The economics of distribution

Front matter

Class _i2Jlii/^

Book „■ L-

GoipglitlN^

Preface

This work endeavours to construct an intelligible, self-consistent theory of Distribution by means of an analysis of those processes of bargaining through which economic distribution is actually conducted, the results of industrial cooperation being apportioned to the owners of the factors of production in the several stages of production.

The chief difficulty lies in coordinating the different factors of production, so as to bring the payments made respectively for the use of land, labour, and capital under a common law of price, and in showing that the same economic forces which determine the market and normal prices of commodities are applicable to the sale of all these uses of the factors of production.

The extension to all these cases of the terminology and modes of measurement hitherto confined to land, or extended tentatively and by analogy to certain other factors, involves a complete restatement of some of the problems of wages and interest. But this unification of the different processes of economic payment has long vi PREFACE.

been felt to be necessary to the construction of a satisfactory theory of distribution, and various approaches in this direction have been made. This work claims to go farther and to reach a common law of price applicable to every sort of sale.

Some of the reasoning is difficult because it involves a necessary abandonment of commonly accepted terminology and the establishment of a new system of economic notation. If, however, the reasoning is valid, it establishes certain important theoretic conclusions, some of which are fraught with large implications in the direction of progressive politics.

In particular, it claims to prove that all processes of bargaining and competition, by which prices are attained and the distribution of wealth achieved, are affected by certain elements of force which assign "forced gains" and other elements of " economic rent " to the buyers or the sellers. There is thus established the existence of a large fund, partaking of the nature of those monopoly and differential rents, long ago recognised in the case of land, which furnish no stimulus to voluntary industrial energy, and which can be taken for public service by taxation without injury to industry.

Much of the material of this work was given in the form of lectures to students of the London School of Economics and Political Science in 1897,

PREFACE. vii

and parts of several chapters have appeared in the Harvard Quarterly Journal of Economics. Since receiving the first proofs of this book, a little volume has come into my hands, entitled "The Theory of Wages," by Mr. H. M. Thompson, which works out independently some of the main points of my criticism of current theories, in particular of the fundamentally erroneous doctrine that " Rent does not enter into the Expenses of Production."

JOHN A. HOBSON.

Contents

OHAPTBS PAOB

I. The Determination of a Market-price • . 1 II. Producer's and Consumer's Rents ... 41

III. The Determination of Long-period Prices and

Chapter I. The Determination Op A Market-price

§ 1. "I am unaware of any rule of justice applicable to the problem of distributing the produce of industry," wrote Professor J. E. Cairnes, and it is common to find in modern economic treatises general expressions of dissatisfaction with existing methods of apportioning wealth among those who have contributed to its production. But there is little agreement as to the nature of the defects in present modes of distribution, nor does the analysis of economic processes commonly adopted by those who indulge in these expressions of dissatisfaction fully justify any such general condemnation. The economic power of landowners, the establishment of trade monopolies or combinations, the weakness of poorer classes of labourers in bargaining with employers, are commonly regarded as defects of the existing industrial order. But the recognition of these defects is quite consistent with a conviction that the general and normal tendency of competitive industry makes for a fair and satisfactory

2 TRE ECONOMICS OF DISTRIBUTION.

distribution of the fruits of industry. For the specific defects named above are seen to be closely associated with restraints of competition, and may plausibly be regarded as exceptions which by no means justify a general condemnation of the justice or utility of a system of distribution based upon freedom of competition.

§ 2. In order to test the character of distribution fairly, we must study it under normal not under exceptional circumstances, and in its constituent acts. Distribution is composed of, or achieved by, transactions which, for lack of any better term, we call bargains. Much investigation has taken place of certain classes of bargains, particularly in reference to sales of the use of the factors of production, and special laws of rent, wages, interest, have been founded upon these studies. The general effect of these studies among earlier economists was to break up the unity of industry: first, by suggesting that bargains for the use of land, of capital, and of labour-power were subject to radically different laws; secondly, by failure to relate these laws of the value or the price of the factors of production to the laws which were found to determine the price of the commodities which they contributed to produce. More recent economic writers have made considerable advances toward the integration or unification of a theory of Distribution, by relating the theories of determining the price of the several factors through an extension of the law of differential rents, and by a scientific formulation of a theory of value which is applicable to the determination of all prices, alike of uses of factors and of commodities.

But the completion of this work of unifying the theory of Distribution has been delayed by a refusal of economists to investigate sufficiently the nature of the bargain per se, so as to find what is common to its different species. So far as England is concerned, this refusal is due to a visible reluctance among students to engage upon purely deductive or speculative problems, except within a certain narrow field of mathematical analysis. The dominance of the historical spirit on the one hand, and the rapid advance of Specialisation in economic study on the other, have unduly drawn attention from the root-problems of deductive economics, which are too often assumed to have been solved, or not to be worth the trouble of solution. To these influences I chiefly attribute the small amount of intellectual energy devoted to the investigation of the process of bargaining which lies at the base of the theory of Distribution.

Such study requires the moderate use of a method which is peculiarly disfavoured by English economists of the present day, and is stigmatised as "Crusoe economics." This recent revolt against speculations, which were barren or illusive because they commonly proceeded from false premises, has gone too far. Such speculative analysis, with all its dangers, is indispensable to the social sciences. The conditions of inductive reasoning from experiments, which exist in many branches of physical science, are here notoriously lacking, and to supply this defect a process of fictitious experiment is substituted, supposititious cases being framed where unessential circumstances are eliminated, so as to enable us to see more clearly the working of certain simple forces.

To study problems of price or value, by plunging into the full intricacy of actual business, is not really a practical but a most unpractical method. To go back to a thoroughly uneconomic condition is usually unprofitable ; but to take, first, cases true to the essential facts of life, though contained in a simpler setting of circumstances than that in which they are actually found, and afterward to introduce the excluded circumstances gradually, in order to see what difference is wrought, — such substitute for the experimental method of the physical sciences is both defensible and highly profitable as a mode of gradual approach toward a real issue. This method I propose to adopt in opening up the nature of a bargain.

§ 3. Bargains are found commonly in clusters at a market-price, being acts of sale or exchange at this common rate. It is therefore first essential to understand how this common price-point is determined.

If A wishes to sell a horse and B is the onlybuyer, it is evident that, if the highest price B is willing to give does not reach the lowest point A is willing to take, there can be no price and no sale.

A asks X20 and fixes reserve at <£15.

B offers £8 and fixes reserve at £\2,

Next suppose A willing to take ^15, while B is willing to give X18. If a sale takes place, the price will obviously lie in the common ground between c£18 and X15. But at what point and how is the point reached? Professor Hadley assumes that a point will be reached and thinks it is determined by "relative skill in bargaining."^

But this attainment of a price by "skill of bargaining " implies ignorance of each other's mind in the case of A and B, or either. If A knows or thinks that B will go to £18 and B does not know that A will sell at <£15, A will stand firm at .£18 and get that price ; if, per contra^ B knows that A will sell at <£15 and A does not know that

1 Hadley's Economics^ p. 73.

B will go to £18, B gets his horse at £15. If neither knows but each suspects the other will go further, "bluff" is the determinant; the bidding proceeds until either A or B believes that any further demand will outstep the limit set by the other in his mind and will lose him the bargain. The determinant here is superior cunning, or, as Hadley says, "skill in bargaining." Or it may be that while A is willing to sell at £15, he may know or suspect that it is more important for B to obtain the horse than for him to sell, in which case he is in the position to extort £18.

So far we have no element of competition : the process by which a price is reached, if it is reached, is one of bargaining from beginning to end.

Now introduce the competitive element upon one side of the transaction. A, the happy owner of the horse, which he will sell for £15 or as much more as he can get, is faced by B and C, who both want the horse and are furnished with effective demand in the shape of cash. Now B and C either set the same limit-price upon A's horse, or they set a different limit-price. If it is equally important to both to get the horse, and they are possessed of equal pecuniary resources, they may conceivably be both willing to bid up to £18 for the horse. In such a case it is a matter of absolute indifference to A whether, after making B and C bid against each other up to £18, he sells to B or to C. Indeed, the casuist would rightly argue

DETEBMINATION OF A MARKET-PRICE. 1

that, since he could not sell to both, and there was no more reason why he should sell to one rather than to the other, he could not sell at all ; but would stand like the Ass of the Fable, who starved to death as he stood at an equal distance from two equally attractive bundles of hay. But elbowing aside our casuist and allowing A to effect a sale at X18 to either B or C, guided by some personal preference or the prospects of future business with the respective parties, it is plain that the competition between B and C has simply placed A in the same position of bargaining superiority as he would occupy in dealing with B alone, on the assumption that he knew the limit-price B had set himself, while B did not know his limit-price. The actual price reached would assign to A the whole gain of the bargain, less the minimum required to compensate B or C for the trouble of bargaining.

But the chance of B and C fixing the same price-limit and adhering to it with equal persistency is infinitely small. In the actual business world we may take it that the two competitors fix a different price-limit, —

B's limit is .£19, and C will not go beyond .£18. Here it will be evident that competition does not fix the price-point, but only a lower limit of price. The price actually reached cannot be less than X18, because B and C will bid against each other up to that point. It may be anywhere between £18 and £19 ; and the actual point will be determined, not by competition, but by those same forces of skill and force in bargaining which operated in the earlier case.

§ 4. Now arises the question : Is the method of determining a price essentially different when we place upon both sides of the transaction a number of genuine competitors, in other words, when we institute a free market ?

What is the determination of a market-price? It is curious to observe how the text-books of English economists have, almost without exception, shirked or slighted this practical question, hurrying the reader to the more abstract consideration of a normal price, and contented, as was Mill, to explain any particular divergence of market-price from normal price by vague reference to temporary fluctuations in supply and demand, which kept market-prices oscillating round a normal price, giving the advantage now to sellers, now to buyers.^

It has generally been considered a satisfactory account to say that the competition between owners of supply on the one hand and exercisers

1 J. S. Mill, Principles of Political Economy, Bk. Ill, Ch. II, § 4.

DETEBMINATION OF A MABKET-PRICE. 9

of demand on the other hand will equalise supply and demand at some point of price. This is Mill's contribution toward the theory of a market-price,^ and it may be said to be generally received in English economic text-books as a sufficient description of a market-price. Professor Marshall, in discussing the price of the corn market, finds it to be such as would " exactly equate supply and demand. "2 Professor Hadley, in his recent book, is content to say that " the market-price of an article under the modern commercial system is the price at which the demand is equal to the supply."

Now such a statement is doubly unsatisfactory. It neither defines a market-price nor explains how a market-price is actually reached. It furnishes no real answer to the question of the celebrated Oxford Professor who was reported to stop his friends in the street in order to ask them why a silk hat cost 20s. The text-book answer to this question consists in showing that the price of a silk hat cannot be 21s., because in that case supply would be in excess of demand, there would be too many hats and too few people to buy them, and the competition of sellers would reduce prices; conversely, the price could not be 19s., therefore 20s. is presented as a point of convergence between two opposing prices which reach at that

1 Cf. Dissertations and Discussions, Vol. IV (" Thornton "). ^Principles (2d ed., p. 392).

point a temporary equilibrium. The supply of hats was equal to the demand at 20s.

This statement that a market-price is one that equalises supply and demand explains nothing. What we want to know is why this equilibrium occurs at 20s. English economists have commonly shirked the direct significance of this question, which requires an investigation of the actual process of equilibration in a market, and have either betaken themselves to an examination of the costs or utilities which lie behind demand and supply, or to the logomachy regarding the meaning of these terms themselves. It is indeed too true that some economists have so used the terms "demand " and " supply " as to beg the question of an equilibration. "We desire," says Cairnes, " to know the circumstances which determine price; and we are told that the selling price is always such that the quantity of a commodity purchased in a given market is equal to the quantity sold in that market." ^

1 Leading Principles, p. 113. Cairnes, however, is wrong in imputing this fault of reasoning to J. S. Mill, though the latter, in the passages in which he expressly defines demand, is illadvised in his language. In the formal definition (Bk. Ill, Ch, II, par. 3) he identifies demand with " quantity demanded." Unfortunately the expression might mean "quantity bought," or it might mean " quantity which buyers would be willing and able to buy at a given price." In a second passage (Bk. Ill, Ch. XVIII, par. 2) demand is held to mean "the quantity of it (commodities) which can find a purchaser," an expression involved in the same ambiguity, for it might be held that only

DETEBMINATION OF A MARKET-PRICE. 11

Where demand is equivalent to quantity demanded in the sense of quantity bought, and supply to quantity supplied or sold, it is evident that the boasted Law of Supply and Demand becomes nothing else than an identical proposition.

But while Cairnes was right in insisting upon the need of an exact explanation of the process by which supply and demand are equilibrated in a price, he was himself unable to throw any further light upon the process than to suggest that the final result depended upon "higgling of the market."

§ 5. The closest formal inquiry into the operation of two-sided competition in a market is that of Bohm-Bawerk. I propose here to take his illustration of the market and to present his reasoning in what I think is a simpler form than that found in his book.

A, B, C, D, E, F, G, H, are sellers of horses. All the horses are supposed to be of the same worth, and all the sellers to have an equal knowledge of the market. They have, however, minimum or reserve prices, which vary from XIO in the case of A, to c£26 in the case of H.

the quantity actually sold " can find a purchaser," or it might include whatever quantity could be sold at a price, assuming it to be offered at that price. Mill's context and general treatment of a market-price, however, makes it pretty clear that he did not mean by " quantity demanded " quantity actually sold, but quantity which buyers were willing to buy if they can find sellers willing and able to sell at a price.

I, J, K, L, M, N, O, P, Q, R, are buyers in the market, with maximum prices which vary from X15 in the case of I to <£30 in the case of R.

Sellers. Price-limits.

HGFEDOB A

.21.

IJKLMNOPQE

Buyers. Price-limits.

Let bidding open at ^10. At this point only 1 will sell ; 10 would buy, and since none will let the other have a bargain, they will overbid. At Xll there are 2 sellers, but the competition of 10 buyers will not allow a sale at that point, and bids still rise ; at ^15 there are 3 sellers, but the other 7 will not allow 3 of their number to buy horses at X15, that sum being less than they would consent to give. At ^15 10s. one of the buyers has dropped out, his limit-price having been exceeded, but there are still 9 buyers against 3 sellers ; these 3 sellers could not fix a bargain with 3 of the buyers because, as they were settling it, the other 6 buyers, finding that they would be left in the cold, would offer better terms and upset the proposed bargains. At ^17 10s. another seller enters in, and another buyer has dropped out, but there are still 8 buyers against 4 sellers, and no bargain can be struck. After c£20 is passed, another seller will have entered, and another buyer have fallen out, leaving 5 sellers faced by 6 buyers. This state continues up to £21. A sale cannot take place, because the would-be excluded buyer, the odd man, will fasten on to any of the 5 possible sales and force up the price. If c£21 is passed, however, this inconvenient odd man drops out, leaving 5 sellers and 5 buyers. Each man can make his bargain at <£21 Is., for 5 are willing to sell, 5 to buy, at that price. But though 5 would sell at .£21 Is., they would rather get more if they can ; they can get more, for all 5 buyers would sooner pay up to £22 than fail to buy a horse. But if the sellers put up the price above £21 10s., a 6th seller would enter the field, and there would be 6 willing sellers against 5 willing buyers — a state of things which would force the price down below £21 10s.

So whereas at any point just over £21 10s. there would be 6 sellers and 5 buyers, at any point just under £21 there would be 6 buyers and 5 sellers. In neither of these conditions is a price possible. On the other hand, at any point between £21 10s. and £21 there are 5 sellers and 5 buyers, and 5 sales can be made satisfactory to each party. In other words, supply and demand are equalised between X21 10s. and £21.

Competition of buyers on the one hand and sellers on the other hand has thus fixed rigid limits for a market-price.

But to fix limits for a price is not to fix a price, and curiously enough Bohm-Bawerk leaves his analysis at this interesting point. The bargain is made possible at any point between the valuation of the most capable of the excluded buyers, M, as lower margin, and the most capable of the excluded sellers, F, as upper margin ; but there is nothing in this analysis to show where it will lie between these margins. Indeed, we may say that if this were the whole process, no price could be fixed at all and no sale would be possible, at any rate by economic settlement. The unerring logic of competing self-interest which has found the price-limits will not find the price-point between those limits. The competition which was so effective when 6 sellers faced 5 buyers, or 5 buyers 6 sellers, seems to collapse when 5 buyers face 5 sellers, and there is no odd man to throw his weight on to an impending bargain. As far as Bohm-Bawerk's analysis is carried, there is no more reason for the market-price being fixed at

DETEBMINATION OF A MARKET-PRICE. 15

one point between the limits rather than at any other point. Indeed, we appear to be landed in the same serious logical difficulty which encountered us before. The 5 sellers would like to get a price as near as possible to £21 10s., the 5 buyers a price as near as possible to £21: here we have a real discrepancy of interest between the parties and no machinery of competition to settle it.

We must plainly recognise that if the sellers and the buyers in this case were really acquainted, not merely with the outward condition of the market but with the subjective valuations which each of them puts upon the act of sale, no sale could be possible by economic means. If the sellers can fix the price near the upper margin, the advantage of one of the buyers is reduced to a minimum, and the whole body of sellers get the best of the bargain ; if the buyers can force the price to near the lower margin, one seller has his advantage reduced to a minimum, and the buyers get the best of the bargain. Why should either party give way ? There is no economic method of reaching a price-point here ; it would be necessary either to agree to split the difference or to "toss-up," neither of which can be reckoned an economic settlement. This, we may take it, is not what would really happen, for the subjective valuations of the various buyers and sellers will not be known to one another. Although, in his elaborate analysis of two-sided competition, Bohm- Bawerk does not even indicate how the price-point is reached, he has hinted in an earlier treatment of " one-sided competition " which exhibits the same difficulty that the price-point will depend upon "skilful bargaining." ^ In other words, the work of competition is not to find a price, and there is no such thing as a " competition price " : competition stakes off a ring, within which bargainers fight it out by force and craft. Taking our present instance, it seems essential to the fixing of a price that one of the bargainers should deceive the other as to the real facts of the case (i.e. as to his subjective valuation), leading the other to suppose that he will not give way any further. For instance, one of the sellers will conceal the fact that he would be willing to sell at ^21, and will hold out for J 21 9s.; one of the buyers believing him, and fearing to be left out in the cold, will show his willingness to accept ; thus the bargaining at any price below £21 9s. will once more partake of competition, since only 4 sellers face 5 buyers, and the equation of buyers and sellers is thus falsely placed at £21 9s. By such fraud or force of superior bargaining the price-limits are drawn together so closely as to approximate toward a money-point, and the "standing out" of one of the 5 sellers may fix the price for all 5 sales at £21 9s. Some such 1 Positive Theory of Capital, p. 200.

DETERMINATION OF A MAREET-PEICE. 17

practice of fraud or force seems necessary to achieve a price-point.

Now, turning to those who have taken part in the process of determining a market-price, we can assign a different part to several groups.

(a) First come the ineffectual buyers and sellers whose limits have been too high and too low for them to take part in an actual sale. In this group fall G and H among sellers, I, J, K, and L among buyers. The desires and actions of these persons have had no influence whatever on the market or the price ; their absence would not have caused any difference.

(5) Next come the effectual buyers and sellers, whose subjective limits lie above and below the limits within which a price-point is fixed, and who, though they take part in the bidding of the market, have no direct influence upon the price. These are A, B, C, D, among sellers, O, P, Q, R, among buyers.

(c) Thirdly come those members of the market whose subjective valuation fixes the possible limits within which 5 sellers would be willing to sell and 5 buyers to buy. Bohm-Bawerk holds that this group should comprise E and F among sellers, M and N among buyers, for he holds that the action of these two pairs fixes the upper and lower limits. " The upper limit is constituted by the valuation of the last buyer who actually exchanges (the last buyer) and that of the most capable seller excluded (the first excluded seller), and the lower limit by the valuation of the least capable seller who actually effects a sale (the last seller) and that of the most capable buyer excluded (the first excluded buyer)." So we get, he says, the very simple formula, " The market-price is limited and determined by the subjective valuation of the two marginal pairs." ^

According to this, the upper limit is fixed by the valuation of F, the first excluded seller, and N, the last actual buyer : the lower limit by the valuations of M, the first excluded buyer, and E, the last actual seller. But N's exact valuation, .£22, neither fixes nor helps to fix the upper limit, for if his valuation, instead of X22, had been <£21 lis., it would have made no difference. Similarly, E's valuation at £20 does not help to fix the lower limit, for if, instead of being X20, it had been <£20 19s., it would have made no difference.

It seems therefore that the valuation of N and E had no direct influence upon the limits which are determined directly and exclusively by the valuations of M and F.

(c?) Lastly, within the price-limits we have the action of one of the effective competitors in assuming the attitude which draws the price to a point. There is, of course, nothing to inform us which one adopts this attitude. We will assume that it is

E, the last actual seller, whose limit-price is <£20, and who perhaps may be considered the stiffest bargainer and the most likely to hold out for a price just below <£21 10s., which after all will give him a less subjective gain than will fall to any of the other sellers whose limit valuation is lower. Or else we may suppose that N, whose subjective gain is smallest among the buyers, makes the successful stand, and, cajoling the sellers into thinking he will not buy at a price much over X21, fixes the price just above that point.

§ 6. Our analysis, if correct, yields information upon two important matters : first, as to the method of determining a price or exchange-rate in a market ; second, as to the distribution of gain arising from a series of bargains at a market-price.

As to the method of determining a price, it proves (a) that competition does not fix a price, but only the approaches to a price ; (5) that within the limits a price-point is fixed by the superior bargaining power of a single buyer or seller.