Elementary principles of economics

Front matter

Copyright^

COPYRIGHT DEPOSIT.

x+xxpx. m

Preface

For Teachers

The words " Elementary Principles " in the title of this book indicate the limits of its scope ; the book is intended to be elementary, not advanced, and to be concerned with economic principles, not their applications.

First, being elementary, it does not attempt to unravel the most difficult tangles of economic theory or to introduce controversial matter. For such studies it should be succeeded by more extensive treatises (e.g., my own : Nature of Capital and Income, Mathematical Investigations in the T/ieory of Value arid Prices, Purchasing Power of Money, and Rate of Interest, which follow out the same general system of thought and exposition as adopted in this book).

Secondly, being devoted to principles, the book is confined to that part or aspect of economics which is now coming to be recognized as capable of scientific treatment in the sense, for instance, in which that term may be applied to physics or biology. The fundamental distinction of a scientific principle is that it is always conditional ; its form of statement is : If A is true, then B is true. Science is primarily concerned with the formulation of such principles or laws. The aim of this book is to formulate some of the fundamental laws relating to economics.

The method and order of treatment are not altogether traditional. The time-honored order of topics — production, exchange, distribution, consumption — has been found impracticable. Such an order was probably originally intended to parallel the natural course of events from the viii PREFACE

production of an article to its consumption ; but to-day this order of topics scarcely retains any traces of such a sequence. "Distribution," for instance, has long ceased to be a description of the processes by which food, clothing, and other goods are distributed after being produced and prior to being consumed, and has become simply a study of the determination of rent, interest, and other market magnitudes. It is not, therefore, surprising that many other textbooks on economics have also broken away from this unfortunate order of topics.

Of the many possible methods of writing economic textbooks, there are three which follow well-denned, though widely different, orders of topics. These are the "historical," the " logical," and the " pedagogical." The historical method follows the order provided by economic history ; the logical begins with a classification of economics in relation to other studies, explains its methodology, and then proceeds by means of abstract examples from the simplest imaginary case of " Robinson Crusoe economics " to the more complex conditions of real life ; the pedagogical begins with the student's existing experience, theories, and prejudices as to economic topics, and proceeds to mold them into a correct and self-consistent whole. The order of the first method, therefore, is from ancient to modern ; that of the second, from simple to complex; and that of the third, from familiar to unfamiliar. The third order is the one here adopted. That the proper method of studying geography is to begin with the locality where the pupil lives is now well recognized. Without such a beginning the effect on the student's mind may be like that betrayed by the schoolgirl, who, after a year's study of geography, was surprised to learn that her own playground was a part of the surface of the earth. In like manner we cannot expect to teach economics successfully unless we begin with the material already existing in the student's mind. Those textbooks which open with a discussion of the rela-

PREFACE IX

tions of economics to anthropology, sociology, jurisprudence, natural science, and biology, overlook the fact that the beginner in economics is totally unprepared even to understand these concepts, much less their relations to one another. The same sort of error is made by those textbooks which begin with a comparative study of the logical machinery by which truth is ground out in economics and in other sciences. The student's logical faculty must be exercised before it can profitably be analyzed.

This book, therefore, aims to take due account of those ideas with which the student's mind is already furnished, and to build on and transform these ideas in a manner adapted to the mind containing them. This is especially needful where the ideas are apt to be fallacious. The economic ideas most familiar to those first approaching the study of economics concern money, — personal pocket money and bank accounts, household expenses and income, the fortunes of the rich. Moreover, these ideas are largely fallacious. Therefore, the subject of money is introduced early in the book and recurred to continually as each new branch of the study is unfolded. For the same reason considerable attention is given to cash accounting, and to those fundamental but neglected principles of economics which underlie accounting in general. Every student at first is a natural "mercantilist," and every teacher has to cope eventually with the prejudices and misconceptions which result from this fact. Yet no textbook has apparently attempted to meet these difficulties at the point where they are first encountered, which is at the beginning.

It may be worth while to distinguish the pedagogical procedure here proposed from that recently advocated under the somewhat infelicitous title of the " Inductive Method." I refer to the method by which the student is at first to be taught economic facts without any formulation of principles. This proposal seems to assume that the

X PREFACE

student's mind is quite a blank to start with, and that it is possible on this tabula rasa to inscribe facts without at the same time intimating how they are related. The truth is, however, that the student's mind is already familiar with a great mass of economic facts acquired at home, on the street, and from the newspapers. He knows something, not only of money and accounts, but of banks, railways, retail trade, labor unions, trusts, the stock market, speculation, the tariff, poverty, wealth, and innumerable other topics. It is equally true that his head is full of theories as to the relations of these facts, — the working of supply and demand, the nature of money, the operation of a protective tariff, etc. The difficulty is that most of his theories and many of his supposed facts are false ; and before we add to his ill-assorted collection of mental furniture we must arrange in orderly fashion that which he already possesses. Moreover, it is almost impossible to impart successfully any considerable mass of disconnected facts. If the teacher does not indicate the true connections, the student will almost inevitably supply false ones ; or else the facts without connections will be also without interest.

These objections to the so-called " inductive method " are not, however, intended as militating against the object which its advocates strive to attain, viz., to make the student think for himself, nor against the chief means by which they actually attain this object, viz., the use of original problems. Every teacher can and should illustrate, emphasize, and elaborate every step in the study of principles by propounding problems. Sumner's collection of problems, or the more recent collections of Taylor or of the University of Chicago, may profitably be used to supplement those which every good teacher will readily invent for himself from the suggestions of the text, of current newspapers, or of students' questions.

What has been said will help explain why greater atten-

PREFACE XI

tion than usual is here paid to certain themes, such as money, bank deposits, accounting, the rate of interest, and the personal distribution of wealth ; as well as why less attention than usual is paid to certain other themes, such as methodology and those obsolete theories like the ''wage fund " theory which (unlike some other obsolete theories) has probably never formed any part of the student's mental stock in trade.

To some critics the abundant use of curves may seem too advanced for an elementary work. But their use is now so common in the advanced treatises to which the student is, if possible, to be led, that their introduction here is but a necessary part of his preparation. The very fact that there is at present no elementary book in which the nature and use of the graphic method has been made clear for the elementary student is a strong argument for its adoption. Moreover, I am persuaded that the "difficulties " in the elementary use of curves are largely imaginary. Every beginner in economics may be assumed to be familiar with latitude and longitude on a map, and perhaps also with the temperature charts in the daily paper. It is a very easy step from these to curves of supply and demand, provided they be used with sufficient frequency and with sufficient system to take lodgment in the student's memory. The student who sees but one diagram in a book will find the initial effort of understanding that diagram scarcely worth while, — not much more worth while than to be taught the use of logarithms without applying them to more than one or two practical examples. As a matter of fact, there are few things which so facilitate the understanding of economic relations at every stage of economic study as the use of diagrams ; and it is believed that, with them, the elementary student can proceed both faster and further in economic analysis than without them.

I have taken so much space to justify those features of this book which will seem new, because many teachers to

Xll PREFACE

whom the first experimental edition was submitted have condemned it at sight as unteachable. I am glad to report, however, that none of the teachers who have actually tested the book in classroom have condemned it. On the contrary, they have been unanimously enthusiastic over its " teachableness," although many of them had begun its use with grave misgivings.

The present (second) experimental edition is a complete revision of the first. A third revision is planned for next year, which will be the first edition to be actually published. In the preface to that edition I shall hope to make adequate acknowledgment of the valuable assistance I have and shall have received from numerous friends and

colleagues.

IRVING FISHER.

August, 191 i.

SUMMARY

Foundation Stones Introduction Capital Income Capital and Income •

Determination of Prices General Prices .

Particular Prices • Rate of Interest .

Principles of Distribution Sources of Income Ownership of Income .

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

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

Chapters XXIII-XXIV Chapters XXV-XXVI

Contents

CHAPTER PAGE

I. Wealth i

II. Property 21

Chapter I

§ i. Definition of Economics and of Wealth

Economics may be most simply defined as the Science of Wealth. It is also known under several other titles, of which the most common is " Political Economy." The purpose of economics is to treat the nature of wealth ; the relation of wealth to human wants, and to the satisfaction of those wants ; the forms of the ownership of wealth ; the modes of its accumulation and dissipation ; the reasons that some people have so much of it and others so little ; and the principles that regulate its exchange and the prices which result from exchange. In a word, everything which concerns wealth in its general sense comes within the scope of economics. It is worth emphasizing at the outset, that the chief purpose of economics is to set forth the relations of wealth to human life and welfare. It is not, however, within the province of economics to study all aspects of human life and welfare, but only such as are connected in some manner with wealth.

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

In the end the student will reach more satisfactory conclusions, if at the beginning he will put aside all thought of such applications, and cease to count himself a free trader or a protectionist, an individualist or a socialist, or, indeed, any other kind of partisan.

We must, then, in the first place, distinguish economic principles from their applications to public problems ; in the second place, we must distinguish those principles from their applications to private problems. Economics does not concern itself with teaching men how to become rich ; nor does a practical skill in the art of becoming rich imply, necessarily, a sound knowledge of economics. Economics, it is true, represents the theory of business ; and business, the practice of economics. But, though they are not in the least conflicting — indeed, to some extent they are mutually helpful — economics and business are nevertheless totally different. The primary requisite of a good business man is to master the detailed facts which concern his own individual operations ; the primary requisite of a good economist is to master the general principles based on business facts. Some of the wildest economic theories have originated among successful financiers. Men who have been trained in Wall Street are often the, most sadly lacking in 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 problems, men take too much for granted.

Our first rule, then, in approaching the study of economics is to take nothing for granted. It is quite as important to be careful in defining familiar terms, such as " prices " and " wages," as in explaining unfamiliar ones, such as " index numbers " and " marginal utility."

The chief purpose of this book is to define clearly the fundamental concepts of economics and to state and prove the fundamental principles of the science. These concepts and

Sec. il WEALTH 3

principles will then serve as a basis for further study. In other books the student will find these concepts and principles applied to problems of public policy, or of business management, or of the economic history of nations. We are not concerned, in this book, with either practical problems or economic history except as they are used occasionally to illustrate the principles under consideration.

Wealth having been designated as the subject matter of economics, the question at once arises : What is wealth ? By wealth is meant material objects owned by human beings {and external to the owner). 1 Any one such object is an "article of wealth," or an "instrument." Thus a locomotive is an article of wealth or an instrument. Other examples are an automobile, a horse, a house, a lot, a chair, a book, a hat, a loaf of bread, or a coin.

1 Every writer may define a term as he pleases, except that he should justify his definition in one or both of two ways : (1) by showing that it accords with common practice; and (2) by showing that it leads to useful results. The above definition of wealth meets both of these requirements. It agrees substantially with the usual understanding of business men, and it leads to a consistent and systematic development of the science.

Some economists add to the definition that an object, to be wealth, must be useful. But utility is really implied in ownership. Unless a thing is useful, no one would care to own it. Nothing is owned which is not useful in the sense that its owner hopes to receive benefits from it, and it is only in this sense that utility is to be employed as a technical term in economics. Therefore, as utility is already implied in ownership, it need not be mentioned separately in our definition. Other writers, while including in their definition the idea of utility, omit the idea of ownership and simply define wealth as " useful material objects." But this definition includes too many "objects." Rain, wind, clouds, the Gulf Stream, the heavenly bodies, especially the sun, from which we derive light, heat, and energy, are all useful and material, but are not appropriated, and so are not wealth as commonly understood. Even more objectionable are those 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 " wealth," involves a species of triple counting. A railway, a railway share, and a railway trip are not three separate items of wealth ; they are respectively wealth, a title to that wealth, and a service of that wealth.

In common parlance " wealth " is often opposed to " poverty," the contrast being between a large amount of wealth and a small amount; precisely as in common 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 some degree of heat, so in economics a poor man is regarded as having some degree of wealth.

Wealth, then, includes all those parts of the material universe that have been appropriated to the uses of mankind. It includes the food we eat, the clothing we wear, the dwellings we inhabit, the merchandise we buy and sell, the tools, machinery, factories, ships, and railways, by which other wealth is manufactured and transported, the land on which we live and work, and the gold by which we buy and sell other wealth. It does not include the sun, moon, or stars, for no man owns them. It is confined to this little planet of ours, and only to certain parts of that ; namely, the appropriated sections of its surface and the appropriated objects upon that surface.

§ 2. Distinction between Money and Wealth

One of the first warnings needed by the beginner is to avoid the common confusion of wealth with money. Few persons, to be sure, are so naive as to imagine that a millionaire is one who has a million dollars of actual money stored away ; but, because money is that particular kind of wealth in terms of which the value of all other kinds of wealth is measured, it is sometimes forgotten that not all wealth is money.

We are not yet ready for an extended study of money, nor even for a definition of money, but as a warning we shall here enumerate a few of the most common fallacies which beset the subject. The nature of these fallacies the student will understand more fully after they have received a more extended treatment.

First, among these fallacies, is the assertion that if one man " makes money," some one else must " lose " it, since there is only a fixed stock of money in the world, and it seems clear that " whatever money the money-maker gets must come out of some one else's pocket." The flaw in this reasoning is the assumption that gains in trade are simply gains in actual money, so that in every business transaction only one party can be the gainer. If this were true, we might as well substitute gambling for business and for manufacturing ; for in gambling the number of dollars won is equal to the number of dollars lost. As a matter of fact, however, it is not in order to obtain money that people engage in trade, but in order to obtain what money will buy, and that is precisely what both parties to a normal transaction eventually do obtain.

Again, some persons have tried to prove that the people of the earth can never pay off their debts because these debts amount to more than the existing supply of money. " If we owe money," it is argued, " we can't pay more money than there is." This assertion sounds plausible, but a moment's thought will show that the same money can be, and in fact is, paid over and over again in discharge of several different debts ; not to mention that some debts are paid without the use of money at all.

A few years ago at a meeting of the American Economic Association a Western banker expressed the opinion that the total amount of money in the world ought to be equivalent to the total wealth of the world; else, he suggested, people would never be able to pay their debts. He explained that in the United States there were twenty dollars of wealth for every dollar of money ; and he inferred that therefore there was but one chance in twenty of a debtor's paying his debts. " I will give five dollars," he said, " to any one who can disprove that statement." When no one accepted the challenge, a wag suggested that it was because there was but one chance in twenty of getting the promised five dollars !

The attempt to equalize money and wealth by increasing money twenty fold would, as we shall see later, prove absolutely futile. The moment we increased the amount of money, the money value of all other forms of wealth would rise, and there would, therefore, still be a discrepancy between the amount of money and the amount of wealth.

A very persistent money fallacy is the notion that sometimes there is not enough money to do the world's business, and that unless at such times the quantity of money is increased, the wheels of business will either stop or slacken their pace. The fact is, however, that any quantity of money, whether large or small, will do the world's business as soon as the level of prices is properly adjusted to that quantity. In a recent article on this subject, an editor of a popular magazine put this fallacy into the very title : " There is not enough money in the world to do the world's work." He says, " The money is not coming out of the ground fast enough to meet the new conditions of life." In reality, money is coming out of the ground faster than the "new conditions " require, with the consequent result of raising prices. This writer contends that the panic of 1907 was due to a scarcity of money, whereas, if the principles to be explained in this book are correct, the panic was due to the fact that gold had been pouring out of the mines for so many years and in such large quantities that speculative tendencies were encouraged and 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 recent meeting of the American Economic Association a very intelligent gentleman asserted that the railways of this country could never have been built in the early fifties had it not been for the lucky discovery of gold in California in

1849, which provided the " means by which we could pay for the construction of the railways." He overlooked the fact that the world does not get its wealth by buying it. One person may buy from another; but the world as a whole does not buy wealth, for the simple reason that there would be no one to buy it from. The world gets its railways, not by buying them, but by building them. What provides our railways is not the gold mines, but the iron mines. Even though there were not. a single cent of money in the world, it would still be possible to have railways. The gold of California enriched those who discovered it, because it enabled them to buy wealth of others ; but it did not provide the world with railways any more than Robinson Crusoe's discovery of money in the ship provided him with food. If money could make the world rich, we should not need to wait for gold discoveries. We could make paper money. This, in fact, has often been tried. The French people once thought they were going to get rich by having the government print unlimited quantities of paper money. Austria, Italy, Argentina, Japan, as well as many other countries, including the American colonies, and the United States, have tried the same experiment with the same results — no real increase in wealth, but simply an increase in the amount of money to be exchanged for wealth.

The idea that money is the essence of wealth was one of the ideas which gave rise to a set of doctrines and practices, called Colbertism or Mercantilism, the earliest so-called "school " of political economy. Colbert was a distinguished minister under Louis XIV of France in the seventeenth century, and a firm believer in the theory that, in order to be wealthy, a nation must have an abundance of money. His theory became known as Mercantilism because it 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, in trade between nations, as in that between individuals, both parties may gain in an exchange transaction ; but the mercantilistic 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 reasons for a protective tariff, but the old fallacious reason still appeals to the multitude. They continue to think that by putting up a high tariff so that people are prevented from spending money abroad and are compelled to keep it at home, the country will in some way be made richer.

Money fallacies of the kinds we have described must be carefully avoided by the student. He should realize that no technical term, such as money, can be used as a basis of reasoning without a carefully formulated definition. All catch phrases should be avoided. Especially should the student be on his guard against every proposition concerning money. " Making money," for instance, is a catch phrase used without any definition. Properly speaking, nobody can "make" money except the man in the mint. The rest of us may gain wealth, but, unless we are counterfeiters, we cannot literally " make " money.

§ 3. Classification of Wealth

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

Sec. 3]

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

It will be seen, however, that the definition of wealth which has been adopted excludes free human beings. It was in order to exclude free human beings from the category of wealth that the phrase " external to the owner " was inserted in the definition. Slaves are wealth, for they are external to their owner ; but freemen are not wealth. 1

There are of course many admissible ways of classifying wealth. That which follows is intended to exhibit the principal groups into which wealth most naturally falls. It is advisable that the student construct other classifications for himself.

Real Estate

Commodities

Land

Land improvements

Raw materials

{Productive land Building land Ways of transit

Buildings , Improvements

on highways Miscellaneous

I Mineral Agricultural Manufactured

Finished products j Durao™^

1 Logically it would be permissible to omit the phrase "external to the owner " in the definition of wealth, and thus include freemen as wealth ; but it seems preferable in a textbook to make our definitions accord with ordinary usage ; and in ordinary usage freemen are not called wealth.

IO ELEMENTARY PRINCIPLES OF ECONOMICS [Chap. I

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

§4. Measurement of Wealth

Having seen what wealth is and what it is not, and having classified it roughly, we shall next examine separately its two essential attributes, materiality and ownership, devoting the remainder of this chapter to the first of these.