the marginal desirability of money decreases rapidly
with an increase of wealth , so that — beyond a comfortable
competence — the addition of millions means little that is
really desirable . In fact, to some men like Mr. Carnegie
swollen fortunes become a burden and responsibility rather
than an addition to personal gratification . In other

words, the desirability of opulence is small.
§ 2 . Evils connected with the Quantity of Wealth
That extreme poverty is an evil needs no proof. We
shall, therefore, not discuss the problem of poverty. The
chief causes of poverty we have already shown , and its
remedies lie beyond the scope of our discussion . Suffice it
to say that the problem is the greatest of all practical

economic problems and is justly claiming a large share of
the attention of philanthropists and reformers. Among
the remedies or partial remedies suggested are socialism ,
old -age pensions, compulsory workmen's insurance, regu
lation of hours of labor, better housing, abolition of disease,

education in thrift, profit-sharing, coöperation , monopo
lization and regulation of labor by trade unions.
At the opposite extreme lie the opposite dangers and
evils of great wealth . If the poor are too hard working,
the rich are too idle. If the poor are underfed, the rich are
overfed. If the poor have the discomforts of squalor and
shabbiness, the rich have the discomforts of excessive style .



If the poor suffer from scanty clothing, the rich suffer
from tight lacing and high -heeled shoes. If the poor suffer
from overcrowding, the rich suffer from the burden of over

grown establishments. If the poor drink alcoholics to get
rid of fatigue, the rich also drink to get rid of ennui.

Not only each extreme has its evils and dangers, but
unequal distribution of wealth has evils and dangers. One
of these is the perverted use of great wealth in a manner to

humiliate, degrade, or demoralize the poor. Unequal dis

tribution of wealth produces a caste feeling, breeding con
tempt for the poor by the rich , and envy of the rich by the

poor. Corresponding to differences in wealth grow up
differences in the mode of living, education, language, and
manners, differences which distinguish the “ gentleman ”
and “ lady " from the common herd , and which gradually

become confused with innate differences, which are quite
another matter. Aristocracies are almost always founded

on wealth and are therefore almost always on a false basis.
There are undoubtedly wide differences between men .
If so - called aristocrats were really all the name would im
ply , the “ best ” in body, mind, and heart, much could be

said in favor of their segregation from the “ vulgar ” crowd,
and the development from them of a better race of men .

But a plutocratic aristocracy is based, not on what men are
in themselves,but on what they possess outside of themselves.
Because of the differences in wealth , the poor serve the

rich . The relation of master and servant is not simply a
commercial relation . It also represents a supposed differ
ence in caste.
Probably the worst demoralization of the poor, growing

out of inequalities of wealth , is the prostitution of the

daughters of the poor for the sons of the rich . All students
of prostitution are agreed that it rests on this economic
basis. For the white - slave traffic most people are blaming
those who engage in it, just as for drunkenness most people
blame the saloon keeper. Doubtless these agents have



their share of moral responsibility. Yet they are merely
the brokers in the business.

The demand and supply are

the important factors, and the demand and supply arise

chiefly because of the unequal distribution of wealth.
Next to the poor selling their souls comes selling their

votes . Bribery and political corruption are largely due to
differences in wealth . In a democracy we have the ideal
conditions for such perverted uses of wealth. In a democ
racy there are two great powers, the power of the ballot
and the power of the purse. The power of the ballot(rests
with the poor because of their numbers.

The power of

the purse rests with the rich. Nothing could be more nat
ural than that the unscrupulous representatives of these

two powers should contrive to get together for mutual
advantage. They need not meet directly. The perverted
politician intervenes as a broker. Many of the city govern
ments of the United States exemplify this condition .


politicians make, on the one side, a business of controlling
the votes of the poor, partly by bribery, partly by dispens

ing “ charity ,” and partly by activity in party organiza
tions ; and , on the other side, they make a business of

“ holding up ” the capitalists who want franchises for street
railways, water, gas, electric light, or telegraph or special
tariff legislation .

The unscrupulous capitalist finds it ad

vantageous to pay toll to the politician, either by actual
bribery or by stock in corporations, or by what a politician

recently called “ honest graft ” in the form of “ tips ” or in

side information as to the stock market, real estate transac
tions, etc. Similarly , in our state legislatures and even in our
national Congress, politicians are of this character . Some

are avowed or secret representatives of capital or “ the
interests " ; others of voters or “ the people.” In this case

the conflict between plutocracy and democracy becomes
more direct and visible .

But it always exists, and will

continue to exist in some form unless one of the two powers
should completely vanquish the other .



§ 3 . Forms of Wealth Injurious to the Owner
We have seen several of the evils , and in particular some
of the misuses, to which wealth may be put. We can better
understand the nature of these and other misuses if we

reëmphasize the fact that the wealth , which is commonly
measured in money, does not include the most important

item of wealth there is — human beings. The evils of wealth
consist largely in an increase of external wealth at the sacri

fice of personal wealth — in this deeper sense of the word

“ personal.” Emerson said “ health is the first wealth .”
The founder of Christianity asked , “ What profiteth it a
man if he gain the whole world and lose his own soul? ”
Many a millionaire would willingly give all his money for
youth , health , or even freedom from pain . Many uses of
external wealth practically injure our personal wealth .
The injury may be physical or moral or both . It is in this

regard especially that “ satisfactions,” in the economic
sense, fails to measure real welfare. Indeed , as regards the

body, we may classify satisfactions into self-benefiting and
self-injurious. Many articles of wealth , though possessing
commercial value, are really injurious to those who use
them . In some cases the articles of wealth referred to are
used almost exclusively by the rich , in others almost ex
clusively by the poor. Among examples of self-injurious

satisfactions or uses of wealth are the consumption of food
or the wearing of clothing or the use of dwellings injurious
to the health, the practice of unhygienic or immoral amuse

ments , the use of narcotics, such as opium in China, hashish
in India , absinthe in France, whisky in Ireland , and alco

holic beverages in western civilization generally . These
may be called perverted uses of wealth , but they are very
common , so common as to give commercial value by millions
of dollars to disease -producing food factories, distilleries,
saloons, dives, gambling houses, low dance halls, and

theaters, houses of prostitution , immoral and degrading




Thę perverted satisfactions here represented

are capitalized like any other satisfaction .

They are often

paraded to show how wealthy a nation is, but as they
weaken the stamina of the people and shorten their lives ,

they really lessen the satisfactions in the end. In any com
plete view of the subject they should be recognized as
sources of national weakness, not strength . This is recog
nized in the great reform movements - housing reform ,

temperance reform , the movement to abolish the “ white
slave ” traffic .

§ 4 . Forms of Wealth Injurious to Society

Other evils of wealth consist in its use by one person to
injure another. Just as we classified some satisfactions into
personally beneficial and injurious, so other satisfactions
may be classified into socially beneficial and injurious.

Examples of socially injurious satisfactions are of many

kinds. Robbery, fraud, embezzlement, arson , and other
criminal acts are too obvious to need more than mention .

A burglar's “ jimmy ” is an article of wealth to the burglar ,
but it nevertheless is a means of injury to society .

Of less obvious examples one is the exploitation of gold
mines when their product depreciates the currency. Except
so far as gold is used as an ornament, or in the arts, its pro
duction at a sufficiently rapid rate, tends to raise prices.
Here we find great gold fields, stamp mills, assay and
smelting works, etc., standing in our accounts as important
items of national capital.

Yet in the last analysis they

are injurious, rather than beneficial, to the country. While
they afford means and opportunities for their individual
owners and exploiters to make great private fortunes, they
do not enrich a nation or the world ; for their sole effect is

merely to change the numbers in which prices are expressed .
Thus the labor and capital invested in gold mines may be

said to be socially wasted. A small amount of money is
2 E



as good a medium of exchange as a large amount. In fact,

if the gold flows out of the gold mines fast enough to raise
prices , the result is social harm rather than good : for it dis
turbs the distribution of wealth and continually tends to
precipitate a crisis.
The gold miner's fortune is thus made not as an addition
to the world 's real wealth , but by an abstraction from the
world 's wealth for his benefit , with secondary effects more or

less injurious. The gold miner, as it were , robs society.
Thus, even the most genuine gold brick , in which there is
no thought or intent to defraud, may prove in the end an
unconscious swindle.

Other examples of socially injurious wealth are such nui
sances as the “ smoke nuisance ” and “ pests ” of various
kinds. A factory which defiles the household linen and
the lungs of the neighborhood is not an unmixed bene

fit. If all the injury it caused could accrue to the factory
owner, he would put in a smoke consumer, or else most wil
lingly suffer a great deduction in the value of his plant. In
stead , he causes a great loss of value thinly distributed over
blackened houses and an injury never capitalized or meas
ured in the health of his fellow citizens. Such cases, where

social interests and individual interests do not run parallel,
justify legal interference. We cannot allow bonfires in a
crowded city , nor freedom of movement on the part of those
carrying infectious diseases.

§ 5 . Forms of Wealth used for Social Racing
The other examples of socially injurious uses of wealth

we shall mention are all cases of social rivalry. Three
special cases will be considered .
The first relates to warfare and the preparation for war.

It is usually conceded that actual warfare is economically

injurious. The best that the apologists for war can say
is that it is inevitable. But it is not so well recognized



that the economic preparation for war is an example of
world waste, albeit an effort toward economy on the part of

each individual nation. When Germany invested millions in
armaments, she merely stimulated France to do the same.
They have been racing with each other ever since, as have
other countries, including England and the United States.
Each battleship which costs $ 10 ,000 ,000, in the end adds

practically nothing to the world 's wealth . On the con
trary, as soon as a similar battleship is added to the navies
of rival powers, the various nations are in precisely the

same relative position as before any battleships were built
at all.

Preparation for war is a species of cutthroat

competition. If six world powers, instead of investing

each $ 10 ,000,000 in a battleship , should agree not to do so ,
the result would be to save $ 60,000,000 from being wasted .
The case would be very different if the ships belonged to the
merchantmarine. In that case , the building of $60,000,000
worth of ships would add that much to the world 's produc

tive capital. The ability of merchant ships is absolute,
that of battleships is relative.

The only object in one

nation 's building a battleship is to increase its strength
relatively to other nations.

Just as soon as this move is

met by the other nations, all the advantage which it was
sought to gain is lost again .
Thus, for the most part, the “ capital ” of nations, in the
form of armaments , represents economic waste, although
no one nation could afford to dispense with it as long as
other nations do not.

Our second example of socially injurious rivalry is com
mercial cutthroat competition . We have seen that what is
often to the interests of individual producers is against the
common interests of producers as a group . Wemay now

add that it may be injurious to the interests of society as a
whole. In fact, we have already noted that a patent and
copyright have their justification in the fact that the play

of unprotected individual interests would practically re



sult in discouraging or suppressing inventions and books.

The same must often be true in many other instances.
Telephone competition is not only injurious to the telephone
companies but to the subscriber, who either has to have

two or more telephones in his house, with all the expense
and annoyance which that implies , or has to lack proper

and easy connection with subscribers to other systems than
the one he employs .

§ 6. Wealth for Vanity
Our third example of socially injurious rivalry is perhaps
the most important and pervasive, although the most

subtle of all. It concerns rivalry in wealth itself, and
introduces us to the subjects of luxury, extravagance , social
ambition , and vanity. Thackeray's novel, “ Vanity Fair ,"
is a satire on the sortof economic rivalry referred to .


ity may be defined as a desire to obtain the ap
proval of others, and vanity leads to social rivalry. This
may be considered as rather a broad definition of vanity,

and it is one which does not necessarily imply any slur,
although most desires which are desires of vanity are sub

ject to criticism or question . The important part played
by vanity in economic affairs is seldom realized. A case
of pure vanity is seen when a man wants merely the badges
of distinction .

For instance, the badge of the Legion of

Honor which Napoleon established in France is much de
sired , merely as a means of obtaining the approval of

other people . It has no intrinsic desirability . It is not
because it is beautiful that it is desired ; it is not because
the badge can keep one warm or appease one's hunger or
fulfill any of the primitive and individual desires of men .

It merely appeals to the instinct to attain distinction in the
eyes of other people. But most cases of vanity are not so
pure, but are mixed with a substratum of actual utility .
For instance , a diamond is desired chiefly out of motives of



vanity, but it is desired also because it appeals to the æs
thetic sense .

It is a curious fact that as soon as we mix

vanity, with some
other motive, people begin to hide behind
ha hatpin . an be ashamed amty of which

this other motive and conceal the vanity of which , for some

reason , they seem to be ashamed . When a woman wears
a diamond hatpin , and can never , by virtue of its position ,

see it herself,whatmotive is there except vanity ? Of course
it may be said that she is an altruist in attempting to pro
vide an article of beauty forother people to admire ; but

the real object, however she may condone or conceal it, is
to display this diamond to other people and to show thereby
that she is able to possess it. Most articles of ornament

pander chiefly to this mode of vanity and come into exist
ence largely and chiefly for this reason , although the admira

tion of actual beauty is a secondary element and a subter
The amusements of mankind are almost always, or to a
large extent, mixed with the motive of vanity . For in

stance , automobiling to -day is not always indulged in for
the sake of sport alone, but also for the sake of display .

Equipages have always been one of the means of displaying
wealth . Narcotics have always been objects desired not
merely for their drug effect, but also for the effect of display .

The habit of using fine wines and expensive drinks in enter
taining has long been one of themethods of social display .

Clothing, even , and housing, are very often objects of

vanity. In fact, historically , clothing originated as orna
ments, like jewelry,rather than as an actual protection from
the weather. Even food is a matter of vanity to a certain

extent. Feasts have been favorite occasions for the exer
cise of this instinct.

A few extreme examples of ostentation will help us to

understand the nature of vanity. Some yea" s ago there
was an American in Florence who carried the idea of display
in his equipage to the extreme of getting a chariot and

having sixteen horses to pull him through the narrow streets




of the city. Ordinarily an attempt to gratify vanity re
sults in the approval which is sought by the individual,
but in extreme cases like this it often results in disapproval,
and this man was known in Florence for years as “ that
fool American .” A well-known French count, who through

marriage became possessed of means, gratified the instincts

of vanity by proceeding to spend untold sums in building
a large and useless colonnade of pillars, simply to show
that he was able to do so . A person not long ago left a
will providing $ 1,000,000 for the erection of his own tomb.
Cleopatra once showed what she could afford by drinking
a dissolved pearl. Pliny shows that after Cleopatra did

this she was imitated by the son of a famous actor, and
the practice of drinking pearls became a sort of fashion

in Rome, as to -day some men of a less subtle vanity light

cigars with $5 bills. It was probably this practice which
led to the phrase “ money to burn." In Philadelphia not
very long ago a lady had a carpet made with a special
design , and when the carpet was completed she was care

ful to have the design destroyed lest any one else should
have a carpet like hers. A well-known speculator is said

to have bought for his wife for $30,000 a particular pink ,
in order that it might be called by her name. In Holland ,
centuries ago , there was a furor over tulip bulbs which

took such a hold on the people that it led to extravagantly
high prices for these symbols of vanity . In 1639 one bulb
sold for what would be approximately $ 2000 in our money.

Another instance is found in the admiration people have
for foreign

importations. Many people really delude

themselves with the idea that they care for an imported

cigar or wine because they believe the article to be superior
to the domestic article. Nor is this the only species of

vanity appeased by the purchase of foreign goods. An art
dealer in San Francisco found that people there preferred
to pay $ 4000 in Paris for the same picture which they could

buy in San Francisco for $ 2000, in order that they might



state that they bought it in Paris. The artists of San Fran
cisco found it advisable, therefore, to take their pictures to
Paris, in order that they might get a higher price from
Americans. Not long ago an American who lives in a well
known cheese-making district in New York paid a very high
price for an imported cheese and took great delight in the

fact that it was imported . As a matter of fact, it had first
been exported from his own town.

There is said to be a

large industry in the exportation of cheese, the same being
naturalized abroad and sent back to this country and
sold as foreign cheese. When the English tariff on French
wines made their price higher in England than in France,
and the French tariff on English intoxicants raised their

price in France, the higher classes in France would consume
the English article, and the higher classes in England would
consume the French article , while both would not use the

domestic article because it was too “ common."
Jewelry has always been regarded as a matter of vanity .

If a chemical method should be developed of making a real
diamond cheaply , the desirability of diamonds would be

destroyed ; they would immediately go out of fashion.
The invention would be self-destructive, and the price of
diamonds and the use of diamonds destroyed .

That is,

diamonds are desired because they are scarce and a badge
of economic power of the people who purchase them . This
is why imitation jewelry is regarded as a sham . Paste
diamonds may be quite, or nearly , as beautiful as real
diamonds, but they can never be nearly as valuable. Those
who use them do so not because they regard them as beau

tiful, but usually in order to make people believe they are
“ real” and that the possessor can afford to buy them .
Sometimes they are worn as symbols of real diamonds kept
for safety in bank vaults .

The owners then appear at the

opera with the imitation jewels. When spoken to of their
jewels, these people will say that they are not real jewels,
but are an exact imitation of real jewels which are in the



safe deposit vaults. In such cases the imitation jewels
serve purely and simply as badges of ownership . There is
then supposed to be no pretense involved . The wearers
would be thought “ cheating ” if they possessed only the

Their virtue consists in

actually having the

“ real thing," which the paste replica proclaims they can

A wealthy woman seriously argued the question of

whether a poor woman had a right to wear an imitation

diamond . Her thought was that, since the poor person
could really not afford to have a real diamond, to wear the
imitation diamond amounted to deceit.

§ 7. The Cost of Vanity
Now the efforts to satisfy vanity are like international

armaments. The chief advantage that social racing gives
to an individual is a relative advantage. But this implies

that he puts other people to a relative disadvantage.


effect on society is to waste the cost of keeping up the race.

This cost consists in the labor expended on the gratification
of vanity, and shows itself in the high prices of articles for
that purpose. The tax thus laid by society upon itself is
enormous, and may bemeasured roughly by the annual pur

chases of articles of pure vanity. Yet people seldom com
plain , for the individual can see little or no difference between

the good he gets from an article of vanity and the good he
gets from any other article. He does not care much about
the pace hemay be setting others , and he does not hold any
other person responsible for the pace which has been set him .
Helooks at the world 's fashions as an inevitable fact, and ad
justs his own actions to it. Our task , however, is to look
at the social effects of his action on others , and of others'

actions on him . His expenditures for vanity may give
him the satisfaction of “ climbing,” but by as much as he
gets ahead of others the others are left behind . They are
all in a social race to get ahead .

In the scramble all are at



great effort or expense , and in the end there is a loss of eco
nomic power similar to the loss of nations racing for military

supremacy. Undoubtedly the race stimulates the racers ,
and may do them some good as a mode of exercising their

abilities , and even lead to useful inventions. The same
may be said of war. But our present purpose is to point out
the cost, which is usually overlooked . If the true cost
could be expressed in figures, it would doubtless amaze

people who have never stopped to see the extent to which
luxury and luxurious rivalry is carried .

Almost all expendi

ture is more or less colored by it.
We have compared the extravagance which is created
by the desire of a man to compete with his neighbor van
ity to a race. We called it social racing. Now when
fashion enters into thematter, as it almost always does, this
race becomes more like a chase.

There are leaders and fol

lowers, and the followers try always to overtake the leaders.
When they do so , the leaders turn in their course in order

to elude their pursuers . The consequence is that fashions
are constantly changing at the hands of the leaders of fash

ion . The leaders of fashion are usually from among the
richest people in the community , and whatever they con
sume, those beneath them in the social or economic scale
wish to consume also .
We may take, as an example , the case of russet shoes,
which are constantly coming in and going out of fashion .
A few years ago a gentleman was surprised to find that
only the highest grades of russet shoes were carried on the

market . When he asked the reason , he was told that russet
shoes had gone out of fashion only a year or two before ;

that now they were coming in , and the only way by which

they could be got in was by putting the highest grades on
the market first, because if the lowest and cheapest grades
were put on , then the leaders of fashion would not want

them , and if the leaders did not want them , then followers
would not want them either . After this initiatory demand








has been satisfied, the shoes are imitated in cheaper grades ,
until finally russet shoes become so common that the lead
ers refuse to wear them longer and they go out of fashion —

only to come back again in a few years, after which the same
cycle is repeated .
One result of this constant search for inequality is often

a pretended inequality. Consequently this constant social
rivalry puts society on more or less of a false basis . There
is a pretended inequality and an effort on the part of the
so -called upper classes to assert a superiority , even in blood ,

over the so -called lower classes. It leads, in other words,

to snobbishness and the caste system .
Vanity is literally insatiable . Without vanity there
would be little use for the fortunes of multimillionaires.

Beyond a modest fortune more money would be to them
entirely superfluous. . Therefore the use to which they put

their millions is of much more moment to society than to
themselves. If they use it to set standards of luxury, they
are using it in a socially injurious manner . They produce

the same effect on society as though they levied a tax on
all persons poorer than themselves. I
§ 8. Remedies for the Evils of Vanity

We have seen that the natural remedy for cutthroat
competition in business is combination .

In the same way

if there could be a general “ disarmament," as it were , or
agreement between the social competitors , it might solve

the problem of social racing.
This indeed has been done on a small scale in schools,
colleges , and clubs.

A good instance is among women ' s

sewing circles. When such a circle is first organized , the
hostess gives a very simple entertainment. At the next
meeting a rival hostess gives something a little more elabor
ate and presently themembers of the circle aremadly racing
in the effort to supply the best entertainment. A reaction



becomes necessary and the ladies finally agree explicitly ,

“ not to serve more than two kinds of cake.”
An example of how this general disarmament works was
seen in San Francisco at the time of the earthquake. There

the people who lived formerly on Nobb Hill in fine houses
had to live in tents or out of doors. So far as this loss was

concerned , it was no loss at all,at first at any rate, because
each man was perfectly willing and liked to live out of doors ,

providing his neighbor lived the same way. But before the
earthquake any one of these people would have been
ashamed to live in a tent because he knew that his neighbors
would wonder why he did not live in a house as good as theirs .

Very similar to social disarmament, is compulsion by
the government. The Dutch government finally took

a hand in the tulip -bulb craze because it was so heavy
and foolish a tax on the national resources, and the traffic
in bulbs was stopped . History contains many examples
of sumptuary laws designed to check social racing.

One cure has been suggested by John Rae which is
ingenious, although it has never been consciously put into

use. He says, and wisely , that we cannot change this in
herent ambition in human nature. All we can do is to turn
it to some good account instead of letting it run to waste.

He suggested that social racing could be made to yield a
revenue to a government by taxing imported luxuries so as
them expensive and therefore desired by the wealthy and
their imitators. A case in point is that of the cheap wines

of France being dear in England because of the tariff and
cost of importation across the channel, and reversely , the

cheap wines in England being dear in France. Each was
fashionable in the country of the other. Now if a tax is

able to create a fashion in this way, through making an
article exclusive, the government gets a revenue by creating
a fashion , so to speak , by making certain imported goods
so rare that they become sought after as matters of fashion ,

so that the tax imposed on society by fashion is made to

accrue to the government.



Another way is to change the fashion of fashion , so to
speak ,so that it may run into useful instead of useless rivalry .
One of the better forms of vanity does not satisfy itself
by display in the usual sense, but seeks to make a record

of power in the financial world . In these days a man may
advertise his wealth in other ways than high living. To be
known as the largest stockholder in a railway is a dis

tinction coveted by men. In fact, in spite of many
evidences to the contrary, there are some indications that

display, in the old sense , is decreasing, especially among
men .

To-day men seldom wear jewelry or gaudy clothing.

Business distinction takes the place of these. Even women
are becoming ambitious to lead in other ways than

“ society.” They seek distinction at women's clubs or as
executives in charitable effort. There is, as a matter of
fact, no reason why rich men and women should not try
to distinguish themselves by doing good , and the tendency
in America to-day is exactly in this line. Rich men are

gradually trying to distinguish themselves by their large
benefactions instead of by their large expenditures.


create great philanthropic foundations and endow hospitals,
sanitariams, libraries, and universities .

A few years ago , in the city of Pittsburg, two wealthy

men vied with each other in attempting to display
fine buildings for the good of the city of Pittsburg, and one,
in order to triumph over his neighbor, who had put up
imposing buildings in one square, purchased the square
immediately adjacent at a very exorbitant price for the
purpose of erecting a still finer building for the use of
the city of Pittsburg.
Social racing of this sort may be socially beneficial and
is an encouraging sign of the times .

At present, however,

great wealth is as a rule either running to waste or taxing
those who cannot keep up with it. Perhaps some day it
may — like other great wastes — be caught and harnessed

and made to do some of the world 's work .