theory of the subject, upon which I was brought up and
which dominates the economic thought, both practical and theoretical, of the
governing and academic classes of this generation, as it has for a hundred years
past. I shall argue that the postulates of the classical theory are applicable
to a special case only and not to the general case, the situation which it
assumes being a limiting point of the possible positions of equilibrium.
Moreover, the characteristics of the special case assumed by the classical
theory happen not to be those of the economic society which we actually live,
with the result that its teaching is misleading and disastrous if we attempt to
apply it to the facts of experience.
The General Theory of Employment, Interest and Money by John Maynard Keynes
@§ Chapter 2
The Postulates of the Classical Economics
MOST treatises on the theory of value and production are primarily
concerned with the distribution of a given volume of employed resources
between different uses and with the conditions which, assuming the employment of
this quantity of resources, determine their relative rewards and the relative
values of their products.{N-ch02-1}[1]
The question, also, of the volume of the available resources, in the
sense of the size of the employable population, the extent of natural wealth and
the accumulated capital equipment, has often been treated descriptively. But the
pure theory of what determines the actual employment of the available
resources has seldom been examined in great detail. To say that it has not been
examined at all would, of course, be absurd. For every discussion concerning
fluctuations of employment, of which there have been many, has been concerned
with it. I mean, not that the topic has been overlooked, but that the
fundamental theory underlying it has been deemed so simple and obvious that it
has received, at the most, a bare mention.{N-ch02-2}[2]
I
The classical theory of employment — supposedly simple and obvious — has been
based. I think, on two fundamental postulates, though practically without
discussion, namely:
i. The wage is equal to the marginal product of labour
That is to say, the wage of an employed person is equal to the value which
would be lost if employment were to be reduced by one unit (after deducting any
other costs which this reduction of output would avoid); subject, however, to
the qualification that the equality may be disturbed, in accordance with certain
principles, if competition and markets are imperfect.
ii. The utility of the wage when a given volume of labour is employed is
equal to the marginal disutility of that amount of employment.
That is to say, the real wage of an employed person is that which is just
sufficient (in the estimation of the employed persons themselves) to induce the
volume of labour actually employed to be forthcoming; subject to the
qualification that the equality for each individual unit of labour may be
disturbed by combination between employable units analogous to the imperfections
of competition which qualify the first postulate. Disutility must be here
understood to cover every kind of reason which might lead a man, or a body of
men, to withhold their labour rather than accept a wage which had to them a
utility below a certain minimum.
This postulate is compatible with what may be called ‘frictional′
unemployment. For a realistic interpretation of it legitimately allows for
various inexactnesses of adjustment which stand in the way of continuous full
employment: for example, unemployment due to a temporary want of balance between
the relative quantities of specialised resources as a result of miscalculation
or intermittent demand; or to time-lags consequent on unforeseen changes; or to
the fact that the change-over from one employment to another cannot be effected
without a certain delay, so that there will always exist in a non-static society
a proportion of resources unemployed ‘between jobs′. In addition to ‘frictional′
unemployment, the postulate is also compatible with ‘voluntary′ unemployment due
to the refusal or inability of a unit of labour, as a result of legislation or
social practices or of combination for collective bargaining or of slow response
to change or of mere human obstinacy, to accept a reward corresponding to the
value of the product attributable to its marginal productivity. But these two
categories of ‘frictional′ unemployment and ‘voluntary′ unemployment are
comprehensive. The classical postulates do not admit of the possibility of the
third category, which I shall define below as ‘involuntary′ unemployment.
Subject to these qualifications, the volume of employed resources is duly
determined, according to the classical theory, by the two postulates. The first
gives us the demand schedule for employment, the second gives us the supply
schedule; and the amount of employment is fixed at the point where the utility
of the marginal product balances the disutility of the marginal employment.
It would follow from this that there are only four possible means of
increasing employment:
(a) An improvement in
organisation or in foresight which diminishes ‘frictional′ unemployment;
(b) a decrease in the
marginal disutility of labour, as expressed by the real wage for which.
additional labour is available, so as to diminish ‘voluntary′ unemployment;
(c) an increase in the
marginal physical productivity of labour in the wage-goods industries (to use
Professor Pigou′s convenient term for goods upon the price of which the utility
of the money-wage depends);
(d) an increase in the
price of non-wage-goods compared with, the price of wage-goods, associated with
a shift in the expenditure of non-wage-earners from wage-goods to
non-wage-goods.
This, to the best of my understanding, is the stance of Professor Pigou′s
Theory of Unemployment — the only detailed account of the classical
theory of employment which exists.{N-ch02-3}[3]
II
Is it true that the above categories are comprehensive in view of the fact
that the population generally is seldom doing as much work as it would like to
do on the basis of the current wage? For, admittedly, more labour would, as a
rule, be forthcoming at the existing money-wage if it were demanded.{N-ch02-4}[4] The classical school reconcile this phenomenon with
their second postulate by arguing that, while the demand for labour at the
existing money-wage may be satisfied before everyone willing to work at this
wage is employed, this situation is due to an open or tacit agreement amongst
workers not to work for less, and that if labour as a whole would agree to a
reduction of money-wages more employment would be forthcoming. If this is the
case, such unemployment, though apparently involuntary, is not strictly so, and
ought to be included under the above category of ‘voluntary′ unemployment due to
the effects of collective bargaining, etc.
This calls for two observations, the first of which relates to the actual
attitude of workers towards real wages and money-wages respectively and is not
theoretically fundamental, but the second of which is fundamental.
Let us assume, for the moment, that labour is not prepared to work for a
lower money-wage and that a reduction in the existing level of money-wages would
lead, through strikes or otherwise, to a withdrawal from the labour market of
labour which is now employed. Does it follow from this that the existing level
of real wages accurately measures the marginal disutility of labour? Not
necessarily. For, although a reduction in the existing money-wage would lead to
a withdrawal of labour, it does not follow that a fall in the value of the
existing money-wage in terms of wage-goods would do so, if it were due to a rise
in the price of the latter. In other words, it may be the case that within a
certain range the demand of labour is for a minimum money-wage and not for a
minimum real wage. The classical school have tacitly assumed that this would
involve no significant change in their theory. But this is not so. For if the
supply of labour is not a function of real wages as its sole variable, their
argument breaks down entirely and leaves the question of what the actual
employment will be quite indeterminate.{N-ch02-5}[5] They do not seem to have realised that, unless the
supply of labour is a function of real wages alone, their supply curve for
labour will shift bodily with every movement of prices. Thus their method is
tied up with their very special assumptions, and cannot be adapted to deal with
the more general case.
Now ordinary experience tells us, beyond doubt, that a situation where labour
stipulates (within limits) for a money-wage rather than a real wage, so far from
being a mere possibility, is the normal case. Whilst workers will usually resist
a reduction of money-wages, it is not their practice to withdraw their labour
whenever there is a rise in the price of wage-goods. It is sometimes said that
it would be illogical for labour to resist a reduction of money-wages but not to
resist a reduction of real wages. For reasons given below (section III), this
might not be so illogical as it appears at first; and, as we shall see later,
fortunately so. But, whether logical or illogical, experience shows that this is
how labour in fact behaves.
Moreover, the contention that the unemployment which characterises a
depression is due to a refusal by labour to accept a reduction of money-wages is
not clearly supported by the facts. It is not very plausible to assert that
unemployment in the United States in 1932 was due either to labour obstinately
refusing to accept a reduction of money-wages or to its obstinately demanding a
real wage beyond what the productivity of the economic machine was capable of
furnishing. Wide variations are experienced in the volume of employment without
any apparent change either in the minimum real demands of labour or in its
productivity. Labour is not more truculent in the depression than in the boom —
far from it. Nor is its physical productivity less. These facts from experience
are a prima facie ground for questioning the adequacy of the classical
analysis.
It would be interesting to see the results of a statistical enquiry into the
actual relationship between changes in money-wages and changes in real wages. In
the case of a change peculiar to a particular industry one would expect the
change in real wages to be in the same direction as the change in money-wages.
But in the case of changes in the general level of wages, it will be found, I
think, that the change in real wages associated with a change in money-wages, so
far from being usually in the same direction, is almost always in the opposite
direction. When money-wages are rising, that is to say, it will be found that
real wages are falling; and when money-wages are falling, real wages are rising.
This is because, in the short period, falling money-wages and rising real wages
are each, for independent reasons, likely to accompany decreasing employment;
labour being readier to accept wage-cuts when employment is falling off, yet
real wages inevitably rising in the same circumstances on account of the
increasing marginal return to a given capital equipment when output is
diminished.
If, indeed, it were true that the existing real wage is a minimum below which
more labour than is now employed will not be forthcoming in any circumstances,
involuntary unemployment, apart from frictional unemployment, would be
non-existent. But to suppose that this is invariably the case would be absurd.
For more labour than is at present employed is usually available at the existing
money-wage, even though the price of wage-goods is rising and, consequently, the
real wage falling. If this is true, the wage-goods equivalent of the existing
money-wage is not an accurate indication of the marginal disutility of labour,
and the second postulate does not hold good.
But there is a more fundamental objection. The second postulate flows from
the idea that the real wages of labour depend on the wage bargains which labour
makes with the entrepreneurs. It is admitted, of course, that the bargains are
actually made in terms of money, and even that the real wages acceptable to
labour are not altogether independent of what the corresponding money-wage
happens to be. Nevertheless it is the money-wage thus arrived at which is held
to determine the real wage. Thus the classical theory assumes that it is always
open to labour to reduce its real wage by accepting a reduction in its
money-wage. The postulate that there is a tendency for the real wage to come to
equality with the marginal disutility of labour clearly presumes that labour
itself is in a position to decide the real wage for which it works, though not
the quantity of employment forthcoming at this wage.
The traditional theory maintains, in short, that the wage bargains
between the entrepreneurs and the workers determine the real wage; so that,
assuming free competition amongst employers and no restrictive combination
amongst workers, the latter can, if they wish, bring their real wages into
conformity with the marginal disutility of the amount of employment offered by
the employers at that wage. If this is not true, then there is no longer any
reason to expect a tendency towards equality between the real wage and the
marginal disutility of labour.
The classical conclusions are intended, it must be remembered, to apply to
the whole body of labour and do not mean merely that a single individual can get
employment by accepting a cut in money-wages which his fellows refuse. They are
supposed to be equally applicable to a closed system as to an open system, and
are not dependent on the characteristics of an open system or on the effects of
a reduction of money-wages in a single country on its foreign trade, which lie,
of course, entirely outside the field of this discussion. Nor are they based on
indirect effects due to a lower wages-bill in terms of money having certain
reactions on the banking system and the state of credit, effects which we shall
examine in detail in Chapter 19. They are based on the belief that in a closed
system a reduction in the general level of money-wages will be accompanied, at
any rate in the short period and subject only to minor qualifications, by some,
though not always a proportionate, reduction in real wages.
Now the assumption that the general level of real wages depends on the
money-wage bargains between the employers and the workers is not obviously true.
Indeed it is strange that so little attempt should have been made to prove or to
refute it. For it is far from being consistent with the general tenor of the
classical theory, which has taught us to believe that prices are governed by
marginal prime cost in terms of money and that money-wages largely govern
marginal prime cost. Thus if money-wages change, one would have expected the
classical school to argue that prices would change in almost the same
proportion, leaving the real wage and the level of unemployment practically the
same as before, any small gain or loss to labour being at the expense or profit
of other elements of marginal cost which have been left unaltered.{N-ch02-6}[6] They seem, however, to have been diverted from this
line of thought, partly by the settled conviction that labour is in a position
to determine its own real wage and partly, perhaps, by preoccupation with the
idea that prices depend on the quantity of money. And the belief in the
proposition that labour is always in a position to determine its own real wage,
once adopted, has been maintained by its being confused with the proposition
that labour is always in a position to determine what real wage shall correspond
to full employment, i.e. the maximum quantity of employment which is
compatible with a given real wage.
To sum up: there are two objections to the second postulate of the classical
theory. The first relates to the actual behaviour of labour. A fall in real
wages due to a rise in prices, with money-wages unaltered, does not, as a rule,
cause the supply of available labour on offer at the current wage to fall below
the amount actually employed prior to the rise of prices. To suppose that it
does is to suppose that all those who are now unemployed though willing to work
at the current wage will withdraw the offer of their labour in the event of even
a small rise in the cost of living. Yet this strange supposition apparently
underlies Professor Pigou′s Theory of Unemployment,{N-ch02-7}[7] and it is what all members of the orthodox school are
tacitly assuming.
But the other, more fundamental, objection, which we shall develop in the
ensuing chapters, flows from our disputing the assumption that the general level
of real wages is directly determined by the character of the wage bargain. In
assuming that the wage bargain determines the real wage the classical school
have slipt in an illicit assumption. For there may be no method
available to labour as a whole whereby it can bring the general level of
money-wages into conformity with the marginal disutility of the current volume
of employment. There may exist no expedient by which labour as a whole can
reduce its real wage to a given figure by making revised money
bargains with the entrepreneurs. This will be our contention. We shall endeavour
to show that primarily it is certain other forces which determine the general
level of real wages. The attempt to elucidate this problem will be one of our
main themes. We shall argue that there has been a fundamental misunderstanding
of how in this respect the economy in which we live actually works.
III
Though the struggle over money-wages between individuals and groups is often
believed to determine the general level of real wages, it is, in fact, concerned
with a different object. Since there is imperfect mobility of labour, and wages
do not tend to an exact equality of net advantage in different occupations, any
individual or group of individuals, who consent to a reduction of money-wages
relatively to others, will suffer a relative reduction in real wages,
which is a sufficient justification for them to resist it. On the other hand it
would be impracticable to resist every reduction of real wages, due to a change
in the purchasing-power of money which affects all workers alike; and in fact
reductions of real wages arising in this way are not, as a rule, resisted unless
they proceed to an extreme degree. Moreover, a resistance to reductions in
money-wages applying to particular industries does not raise the same
insuperable bar to an increase in aggregate employment which would result from a
similar resistance to every reduction in real wages.
In other words, the struggle about money-wages primarily affects the
distribution of the aggregate real wage between different
labour-groups, and not its average amount per unit of employment, which depends,
as we shall see, on a different set of forces. The effect of combination on the
part of a group of workers is to protect their relative real wage. The
general level of real wages depends on the other forces of the economic
system.
Thus it is fortunate that the workers, though unconsciously, are
instinctively more reasonable economists than the classical school, inasmuch as
they resist reductions of money-wages, which are seldom or never of an all-round
character, even though the existing real equivalent of these wages exceeds the
marginal disutility of the existing employment; whereas they do not resist
reductions of real wages, which are associated with increases in aggregate
employment and leave relative money-wages unchanged, unless the reduction
proceeds so far as to threaten a reduction of the real wage below the marginal
disutility of the existing volume of employment. Every trade union will put up
some resistance to a cut in money-wages, however small. But since no trade union
would dream of striking on every occasion of a rise in the cost of living, they
do not raise the obstacle to any increase in aggregate employment which is
attributed to them by the classical school.
IV
We must now define the third category of unemployment, namely ‘involuntary′
unemployment in the strict sense, the possibility of which the classical theory
does not admit.
Clearly we do not mean by ‘involuntary′ unemployment the mere existence of an
unexhausted capacity to work. An eight-hour day does not constitute unemployment
because it is not beyond human capacity to work ten hours. Nor should we regard
as ‘involuntary′ unemployment the withdrawal of their labour by a body of
workers because they do not choose to work for less than a certain real reward.
Furthermore, it will be convenient to exclude ‘frictional′ unemployment from our
definition of ‘involuntary′ unemployment. My definition is, therefore, as
follows: Men are involuntarily unemployed if, in the event of a small rise
in the price of wage-goods relatively to the money-wage, both the aggregate
supply of labour willing to work for the current money-wage and the aggregate
demand for it at that wage would be greater than the existing volume of
employment. An alternative definition, which amounts, however, to the same
thing, will be given in the next chapter (p. 26 below).
It follows from this definition that the equality of the real wage to the
marginal disutility of employment presupposed by the second postulate,
realistically interpreted, corresponds to the absence of ‘involuntary′
unemployment. This state of affairs we shall describe as ‘full′ employment, both
‘frictional′ and ‘voluntary′ unemployment being consistent with ‘full”
employment thus defined. This fits in, we shall find, with other characteristics
of the classical theory, which is best regarded as a theory of distribution in
conditions of full employment. So long as the classical postulates hold good,
unemployment, which is in the above sense involuntary, cannot occur. Apparent
unemployment must, therefore, be the result either of temporary loss of work of
the ‘between jobs′ type or of intermittent demand for highly specialised
resources or of the effect of a trade union ‘closed shop′ on the employment of
free labour. Thus writers in the classical tradition, overlooking the special
assumption underlying their theory, have been driven inevitably to the
conclusion, perfectly logical on their assumption, that apparent unemployment
(apart from the admitted exceptions) must be due at bottom to a refusal by the
unemployed factors to accept a reward which corresponds to their marginal
productivity. A classical economist may sympathise with labour in refusing to
accept a cut in its money-wage, and he will admit that it may not be wise to
make it to meet conditions which are temporary; but scientific integrity forces
him to declare that this refusal is, nevertheless, at the bottom of the
trouble.
Obviously, however, if the classical theory is only applicable to the case of
full employment, it is fallacious to apply it to the problems of involuntary
unemployment — if there be such a thing (and who will deny it?). The classical
theorists resemble Euclidean geometers in a non-Euclidean world who, discovering
that in experience straight lines apparently parallel often meet, rebuke the
lines for not keeping straight as the only remedy for the unfortunate collisions
which are occurring. Yet, in truth, there is no remedy except to throw over the
axiom of parallels and to work out a non-Euclidean geometry. Something similar
is required today in economics. We need to throw over the second postulate of
the classical doctrine and to work out the behaviour of a system in which
involuntary unemployment in the strict sense is possible.
V
In emphasising our point of departure from the classical system, we must not
overlook an important point of agreement. For we shall maintain the first
postulate as heretofore, subject only to the same qualifications as in the
classical theory; and we must pause, for a moment, to consider what this
involves.
It means that, with a given organisation, equipment and technique, real wages
and the volume of output (and hence of employment) are uniquely correlated, so
that, in general, an increase in employment can only occur to the accompaniment
of a decline in the rate of real wages. Thus I am not disputing this vital fact
which the classical economists have (rightly) asserted as indefeasible. In a
given state of organisation, equipment and technique, the real wage earned by a
unit of labour has a unique (inverse) correlation with the volume of employment.
Thus if employment increases, then, in the short period, the reward per
unit of labour in terms of wage-goods must, in general, decline and profits
increase.{N-ch02-8}[8] This is simply the obverse of the familiar proposition
that industry is normally working subject to decreasing returns in the short
period during which equipment etc. is assumed to be constant; so that the
marginal product in the wage-good industries (which governs real wages)
necessarily diminishes as employment is increased. So long, indeed, as this
proposition holds, any means of increasing employment must lead at the
same time to a diminution of the marginal product and hence of the rate of wages
measured in terms of this product.
But when we have thrown over the second postulate, a decline in employment,
although necessarily associated with labour′s receiving a wage equal in
value to a larger quantity of wage-goods, is not necessarily due to labour′s
demanding a larger quantity of wage-goods; and a willingness on the
part of labour to accept lower money-wages is not necessarily a remedy for
unemployment. The theory of wages in relation to employment, to which we are
here leading up, cannot be fully elucidated, however, until Chapter 19 and its
Appendix have been reached.
VI
From the time of Say and Ricardo the classical economists have taught that
supply creates its own demand; meaning by this in some significant, but not
clearly defined, sense that the whole of the costs of production must
necessarily be spent in the aggregate, directly or indirectly, on purchasing the
product.
In J. S. Mill′s Principles of Political Economy the doctrine is
expressly set forth:
What constitutes the means of payment for commodities is simply
commodities. Each person′s means of paying for the productions of other people
consist of those which he himself possesses. All sellers are inevitably, and by
the meaning of the word, buyers. Could we suddenly double the productive powers
of the country, we should double the supply of commodities in every market; but
we should, by the same stroke, double the purchasing power. Everybody would
bring a double demand as well as supply; everybody would be able to buy twice as
much, because every one would have twice as much to offer in exchange.
[Principles of Political Economy, Book III, Chap. xiv. § 2.]
As a corollary of the same doctrine, it has been supposed that any individual
act of abstaining from consumption necessarily leads to, and amounts to the same
thing as, causing the labour and commodities thus released from supplying
consumption to be invested in the production of capital wealth. The following
passage from Marshall′s Pure Theory of Domestic Values{N-ch02-9}[9] illustrates the traditional approach:
The whole of a man′s income is expended in the purchase of
services and of commodities. It is indeed commonly said that a man spends some
portion of his income and saves another. But it is a familiar economic axiom
that a man purchases labour and commodities with that portion of his income
which he saves just as much as he does with that he is said to spend. He is said
to spend when he seeks to obtain present enjoyment from the services and
commodities which he purchases. He is said to save when he causes the labour and
the commodities which he purchases to be devoted to the production of wealth
from which he expects to derive the means of enjoyment in the future.
It is true that it would not be easy to quote comparable passages from
Marshall′s later work{N-ch02-10}[10] or from Edgeworth or Professor Pigou. The doctrine is
never stated today in this crude form. Nevertheless it still underlies the whole
classical theory, which would collapse without it. Contemporary economists, who
might hesitate to agree with Mill, do not hesitate to accept conclusions which
require Mill′s doctrine as their premise. The conviction, which runs, for
example, through almost all Professor Pigou′s work, that money makes no real
difference except frictionally and that the theory of production and employment
can be worked out (like Mill′s) as being based on ‘real′ exchanges with money
introduced perfunctorily in a later chapter, is the modern version of the
classical tradition. Contemporary thought is still deeply steeped in the notion
that if people do not spend their money in one way they will spend it in
another.{N-ch02-11}[11] Post-war economists seldom, indeed, succeed in
maintaining this standpoint consistently; for their thought today is
too much permeated with the contrary tendency and with facts of experience too
obviously inconsistent with their former view.{N-ch02-12}[12] But they have not drawn sufficiently far-reaching
consequences; and have not revised their fundamental theory.
In the first instance, these conclusions may have been applied to the kind of
economy in which we actually live by false analogy from some kind of
non-exchange Robinson Crusoe economy, in which the income which individuals
consume or retain as a result of their productive activity is, actually and
exclusively, the output in specie of that activity. But, apart from
this, the conclusion that the costs of output are always covered in the
aggregate by the sale-proceeds resulting from demand, has great plausibility,
because it is difficult to distinguish it from another, similar-looking
proposition which is indubitable, namely that income derived in the aggregate by
all the elements in the community concerned in a productive activity necessarily
has a value exactly equal to the value of the output.
Similarly it is natural to suppose that the act of an individual, by which he
enriches himself without apparently taking anything from anyone else, must also
enrich the community as a whole; so that (as in the passage just quoted from
Marshall) an act of individual saving inevitably leads to a parallel act of
investment. For, once more, it is indubitable that the sum of the net increments
of the wealth of individuals must be exactly equal to the aggregate net
increment of the wealth of the community.
Those who think in this way are deceived, nevertheless, by an optical
illusion, which makes two essentially different activities appear to be the
same. They are fallaciously supposing that there is a nexus which unites
decisions to abstain from present consumption with decisions to provide for
future consumption; whereas the motives which determine the latter are not
linked in any simple way with the motives which determine the former.
It is, then, the assumption of equality between the demand price of output as
a whole and its supply price which is to be regarded as the classical theory′s
‘axiom of parallels′. Granted this, all the rest follows — the social advantages
of private and national thrift, the traditional attitude towards the rate of
interest, the classical theory of unemployment, the quantity theory of money,
the unqualified advantages of laissez-faire in respect of foreign trade
and much else which we shall have to question.
VII
At different points in this chapter we have made the classical theory to
depend in succession on the assumptions:
(1) that the real wage is equal
to the marginal disutility of the existing employment;
(2) that there is no such thing
as involuntary unemployment in the strict sense;
(3) that supply creates its own
demand in the sense that the aggregate demand price is equal to the aggregate
supply price for all levels of output and employment.
These three assumptions, however, all amount to the same thing in the sense
that they all stand and fall together, any one of them logically involving the
other two.
The General Theory of Employment, Interest and Money by John Maynard Keynes
@§ Chapter 3
The Principle of Effective Demand
I
WE need, to start with, a few terms which will be defined precisely
later. In a given state of technique, resources and costs, the employment of a
given volume of labour by an entrepreneur involves him in two kinds of expense:
first of all, the amounts which he pays out to the factors of production
(exclusive of other entrepreneurs) for their current services, which we shall
call the factor cost of the employment in question; and secondly, the
amounts which he pays out to other entrepreneurs for what he has to purchase
from them together with the sacrifice which he incurs by employing the equipment
instead of leaving it idle, which we shall call the user cost of the
employment in question.{N-ch03-1}[1] The excess of the value of the resulting output over
the sum of its factor cost and its user cost is the profit or, it we shall call
it, the income of the entrepreneur. The factor cost is, of course, the
same thing, looked at from the point of view of the entrepreneur, as what the
factors of production regard as their income. Thus the factor cost and the
entrepreneur′s profit make up, between them, what we shall define as the
total income resulting from the employment given by the entrepreneur.
The entrepreneur′s profit thus defined is, as it should be, the quantity which
he endeavours to maximise when he is deciding what amount, of employment to
offer. It is sometimes convenient, when we are looking at it from the
entrepreneur′s standpoint, to call the aggregate income (i.e. factor
cost plus profit) resulting from a given amount of employment the
proceeds of that employment. On the other hand, the aggregate supply
price{N-ch03-2}[2] of the output of a given amount of employment is the
expectation of proceeds which will just make it worth the while of the
entrepreneurs to give that employment.{N-ch03-3}[3]
It follows that in a given situation of technique, resources and factor cost
per unit of employment, the amount of employment, both in each individual firm
and industry and in the aggregate, depends on the amount of the proceeds which
the entrepreneurs expect to receive from the corresponding output.{N-ch03-4}[4] For entrepreneurs will endeavour to fix the amount of
employment at the level which they expect to maximise the excess of the proceeds
over the factor cost.
Let Z be the aggregate supply price of the output from employing
N men, the relationship between Z and N being written
Z = φ(N), which can be called the Aggregate Supply
Function.{N-ch03-5}[5] Similarly, let D be the proceeds which
entrepreneurs expect to receive from the employment of N men, the
relationship between D and N being written D =
f(N), which can be called the Aggregate Demand
Function.
Now if for a given value of N the expected proceeds are greater than the
aggregate supply price, i.e. if D is greater than Z, there will be an
incentive to entrepreneurs to increase employment beyond N and, if necessary, to
raise costs by competing with one another for the factors of production, up to
the value of N for which Z has become equal to D. Thus the volume of employment
is given by the point of intersection between the aggregate demand function and
the aggregate supply function; for it is at this point that the entrepreneurs′
expectation of profits will be maximised. The value of D at the point of the
aggregate demand function, where it is intersected by the aggregate supply
function, will be called the effective demand. Since this is the
substance of the General Theory of Employment, which it will be our object to
expound, the succeeding chapters will be largely occupied with examining the
various factors upon which these two functions depend.
The classical doctrine, on the other hand, which used to be expressed
categorically in the statement that “Supply creates its own Demand” and
continues to underlie all orthodox economic theory, involves a special
assumption as to the relationship between these two functions. For “Supply
creates its own Demand” must mean that f(N) and φ(N) are equal for all
values of N, i.e. for all levels of output and employment; and that
when there is an increase in Z( = f(N)) corresponding to an increase in
N, D( =f(N)) necessarily increases by the same amount as Z. The
classical theory assumes, in other words, that the aggregate demand price (or
proceeds) always accommodates itself to the aggregate supply price; so that,
whatever the value of N may be, the proceeds D assume a value equal to the
aggregate supply price Z which corresponds to N. That is to say, effective
demand, instead of having a unique equilibrium value, is an infinite range of
values all equally admissible; and the amount of employment is indeterminate
except in so far as the marginal disutility of labour sets an upper limit.
If this were true, competition between entrepreneurs would always lead to an
expansion of employment up to the point at which the supply of output as a whole
ceases to be elastic, i.e. where a further increase in the value of the
effective demand will no longer be accompanied by any increase in output.
Evidently this amounts to the same thing as full employment. In the previous
chapter we have given a definition of full employment in terms of the behaviour
of labour. An alternative, though equivalent, criterion is that at which we have
now arrived, namely a situation, in which aggregate employment is inelastic in
response to an increase in the effective demand for its output. Thus Say′s law,
that the aggregate demand price of output as a whole is equal to its aggregate
supply price for all volumes of output, is equivalent to the proposition that
there is no obstacle to full employment. If, however, this is not the true law
relating the aggregate demand and supply functions, there is a vitally important
chapter of economic theory which remains to be written and without which all
discussions concerning the volume of aggregate employment are futile.
II
A brief summary of the theory of employment to be worked out in the course of
the following chapters may, perhaps, help the reader at this stage, even though
it may not be fully intelligible. The terms involved will be more carefully
defined in due course. In this summary we shall assume that the money-wage and
other factor costs are constant per unit of labour employed. But this
simplification, with which we shall dispense later, is introduced solely to
facilitate the exposition. The essential character of the argument is precisely
the same whether or not money-wages, etc., are liable to change.
The outline of our theory can be expressed as follows. When employment
increases aggregate real income is increased. The psychology of the community is
such that when aggregate real income is increased aggregate consumption is
increased, but not by so much as income. Hence employers would make a loss if
the whole of the increased employment were to be devoted to satisfying the
increased demand for immediate consumption. Thus, to justify any given amount of
employment there must be an amount of current investment sufficient to absorb
the excess of total output over what the community chooses to consume when
employment is at the given level. For unless there is this amount of investment,
the receipts of the entrepreneurs will be less than is required to induce them
to offer the given amount of employment. It follows, therefore, that, given what
we shall call the community′s propensity to consume, the equilibrium level of
employment, i.e. the level at which there is no inducement to employers as a
whole either to expand or to contract employment, will depend on the amount of
current investment. The amount of current investment will depend, in turn, on
what we shall call the inducement to invest; and the inducement to invest will
be found to depend on the relation between the schedule of the marginal
efficiency of capital and the complex of rates of interest on loans of various
maturities and risks.
Thus, given the propensity to consume and the rate of new investment, there
will be only one level of employment consistent with equilibrium; since any
other level will lead to inequality between the aggregate supply price of output
as a whole and its aggregate demand price. This level cannot be greater
than full employment, i.e. the real wage cannot be less than the marginal
disutility of labour. But there is no reason in general for expecting it to be
equal to full employment. The effective demand associated with full
employment is a special case, only realised when the propensity to consume and
the inducement to invest stand in a particular relationship to one another. This
particular relationship, which corresponds to the assumptions of the classical
theory, is in a sense an optimum relationship. But it can only exist when, by
accident or design, current investment provides an amount of demand just equal
to the excess of the aggregate supply price of the output resulting from full
employment over what the community will choose to spend on consumption when it
is fully employed.
This theory can be summed up in the following propositions:
(1) In a given situation of technique, resources and costs, income (both
money-income and real income) depends on the volume of employment N.
(2) The relationship between the community′s income and what it can be
expected to spend on consumption, designated by D1, will
depend on the psychological characteristic of the community, which we shall call
its propensity to consume. That is to say, consumption will depend on
the level of aggregate income and, therefore, on the level of employment N,
except when there is some change in the propensity to consume.
(3) The amount of labour N which the entrepreneurs decide to employ depends
on the sum (D) of two quantities, namely D1, the amount
which the community is expected to spend on consumption, and D2, the amount which it is expected to devote to new investment. D
is what we have called above the effective demand.
(4) Since D1 + D2 = D = φ(N), where φ
is the aggregate supply function, and since, as we have seen in (2) above, D1 is a function of N, which we may write χ(N), depending on the
propensity to consume, it follows that φ(N) - χ(N) = D2.
(5) Hence the volume of employment in equilibrium depends on (i) the
aggregate supply function, φ, (ii) the propensity to consume, χ, and (iii) the
volume of investment, D2. This is the essence of the General
Theory of Employment.
(6) For every value of N there is a corresponding marginal productivity of
labour in the wage-goods industries; and it is this which determines the real
wage. (5) is, therefore, subject to the condition that N cannot exceed
the value which reduces the real wage to equality with the marginal
disutility of labour. This means that not all changes in D are compatible with
our temporary assumption that money-wages are constant. Thus it will be
essential to a full statement of our theory to dispense with this
assumption.
(7) On the classical theory, according to which D = φ(N) for all values of N,
the volume of employment is in neutral equilibrium for all values of N less than
its maximum value; so that the forces of competition between entrepreneurs may
be expected to push it to this maximum value. Only at this point, on the
classical theory, can there be stable equilibrium.
(8) When employment increases, D1will
increase, but not by so much as D; since when our income increases our
consumption increases also, but not by so much. The key to our practical problem
is to be found in this psychological law. For it follows from this that the
greater the volume of employment the greater will be the gap between the
aggregate supply price (Z) of the corresponding output and the sum (D1) which the entrepreneurs can expect to get back out of the
expenditure of consumers. Hence, if there is no change in the propensity to
consume, employment cannot increase, unless at the same time D2 is increasing so as to fill the increasing gap between Z and
D1. Thus — except on the special assumptions of the
classical theory according to which there is some force in operation which, when
employment increases, always causes D2 to increase
sufficiently to fill the widening gap between Z and D1 — the
economic system may find itself in stable equilibrium with N at a level below
full employment, namely at the level given by the intersection of the aggregate
demand function with the aggregate supply function.
Thus the volume of employment is not determined by the marginal disutility of
labour measured in terms of real wages, except in so far as the supply of labour
available at a given real wage sets a maximum level to employment. The
propensity to consume and the rate of new investment determine between them the
volume of employment, and the volume of employment is uniquely related to a
given level of real wages — not the other way round. If the propensity to
consume and the rate of new investment result in a deficient effective demand,
the actual level of employment will fall short of the supply of labour
potentially available at the existing real wage, and the equilibrium real wage
will be greater than the marginal disutility of the equilibrium level
of employment.
This analysis supplies us with an explanation of the paradox of poverty in
the midst of plenty. For the mere existence of an insufficiency of effective
demand may, and often will, bring the increase of employment to a standstill
before a level of full employment has been reached. The insufficiency
of effective demand will inhibit the process of production in spite of the fact
that the marginal product of labour still exceeds in value the marginal
disutility of employment.
Moreover the richer the community, the wider will tend to be the gap between
its actual and its potential production; and therefore the more obvious and
outrageous the defects of the economic system. For a poor community will be
prone to consume by far the greater part of its output, so that a very modest
measure of investment will be sufficient to provide full employment; whereas a
wealthy community will have to discover much ampler opportunities for investment
if the saving propensities of its wealthier members are to be compatible with
the employment of its poorer members. If in a potentially wealthy community the
inducement to invest is weak, then, in spite of its potential wealth, the
working of the principle of effective demand will compel it to reduce its actual
output, until, in spite of its potential wealth, it has become so poor that its
surplus over its consumption is sufficiently diminished to correspond to the
weakness of the inducement to invest.
But worse still. Not only is the marginal propensity to consume{N-ch03-6}[6] weaker in a wealthy community, but, owing to its
accumulation of capital being already larger, the opportunities for further
investment are less attractive unless the rate of interest falls at a
sufficiently rapid rate; which brings us to the theory of the rate of interest
and to the reasons why it does not automatically fall to the appropriate level,
which will occupy Book IV.
Thus the analysis of the Propensity to Consume, the definition of the
Marginal Efficiency of Capital and the theory of the Rate of Interest are the
three main gaps in our existing knowledge which it will be necessary to fill.
When this has been accomplished, we shall find that the Theory of Prices falls
into its proper place as a matter which is subsidiary to our general theory. We
shall discover, however, that Money plays an essential part in our theory of the
Rate of Interest; and we shall attempt to disentangle the peculiar
characteristics of Money which distinguish it from other things.
III
The idea that we can safely neglect the aggregate demand function is
fundamental to the Ricardian economics, which underlie what we have been taught
for more than a century. Malthus, indeed, had vehemently opposed Ricardo′s
doctrine that it was impossible for effective demand to be deficient; but
vainly. For, since Malthus was unable to explain clearly (apart from an appeal
to the facts of common observation) how and why effective demand could be
deficient or excessive, he failed to furnish an alternative construction; and
Ricardo conquered England as completely as the Holy Inquisition conquered Spain.
Not only was his theory accepted by the city, by statesmen and by the academic
world. But controversy ceased; the other point of view completely disappeared;
it ceased to be discussed. The great puzzle of Effective Demand with which
Malthus had wrestled vanished from economic literature. You will not find it
mentioned even once in the whole works of Marshall, Edgeworth and Professor
Pigou, from whose hands the classical theory has received its most mature
embodiment. It could only live on furtively, below the surface, in the
underworlds of Karl Marx, Silvio Gesell or Major Douglas.
The completeness of the Ricardian victory is something of a curiosity and a
mystery. It must have been due to a complex of suitabilities in the doctrine to
the environment into which it was projected. That it reached conclusions quite
different from what the ordinary uninstructed person would expect, added, I
suppose, to its intellectual prestige. That its teaching, translated into
practice, was austere and often unpalatable, lent it virtue. That it was adapted
to carry a vast and consistent logical superstructure, gave it beauty. That it
could explain much social injustice and apparent cruelty as an inevitable
incident in the scheme of progress, and the attempt to change such things as
likely on the whole to do more harm than good, commanded it to authority. That
it afforded a measure of justification to the free activities of the individual
capitalist, attracted to it the support of the dominant social force behind
authority.
But although the doctrine itself has remained unquestioned by orthodox
economists up to a late date, its signal failure for purposes of scientific
prediction has greatly impaired, in the course of time, the prestige of its
practitioners. For professional economists, after Malthus, were apparently
unmoved by the lack of correspondence between the results of their theory and
the facts of observation;— a discrepancy which the ordinary man has not failed
to observe, with the result of his growing unwillingness to accord to economists
that measure of respect which he gives to other groups of scientists whose
theoretical results are confirmed by observation when they are applied to the
facts.
The celebrated optimism of traditional economic theory, which has
led to economists being looked upon as Candides, who, having left this world for
the cultivation of their gardens, teach that all is for the best in the best of
all possible worlds provided we will let well alone, is also to be traced, I
think, to their having neglected to take account of the drag on prosperity which
can be exercised by an insufficiency of effective demand. For there would
obviously be a natural tendency towards the optimum employment of resources in a
Society which was functioning after the manner of the classical postulates. It
may well be that the classical theory represents the way in which we should like
our Economy to behave. But to assume that it actually does so is to assume our
difficulties away.
The General Theory of Employment, Interest and Money by John Maynard Keynes
@§ Chapter 4
The Choice of Units
I
IN this and the next three chapters we shall he occupied with an
attempt to clear up certain perplexities which have no peculiar or exclusive
relevance to the problems which it is our special purpose to examine. Thus these
chapters are in the nature of a digression, which will prevent us for a time
from pursuing our main theme. Their subject-matter is only discussed here
because it does not happen to have been already treated elsewhere in a way which
I find adequate to the needs of my own particular enquiry.
The three perplexities which most impeded my progress in writing this book,
so that I could not express myself conveniently until I had found some solution
for them, are: firstly, the choice of the units of quantity appropriate to the
problems of the economic system as a whole; secondly, the part played by
expectation in economic analysis; and, thirdly, the definition of income.
II
That the units, in terms of which economists commonly work, are
unsatisfactory can be illustrated by the concepts of the National Dividend, the
stock of real capital and the general price-level:—
(i) The National Dividend, as defined by Marshall and Professor Pigou,{N-ch04-1}[1]
measures the volume of current output or real income and not the value of output
or money-income.{N-ch04-2}[2]
Furthermore, it depends, in some sense, on net output; — on the net
addition, that is to say, to the resources of the community available for
consumption or for retention as capital stock, due to the economic activities
and sacrifices of the current period, after allowing for the wastage of the
stock of real capital existing at the commencement of the period. On this basis
an attempt is made to erect a quantitative science. But it is a grave objection
to this definition for such a purpose that the community′s output of goods and
services is a non-homogeneous complex which cannot be measured, strictly
speaking, except in certain special cases, as for example when all the items of
one output are included in the same proportions in another output.
(ii) The difficulty is even greater when, in order to calculate net output,
we try to measure the net addition to capital equipment; for we have to find
some basis for a quantitative comparison between the new items of equipment
produced during the period and the old items which have perished by wastage. In
order to arrive at the net National Dividend, Professor Pigou{N-ch04-3}[3]
deducts such obsolescence, etc., “as may fairly be called ‘normal′; and the
practical test of normality is that the depletion is sufficiently regular to be
foreseen, if not in detail, at least in the large.” But, since this deduction is
not a deduction in terms of money, he is involved in assuming that there can be
a change in physical quantity, although there has been no physical change;
i.e. he is covertly introducing changes in value. Moreover, he
is unable to devise any satisfactory formula{N-ch04-4}[4]
to evaluate new equipment against old when, owing to changes in technique, the
two are not identical. I believe that the concept at which Professor Pigou is
aiming is the right and appropriate concept for economic analysis. But, until a
satisfactory system of units has been adopted, its precise definition is an
impossible task. The problem of comparing one real output with another and of
then calculating net output by setting off new items of equipment against the
wastage of old items presents conundrums which permit, one can confidently say,
of no solution.
(iii) Thirdly, the well-known, but unavoidable, element of vagueness which
admittedly attends the concept of the general price-level makes this term very
unsatisfactory for the purposes of a causal analysis, which ought to be
exact.
Nevertheless these difficulties are rightly regarded as “conundrums.” They
are “purely theoretical” in the sense that they never perplex, or indeed enter
in any way into, business decisions and have no relevance to the causal sequence
of economic events, which are clear-cut and determinate in spite of the
quantitative indeterminacy of these concepts. It is natural, therefore, to
conclude that they not only lack precision but are unnecessary. Obviously our
quantitative analysis must be expressed without using any quantitatively vague
expressions. And, indeed, as soon as one makes the attempt, it becomes clear, as
I hope to show, that one can get on much better without them.
The fact that two incommensurable collections of miscellaneous objects cannot
in themselves provide the material for a quantitative analysis need not, of
course, prevent us from making approximate statistical comparisons, depending on
some broad element of judgment rather than of strict calculation, which may
possess significance and validity within certain limits. But the proper place
for such things as net real output and the general level of prices lies within
the field of historical and statistical description, and their purpose should be
to satisfy historical or social curiosity, a purpose for which perfect precision
— such as our causal analysis requires, whether or not our knowledge of the
actual values of the relevant quantities is complete or exact — is neither usual
nor necessary. To say that net output to-day is greater, but the price-level
lower, than ten years ago or one year ago, is a proposition of a similar
character to the statement that Queen Victoria was a better queen but not a
happier woman than Queen Elizabeth — a proposition not without meaning and not
without interest, but unsuitable as material for the differential calculus. Our
precision will be a mock precision if we try to use such partly vague and
non-quantitative concepts as the basis of a quantitative analysis.
III
On every particular occasion, let it be remembered, an entrepreneur
is concerned with decisions as to the scale on which to work a given capital
equipment; and when we say that the expectation of an increased demand,
i.e. a raising of the aggregate demand function, will lead to an
increase in aggregate output, we really mean that the firms, which own the
capital equipment, will be induced to associate with it a greater aggregate
employment of labour. In the case of an individual firm or industry producing a
homogeneous product we can speak legitimately, if we wish, of increases or
decreases of output. But when we are aggregating the activities of all firms, we
cannot speak accurately except in terms of quantities of employment applied to a
given equipment. The concepts of output as a whole and its price-level are not
required in this context, since we have no need of an absolute measure of
current aggregate output, such as would enable us to compare its amount with the
amount which would result from the association of a different capital equipment
with a different quantity of employment. When, for purposes of description or
rough comparison, we wish to speak of an increase of output, we must rely on the
general presumption that the amount of employment associated with a given
capital equipment will be a satisfactory index of the amount of resultant
output; — the two being presumed to increase and decrease together, though not
in a definite numerical proportion.
In dealing with the theory of employment I propose, therefore, to make use of
only two fundamental units of quantity, namely, quantities of money-value and
quantities of employment. The first of these is strictly homogeneous, and the
second can be made so. For, in so far as different grades and kinds of labour
and salaried assistance enjoy a more or less fixed relative remuneration, the
quantity of employment can be sufficiently defined for our purpose by taking an
hour′s employment of ordinary labour as our unit and weighting an hour′s
employment of special labour in proportion to its remuneration; i.e. an
hour of special labour remunerated at double ordinary rates will count as two
units. We shall call the unit in which the quantity of employment is measured
the labour-unit; and the money-wage of a labour-unit we shall call the
wage-unit.{N-ch04-5}[5]
Thus, if E is the wages (and salaries) bill, W the wage-unit, and N the quantity
of employment, E = N.W.
This assumption of homogeneity in the supply of labour is not upset by the
obvious fact of great differences in the specialised skill of individual workers
and in their suitability for different occupations. For, if the remuneration of
the workers is proportional to their efficiency, the differences are dealt with
by our having regarded individuals as contributing to the supply of labour in
proportion to their remuneration; whilst if, as output increases, a given firm
has to bring in labour which is less and less efficient for its special purposes
per wage-unit paid to it, this is merely one factor among others leading to a
diminishing return from the capital equipment in terms of output as more labour
is employed on it. We subsume, so to speak, the non-homogeneity of equally
remunerated labour units in the equipment, which we regard as less and less
adapted to employ the available labour units as output increases, instead of
regarding the available labour units as less and less adapted to use a
homogeneous capital equipment. Thus if there is no surplus of specialised or
practised labour and the use of less suitable labour involves a higher labour
cost per unit of output, this means that the rate at which the return from the
equipment diminishes as employment increases is more rapid than it would be if
there were such a surplus.{N-ch04-6}[6]
Even in the limiting case where different labour units were so highly
specialised as to be altogether incapable of being substituted for one another,
there is no awkwardness; for this merely means that the elasticity of supply of
output from a particular type of capital equipment falls suddenly to zero when
all the available labour specialised to its use is already employed.{N-ch04-7}[7]
Thus our assumption of a homogeneous unit of labour involves no difficulties
unless there is great instability in the relative remuneration of different
labour-units; and even this difficulty can be dealt with, if it arises, by
supposing a rapid liability to change in the supply of labour and the shape of
the aggregate supply function.
It is my belief that much unnecessary perplexity can be avoided if we limit
ourselves strictly to the two units, money and labour, when we are dealing with
the behaviour of the economic system as a whole; reserving the use of units of
particular outputs and equipments to the occasions when we are analysing the
output of individual firms or industries in isolation; and the use of vague
concepts, such as the quantity of output as a whole, the quantity of capital
equipment as a whole and the general level of prices, to the occasions when we
are attempting some historical comparison which is within certain (perhaps
fairly wide) limits avowedly unprecise and approximate.
It follows that we shall measure changes in current output by reference to
the number of men employed (whether to satisfy consumers or to produce fresh
capital equipment) on the existing capital equipment, skilled workers being
weighted in proportion to their remuneration. We have no need of a quantitative
comparison between this output and the output which would result from
associating a different set of workers with a different capital equipment. To
predict how entrepreneurs possessing a given equipment will respond to a shift
in the aggregate demand function it is not necessary to know how the quantity of
the resulting output, the standard of life and the general level of prices would
compare with what they were at a different date or in another country.
IV
It is easily shown that the conditions of supply, such as are usually
expressed in terms of the supply curve, and the elasticity of supply relating
output to price, can be handled in terms of our two chosen units by means of the
aggregate supply function, without reference to quantities of output, whether we
are concerned with a particular firm or industry or with economic activity as a
whole. For the aggregate supply function for a given firm (and similarly for a
given industry or for industry as a whole) is given by
Zr = φr(Nr),
where Zr is the return the expectation of which will
induce a level of employment Nr. If, therefore, the relation
between employment and output is such that an employment Nr
results in an output Or, where Or =
ψr(Nr), it follows that
p = Zr/Or = φr(Nr)/ψr(Nr)
is the ordinary supply curve.
Thus in the case of each homogeneous commodity, for which Or = ψr(Nr) has a definite
meaning, we can evaluate Zr = ψr(Nr) in the ordinary way; but we can then aggregate the Nr′s in a way which we cannot aggregate the
Or′s, since ΣOr is not a numerical
quantity. Moreover, if we can assume that, in a given environment, a given
aggregate employment will be distributed in a unique way between different
industries, so that Nr is a function of N, further
simplifications are possible.
The General Theory of Employment, Interest and Money by John Maynard Keynes
@§ Chapter 5
Expectation as Determining Output and Employment
I
ALL production is for the purpose of ultimately satisfying a
consumer. Time usually elapses, however — and sometimes much time — between the
incurring of costs by the producer (with the consumer in view) and the purchase
of the output by the ultimate consumer. Meanwhile the entrepreneur (including
both the producer and the investor in this description) has to form the best
expectations{N-ch05-1}[1]
he can as to what the consumers will be prepared to pay when he is ready to
supply them (directly or indirectly) after the elapse of what may be a lengthy
period; and he has no choice but to be guided by these expectations, if he is to
produce at all by processes which occupy time.
These expectations, upon which business decisions depend, fall into two
groups, certain individuals or firms being specialised in the business of
framing the first type of expectation and others in the business of framing the
second. The first type is concerned with the price which a manufacturer can
expect to get for his “finished” output at the time when he commits himself to
starting the process which will produce it; output being “finished” (from the
point of view of the manufacturer) when it is ready to be used or to be sold to
a second party. The second type is concerned with what the entrepreneur can hope
to earn in the shape of future returns if he purchases (or, perhaps,
manufactures) “finished” output as an addition to his capital equipment. We may
call the former short-term expectation and the latter long-term
expectation.
Thus the behaviour of each individual firm in deciding its daily{N-ch05-2}[2]
output will be determined by its short-term expectations — expectations
as to the cost of output on various possible scales and expectations as to the
sale-proceeds of this output; though, in the case of additions to capital
equipment and even of sales to distributors, these short-term expectations will
largely depend on the long-term (or medium-term) expectations of other parties.
It is upon these various expectations that the amount of employment which the
firms offer will depend. The actually realised results of the
production and sale of output will only be relevant to employment in so far as
they cause a modification of subsequent expectations. Nor, on the other hand,
are the original expectations relevant, which led the firm to acquire the
capital equipment and the stock of intermediate products and half-finished
materials with which it finds itself at the time when it has to decide the next
day′s output. Thus, on each and every occasion of such a decision, the decision
will be made, with reference indeed to this equipment and stock, but in the
light of the current expectations of prospective costs and
sale-proceeds.
Now, in general, a change in expectations (whether short-term or
long-term) will only produce its full effect on employment over a considerable
period. The change in employment due to a change in expectations will not be the
same on the second day after the change as on the first, or the same on the
third day as on the second, and so on, even though there be no further change in
expectations. In the case of short-term expectations this is because changes in
expectation are not, as a rule, sufficiently violent or rapid, when they are for
the worse, to cause the abandonment of work on all the productive processes
which, in the light of the revised expectation, it was a mistake to have begun;
whilst, when they are for the better, some time for preparation must needs
elapse before employment can reach the level at which it would have stood if the
state of expectation had been revised sooner. In the case of long-term
expectations, equipment which will not be replaced will continue to give
employment until it is worn out; whilst when the change in long-term
expectations is for the better, employment may be at a higher level at first,
than it will be after there has been time to adjust the equipment to the new
situation.
If we suppose a state of expectation to continue for a sufficient length of
time for the effect on employment to have worked itself out so completely that
there is, broadly speaking, no piece of employment going on which would not have
taken place if the new state of expectation had always existed, the steady level
of employment thus attained may be called the long-period employment{N-ch05-3}[3]
corresponding to that state of expectation. It follows that, although
expectation may change so frequently that the actual level of employment has
never had time to reach the long-period employment corresponding to the existing
state of expectation, nevertheless every state of expectation has its definite
corresponding level of long-period employment.
Let us consider, first of all, the process of transition to a long-period
position due to a change in expectation, which is not confused or interrupted by
any further change in expectation. We will first suppose that the change is of
such a character that the new long-period employment will be greater than the
old. Now, as a rule, it will only be the rate of input which will be much
affected at the beginning, that is to say, the volume of work on the earlier
stages of new processes of production, whilst the output of consumption-goods
and the amount of employment on the later stages of processes which were started
before the change will remain much the same as before. In so far as there were
stocks of partly finished goods, this conclusion may be modified; though it is
likely to remain true that the initial increase in employment will be modest.
As, however, the days pass by, employment will gradually increase. Moreover, it
is easy to conceive of conditions which will cause it to increase at some stage
to a higher level than the new long-period employment. For the process
of building up capital to satisfy the new state of expectation may lead to more
employment and also to more current consumption than will occur when the
long-period position has been reached. Thus the change in expectation may lead
to a gradual crescendo in the level of employment, rising to a peak and then
declining to the new long-period level. The same thing may occur even if the new
long-period level is the same as the old, if the change represents a
change in the direction of consumption which renders certain existing processes
and their equipment obsolete. Or again, if the new long-period employment is
less than the old, the level of employment during the transition may fall for a
time below what the new long-period level is going to be. Thus a mere
change in expectation is capable of producing an oscillation of the same kind of
shape as a cyclical movement, in the course of working itself out. It was
movements of this kind which I discussed in my Treatise on Money in
connection with the building up or the depletion of stocks of working and liquid
capital consequent on change.
An uninterrupted process of transition, such as the above, to a new
long-period position can be complicated in detail. But the actual course of
events is more complicated still. For the state of expectation is liable to
constant change, a new expectation being superimposed long before the previous
change has fully worked itself out; so that the economic machine is occupied at
any given time with a number of overlapping activities, the existence of which
is due to various past states of expectation.
II
This leads us to the relevance of this discussion for our present purpose. It
is evident from the above that the level of employment at any time depends, in a
sense, not merely on the existing state of expectation but on the states of
expectation which have existed over a certain past period. Nevertheless past
expectations, which have not yet worked themselves out, are embodied in the
to-day′s capital equipment with reference to which the entrepreneur has to make
to-day′s decisions, and only influence his decisions in so far as they are so
embodied. It follows, therefore, that, in spite of the above, to-day′s
employment can be correctly described as being governed by to-day′s expectations
taken in conjunction with to-day′s capital equipment.
Express reference to current long-term expectations can seldom be avoided.
But it will often be safe to omit express reference to short-term
expectation, in view of the fact that in practice the process of revision
of short-term expectation is a gradual and continuous one, carried on largely in
the light of realised results; so that expected and realised results run into
and overlap one another in their influence. For, although output and employment
are determined by the producer′s short-term expectations and not by past
results, the most recent results usually play a predominant part in determining
what these expectations are. It would be too complicated to work out the
expectations de novo whenever a productive process was being started;
and it would, moreover, be a waste of time since a large part of the
circumstances usually continue substantially unchanged from one day to the next.
Accordingly it is sensible for producers to base their expectations on the
assumption that the most recently realised results will continue, except in so
far as there are definite reasons for expecting a change. Thus in practice there
is a large overlap between the effects on employment of the realised
sale-proceeds of recent output and those of the sale-proceeds expected from
current input; and producers′ forecasts are more often gradually modified in the
light of results than in anticipation of prospective changes.{N-ch05-4}[4]
Nevertheless, we must not forget that, in the case of durable goods, the
producer′s short-term expectations are based on the current long-term
expectations of the investor; and it is of the nature of long-term expectations
that they cannot be checked at short intervals in the light of realized results.
Moreover, as we shall see in Chapter 12, where we shall consider long-term
expectations in more detail, they are liable to sudden revision. Thus the factor
of current long-term expectations cannot be even approximately eliminated or
replaced by realised results.
The General Theory of Employment, Interest and Money by John Maynard Keynes
@§ Chapter 6
The Definition of Income, Saving and Investment
I. Income
DURING any period of time an entrepreneur will have sold finished
output to consumers or to other entrepreneurs for a certain sum which we will
designate as A. He will also have spent a certain sum, designated by A1, on purchasing finished output from other entrepreneurs. And he
will end up with a capital equipment, which term includes both his stocks of
unfinished goods or working capital and his stocks of finished goods, having a
value G.
Some part, however, of A + G - A1 will be attributable,
not to the activities of the period in question, but to the capital equipment
which he had at the beginning of the period. We must, therefore, in order to
arrive at what we mean by the income of the current period, deduct from
A + G - A1 a certain sum, to represent that part of its
value which has been (in some sense) contributed by the equipment inherited from
the previous period. The problem of defining income is solved as soon as we have
found a satisfactory method for calculating this deduction.
There are two possible principles for calculating it, each of which has a
certain significance; — one of them in connection with production, and the other
in connection with consumption. Let us consider them in turn.
(i) The actual value G of the capital equipment at the end of the period is
the net result of the entrepreneur, on the one hand, having maintained and
improved it during the period, both by purchases from other entrepreneurs and by
work done upon it by himself, and, on the other hand, having exhausted or
depreciated it through using it to produce output. If he had decided not
to use it to produce output, there is, nevertheless, a certain optimum sum
which it would have paid him to spend on maintaining and improving it. Let us
suppose that, in this event, he would have spent B′ on its maintenance and
improvement, and that, having had this spent on it, it would have been worth G′
at the end of the period. That is to say, G′ - B′ is the maximum net value which
might have been conserved from the previous period, if it had not been used to
produce A. The excess of this potential value of the equipment over G - A1 is the measure of what has been sacrificed (one way or another)
to produce A. Let us call this quantity, namely
(G′ - B′) - (G - A1),
which measures the sacrifice of value involved in the production of
A, the user cost of A. User cost will be written U.{N-ch06-1}[1]
The amount paid out by the entrepreneur to the other factors of production in
return for their services, which from their point of view is their income, we
will call the factor cost of A. The sum of the factor cost F and the
user cost U we shall call the prime cost of the output A.
We can then define the income{N-ch06-2}[2]
of the entrepreneur as being the excess of the value of his finished output sold
during the period over his prime cost. The entrepreneur′s income, that is to
say, is taken as being equal to the quantity, depending on his scale of
production, which he endeavours to maximise, i.e., to his gross profit
in the ordinary sense of this term;— which agrees with common sense. Hence,
since the income of the rest of the community is equal to the entrepreneur′s
factor cost, aggregate income is equal to A - U.
Income, thus defined, is a completely unambiguous quantity. Moreover, since
it is the entrepreneur′s expectation of the excess of this quantity over his
out-goings to the other factors of production which he endeavours to maximise
when he decides how much employment to give to the other factors of production,
it is the quantity which is causally significant for employment.
It is conceivable, of course, that G - A1 may exceed G′ -
B′, so that user cost will be negative. For example, this may well be the case
if we happen to choose our period in such a way that input has been increasing
during the period but without there having been time for the increased output to
reach the stage of being finished and sold. It will also be the case, whenever
there is positive investment, if we imagine industry to be so much integrated
that entrepreneurs make most of their equipment for themselves. Since, however,
user cost is only negative when the entrepreneur has been increasing his capital
equipment by his own labour, we can, in an economy where capital equipment is
largely manufactured by different firms from those which use it, normally think
of user cost as being positive. Moreover, it is difficult to conceive of a case
where marginal user cost associated with an increase in A,
i.e.dU/dA, will be other than positive.
It may be convenient to mention here, in anticipation of the latter part of
this chapter, that, for the community as a whole, the aggregate consumption
(C) of the period is equal to Σ(A - A1), and the
aggregate investment (I) is equal to Σ (A1 - U).
Moreover, U is the individual entrepreneur′s disinvestment (and -U his
investment) in respect of his own equipment exclusive of what he buys from other
entrepreneurs. Thus in a completely integrated system (where A1 = 0) consumption is equal to A and investment to -U,
i.e. to G - (G′ - B′). The slight complication of the above, through the
introduction of A1, is simply due to the desirability of
providing in a generalised way for the case of a non-integrated system of
production.
Furthermore, the effective demand is simply the aggregate income (or
proceeds) which the entrepreneurs expect to receive, inclusive of the incomes
which they will hand on to other factors of production, from the amount of
current employment which they decide to give. The aggregate demand function
relates various hypothetical quantities of employment to the proceeds which
their outputs are expected to yield; and the effective demand is the point on
the aggregate demand function which becomes effective because, taken in
conjunction with the conditions of supply, it corresponds to the level of
employment which maximises the entrepreneur′s expectation of profit.
This set of definitions also has the advantage that we can equate the
marginal proceeds (or income) to the marginal factor cost; and thus arrive at
the same sort of propositions relating marginal proceeds thus defined to
marginal factor costs as have been stated by those economists who, by ignoring
user cost or assuming it to be zero, have equated supply price{N-ch06-3}[3]
to marginal factor cost.{N-ch06-4}[4]
(ii) We turn, next, to the second of the principles referred to above. We
have dealt so far with that part of the change in the value of the capital
equipment at the end of the period as compared with its value at the beginning
which is due to the voluntary decisions of the entrepreneur in seeking
to maximise his profit. But there may, in addition, be an involuntary
loss (or gain) in the value of his capital equipment, occurring for reasons
beyond his control and irrespective of his current decisions, on account of
(e.g.) a change in market values, wastage by obsolescence or the mere
passage of time, or destruction by catastrophe such as war or earthquake. Now
some part of these involuntary losses, whilst they are unavoidable, are —
broadly speaking — not unexpected; such as losses through the lapse of time
irrespective of use, and also “normal” obsolescence which, as Professor Pigou
expresses it, “is sufficiently regular to be foreseen, if not in detail, at
least in the large”, including, we may add, those losses to the community as a
whole which are sufficiently regular to be commonly regarded as “insurable
risks”. Let us ignore for the moment the fact that the amount of the expected
loss depends on when the expectation is assumed to be framed, and let us call
the depreciation of the equipment, which is involuntary but not unexpected, i.e.
the excess of the expected depreciation over the user cost, the
supplementary cost, which will be written V. It is, perhaps, hardly
necessary to point out that this definition is not the same as Marshall′s
definition of supplementary cost, though the underlying idea, namely, of dealing
with that part of the expected depreciation which does not enter into prime
cost, is similar.
In reckoning, therefore, the net income and the net profit
of the entrepreneur it is usual to deduct the estimated amount of the
supplementary cost from his income and gross profit as defined above. For the
psychological effect on the entrepreneur, when he is considering what he is free
to spend and to save, of the supplementary cost is virtually the same as though
it came off his gross profit. In his capacity as a producer deciding
whether or not to use the equipment, prime cost and gross profit, as defined
above, are the significant concepts. But in his capacity as a consumer
the amount of the supplementary cost works on his mind in the same way as if it
were a part of the prime cost. Hence we shall not only come nearest to common
usage but will also arrive at a concept which is relevant to the amount of
consumption, if, in defining aggregate net income, we deduct the supplementary
cost as well as the user cost, so that aggregate net income is equal to
A - U - V.
There remains the change in the value of the equipment, due to unforeseen
changes in market values, exceptional obsolescence or destruction by
catastrophe, which is both involuntary and — in a broad sense — unforeseen. The
actual loss under this head, which we disregard even in reckoning net income and
charge to capital account, may be called the windfall loss.
The causal significance of net income lies in the psychological
influence of the magnitude of V on the amount of current consumption, since
net income is what we suppose the ordinary man to reckon his available
income to be when he is deciding how much to spend on current consumption. This
is not, of course, the only factor of which he takes account when he is deciding
how much to spend. It makes a considerable difference, for example, how much
windfall gain or loss he is making on capital account. But there is a difference
between the supplementary cost and a windfall loss in that changes in the former
are apt to affect him in just the same way as changes in his gross
profit. It is the excess of the proceeds of the current output over the sum
of the prime cost and the supplementary cost which is relevant to the
entrepreneur′s consumption; whereas, although the windfall loss (or gain) enters
into his decisions, it does not enter into them on the same scale — a given
windfall loss does not have the same effect as an equal supplementary cost.
We must now recur, however, to the point that the line between supplementary
costs and windfall losses, i.e. between those unavoidable losses which we think
it proper to debit to income account and those which it is reasonable to reckon
as a windfall loss (or gain) on capital account, is partly a conventional or
psychological one, depending on what are the commonly accepted criteria for
estimating the former. For no unique principle can be established for the
estimation of supplementary cost, and its amount will depend on our choice of an
accounting method. The expected value of the supplementary cost, when the
equipment was originally produced, is a definite quantity. But if it is
re-estimated subsequently, its amount over the remainder of the life of the
equipment may have changed as a result of a change in the meantime in our
expectations; the windfall capital loss being the discounted value of the
difference between the former and the revised expectation of the prospective
series of U + V. It is a widely approved principle of business accounting,
endorsed by the Inland Revenue authorities, to establish a figure for the sum of
the supplementary cost and the user cost when the equipment is acquired and to
maintain this unaltered during the life of the equipment, irrespective of
subsequent changes in expectation. In this case the supplementary cost over any
period must be taken as the excess of this predetermined figure over the actual
user cost. This has the advantage of ensuring that the windfall gain or loss
shall be zero over the life of the equipment taken as a whole. But it is also
reasonable in certain circumstances to recalculate the allowance for
supplementary cost on the basis of current values and expectations at an
arbitrary accounting interval, e.g. annually. Business men in fact
differ as to which course they adopt. It may be convenient to call the initial
expectation of supplementary cost when the equipment is first acquired the
basic supplementary cost, and the same quantity recalculated up to date
on the basis of current values and expectations the current supplementary
cost.
Thus we cannot get closer to a quantitative definition of supplementary cost
than that it comprises those deductions from his income which a typical
entrepreneur makes before reckoning what he considers his income for the purpose
of declaring a dividend (in the case of a corporation) or of deciding the scale
of his current consumption (in the case of an individual). Since windfall
charges on capital account are not going to be ruled out of the picture, it is
clearly better, in case of doubt, to assign an item to capital account, and to
include in supplementary cost only what rather obviously belongs there. For any
overloading of the former can be corrected by allowing it more influence on the
rate of current consumption than it would otherwise have had.
It will be seen that our definition of net income comes very close
to Marshall′s definition of income, when he decided to take refuge in
the practices of the Income Tax Commissioners and — broadly speaking — to regard
as income whatever they, with their experience, choose to treat as such. For the
fabric of their decisions can he regarded as the result of the most careful and
extensive investigation which is available, to interpret what, in practice, it
is usual to treat as net income. It also corresponds to the money value of
Professor Pigou′s most recent definition of the National Dividend.{N-ch06-5}[5]
It remains true, however, that net income, being based on an equivocal
criterion which different authorities might interpret differently, is not
perfectly clear-cut. Professor Hayek, for example, has suggested that an
individual owner of capital goods might aim at keeping the income he derives
from his possession constant, so that he would not feel himself free to spend
his income on consumption until he had set aside sufficient to offset any
tendency of his investment-income to decline for whatever reason.{N-ch06-6}[6]
I doubt if such an individual exists; but, obviously, no theoretical objection
can be raised against this deduction as providing a possible psychological
criterion of net income. But when Professor Hayek infers that the concepts of
saving and investment suffer from a corresponding vagueness, he is only right if
he means net saving and net investment. The saving
and the investment, which are relevant to the theory of employment, are
clear of this defect, and are capable of objective definition, as we have shown
above.
Thus it is a mistake to put all the emphasis on net income, which is
only relevant to decisions concerning consumption, and is, moreover, only
separated from various other factors affecting consumption by a narrow line; and
to overlook (as has been usual) the concept of income proper, which is
the concept relevant to decisions concerning current production and is quite
unambiguous.
The above definitions of income and of net income are intended to conform as
closely as possible to common usage. It is necessary, therefore, that I should
at once remind the reader that in my Treatise on Money I defined income
in a special sense. The peculiarity in my former definition related to that part
of aggregate income which accrues to the entrepreneurs, since I took neither the
profit (whether gross or net) actually realised from their current operations
nor the profit which they expected when they decided to undertake their current
operations, but in some sense (not, as I now think, sufficiently defined if we
allow for the possibility of changes in the scale of output) a normal or
equilibrium profit; with the result that on this definition saving exceeded
investment by the amount of the excess of normal profit over the actual profit.
I am afraid that this use of terms has caused considerable confusion, especially
in the case of the correlative use of saving; since conclusions (relating, in
particular, to the excess of saving over investment), which were only valid if
the terms employed were interpreted in my special sense, have been frequently
adopted in popular discussion as though the terms were being employed in their
more familiar sense. For this reason, and also because I no longer require my
former terms to express my ideas accurately, I have decided to discard them —
with much regret for the confusion which they have caused.
II. Saving and Investment
Amidst the welter of divergent usages of terms, it is agreeable to discover
one fixed point. So far as I know, everyone is agreed that saving means
the excess of income over expenditure on consumption. Thus any doubts about the
meaning of saving must arise from doubts about the meaning either of
income or of consumption. Income we have defined above.
Expenditure on consumption during any period must mean the value of goods sold
to consumers during that period, which throws us back to the question of what is
meant by a consumer-purchaser. Any reasonable definition of the line between
consumer-purchasers and investor-purchasers will serve us equally well, provided
that it is consistently applied. Such problem as there is, e.g. whether
it is right to regard the purchase of a motor-car as a consumer-purchase and the
purchase of a house as an investor-purchase, has been frequently discussed and I
have nothing material to add to the discussion. The criterion must obviously
correspond to where we draw the line between the consumer and the entrepreneur.
Thus when we have defined A1 as the value of what one
entrepreneur has purchased from another, we have implicitly settled the
question. It follows that expenditure on consumption can be unambiguously
defined as Σ(A - A1), where ΣA is the total sales made
during the period and ΣA1 is the total sales made by one
entrepreneur to another. In what follows it will be convenient, as a rule, to
omit Σ and write A for the aggregate sales of all kinds, A1
for the aggregate sales from one entrepreneur to another and U for the aggregate
user costs of the entrepreneurs.
Having now defined both income and consumption, the
definition of saving, which is the excess of income over consumption,
naturally follows. Since income is equal to A - U and consumption is equal to A
- A1, it follows that saving is equal to A1 - U. Similarly, we have net saving for the excess of
net income over consumption, equal to A1 - U -
V.
Our definition of income also leads at once to the definition of current
investment. For we must mean by this the current addition to the value of
the capital equipment which has resulted from the productive activity of the
period. This is, clearly, equal to what we have just defined as saving. For it
is that part of the income of the period which has not passed into consumption.
We have seen above that as the result of the production of any period
entrepreneurs end up with having sold finished output having a value A and with
a capital equipment which has suffered a deterioration measured by U (or an
improvement measured by -U where U is negative) as a result of having produced
and parted with A1 after allowing for purchases 1 from other entrepreneurs. During the same period finished
output having a value A - A1 will have passed into
consumption. The excess of A - U over A - A1, namely A1 - U, is the addition to capital equipment as a result of the
productive activities of the period and is, therefore, the investment
of the period. Similarly A1 - U - V, which is the
net addition to capital equipment, after allowing for normal impairment
in the value of capital apart from its being used and apart from windfall
changes in the value of the equipment chargeable to capital account, is the
net investment of the period.
Whilst, therefore, the amount of saving is an outcome of the collective
behaviour of individual consumers and the amount of investment of the collective
behaviour of individual entrepreneurs, these two amounts are necessarily equal,
since each of them is equal to the excess of income over consumption. Moreover,
this conclusion in no way depends on any subtleties or peculiarities in the
definition of income given above. Provided it is agreed that income is equal to
the value of current output, that current investment is equal to the value of
that part of current output which is not consumed, and that saving is equal to
the excess of income over consumption — all of which is conformable both to
common sense and to the traditional usage of the great majority of economists —
the equality of saving and investment necessarily follows. In short—
Income = value of output = consumption + investment. Saving
= income - consumption. Therefore saving = investment.
Thus any set of definitions which satisfy the above
conditions leads to the same conclusion. It is only by denying the validity of
one or other of them that the conclusion can avoided.
The equivalence between the quantity of saving and the quantity of investment
emerges from the bilateral character of the transactions between the
producer on the one hand and, on the other hand, the consumer or the purchaser
of capital equipment.
Income is created by the value in excess of user cost which the producer
obtains for the output he has sold; but the whole of this output must obviously
have been sold either to a consumer or to another entrepreneur; and each
entrepreneur′s current investment is equal to the excess of the equipment which
he has purchased from other entrepreneurs over his own user cost. Hence, in the
aggregate the excess of income over consumption, which we call saving, cannot
differ from the addition to capital equipment which we call investment. And
similarly with net saving and net investment. Saving, in fact, is a mere
residual. The decisions to consume and the decisions to invest between them
determine incomes. Assuming that the decisions to invest become effective, they
must in doing so either curtail consumption or expand income. Thus the act of
investment in itself cannot help causing the residual or margin, which we call
saving, to increase by a corresponding amount.
It might be, of course, that individuals were so tête montée in
their decisions as to how much they themselves would save and invest
respectively, that there would be no point of price equilibrium at which
transactions could take place. In this case our terms would cease to be
applicable, since output would no longer have a definite market value, prices
would find no resting-place between zero and infinity. Experience shows,
however, that this, in fact, is not so; and that there are habits of
psychological response which allow of an equilibrium being reached at which the
readiness to buy is equal to the readiness to sell. That there should be such a
thing as a market value for output is, at the same time, a necessary condition
for money-income to possess a definite value and a sufficient condition for the
aggregate amount which saving individuals decide to save to be equal to the
aggregate amount which investing individuals decide to invest.
Clearness of mind on this matter is best reached, perhaps, by thinking in
terms of decisions to consume (or to refrain from consuming) rather than of
decisions to save. A decision to consume or not to consume truly lies within the
power of the individual; so does a decision to invest or not to invest. The
amounts of aggregate income and of aggregate saving are the results of
the free choices of individuals whether or not to consume and whether or not to
invest; but they are neither of them capable of assuming an independent value
resulting from a separate set of decisions taken irrespective of the decisions
concerning consumption and investment. In accordance with this principle, the
conception of the propensity to consume will, in what follows, take the
place of the propensity or disposition to save.
The General Theory of Employment, Interest and Money by John Maynard Keynes
Appendix on User Cost
I
USER cost has, I think, an importance for the classical theory of
value which has been overlooked. There is more to be said about it than would be
relevant or appropriate in this place. But, as a digression, we will examine it
somewhat further in this appendix.
An entrepreneur′s user cost is by definition equal to
A1 + (G′ - B′) - G,
where A1 is the amount of our entrepreneur′s purchases
from other entrepreneurs, G the actual value of his capital equipment at the end
of the period, and G′ the value it might have had at the end of the period if he
had refrained from using it and had spent the optimum sum B′ on its maintenance
and improvement. Now G - (G′ - B′), namely the increment in the value of the
entrepreneurs equipment beyond the net value which he has inherited from the
previous period, represents the entrepreneur′s current investment in his
equipment and can be written I. Thus U, the user cost of his sales-turnover A,
is equal to A1 - I where A1 is what he
has bought from other entrepreneurs and I is what he has currently invested in
his own equipment. A little reflection will show that all this is no more than
common sense. Some part of his outgoings to other entrepreneurs is balanced by
the value of his current investment in his own equipment, and the rest
represents the sacrifice which the output he has sold must have cost him over
and above the total sum which he has paid out to the factors of production. If
the reader tries to express the substance of this otherwise, he will find that
its advantage lies in its avoidance of insoluble (and unnecessary) accounting
problems. There is, I think, no other way of analysing the current proceeds of
production unambiguously. If industry is completely integrated or if the
entrepreneur has bought nothing from outside, so that A1 =
0, the user cost is simply the equivalent of the current disinvestment involved
in using the equipment; but we are still left with the advantage that we do not
require at any stage of the analysis to allocate the factor cost between the
goods which are sold and the equipment which is retained. Thus we can regard the
employment given by a firm, whether integrated or individual, as depending on a
single consolidated decision — a procedure which corresponds to the actual
interlocking character of the production of what is currently sold with total
production.
The concept of user cost enables us, moreover, to give a clearer definition
than that usually adopted of the short-period supply price of a unit of a firm′s
saleable output. For the short-period supply price is the sum of the marginal
factor cost and the marginal user cost.
Now in the modern theory of value it has been a usual practice to equate the
short-period supply price to the marginal factor cost alone. It is obvious,
however, that this is only legitimate if marginal user cost is zero or if
supply-price is specially defined so as to be net of marginal user cost, just as
I have defined (Chapter 3) “proceeds” and “aggregate supply price” as being net
of aggregate user cost. But, whereas it may be occasionally convenient in
dealing with output as a whole to deduct user cost, this procedure
deprives our analysis of all reality if it is habitually (and tacitly) applied
to the output of a single industry or firm, since it divorces the “supply price”
of an article from any ordinary sense of its “price”; and some confusion may
have resulted from the practice of doing so. It seems to have been assumed that
“supply price” has an obvious meaning as applied to a unit of the saleable
output of an individual firm, and the matter has not been deemed to require
discussion. Yet the treatment both of what is purchased from other firms and of
the wastage of the firm′s own equipment as a consequence of producing the
marginal output involves the whole pack of perplexities which attend the
definition of income. For, even if we assume that the marginal cost of purchases
from other firms involved in selling an additional unit of output has to be
deducted from the sale-proceeds per unit in order to give us what we mean by our
firm′s supply price, we still have to allow for the marginal disinvestment in
the firm′s own equipment involved in producing the marginal output. Even if all
production is carried on by a completely integrated firm, it is still
illegitimate to suppose that the marginal user cost is zero, i.e. that
the marginal disinvestment in equipment due to the production of the marginal
output can generally be neglected.
The concepts of user cost and of supplementary cost also enable us to
establish a clearer relationship between long-period supply price and
short-period supply price. Long-period cost must obviously include an amount to
cover the basic supplementary cost as well as the expected prime cost
appropriately averaged over the life of the equipment. That is to say, the
long-period cost of the output is equal to the expected sum of the prime cost
and the supplementary cost; and, furthermore, in order to yield a normal profit,
the long-period supply price must exceed the long-period cost thus calculated by
an amount determined by the current rate of interest on loans of comparable term
and risk, reckoned as a percentage of the cost of the equipment. Or if we prefer
to take a standard “pure” rate of interest, we must include in the long-period
cost a third term which we might call the risk-cost to cover the
unknown possibilities of the actual yield differing from the expected yield.
Thus the long-period supply price is equal to the sum of the prime cost, the
supplementary cost, the risk cost and the interest cost, into which several
components it can be analysed. The short-period supply price, on the other hand,
is equal to the marginal prime cost. The entrepreneur must, therefore,
expect, when he buys or constructs his equipment, to cover his supplementary
cost, his risk cost and his interest cost out of the excess marginal value of
the prime cost over its average value; so that in long-period equilibrium the
excess of the marginal prime cost over the average prime cost is equal to the
sum of the supplementary, risk and interest costs.{N-ch06a-7}[7]
The level of output, at which marginal prime cost is exactly equal to the sum
of the average prime and supplementary costs, has a special importance, because
it is the point at which the entrepreneur′s trading account breaks even. It
corresponds, that is to say, to the point of zero net profit; whilst with a
smaller output than this he is trading at a net loss. The extent to which the
supplementary cost has to be provided for apart from the prime cost varies very
much from one type of equipment to another. Two extreme cases are the
following:
(i) Some part of the maintenance of the equipment must necessarily take place
pari passu with the act of using it (e.g. oiling the machine).
The expense of this (apart from outside purchases) is included in the factor
cost. If, for physical reasons, the exact amount of the whole of the current
depreciation has necessarily to be made good in this way, the amount of the user
cost (apart from outside purchases) would be equal and opposite to that of the
supplementary cost; and in long-period equilibrium the marginal factor cost
would exceed the average factor cost by an amount equal to the risk and interest
cost.
(ii) Some part of the deterioration in the value of the equipment only occurs
if it is used. The cost of this is charged in user cost, in so far as it is not
made good pari passu with the act of using it. If loss in the value of
the equipment could only occur in this way, supplementary cost would be
zero.
It may be worth pointing out that an entrepreneur does not use his oldest and
worst equipment first, merely because its user cost is low; since its low user
cost may be outweighed by its relative inefficiency, i.e. by its high
factor cost. Thus an entrepreneur uses by preference that part of his equipment
for which the user cost plus factor cost is least per unit of
output.{N-ch06a-8}[8]
It follows that for any given volume of output of the product in question there
is a corresponding user cost,{N-ch06a-9}[9]
but that this total user cost does not bear a uniform relation to the marginal
user cost, i.e. to the increment of user cost due to an increment in
the rate of output.
II
User cost constitutes one of the links between the present and the future.
For in deciding his scale of production an entrepreneur has to exercise a choice
between using up his equipment now and preserving it to be used later on. It is
the expected sacrifice of future benefit involved in present use which
determines the amount of the user cost, and it is the marginal amount of this
sacrifice which, together with the marginal factor cost and the expectation of
the marginal proceeds, determines his scale of production. How, then, is the
user cost of an act of production calculated by the entrepreneur?
We have defined the user cost as the reduction in the value of the equipment
due to using it as compared with not using it, after allowing for the cost of
the maintenance and improvements which it would be worth while to undertake and
for purchases from other entrepreneurs. It must be arrived at, therefore, by
calculating the discounted value of the additional prospective yield which would
be obtained at some later date if it were not used now. Now this must be at
least equal to the present value of the opportunity to postpone replacement
which will result from laying up the equipment; and it may be more.{N-ch06a-10}[10]
If there is no surplus or redundant stock, so that more units of similar
equipment are being newly produced every year either as an addition or in
replacement, it is evident that marginal user cost will be calculable by
reference to the amount by which the life or efficiency of the equipment will be
shortened if it is used, and the current replacement cost. If, however, there is
redundant equipment, then the user cost will also depend on the rate of interest
and the current (i.e. re-estimated) supplementary cost over the period
of time before the redundancy is expected to be absorbed through wastage, etc.
In this way interest cost and current supplementary cost enter indirectly into
the calculation of user cost.
The calculation is exhibited in its simplest and most intelligible form when
the factor cost is zero. e.g. in the case of a redundant stock of a raw
material such as copper, on the lines which I have worked out in my Treatise
on Money, vol. ii. chap. 29. Let us take the prospective values of copper
at various future dates, a series which will be governed by the rate at which
redundancy is being absorbed and gradually approaches the estimated normal cost.
The present value or user cost of a ton of surplus copper will then be equal to
the greatest of the values obtainable by subtracting from the estimated future
value at any given date of a ton of copper the interest cost and the current
supplementary cost on a ton of copper between that date and the present.
In the same way the user cost of a ship or factory or machine, when these
equipments are in redundant supply, is its estimated replacement cost discounted
at the percentage rate of its interest and current supplementary costs to the
prospective date of absorption of the redundancy.
We have assumed above that the equipment will be replaced in due course by an
identical article. If the equipment in question will not be renewed identically
when it is worn out, then its user cost has to be calculated by taking a
proportion of the user cost of the new equipment, which will be erected to do
its work when it is discarded, given by its comparative efficiency.
III
The reader should notice that, where the equipment is not obsolescent but
merely redundant for the time being, the difference between the actual user cost
and its normal value (i.e. the value when there is no redundant
equipment) varies with the interval of time which is expected to elapse before
the redundancy is absorbed. Thus if the type of equipment in question is of all
ages and not “bunched′ so that a fair proportion is reaching the end of its life
annually, the marginal user cost will not decline greatly unless the redundancy
is exceptionally excessive. In the case of a general slump, marginal user cost
will depend on how long entrepreneurs expect the slump to last. Thus the rise in
the supply price when affairs begin to mend may be partly due to a sharp
increase in marginal user cost due to a revision of their expectations.
It has sometimes been argued, contrary to the opinion of business men, that
organised schemes for scrapping redundant plant cannot have the desired effect
of raising prices unless they apply to the whole of the redundant
plant. But the concept of user cost shows how the scrapping of (say) half the
redundant plant may have the effect or raising prices immediately. For
absorption of the redundancy nearer, user cost and consequently increasesthe
current supply price. Thus business men would seem to have the notion of user
cost implicitly in mind, though they do not formulate it distinctly.
If the supplementary cost is heavy, it follows that the marginal user cost
will be low when there is surplus equipment. Moreover, where there is surplus
equipment, the marginal factor and user costs are unlikely to be much in excess
of their average value. If both these conditions are fulfilled, the existence of
surplus equipment is likely to lead to the entrepreneur′s working at a net loss,
and perhaps at a heavy net loss. There will not be a sudden transition from this
state of affairs to a normal profit, taking place at the moment when the
redundancy is absorbed. As the redundancy becomes less, the user cost will
gradually increase; and the excess of marginal over average factor and user cost
may also gradually increase.
IV
In Marshall′s Principles of Economics (6th ed. p. 360) a part of
user cost is included in prime cost under the heading of “extra wear-and-tear of
plant”. But no guidance is given as to how this item is to be calculated or as
to its importance. In his Theory of Unemployment (p. 42) Professor
Pigou expressly assumes that the marginal disinvestment in equipment due to the
marginal output can, in general, be neglected: “The differences in the quantity
of wear-and-tear suffered by equipment and in the costs of non-manual labour
employed, that are associated with differences in output, are ignored, as being,
in general, of secondary importance”.{N-ch06a-11}[11]
Indeed, the notion that the disinvestment in equipment is zero at the margin of
production runs through a good deal of recent economic theory. But the whole
problem is brought to an obvious head as soon as it is thought necessary to
explain exactly what is meant by the supply price of an individual firm.
It is true that the cost of maintenance of idle plant may often, for the
reasons given above, reduce the magnitude of marginal user cost, especially in a
slump which is expected to last a long time. Nevertheless a very low user cost
at the margin is not a characteristic of the short period as such, but of
particular situations and types of equipment where the cost of maintaining idle
plant happens to be heavy, and of those disequilibria which are characterised by
very rapid obsolescence or great redundancy, especially if it is coupled with a
large proportion of comparatively new plant.
In the case of raw materials the necessity of allowing for user cost is
obvious;— if a ton of copper is used up to-day it cannot be used to-morrow, and
the value which the copper would have for the purposes of to-morrow must clearly
be reckoned as a part of the marginal cost. But the fact has been overlooked
that copper is only an extreme case of what occurs whenever capital equipment is
used to produce. The assumption that there is a sharp division between raw
materials where we must allow for the disinvestment due to using them and fixed
capital where we can safely neglect it does not correspond to the facts; —
especially in normal conditions where equipment is falling due for replacement
every year and the use of equipment brings nearer the date at which replacement
is necessary.
It is an advantage of the concepts of user cost and supplementary cost that
they are as applicable to working and liquid capital as to fixed capital. The
essential difference between raw materials and fixed capital lies not in their
liability to user and supplementary costs, but in the fact that the return to
liquid capital consists of a single term; whereas in the case of fixed capital,
which is durable and used up gradually, the return consists of a series of user
costs and profits earned in successive periods.
The General Theory of Employment, Interest and Money by John Maynard Keynes
@§ Chapter 7
The Meaning of Saving and Investment Further Considered
I
IN the previous chapter Saving and Investment
have been so defined that they are necessarily equal in amount, being, for the
community as a whole, merely different aspects of the same thing. Several
contemporary writers (including myself in my Treatise on Money) have,
however, given special definitions of these terms on which they are not
necessarily equal. Others have written on the assumption that they may be
unequal without prefacing their discussion with any definitions at all. It will
be useful, therefore, with a view to relating the foregoing to other discussions
of these terms, to classify some of the various uses of them which a pear to be
current.
So ar as I know, everyone agrees in meaning by Saving the excess of
income over what is spent on consumption. It would certainly be very
inconvenient and misleading not to mean this. Nor is there any important
difference of opinion as to what is meant by expenditure on consumption. Thus
the differences of usage arise either out of the definition of Investment
or out of that of Income.
II
Let us take Investment first. In popular usage it is common to mean
by this the purchase of an asset, old or new, by an individual or a corporation.
Occasionally, the term might be restricted to the purchase of an asset on the
Stock Exchange. But we speak just as readily of investing, for example, in a
house, or in a machine, or in a stock of finished or unfinished goods; and,
broadly speaking, new investment, as distinguished from reinvestment, means the
purchase of a capital asset of any kind out of income. If we reckon the sale of
an investment as being negative investment, i.e. disinvestment, my own
definition is in accordance with popular usage; since exchanges of old
investments necessarily cancel out. We have, indeed, to adjust for the creation
and discharge of debts (including changes in the quantity of credit or money);
but since for the community as a whole the increase or decrease of the aggregate
creditor position is always exactly equal to the increase or decrease of the
aggregate debtor position, this complication also cancels out when we are
dealing with aggregate investment. Thus, assuming that income in the popular
sense corresponds to my net income, aggregate investment in the popular sense
coincides with my definition of net investment, namely the net addition to all
kinds of capital equipment, after allowing for those changes in the value of the
old capital equipment which are taken into account in reckoning net income.
Investment, thus defined, includes, therefore, the increment of capital
equipment, whether it consists of fixed capital, working capital or liquid
capital; and the significant differences of definition (apart from the
distinction between investment and net investment) are due to the exclusion from
investment of one or more of these categories.
Mr. Hawtrey, for example, who attaches great importance to changes in liquid
capital, i.e. to undesigned increments (or decrements) in the stock of
unsold goods, has suggested a possible definition of investment from which such
changes are excluded. In this case an excess of saving over investment would be
the same thing as an undesigned increment in the stock of unsold goods, i.e.
as an increase of liquid capital. Mr. Hawtrey has not convinced me that
this is the factor to stress; for it lays all the emphasis on the correction of
changes which were in the first instance unforeseen, as compared with those
which are, rightly or wrongly, anticipated. Mr. Hawtrey regards the daily
decisions of entrepreneurs concerning their scale of output as being varied from
the scale of the previous day by reference to the changes in their stock of
unsold goods. Certainly, in the case of consumption goods, this plays an
important part in their decisions. But I see no object in excluding the play of
other factors on their decisions; and I prefer, therefore, to emphasise the
total change of effective demand and not merely that part of the change in
effective demand which reflects the increase or decrease of unsold stocks in the
previous period. Moreover, in the case of fixed capital, the increase or
decrease of unused capacity corresponds to the increase or decrease in unsold
stocks in its effect on decisions to produce; and I do not see how Mr. Hawtrey′s
method can handle this at least equally important factor.
It seems probable that capital formation and capital consumption, as used by
the Austrian school of economists, are not identical either with investment and
disinvestment as defined above or with net investment and disinvestment. In
particular, capital consumption is said to occur in circumstances where there is
quite clearly no net decrease in capital equipment as defined above. I have,
however, been unable to discover a reference to any passage where the meaning of
these terms is clearly explained. The statement, for example, that capital
formation occurs when there is a lengthening of the period of production does
not much advance matters.
III
We come next to the divergences between Saving and Investment which are due
to a special definition of income and hence of the excess of income over
consumption. My own use of terms in my Treatise on Money is an example
of this. For, as I have explained in Chapter 6 above, the definition of income,
which I there employed, differed from my present definition by reckoning as the
income of entrepreneurs not their actually realised profits but (in some sense)
their “normal profit”. Thus by an excess of saving over investment I meant that
the scale of output was such that entrepreneurs were earning a less than normal
profit from their ownership of the capital equipment; and by an increased excess
of saving over investment I meant that a decline was taking place in the actual
profits, so that they would be under a motive to contract output.
As I now think, the volume of employment (and consequently of output and real
income) is fixed by the entrepreneur under the motive of seeking to maximise its
present and prospective profits (the allowance for user cost being determined by
his view as to the use of equipment which will maximise his return from it over
its whole life); whilst the volume of employment which will maximise his profit
depends on the aggregate demand function given by his expectations of the sum of
the proceeds resulting from consumption and investment respectively on various
hypotheses. In my Treatise on Money the concept of changes in
the excess of investment over saving, as there defined, was a way of handling
changes in profit, though I did not in that book distinguish clearly between
expected and realised results.{N-ch07-1}[1]
I there argued that change in the excess of investment over saving was the
motive force governing changes in the volume of output. Thus the new argument,
though (as I now think) much more accurate and instructive, is essentially a
development of the old. Expressed in the language of my Treatise on
Money, it would run: the expectation of an increased excess of Investment
over Saving, given the former volume of employment and output, will induce
entrepreneurs to increase the volume of employment and output. The significance
of both my present and my former arguments lies in their attempt to show that
the volume of employment is determined by the estimates of effective demand made
by the entrepreneurs, an expected increase of investment relatively to saving as
defined in my Treatise on Money being a criterion of an increase in
effective demand. But the exposition in my Treatise on Money is, of
course, very confusing and incomplete in the light of the further developments
here set forth.
Mr. D. H. Robertson has defined to-day′s income as being equal to
yesterday′s consumption plus investment, so that to-day′s
saving, in his sense, is equal to yesterday′s investment plus the
excess of yesterday′s consumption over to-day′s consumption. On this definition
saving can exceed investment, namely, by the excess of yesterday′s income (in my
sense) over to-day′s income. Thus when Mr. Robertson says that there is an
excess of saving over investment, he means literally the same thing as I mean
when I say that income is falling, and the excess of saving in his sense is
exactly equal to the decline of income in my sense. If it were true that current
expectations were always determined by yesterday′s realised results, to-day′s
effective demand would be equal to yesterday′s income. Thus Mr. Robertson′s
method might be regarded as an alternative attempt to mine (being, perhaps, a
first approximation to it) to make the same distinction, so vital for causal
analysis, that I have tried to make by the contrast between effective demand and
income.{N-ch07-2}[2]
IV
We come next to the much vaguer ideas associated with the phrase “forced
saving”. Is any clear significance discoverable in these? In my Treatise on
Money (vol. i. p. 171, footnote) I gave some references to earlier uses of
this phrase and suggested that they bore some affinity to the difference between
investment and “saving” in the sense in which I there used the latter term. I am
no longer confident that there was in fact so much affinity as I then supposed.
In any case, I feel sure that “forced saving” and analogous phrases employed
more recently (e.g. by Professor Hayek or Professor Robbins) have no
definite relation to the difference between investment and “saving” in the sense
intended in my Treatise on Money. For whilst these authors have not
explained exactly what they mean by this term, it is clear that “forced saving”,
in their sense, is a phenomenon which results directly from, and is measured by,
changes in the quantity of money or bank-credit.
It is evident that a change in the volume of output and employment will,
indeed, cause a change in income measured in wage-units; that a change in the
wage-unit will cause both a redistribution of income between borrowers and
lenders and a change in aggregate income measured in money; and that in either
event there will (or may) be a change in the amount saved. Since, therefore,
changes in the quantity of money may result, through their effect on the rate of
interest, in a change in the volume and distribution of income (as we shall show
later), such changes may involve, indirectly, a change in the amount saved. But
such changes in the amounts saved are no more “forced savings” than any other
changes in the amounts saved due to a change in circumstances; and there is no
means of distinguishing between one case and another, unless we specify the
amount saved in certain given conditions as our norm or standard. Moreover, as
we shall see, the amount of the change in aggregate saving which results from a
given change in the quantity of money is highly variable and depends on many
other factors.
Thus “forced saving” has no meaning until we have specified some standard
rate of saving. If we select (as might be reasonable) the rate of saying which
corresponds to an established state of full employment, the above definition
would become: “Forced saving is the excess of actual saving over what would be
saved if there were full employment in a position of long-period equilibrium”.
This definition would make good sense, but a sense in which a forced excess of
saving would be a very rare and a very unstable phenomenon, and a forced
deficiency of saving the usual state of affairs.
Professor Hayek′s interesting “Note on the Development of the Doctrine of
Forced Saving”{N-ch07-3}[3]
shows that this was in fact the original meaning of the term. “Forced saving” or
“forced frugality” was, in the first instance, a conception of Bentham′s; and
Bentham expressly stated that he had in mind the consequences of an increase in
the quantity of money (relatively to the quantity of things vendible for money)
in circumstances of “all hands being employed and employed in the most
advantageous manner”{N-ch07-4}[4].
In such circumstances, Bentham points out, real income cannot be increased, and,
consequently, additional investment, taking place as a result of the transition,
involves forced frugality “at the expense of national comfort and national
justice”. All the nineteenth-century writers who dealt with this matter had
virtually the same idea in mind. But an attempt to extend this perfectly clear
notion to conditions of less than full employment involves difficulties. It is
true, of course (owing to the fact of diminishing returns to an increase in the
employment applied to a given capital equipment), that any increase in
employment involves some sacrifice of real income to those who were already
employed, but an attempt to relate this loss to the increase in investment which
may accompany the increase in employment is not likely to be fruitful. At any
rate I am not aware of any attempt having been made by the modern writers who
are interested in “forced saving” to extend the idea to conditions where
employment is increasing; and they seem, as a rule, to overlook the fact that
the extension of the Benthamite concept of forced frugality to conditions of
less than full employment requires some explanation or qualification.
V
The prevalence of the idea that saving and investment, taken in their
straightforward sense, can differ from one another, is to be explained, I think,
by an optical illusion due to regarding an individual depositor′s relation to
his bank as being a one-sided transaction, instead of seeing it as the two-sided
transaction which it actually is. It is supposed that a depositor and his bank
can somehow contrive between them to perform an operation by which savings can
disappear into the banking system so that they are lost to investment, or,
contrariwise, that the banking system can make it possible for investment to
occur, to which no saving corresponds. But no one can save without acquiring an
asset, whether it be cash or a debt or capital-goods; and no one can acquire an
asset which he did not previously possess, unless either an asset of
equal value is newly produced or someone else parts with an asset of that value
which he previously had. In the first alternative there is a corresponding new
investment: in the second alternative someone else must be dis-saving an equal
sum. For his loss of wealth must be due to his consumption exceeding his income,
and not to a loss on capital account through a change in the value of a
capital-asset, since it is not a case of his suffering a loss of value which his
asset formerly had; he is duly receiving the current value of his asset and yet
is not retaining this value in wealth of any form, i.e. he must be
spending it on current consumption in excess of current income. Moreover, if it
is the banking system which parts with an asset, someone must be parting with
cash. It follows that the aggregate saving of the first individual and of others
taken together must necessarily be equal to the amount of current new
investment.
The notion that the creation of credit by the banking system allows
investment to take place to which “no genuine saving” corresponds can only be
the result of isolating one of the consequences of the increased bank-credit to
the exclusion of the others. If the grant of a bank credit to an entrepreneur
additional to the credits already existing allows him to make an addition to
current investment which would not have occurred otherwise, incomes will
necessarily be increased and at a rate which will normally exceed the
rate of increased investment. Moreover, except in conditions of full employment,
there will be an increase of real income as well as of money-income. The public
will exercise “a free choice” as to the proportion in which they divide their
increase of income between saving and spending; and it is impossible that the
intention of the entrepreneur who has borrowed in order to increase investment
can become effective (except in substitution for investment by other
entrepreneurs which would have occurred otherwise) at a faster rate than the
public decide to increase their savings. Moreover, the savings which result from
this decision are just as genuine as any other savings. No one can be compelled
to own the additional money corresponding to the new bank-credit, unless he
deliberately prefers to hold more money rather than some other form of wealth.
Yet employment, incomes and prices cannot help moving in such a way that in the
new situation someone does choose to hold the additional money. It is true that
an unexpected increase of investment in a particular direction may cause an
irregularity in the rate of aggregate saving and investment which would not have
occurred if it has been sufficiently foreseen. It is also true that the grant of
the bank-credit will set up three tendencies (1) for output to increase, (2) for
the marginal product to rise in value in terms of the wage-unit (which in
conditions of decreasing return must necessarily accompany an increase of
output), and (3) for the wage-unit to rise in terms of money (since this is a
frequent concomitant of better employment); and these tendencies may affect the
distribution of real income between different groups. But these tendencies are
characteristic of a state of increasing output as such, and will occur just as
much if the increase in output has been initiated otherwise than by an increase
in bank-credit. They can only be avoided, by avoiding any course of action
capable of improving employment. Much of the above, however, is anticipating the
result of discussions which have not yet been reached.
Thus the old-fashioned view that saving always involves investment, though
incomplete and misleading, is formally sounder than the newfangled view that
there can be saving without investment or investment without “genuine” saving.
The error lies in proceeding to the plausible inference that, when an individual
saves, he will increase aggregate investment by an equal amount. It is true,
that, when an individual saves he increases his own wealth. But the conclusion
that he also increases aggregate wealth fails to allow for the possibility that
an act of individual saving may react on someone else′s savings and hence on
someone else′s wealth.
The reconciliation of the identity between saving and investment with the
apparent “free-will” of the individual to save what he chooses irrespective of
what he or others may be investing, essentially depends on saving being, like
spending, a two-sided affair. For although the amount of his own saving is
unlikely to have any significant influence on his own income, the reactions of
the amount of his consumption on the incomes of others makes it impossible for
all individuals simultaneously to save any given sums. Every such attempt to
save more by reducing consumption will so affect incomes that the attempt
necessarily defeats itself. It is, of course, just as impossible for the
community as a whole to save less than the amount of current
investment, since the attempt to do so will necessarily raise incomes to a level
at which the sums which individuals choose to save add up to a figure exactly
equal to the amount of investment.
The above is closely analogous with the proposition which harmonises the
liberty, which every individual possesses, to change, whenever he chooses, the
amount of money he holds, with the necessity for the total amount of money,
which individual balances add up to, to be exactly equal to the amount of cash
which the banking system has created. In this latter case the equality is
brought about by the fact that the amount of money which people choose to hold
is not independent of their incomes or of the prices of the things (primarily
securities), the purchase of which is the natural alternative to holding money.
Thus incomes and such prices necessarily change until the aggregate of the
amounts of money which individuals choose to hold at the new level of incomes
and prices thus brought about has come to equality with the amount of money
created by the banking system. This, indeed, is the fundamental proposition of
monetary theory.
Both these propositions follow merely from the fact that there cannot be a
buyer without a seller or a seller without a buyer. Though an individual whose
transactions are small in relation to the market can safely neglect the fact
that demand is not a one-sided transaction, it makes nonsense to neglect it when
we come to aggregate demand. This is the vital difference between the theory of
the economic behaviour of the aggregate and the theory of the behaviour of the
individual unit, in which we assume that changes in the individual′s own demand
do not affect his income.
The General Theory of Employment, Interest and Money by John Maynard Keynes
Book III The Propensity to Consume
@§ Chapter 8
The Propensity to Consume: I. The Objective Factors
I
WE are now in a position to return to our main theme, from which we
broke off at the end of Book I in order to deal with certain general problems of
method and definition. The ultimate object of our analysis is to discover what
determines the volume of employment. So far we have established the preliminary
conclusion that the volume of employment is determined by the point of
intersection of the aggregate supply function with the aggregate demand
function. The aggregate supply function, however, which depends in the main on
the physical conditions of supply, involves few considerations which are not
already familiar. The form may be unfamiliar but the underlying factors are not
new. We shall return to the aggregate supply function in Chapter 20, where we
discuss its inverse under the name of the employment function. But, in
the main, it is the part played by the aggregate demand function which has been
overlooked; and it is to the aggregate demand function that we shall devote
Books III and IV.
The aggregate demand function relates any given level of employment to the
“proceeds” which that level of employment is expected to realise. The “proceeds”
are made up of the sum of two quantities — the sum which will be spent on
consumption when employment is at the given level, and the sum which will be
devoted to investment. The factors which govern these two quantities are largely
distinct. In this book we shall consider the former, namely what factors
determine the sum which will be spent on consumption when employment is at a
given level; and in Book IV we shall proceed to the factors which determine the
sum which will be devoted to investment.
Since we are here concerned in determining what sum will be spent on
consumption when employment is at a given level, we should, strictly speaking,
consider the function which relates the former quantity (C) to the latter (N).
It is more convenient, however, to work in terms of a slightly different
function, namely, the function which relates the consumption in terms of
wage-units (Cw) to the income in terms of wage-units (Yw) corresponding to a level of employment N. This suffers from
the objection that Yw is not a unique function of N, which
is the same in all circumstances. For the relationship between Yw and N may depend (though probably in a very minor degree) on
the precise nature of the employment. That is to say, two different
distributions of a given aggregate employment N between different employments
might (owing to the different shapes of the individual employment functions — a
matter to be discussed in Chapter 20 below) lead to different values of Yw. In conceivable circumstances a special allowance might have to
be made for this factor. But in general it is a good approximation to regard
Yw as uniquely determined by N. We will therefore define
what we shall call the propensity to consume as the functional
relationship χ between Yw a given level of income in terms
of wage-units, and Cw the expenditure on consumption out of
that level of income, so that
Cw = χ(Yw)
or C = W.χ(Yw).
The amount that the community spends on consumption obviously depends (i)
partly on the amount of its income, (ii) partly on the other objective attendant
circumstances, and (iii) partly on the subjective needs and the psychological
propensities and habits of the individuals composing it and the principles on
which the income is divided between them (which may suffer modification as
output is increased). The motives to spending interact and the attempt to
classify them runs the danger of false division. Nevertheless it will clear our
minds to consider them separately under two broad heads which we shall call the
subjective factors and the objective factors. The subjective factors, which we
shall consider in more detail in the next Chapter, include those psychological
characteristics of human nature and those social practices and institutions
which, though not unalterable, are unlikely to undergo a material change over a
short period of time except in abnormal or revolutionary circumstances. In an
historical enquiry or in comparing one social system with another of a different
type, it is necessary to take account of the manner in which changes in the
subjective factors may affect the propensity to consume. But, in general, we
shall in what follows take the subjective factors as given; and we shall assume
that the propensity to consume depends only on changes in the objective
factors.
II
The principal objective factors which influence the propensity to consume
appear to be the following:
(1) A change in the
wage-unit. — Consumption (C) is obviously much more a function of (in some
sense) real income than of money-income. In a given state of technique and
tastes and of social conditions determining the distribution of income, a man′s
real income will rise and fall with the amount of his command over labour-units,
i.e. with the amount of his income measured in wage-units; though when
the aggregate volume of output changes, his real income will (owing to the
operation of decreasing returns) rise less than in proportion to his income
measured in wage-units. As a first approximation, therefore, we can reasonably
assume that, if the wage-unit changes, the expenditure on consumption
corresponding to a given level of employment will, like prices, change in the
same proportion; though in some circumstances we may have to make an allowance
for the possible reactions on aggregate consumption of the change in the
distribution of a given real income between entrepreneurs and rentiers resulting
from a change in the wage-unit. Apart from this, we have already allowed for
changes in the wage-unit by defining the propensity to consume in terms of
income measured in terms of wage-units.
(2) A change in the
difference between income and net income. We have shown above that the
amount of consumption depends on net income rather than on income, since it is,
by definition, his net income that a man has primarily in mind when he is
deciding his scale of consumption. In a given situation there may be a somewhat
stable relationship between the two, in the sense that there will be a function
uniquely relating different levels of income to the corresponding levels of net
income. If, however, this should not be the case, such part of any change in
income as is not reflected in net income must be neglected since it will have no
effect on consumption; and, similarly, a change in net income, not reflected in
income, must be allowed for. Save in exceptional circumstances, however, I doubt
the practical importance of this factor. We will return to a fuller discussion
of the effect on consumption of the difference between income and net income in
the fourth section of this chapter.
(3) Windfall changes in
capital-values not allowed for in calculating net income. — These are of
much more importance in modifying the propensity to consume, since they will
bear no stable or regular relationship to the amount of income. The consumption
of the wealth-owning class may be extremely susceptible to unforeseen changes in
the money-value of its wealth. This should be classified amongst the major
factors capable of causing short-period changes in the propensity to
consume.
(4) Changes in the rate of
time-discounting, i.e. in the ratio of exchange between present goods
and future goods. — This is not quite the same thing as the rate of
interest, since it allows for future changes in the purchasing power of money in
so far as these are foreseen. Account has also to be taken of all kinds of
risks, such as the prospect of not living to enjoy the future goods or of
confiscatory taxation. As an approximation, however, we can identify this with
the rate of interest.
The influence of this factor on the rate of
spending out of a given income is open to a good deal of doubt. For the
classical theory of the rate of interest,{N-ch08-1}[1]
which was based on the idea that the rate of interest was the factor which
brought the supply and demand for savings into equilibrium, it was convenient to
suppose that expenditure on consumption is cet. par. negatively
sensitive to changes in the rate of interest, so that any rise in the rate of
interest would appreciably diminish consumption. It has long been recognised,
however, that the total effect of changes in the rate of interest on the
readiness to spend on present consumption is complex and uncertain, being
dependent on conflicting tendencies, since some of the subjective motives
towards saving will be more easily satisfied if the rate of interest rises,
whilst others will be weakened. Over a long period substantial changes in the
rate of interest probably tend to modify social habits considerably, thus
affecting the subjective propensity to spend — though in which direction it
would be hard to say, except in the light of actual experience. The usual type
of short-period fluctuation in the rate of interest is not likely, however, to
have much direct influence on spending either way. There are not many
people who will alter their way of living because the rate of interest has
fallen from 5 to 4 per cent, if their aggregate income is the same as before.
Indirectly there may be more effects, though not all in the same direction.
Perhaps the most important influence, operating through changes in the rate of
interest, on the readiness to spend out of a given income, depends on the effect
of these changes on the appreciation or depreciation in the price of securities
and other assets. For if a man is enjoying a windfall increment in the value of
his capital, it is natural that his motives towards current spending should be
strengthened, even though in terms of income his capital is worth no more than
before; and weakened if he is suffering capital losses. But this indirect
influence we have allowed for already under (3) above. Apart from this, the main
conclusion suggested by experience is, I think, that the short-period influence
of the rate of interest on individual spending out of a given income is
secondary and relatively unimportant, except, perhaps, where unusually large
changes are in question. When the rate of interest falls very low indeed, the
increase in the ratio between an annuity purchasable for a given sum and the
annual interest on that sum may, however, provide an important source of
negative saving by encouraging the practice of providing for old age by the
purchase of an annuity.
The abnormal situation, where the
propensity to consume may be sharply affected by the development of extreme
uncertainty concerning the future and what it may bring forth, should also,
perhaps, be classified under this heading.
(5) Changes in fiscal
policy. — In so far as the inducement to the individual to save depends on
the future return which he expects, it clearly depends not only on the rate of
interest but on the fiscal policy of the Government. Income taxes, especially
when they discriminate against “unearned” income, taxes on capital-profits,
death-duties and the like are as relevant as the rate of interest; whilst the
range of possible changes in fiscal policy may be greater, in expectation at
least, than for the rate of interest itself. If fiscal policy is used as a
deliberate instrument for the more equal distribution of incomes, its effect in
increasing the propensity to consume is, of course, all the greater.{N-ch08-2}[2]
We must also take account of the effect on the
aggregate propensity to consume of Government sinking funds for the discharge of
debt paid for out of ordinary taxation. For these represent a species of
corporate saving, so that a policy of substantial sinking funds must be regarded
in given circumstances as reducing the propensity to consume. It is for this
reason that a change-over from a policy of Government borrowing to the opposite
policy of providing sinking funds (or vice versa) is capable of causing
a severe contraction (or marked expansion) of effective demand.
(6) Changes in expectations
of the relation between the present and the future level of income. — We
must catalogue this factor for the sake of formal completeness. But, whilst it
may affect considerably a particular individual′s propensity to consume, it is
likely to average out for the community as a whole. Moreover, it is a matter
about which there is, as a rule, too much uncertainty for it to exert much
influence.
We are left therefore, with the conclusion that in a given situation the
propensity to consume may be considered a fairly stable function, provided that
we have eliminated changes in the wage-unit in terms of money. Windfall changes
in capital-values will be capable of changing the propensity to consume, and
substantial changes in the rate of interest and in fiscal policy may make some
difference; but the other objective factors which might affect it, whilst they
must not be overlooked, are not likely to be important in ordinary
circumstances.
The fact that, given the general economic situation, the expenditure on
consumption in terms of the wage-unit depends in the main, on the volume of
output and employment is the justification for summing up the other factors in
the portmanteau function “propensity to consume”. For whilst the other factors
are capable of varying (and this must not be forgotten), the aggregate income
measured in terms of the wage-unit is, as a rule, the principal variable upon
which the consumption-constituent of the aggregate demand function will
depend.
III
Granted, then, that the propensity to consume is a fairly stable function so
that, as a rule, the amount of aggregate consumption mainly depends on the
amount of aggregate income (both measured in terms of wage-units), changes in
the propensity itself being treated as a secondary influence, what is the normal
shape of this function?
The fundamental psychological law, upon which we are entitled to depend with
great confidence both a priori from our knowledge of human nature and
from the detailed facts of experience, is that men are disposed, as a rule and
on the average, to increase their consumption as their income increases, but not
by as much as the increase in their income. That is to say, if Cw is the amount of consumption and Yw is
income (both measured in wage-units) ΔCw has the same sign
as ΔYw but is smaller in amount, i.e. dCw/dYw is positive and less than
unity.
This is especially the case where we have short periods in view, as in the
case of the so-called cyclical fluctuations of employment during which habits,
as distinct from more permanent psychological propensities, are not given time
enough to adapt themselves to changed objective circumstances. For a man′s
habitual standard of life usually has the first claim on his income, and he is
apt to save the difference which discovers itself between his actual income and
the expense of his habitual standard; or, if he does adjust his expenditure to
changes in his income, he will over short periods do so imperfectly. Thus a
rising income will often be accompanied by increased saving, and a falling
income by decreased saving, on a greater scale at first than subsequently.
But, apart from short-period changes in the level of income, it is
also obvious that a higher absolute level of income will tend, as a rule, to
widen the gap between income and consumption. For the satisfaction of the
immediate primary needs of a man and his family is usually a stronger motive
than the motives towards accumulation, which only acquire effective sway when a
margin of comfort has been attained. These reasons will lead, as a rule, to a
greater proportion of income being saved as real income increases. But
whether or not a greater proportion is saved, we take it as a fundamental
psychological rule of any modern community that, when its real income is
increased, it will not increase its consumption by an equal absolute
amount, so that a greater absolute amount must be saved, unless a large and
unusual change is occurring at the same time in other factors. As we shall show
subsequently,{N-ch08-3}[3]
the stability of the economic system essentially depends on this rule prevailing
in practice. This means that, if employment and hence aggregate income increase,
not all the additional employment will be required to satisfy the needs
of additional consumption.
On the other hand, a decline in income due to a decline in the level of
employment, if it goes far, may even cause consumption to exceed income not only
by some individuals and institutions using up the financial reserves which they
have accumulated in better times, but also by the Government, which will be
liable, willingly or unwillingly, to run into a budgetary deficit or will
provide unemployment relief, for example, out of borrowed money. Thus, when
employment falls to a low level, aggregate consumption will decline by a smaller
amount than that by which real income has declined, by reason both of the
habitual behaviour of individuals and also of the probable policy of
governments; which is the explanation why a new position of equilibrium can
usually be reached within a modest range of fluctuation. Otherwise a fall in
employment and income, once started, might proceed to extreme lengths.
This simple principle leads, it will be seen, to the same conclusion as
before, namely, that employment can only increase pari passu with an
increase in investment; unless, indeed, there is a change in the propensity to
consume. For since consumers will spend less than the increase in aggregate
supply price when employment is increased, the increased employment will prove
unprofitable unless there is an increase in investment to fill the gap.
IV
We must not underestimate the importance of the fact already mentioned above
that, whereas employment is a function of the expected consumption and the
expected investment, consumption is, cet. par., a function of net
income, i.e. of net investment (net income being equal to
consumption plus net investment). In other words, the larger the
financial provision which it is thought necessary to make before reckoning net
income, the less favourable to consumption, and therefore to employment, will a
given level of investment prove to be.
When the whole of this financial provision (or supplementary cost) is in fact
currently expended in the upkeep of the already existing capital equipment, this
point is not likely to be overlooked. But when the financial provision
exceeds the actual expenditure on current upkeep, the practical results
of this in its effect on employment are not always appreciated. For the amount
of this excess neither directly gives rise to current investment nor is
available to pay for consumption. It has, therefore, to be balanced by new
investment, the demand for which has arisen quite independently of the current
wastage of old equipment against which the financial provision is being made;
with the result that the new investment available to provide current income is
correspondingly diminished and a more intense demand for new investment is
necessary to make possible a given level of employment. Moreover, much the same
considerations apply to the allowance for wastage included in user cost, in so
far as the wastage is not actually made good.
Take a house which continues to be habitable until it is demolished or
abandoned. If a certain sum is written off its value out of the annual rent paid
by the tenants, which the landlord neither spends on upkeep nor regards as net
income available for consumption, this provision, whether it is a part of U or
of V, constitutes a drag on employment all through the life of the house,
suddenly made good in a lump when the house has to be rebuilt.
In a stationary economy all this might not be worth mentioning, since in each
year the depreciation allowances in respect of old houses would be exactly
offset by the new houses built in replacement of those reaching the end of their
lives in that year. But such factors may be serious in a non-static economy,
especially during a period which immediately succeeds a lively burst of
investment in long-lived capital. For in such circumstances a very large
proportion of the new items of investment may be absorbed by the larger
financial provisions made by entrepreneurs in respect of existing capital
equipment, upon the repairs and renewal of which, though it is wearing out with
time, the date has not yet arrived for spending anything approaching the full
financial provision which is being set aside; with the result that incomes
cannot rise above a level which is low enough to correspond with a low aggregate
of net investment. Thus sinking funds, etc., are apt to withdraw spending power
from the consumer long before the demand for expenditure on replacements (which
such provisions are anticipating) comes into play; i.e. they diminish
the current effective demand and only increase it in the year in which the
replacement is actually made. If the effect of this is aggravated by “financial
prudence”, i.e. by its being thought advisable to “write off” the
initial cost more rapidly than the equipment actually wears out, the
cumulative result may be very serious indeed.
In the United States, for example, by 1929 the rapid capital expansion of the
previous five years had led cumulatively to the setting up of sinking funds and
depreciation allowances, in respect of plant which did not need replacement, on
so huge a scale that an enormous volume of entirely new investment was required
merely to absorb these financial provisions; and it became almost hopeless to
find still more new investment on a sufficient scale to provide for such new
saving as a wealthy community in full employment would be disposed to set aside.
This factor alone was probably sufficient to cause a slump. And, furthermore,
since “financial prudence” of this kind continued to be exercised through the
slump by those great corporations which were still in a position to afford it,
it offered a serious obstacle to early recovery.
Or again, in Great Britain at the present time (1935) the substantial amount
of house-building and of other new investments since the war has led to an
amount of sinking funds being set up much in excess of any present requirements
for expenditure on repairs and renewals, a tendency which has been accentuated,
where the investment has been made by local authorities and public boards, by
the principles of “sound” finance which often require sinking funds sufficient
to write off the initial cost some time before replacement will actually fall
due; with the result that even if private individuals were ready to spend the
whole of their net incomes it would be a severe task to restore full employment
in the face of this heavy volume of statutory provision by public and
semi-public authorities, entirely associated from any corresponding new
investment. The sinking funds of local authorities now stand, I think,{N-ch08-4}[4]
at an annual figure of more than half the amount which these authorities are
spending on the whole of their new developments.{N-ch08-5}[5]
Yet it is not certain that the Ministry of Health are aware, when they insist on
stiff sinking funds by local authorities, how much they may be aggravating the
problem of unemployment. In the case of advances by Building Societies to help
an individual to build his own house, the desire to be clear of debt more
rapidly than the house actually deteriorates may stimulate the house-owner to
save more than he otherwise would; — though this factor should be classified,
perhaps, as diminishing the propensity to consume directly rather than through
its effect on net income. In actual figures, repayments of mortgages advanced by
Building Societies, which amounted to £24,000,000 in 1925, had risen to
£68,000,000 by 1933, as compared with new advances of £103,000,000; and to-day
the repayments are probably still higher.
That it is investment, rather than net investment, which emerges from the
statistics of output, is brought out forcibly and naturally in Mr. Colin Clark′s
National Income, 1924-1931. He also shows what a large proportion
depreciation, etc., normally bears to the value of investment. For example, he
estimates that in Great Britain, over the years 1928-1931,{N-ch08-6}[6]
the investment and the net investment were as follows, though his gross
investment is probably somewhat greater than my investment, inasmuch as it may
include a part of user cost, and it is not clear how closely his “net
investment” corresponds to my definition of this term:
(£ million)
1928
1929
1930
1931
Gross Investment-Output
791
731
620
482
“Value of physical wasting of old capital”
433
435
437
439
Net Investment
358
296
183
43
Mr. Kuznets has arrived at much the same conclusion in compiling the
statistics of the Gross Capital Formation (as he calls what I call
investments in the United States) 1919-1933. The physical fact, to which the
statistics of output correspond, is inevitably the gross, and not the net,
investment. Mr. Kuznets has also discovered the difficulties in passing from
gross investment to net investment. “The difficulty”, he writes, “of passing
from gross to net capital formation, that is, the difficulty of correcting for
the consumption of existing durable commodities, is not only in the lack of
data. The very concept of annual consumption of commodities that last over a
number of years suffers from ambiguity”.{N-ch08-7}[7]
He falls back, therefore, “on the assumption that the allowance for depreciation
and depletion on the books of business firms describes correctly the volume of
consumption of already existing′ finished durable goods used by business firms”.
On the other hand, he attempts no deduction at all in respect of houses and
other durable commodities in the hands of individuals. His very interesting
results for the United States can be summarised as follows:
(Millions of
Dollars)
1925
1926
1927
1928
1929
Gross capital formation (after allowing for net change in
business inventories)
30,706
33,571
31,157
33,934
34,491
Entrepreneurs′ servicing, repairs, maintenance,
depreciation and depletion
7,685
8,288
8,223
8,481
9,010
Net capital formation (on Mr. Kuznets′definition)
23,021
25,293
22,934
25,453
25,481
(Millions of
Dollars)
1930
1931
1932
1933
Gross capital formation (after allowing for net change in
business inventories)
27,538
19,721
7,780
14,879
Entrepreneurs′ servicing, repairs, maintenance,
depreciation and depletion
8,502
7,623
6,543
8,204
Net capital formation (on Mr. Kuznets′ definition)
19,036
11,098
1,237
6,675
Several facts emerge with prominence from this table. Net capital formation
was very steady over the quinquennium 1925-1929, with only a 10 per cent
increase in the latter part of the upward movement. The deduction for
entrepreneurs′ repairs, maintenance, depreciation and depletion remained at a
high figure even at the bottom of the slump. But Mr. Kuznets′ method must surely
lead to too low an estimate of the annual increase in depreciation, etc.; for he
puts the latter at less than 1 1/2 per cent per annum of the new net capital
formation. Above all, net capital formation suffered an appalling collapse after
1929, falling in 1932 to a figure no less than 95 per cent below the average
of the quinquennium 1925-1929.
The above is, to some extent, a digression. But it is important to emphasise
the magnitude of the deduction which has to be made from the income of a
society, which already possesses a large stock of capital, before we arrive at
the net income which is ordinarily available for consumption. For if we overlook
this, we may underestimate the heavy drag on the propensity to consume which
exists even in conditions where the public is ready to consume a very large
proportion of its net income.
Consumption — to repeat the obvious — is the sole end and object of all
economic activity. Opportunities for employment are necessarily limited by the
extent of aggregate demand. Aggregate demand can be derived only from present
consumption or from present provision for future consumption. The consumption
for which we can profitably provide in advance cannot be pushed indefinitely
into the future. We cannot, as a community, provide for future consumption by
financial expedients but only by current physical output. In so far as our
social and business organisation separates financial provision for the future
from physical provision for the future so that efforts to secure the former do
not necessarily carry the latter with them, financial prudence will be liable to
diminish aggregate demand and thus impair well-being, as there are many examples
to testify. The greater, moreover, the consumption for which we have provided in
advance, the more difficult it is to find something further to provide for in
advance, and the greater our dependence on present consumption as a source of
demand. Yet the larger our incomes, the greater, unfortunately, is the margin
between our incomes and our consumption. So, failing some novel expedient, there
is, as we shall see, no answer to the riddle, except that there must be
sufficient unemployment to keep us so poor that our consumption falls short of
our income by no more than the equivalent of the physical provision for future
consumption which it pays to produce to-day.
Or look at the matter thus. Consumption is satisfied partly by objects
produced currently and partly by objects produced previously, i.e. by
disinvestment. To the extent that consumption is satisfied by the latter, there
is a contraction of current demand, since to that extent a part of current
expenditure fails to find its way back as a part of net income. Contrariwise
whenever an object is produced within the period with a view to satisfying
consumption subsequently, an expansion of current demand is set up. Now all
capital-investment is destined to result, sooner or later, in
capital-disinvestment. Thus the problem of providing that new capital-investment
shall always outrun capital-disinvestment sufficiently to fill the gap between
net income and consumption, presents a problem which is increasingly difficult
as capital increases. New capital-investment can only take place in excess of
current capital-disinvestment if future expenditure on consumption is
expected to increase. Each time we secure to-day′s equilibrium by increased
investment we are aggravating the difficulty of securing equilibrium to-morrow.
A diminished propensity to consume to-day can only be accommodated to the public
advantage if an increased propensity to consume is expected to exist some day.
We are reminded of “The Fable of the Bees” — the gay of to-morrow are absolutely
indispensable to provide a raison d′être for the grave of to-day.
It is a curious thing, worthy of mention, that the popular mind seems only to
be aware of this ultimate perplexity where public investment is
concerned, as in the case of road-building and house-building and the like. It
is commonly urged as an objection to schemes for raising employment by
investment under the auspices of public authority that it is laying up trouble
for the future. “What will you do,” it is asked, “when you have built all the
houses and roads and town halls and electric grids and water supplies and so
forth which the stationary population of the future can be expected to require?”
But it is not so easily understood that the same difficulty applies to private
investment and to industrial expansion; particularly to the latter, since it is
much easier to see an early satiation of the demand for new factories and plant
which absorb individually but little money, than of the demand for
dwelling-houses.
The obstacle to a clear understanding is, in these examples, much the same as
in many academic discussions of capital, namely, an inadequate appreciation of
the fact that capital is not a self-subsistent entity existing apart from
consumption. On the contrary, every weakening in the propensity to consume
regarded as a permanent habit must weaken the demand for capital as well as the
demand for consumption.
The General Theory of Employment, Interest and Money by John Maynard Keynes
Book III The Propensity to Consume
@§ Chapter 9
The Propensity to Consume: II. The Subjective Factors
I
THERE remains the second category of factors which affect the
amount of consumption out of a given income, namely, those subjective and social
incentives which determine how much is spent, given the aggregate of income in
terms of wage-units and given the relevant objective factors which we have
already discussed. Since, however, the analysis of these factors raises no point
of novelty, it may be sufficient if we give a catalogue of the more important,
without enlarging on them at any length.
There are, in general, eight main motives or objects of a subjective
character which lead individuals to refrain from spending out of their
incomes:
(i) To build up a reserve
against unforeseen contingencies;
(ii) To provide for an
anticipated future relation between the income and the needs of the individual
or his family different from that which exists in the present, as, for example,
in relation to old age, family education, or the maintenance of dependents;
(iii) To enjoy interest and
appreciation, i.e. because a larger real consumption at a later date is
preferred to a smaller immediate consumption;
(iv) To enjoy a gradually
increasing expenditure, since it gratifies a common instinct to look forward to
a gradually improving standard of life rather than the contrary, even though the
capacity for enjoyment may be diminishing;
(v) To enjoy a sense of
independence and the power to do things, though without a clear idea or definite
intention of specific action;
(vi) To secure a masse de
manoeuvre to carry out speculative or business projects;
(vii) To bequeath a
fortune;
(viii) To satisfy pure
miserliness, i.e. unreasonable but insistent inhibitions against acts
of expenditure as such.
These eight motives might be called the motives of Precaution, Foresight,
Calculation, Improvement, Independence, Enterprise, Pride and Avarice; and we
could also draw up a corresponding list of motives to consumption such as
Enjoyment, Short-sightedness, Generosity, Miscalculation, Ostentation and
Extravagance.
Apart from the savings accumulated by individuals, there is also the large
amount of income, varying perhaps from one-third to two-thirds of the total
accumulation in a modern industrial community such as Great Britain or the
United States, which is withheld by Central and Local Government, by
Institutions and by Business Corporations — for motives largely analogous to,
but not identical with, those actuating individuals, and mainly the four
following:
(i) The motive of enterprise —
to secure resources to carry out further capital investment without incurring
debt or raising further capital on the market;
(ii) The motive of liquidity —
to secure liquid resources to meet emergencies, difficulties and
depressions;
(iii) The motive of improvement
— to secure a gradually increasing income, which, incidentally, will protect the
management from criticism, since increasing income due to accumulation is seldom
distinguished from increasing income due to efficiency;
(iv) The motive of financial
prudence and the anxiety to be “on the right side” by making a financial
provision in excess of user and supplementary cost, so as to discharge debt and
write off the cost of assets ahead of, rather than behind, the actual rate of
wastage and obsolescence, the strength of this motive mainly depending on the
quantity and character of the capital equipment and the rate of technical
change.
Corresponding to these motives which favour the withholding of a part of
income from consumption, there are also operative at times motives which lead to
an excess of consumption over income. Several of the motives towards positive
saving catalogued above as affecting individuals have their intended counterpart
in negative saving at a later date, as, for example, with saving to provide for
family needs or old age. Unemployment relief financed by borrowing is best
regarded as negative saving.
Now the strength of all these motives will vary enormously according to the
institutions and organisation of the economic society which we presume,
according to habits formed by race, education, convention, religion and current
morals, according to present hopes and past experience, according to the scale
and technique of capital equipment, and according to the prevailing distribution
of wealth and the established standards of life. In the argument of this book,
however, we shall not concern ourselves, except in occasional digressions, with
the results of far-reaching social changes or with the slow effects of secular
progress. We shall, that is to say, take as given the main background of
subjective motives to saving and to consumption respectively. In so far as the
distribution of wealth is determined by the more or less permanent social
structure of the community, this also can be reckoned a factor, subject only to
slow change and over a long period, which we can take as given in our present
context.
II
Since, therefore, the main background of subjective and social incentives
changes slowly, whilst the short-period influence of changes in the rate of
interest and the other objective factors is often of secondary importance, we
are left with the conclusion that short-period changes in consumption largely
depend on changes in the rate at which income (measured in wage-units) is being
earned and not on changes in the propensity to consume out of a given
income.
We must, however, guard against a misunderstanding. The above means that the
influence of moderate changes in the rate of interest on the propensity
to consume is usually small. It does not mean that changes in the rate of
interest have only a small influence on the amounts actually saved and
consumed. Quite the contrary. The influence of changes in the rate of interest
on the amount actually saved is of paramount importance, but is in the
opposite direction to that usually supposed. For even if the attraction of
the larger future income to be earned from a higher rate of interest has the
effect of diminishing the propensity to consume, nevertheless we can be certain
that a rise in the rate of interest will have the effect of reducing the amount
actually saved. For aggregate saving is governed by aggregate investment; a rise
in the rate of interest (unless it is offset by a corresponding change in the
demand-schedule for investment) will diminish investment; hence a rise in the
rate of interest must have the effect of reducing incomes to a level at which
saving is decreased in the same measure as investment. Since incomes will
decrease by a greater absolute amount than investment, it is, indeed, true that,
when the rate of interest rises, the rate of consumption will decrease. But this
does not mean that there will be a wider margin for saving. On the contrary,
saving and spending will both decrease.
Thus, even if it is the case that a rise in the rate of interest would cause
the community to save more out of a given income, we can be quite sure
that a rise in the rate of interest (assuming no favourable change in the
demand-schedule for investment) will decrease the actual aggregate of savings.
The same line of argument can even tell us by how much a rise in the rate of
interest will, cet. par., decrease incomes. For incomes will have to
fall (or be redistributed) by just that amount which is required, with the
existing propensity to consume to decrease savings by the same amount by which
the rise in the rate of interest will, with the existing marginal efficiency of
capital, decrease investment. A detailed examination of this aspect will occupy
our next chapter.
The rise in the rate of interest might induce us to save more, if
our incomes were unchanged. But if the higher rate of interest retards
investment, our incomes will not, and cannot, be unchanged. They must
necessarily fall, until the declining capacity to save has sufficiently offset
the stimulus to save given by the higher rate of interest. The more virtuous we
are, the more determinedly thrifty, the more obstinately orthodox in our
national and personal finance, the more our incomes will have to fall when
interest rises relatively to the marginal efficiency of capital. Obstinacy can
bring only a penalty and no reward. For the result is inevitable.
Thus, after all, the actual rates of aggregate saving and spending do not
depend on Precaution, Foresight, Calculation, Improvement, Independence,
Enterprise, Pride or Avarice. Virtue and vice play no part. It all depends on
how far the rate of interest is favourable to investment, after taking account
of the marginal efficiency of capital. No, this is an overstatement. If the rate
of interest were so governed as to maintain continuous full employment, Virtue
would resume her sway; — the rate of capital accumulation would depend on the
weakness of the propensity to consume. Thus, once again, the tribute that
classical economists pay to her is due to their concealed assumption that the
rate of interest always is so governed.
The General Theory of Employment, Interest and Money by John Maynard Keynes
Book III The Propensity to Consume
@§ Chapter 10
The Marginal Propensity to Consume and the Multiplier
WE established in Chapter 8 that employment can only increase
pari passu with investment. We can now carry this line of thought a
stage further. For in given circumstances a definite ratio, to be called the
Multiplier, can be established between income and investment and,
subject to certain simplifications, between the total employment and the
employment directly employed on investment (which we shall call the primary
employment). This further step is an integral part of our theory of
employment, since it establishes a precise relationship, given the propensity to
consume, between aggregate employment and income and the rate of investment. The
conception of the multiplier was first introduced into economic theory by Mr. R.
F. Kahn in his article on “The Relation of Home Investment to Unemployment”
(Economic Journal, June 1931). His argument in this article depended on
the fundamental notion that, if the propensity to consume in various
hypothetical circumstances is (together with certain other conditions) taken as
given and we conceive the monetary or other public authority to take steps to
stimulate or to retard investment, the change in the amount of employment will
be a function of the net change in the amount of investment; and it aimed at
laying down general principles by which to estimate the actual quantitative
relationship between an increment of net investment and the increment of
aggregate employment which will be associated with it. Before coming to the
multiplier, however, it will be convenient to introduce the conception of the
marginal propensity to consume.
I
The fluctuations in real income under consideration in this book are those
which result from applying different quantities of employment (i.e. of
labour-units) to a given capital equipment, so that real income increases and
decreases with the number of labour-units employed. If, as we assume in general,
there is a decreasing return at the margin as the number of labour-units
employed on the given capital equipment is increased, income measured in terms
of wage-units will increase more than in proportion to the amount of employment,
which, in turn, will increase more than in proportion to the amount of real
income measured (if that is possible) in terms of product. Real income measured
in terms of product and income measured in terms of wage-units will, however,
increase and decrease together (in the short period when capital equipment is
virtually unchanged). Since, therefore, real income, in terms of product, may be
incapable of precise numerical measurement, it is often convenient to regard
income in terms of wage-units (Yw) as an adequate working
index of changes in real income. In certain contexts we must not overlook the
fact that, in general, Yw increases and decreases in a
greater proportion than real income; but in other contexts the fact that they
always increase and decrease together renders them virtually
interchangeable.
Our normal psychological law that, when the real income of the community
increases or decreases, its consumption will increase or decrease but not so
fast, can, therefore, be translated — not, indeed, with absolute accuracy but
subject to qualifications which are obvious and can easily be stated in a
formally complete fashion — into the propositions that ΔCw
and ΔYw have the same sign, but ΔYw >
ΔCw, where Cw is the consumption in
terms of wage-units. This is merely a repetition of the proposition already
established on p. 29 above.
Let us define, then, dCw/dYw as the marginal propensity to consume.
This quantity is of considerable importance, because it tells us how the next
increment of output will have to be divided between consumption and investment.
For ΔYw = ΔCw + ΔIw,
where ΔCw and ΔIw are the increments of
consumption and investment; so that we can write ΔYw =
kΔIw, where 1 - (1/k) is equal to the
marginal propensity to consume.
Let us call k the investment multiplier. It tells us that,
when there is an increment of aggregate investment, income will increase by an
amount which is k times the increment of investment.
II
Mr. Kahn′s multiplier is a little different from this, being what we may call
the employment multiplier designated by k′, since it measures
the ratio of the increment of total employment which is associated with a given
increment of primary employment in the investment industries. That is to say, if
the increment of investment ΔIw leads to an increment of
primary employment ΔN2 in the investment industries, the
increment of total employment ΔN = k′ΔN2.
There is no reason in general to suppose that k = k′. For
there is no necessary presumption that the shapes of the relevant portions of
the aggregate supply functions for different types of industry are such that the
ratio of the increment of employment in the one set of industries to the
increment of demand which has stimulated it will be the same as in the other set
of industries.{N-ch10-1}[1]
It is easy, indeed, to conceive of cases, as, for example, where the marginal
propensity to consume is widely different from the average propensity, in which
there would be a presumption in favour of ΔYw/ΔN and ΔIw/ΔN2, since there would be very divergent
proportionate changes in the demands for consumption-goods and investment-goods
respectively. If we wish to take account of such possible differences in the
shapes of the relevant portions of the aggregate supply functions for the two
groups of industries respectively, there is no difficulty in rewriting the
following argument in the more generalised form. But to elucidate the ideas
involved, it will be convenient to deal with the simplified case where
k= k′.
It follows, therefore, that, if the consumption psychology of the community
is such that they will choose to consume, e.g., nine-tenths of an
increment of income,{N-ch10-2}[2]
then the multiplier k is 10; and the total employment caused by
(e.g.) increased public works will be ten times the primary employment
provided by the public works themselves, assuming no reduction of investment in
other directions. Only in the event of the community maintaining their
consumption unchanged in spite of the increase in employment and hence in real
income, will the increase of employment be restricted to the primary employment
provided by the public works. If, on the other hand, they seek to consume the
whole of any increment of income, there will be no point of stability and prices
will rise without limit. With normal psychological suppositions, an increase in
employment will only be associated with a decline in consumption if there is at
the same time a change in the propensity to consume — as the result, for
instance, of propaganda in time of war in favour of restricting individual
consumption; and it is only in this event that the increased employment in
investment will be associated with an unfavourable repercussion on employment in
the industries producing for consumption.
This only sums up in a formula what should by now be obvious to the reader on
general grounds. An increment of investment in terms of wage-units cannot occur
unless the public are prepared to increase their savings in terms of wage-units.
Ordinarily speaking, the public will not do this unless their aggregate income
in terms of wage-units is increasing, Thus their effort to consume a part of
their increased incomes will stimulate output until the new level (and
distribution) of incomes provides a margin of saving sufficient to correspond to
the increased investment. The multiplier tells us by how much their employment
has to be increased to yield an increase in real income sufficient to induce
them to do the necessary extra saving, and is a function of their psychological
propensities.{N-ch10-3}[3]
If saving is the pill and consumption is the jam, the extra jam has to be
proportioned to the size of the additional pill. Unless the psychological
propensities of the public are different from what we are supposing, we have
here established the law that increased employment for investment must
necessarily stimulate the industries producing for consumption and thus lead to
a total increase of employment which is a multiple of the primary employment
required by the investment itself.
It follows from the above that, if the marginal propensity to consume is not
far short of unity, small fluctuations in investment will lead to wide
fluctuations in employment; but, at the same time, a comparatively small
increment of investment will lead to full employment. If, on the other hand, the
marginal propensity to consume is not much above zero, small fluctuations in
investment will lead to correspondingly small fluctuations in employment; but,
at the same time, it may require a large increment of investment to produce full
employment. In the former case involuntary unemployment would be an easily
remedied malady, though liable to be troublesome if it is allowed to develop. In
the latter case, employment may be less variable but liable to settle down at a
low level and to prove recalcitrant to any but the most drastic remedies. In
actual fact the marginal propensity to consume seems to lie somewhere between
these two extremes, though much nearer to unity than to zero; with the result
that we have, in a sense, the worst of both worlds, fluctuations in employment
being considerable and, at the same time, the increment in investment required
to produce full employment being too great to be easily handled. Unfortunately
the fluctuations have been sufficient to prevent the nature of the malady from
being obvious, whilst its severity is such that it cannot be remedied unless its
nature is understood.
When full employment is reached, any attempt to increase investment still
further will set up a tendency in money-prices to rise without limit,
irrespective of the marginal propensity to consume; i.e. we shall have
reached a state of true inflation.{N-ch10-4}[4]
Up to this point, however, rising prices will be associated with an increasing
aggregate real income.
III
We have been dealing so far with a net increment of investment. If,
therefore, we wish to apply the above without qualification to the effect of
(eg.) increased public works, we have to assume that there is no offset through
decreased investment in other directions,-and also, of course, no associated
change in the propensity of the community to consume. Mr. Kahn was mainly
concerned in the article referred to above in considering what offsets we ought
to take into account as likely to be important, and in suggesting quantitative
estimates. For in an actual case there are several factors besides some specific
increase of investment of a given kind which enter into the final result. If,
for example, a Government employs 100,000 additional men on public works, and if
the multiplier (as defined above) is 4, it is not safe to assume that aggregate
employment will increase by 400,000. For the new policy may have adverse
reactions on investment in other directions.
It would seem (following Mr. Kahn) that the following are likely in a modern
community to be the factors which it is most important not to overlook (though
the first two will not be fully intelligible until after Book IV. has been
reached):
(i) The method of financing the
policy and the increased working cash, required by- the increased employment and
the associated rise of prices, may have the effect of increasing the rate of
interest and so retarding investment in other directions, unless the monetary
authority takes steps to the contrary; whilst, at the same time, the increased
cost of capital goods will reduce their marginal efficiency to the private
investor, and this will require an actual fall in the rate of interest
to offset it.
(ii) With the confused
psychology which often prevails, the Government programme may, through its
effect on “confidence”, increase liquidity-preference or diminish the marginal
efficiency of capital, which, again, may retard other investment unless measures
are taken to offset it.
(iii) In an open system with
foreign-trade relations, some part of the multiplier of the increased investment
will accrue to the benefit of employment in foreign countries, since a
proportion of the increased consumption will diminish our own country′s
favourable foreign balance; so that, if we consider only the effect on domestic
employment as distinct from world employment, we must diminish the full figure
of the multiplier. On the other hand our own country may recover a portion of
this leakage through favourable repercussions due to the action of the
multiplier in the foreign country in increasing its economic activity.
Furthermore, if we are considering changes of a substantial amount, we have
to allow for a progressive change in the marginal propensity to consume, as the
position of the margin is gradually shifted; and hence in the multiplier. The
marginal propensity to consume is not constant for all levels of employment, and
it is probable that there will be, as a rule, a tendency for it to diminish as
employment increases; when real income increases, that is to say, the community
will wish to consume a gradually diminishing proportion of it.
There are also other factors, over and above the operation of the general
rule just mentioned, which may operate to modify the marginal propensity to
consume, and hence the multiplier; and these other factors seem likely, as a
rule, to accentuate the tendency of the general rule rather than to offset it.
For, in the first place, the increase of employment will tend, owing to the
effect of diminishing-returns in the short period, to increase the proportion of
aggregate income which accrues to the entrepreneurs, whose individual marginal
propensity to consume is probably less than the average for the community as a
whole. In the second place, unemployment is likely to be associated with
negative saving in certain quarters, private or public, because the unemployed
may be living either on the savings of themselves and their friends or on public
relief which is partly financed out of loans; with the result that re-employment
will gradually diminish these particular acts of negative saving and reduce,
therefore, the marginal propensity to consume more rapidly than would have
occurred from an equal increase in the community′s real income accruing in
different circumstances.
In any case, the multiplier is likely to be greater for a small net increment
of investment than for a large increment; so that, where substantial changes are
in view, we must be guided by the average value of the multiplier based on the
average marginal propensity to consume over the range in question.
Mr. Kahn has examined the probable quantitative result of such factors as
these in certain hypothetical special cases. But, clearly, it is not possible to
carry any generalisation very far. One can only say, for example, that a typical
modern community would probably tend to consume not much less than 8o per cent.
of any increment of real income, if it were a closed system with the consumption
of the unemployed paid for by transfers from the consumption of other consumers,
so that the multiplier after allowing for offsets would not be much less than 5.
In a country, however, where foreign trade accounts for, say, 20 per cent. of
consumption and where the unemployed receive out of loans or their equivalent up
to, say, 50 per cent. of their normal consumption when in work, the multiplier
may fall as low as 2 or 3 times the employment provided by a specific new
investment. Thus a given fluctuation of investment will be associated with a
much less violent fluctuation of employment in a country in which foreign trade
plays a large part and unemployment relief is financed on a larger scale out of
borrowing (as was the case, eg., in Great Britain in 1931), than in a
country in which these factors are less important (as in the United States in
1932).{N-ch10-5}[5]
It is, however, to the general principle of the multiplier to which we have
to look for an explanation of how fluctuations in the amount of investment,
which are a comparatively small proportion of the national income, are capable
of generating fluctuations in aggregate employment and income so much greater in
amplitude than themselves.
IV
The discussion has been carried on, so far, on the basis of a change in
aggregate investment which has been foreseen sufficiently in advance for the
consumption industries to advance pari passu with the capital-goods
industries without more disturbance to the price of consumption-goods than is
consequential, in conditions of decreasing returns, on an increase in the
quantity which is produced.
In general, however, we have to take account of the case where the initiative
comes from an increase in the output of the capital-goods industries which was
not fully foreseen. It is obvious that an initiative of this description only
produces its full effect on employment over a period of time. I have found,
however, in discussion that this ‘obvious fact often gives rise to some
confusion between the logical theory of the multiplier, which holds good
continuously, without time-lag, at all moments of time, and the consequences of
an expansion in the capital-goods industries which take gradual effect, subject
to time-lag and only after an interval.
The relationship between these two things can be cleared u by pointing out,
firstly that an unforeseen, or imperfectly foreseen, expansion in the
capital-goods industries does not have an instantaneous effect of equal amount
on the aggregate of investment but causes a gradual increase of the latter; and,
secondly, that it may cause a temporary departure of the marginal propensity to
consume away from its normal value, followed, however, by a gradual return to
it.
Thus an expansion in the capital-goods industries causes a series of
increments in aggregate investment occurring in successive periods over an
interval of time, and a series of values of the marginal propensity to consume
in these successive periods which differ both from what the values would have
been if the expansion had been foreseen and from what they will be when the
community has settled down to a new steady level of aggregate investment. But in
every interval of time the theory of the multiplier holds good in the sense that
the increment of aggregate demand is equal to the increment of aggregate
investment multiplied by the marginal propensity to consume.
The explanation of these two sets of facts can be seen most clearly by taking
the extreme case where the expansion of employment in the capital-goods
industries is so entirely unforeseen that in the first instance there is no
increase whatever in the output of consumption-goods. In this event the efforts
of those newly employed in the capital-goods industries to consume a proportion
of their increased incomes will raise the prices of consumption-goods until a
temporary equilibrium between demand and supply has been brought about partly by
the high prices causing a postponement of consumption, partly by a
redistribution of income in favour of the saving classes as an effect of the
increased profits resulting from the higher prices, and partly by the higher
prices causing a depletion of stocks. So far as the balance is restored by a
postponement of consumption there is a temporary reduction of the marginal
propensity to consume, i.e. of the multiplier itself, and in so far as
there is a depletion of stocks, aggregate investment increases for the time
being by less than the increment of investment in the capital-goods industries,
— i.e. the thing to he !multiplied does not increase by the full
increment of investment in the capital-goods industries. As time goes on,
however, the consumption-goods industries adjust themselves to the new demand,
so that when the deferred consumption is enjoyed, the marginal propensity to
consume rises temporarily above its normal level , to compensate for the extent
to which it previously fell below it, and eventually returns to its normal
level; whilst the restoration of stocks to their previous figure causes the
increment of aggregate investment to be temporarily greater than the increment
of investment in the capital-goods industries (the increment of working capital
corresponding to the greater output also having temporarily the same
effect).
The fact that an unforeseen change only exercises its full effect on
employment over a period of time is important in certain contexts;-in particular
it plays a part in the analysis of the trade cycle (on lines such as I followed
in my Treatise on Month). But it does not in any way affect the
significance of the theory of the multiplier as set forth in this chapter; nor
render it inapplicable as an indicator of the total benefit to employment to be
expected from an expansion in the capital-goods industries. Moreover, except in
conditions where the consumption industries are already working almost at
capacity so that an expansion of output requires an expansion of plant and not
merely the more intensive employment of the existing plant, there is no reason
to suppose that more than a brief interval of time need elapse before employment
in the consumption industries is advancing pars passu with employment
in the cap ital-goods industries with the multiplier operating near its normal
figure.
V
We have seen above that the greater the marginal propensity to consume, the
greater the multiplier, and hence the greater the disturbance to employment
corresponding to a given change in investment. This might seem to lead to the
paradoxical conclusion that a poor community in which saving is a very small
proportion of income will be more subject to violent fluctuations than a wealthy
community where saving is a larger proportion of income and the multiplier
consequently smaller.
This conclusion, however, would overlook the distinction between the effects
of the marginal propensity to consume and those of the average propensity to
consume. For whilst a high marginal propensity to consume involves a larger
proportionate effect from given percentage change in investment, the
absolute effect will, nevertheless, be small if the average
propensity to consume is also high. This may be illustrated as follows by a
numerical example.
Let us suppose that a community′s propensity to consume is such that, so long
as its real income does not exceed the output from employing 5,000,000 men on
its existing capital equipment, it consumes the whole of its income; that of the
output of the next 100,000 additional men employed it consumes 99 per cent., of
the next 100,000 after that 98 per cent., of the third 100,000 97 per cent. and
so on; and that 10,000,000 men employed represents full employment. It follows
from this that, when 5,000,000 + n x 100,000 men are employed, the
multiplier at the margin is 100/n, and n(n + 1)/2.(50
+ n) per cent. of the national income is invested.
Thus when 5,200,000 men are employed the multiplier is very large, namely 5o,
but investment is only a trifling proportion of current income, namely, 0.06 per
cent.; with the result that if investment falls off by a large proportion, say
about two-thirds, employment will only decline to 6,900,000, i.e. by
about 2 per cent. On the other hand, when 9,000,000 men are employed, the
marginal multiplier is comparatively small, namely 21, but investment is now a
substantial proportion of current income, namely, 9 per cent.; with the result
that if investment falls by two-thirds, employment will decline to 6,900,000,
namely, by 23 per cent. In the limit where investment falls off to zero,
employment will decline by about 4 per cent. in the former case, whereas in the
latter case it will decline by 44 per cent.{N-ch10-6}[6]
In the above example, the poorer of the two communities under comparison is
poorer by reason of under-employment. But the same reasoning applies by easy
adaptation if the poverty is due to inferior skill, technique or equipment. Thus
whilst the multiplier is larger in a poor community, the effect on employment of
fluctuations in investment will be much greater in a wealthy community, assuming
that in the latter current investment represents a much larger proportion of
current output.{N-ch10-7}[7]
It is also obvious from the above that the employment of a given number of
men on public works will (on the assumptions made) have a much larger effect on
aggregate employment at a time when there is severe unemployment, than it will
have later on when full employment is approached. In the above example, if, at a
time when employment has fallen to 5,200,000, an additional 100,000 men are
employed on public works, total employment will rise to 6,400,000. But if
employment is already 9,000,000 when the additional 100,000 men are taken on for
public works, total employment will only rise to 9,200,000. Thus public works
even of doubtful utility may pay for themselves over and over again at a time of
severe unemployment, if only from the diminished cost of relief expenditure,
provided that we can assume that a smaller proportion of income is saved when
unemployment is greater; but they may become a more doubtful proposition as a
state of full employment is approached. Furthermore, if our assumption is
correct that the marginal propensity to consume falls off steadily as we
approach full employment, it follows that it will become more and more
troublesome to secure a further given increase of employment by further
increasing investment.
It should not be difficult to compile a chart of the marginal propensity to
consume at each stage of a trade cycle from the statistics (if they were
available) of aggregate income and aggregate investment at successive dates. At
present, however, our statistics are not accurate enough (or compiled
sufficiently with this specific object in view) to allow us to infer more than
highly approximate estimates. The best for the purpose, of which 1 am aware, are
Mr. Kuznets′ figures for the United States (already referred to in Chapter 8
above), though they are, nevertheless, very precarious. Taken in conjunction
with estimates of national income these suggest, for what they are worth, both a
lower figure and a more stable figure for the investment multiplier than I
should have expected. If single years are taken in isolation, the results look
rather wild. But if they are grouped in pairs, the multiplier seems to have been
less than 3 and probably fairly stable in the neighbourhood of 2.5. This
suggests a marginal propensity to consume not exceeding 6o to 70 per cent. — a
figure quite plausible for the boom, but surprisingly, and, in my judgment,
improbably low for the slump. It is possible, however, that the extreme
financial conservatism of corporate finance in the United States, even during
the slump, may account for it. In other words, if, when investment is falling
heavily through a failure to undertake repairs and replacements, financial
provision is made, nevertheless, in respect of such wastage, the effect is to
prevent the rise in the marginal propensity to consume which would have occurred
otherwise. I suspect that this factor may have played a significant part in
aggravating the degree of the recent slump in the United States. On the other
hand, it is possible that the statistics somewhat overstate the decline in
investment, which is alleged to have fallen off by more than 75 percent. in 1932
compared with 1929, whilst net “capital formation” declined by more than 95 per
cent.; — a moderate change in these estimates being capable of making a
substantial difference to the multiplier.
VI
When involuntary unemployment exists, the marginal disutility of labour is
necessarily less than the utility of the marginal product. Indeed it may be much
less. For a man who has been long unemployed some measure of labour, instead of
involving disutility, may have a positive utility. If this is accepted, the
above reasoning shows how “wasteful” loan expenditure{N-ch10-8}[8]
may nevertheless enrich the community on balance. Pyramid-building, earthquakes,
even wars may serve to increase wealth, if the education of our statesmen on the
principles of the classical economics stands in the way of anything better.
It is curious how common sense, wriggling for an escape from absurd
conclusions, has been apt to reach a preference for wholly “wasteful”
forms of loan expenditure rather than for partly wasteful forms, which,
because they are not wholly wasteful, tend to be judged on strict “business”
principles. For example, unemployment relief financed by loans is more readily
accepted than the financing of improvements at a charge below the current rate
of interest; whilst the form of digging holes in the ground known as
gold-mining, which not only adds nothing whatever to the real wealth of the
world but involves the disutility of labour, is the most acceptable of all
solutions.
If the Treasury were to fill old bottles with banknotes, bury them at
suitable depths in disused coalmines which are then filled up to the surface
with town rubbish, and leave it to private enterprise on well-tried principles
of laissez-faire to dig the notes up again (the right to do so being
obtained, of course, by tendering for leases of the note-bearing territory),
there need be no more unemployment and, with the help of the repercussions, the
real income of the community, and its capital wealth also, would probably become
a good deal greater than it actually is. It would, indeed, be more sensible to
build houses and the like; but if there are political and practical difficulties
in the way of this, the above would be better than nothing.
The analogy between this expedient and the goldmines of the real world is
complete. At periods when gold is available at suitable depths experience shows
that the real wealth of the world increases rapidly; and when but little of it
is so available, our wealth suffers stagnation or decline. Thus gold-mines are
of the greatest value and importance to civilisation. just as wars have been the
only form of large-scale loan expenditure which statesmen have thought
justifiable, so gold-mining is the only pretext for digging holes in the ground
which has recommended itself to bankers as sound finance; and each of these
activities has played its part in progress-failing something better. To mention
a detail, the tendency in slumps for the price of gold to rise in terms of
labour and materials aids eventual recovery, because it increases the depth at
which gold-digging pays and lowers the minimum grade of ore which is
payable.
In addition to the probable effect of increased supplies of gold on the rate
of interest, gold-mining is for two reasons a highly practical form of
investment, if we are precluded from increasing employment by means which at the
same time increase our stock of useful wealth. In the first place, owing to the
gambling attractions which it offers it is carried on without too close a regard
to the ruling rate of interest. In the second place the result, namely, the
increased stock of gold, does not, as in other cases, have the effect of
diminishing its marginal utility. Since the value of a house depends on its
utility, every house which is built serves to diminish the prospective rents
obtainable from further house-building and therefore lessens the attraction of
further similar investment unless the rate of interest is falling part
passu. But the fruits of gold-mining do not suffer from this disadvantage,
and a check can only come through a rise of the wage-unit in terms of gold,
which is not likely to occur unless and until employment is substantially
better. Moreover, there is no subsequent reverse effect on account of provision
for user and supplementary costs, as in the case of less durable forms of
wealth.
Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled
wealth, in that it possessed two activities, namely, pyramid-building as well as
the search for the precious metals, the fruits of which, since they could not
serve the needs of man by being consumed, did not stale with abundance. The
Middle Ages built cathedrals and sang dirges. Two pyramids, two masses for the
dead, are twice as good as one; but not so two railways from London to York.
Thus we are so sensible, have schooled ourselves to so close a semblance of
prudent financiers, taking careful thought before we add to the “financial”
burdens of posterity by building them houses to live in, that we have no such
easy escape from the sufferings of unemployment. We have to accept them as an
inevitable result of applying to the conduct of the State the maxims which are
best calculated to “enrich” an individual by enabling him to pile up claims to
enjoyment which he does not intend to exercise at any definite time.
The General Theory of Employment, Interest and Money by John Maynard Keynes
Book IV The Inducement to Invest
@§ Chapter 11
The Marginal Efficiency of Capital
I
WHEN a man buys an investment or capital-asset, he purchases the
right to the series of prospective returns, which he expects to obtain from
selling its output, after deducting the running expenses of obtaining that
output, during the life of the asset. This series of annuities Q1, Q2, ... Qn it is
convenient to call the prospective yield of the investment.
Over against the prospective yield of the investment we have the supply
price of the capital-asset, meaning by this, not the market-price at which
an asset of the type in question can actually be purchased in the market, but
the price which would just induce a manufacturer newly to produce an additional
unit of such assets, i.e. what is sometimes called its replacement
cost. The relation between the prospective yield of a capital-asset and its
supply price or replacement cost, i.e. the relation between the
prospective yield of one more unit of that type of capital and the cost of
producing that unit, furnishes us with the marginal efficiency of
capital of that type. More precisely, I define the marginal efficiency of
capital as being equal to that rate of discount which would make the present
value of the series of annuities given by the returns expected from the
capital-asset during its life just equal to its supply price. This gives us the
marginal efficiencies of particular types of capital-assets. The greatest of
these marginal efficiencies can then be regarded as the marginal efficiency of
capital in general.
The reader should note that the marginal efficiency of capital is here
defined in terms of the expectation of yield and of the current
supply price of the capital-asset. It depends on the rate of return
expected to be obtainable on money if it were invested in a newly
produced asset; not on the historical result of what an investment has
yielded on its original cost if we look back on its record after its life is
over.
If there is an increased investment in any given type of capital during any
period of time, the marginal efficiency of that type of capital will diminish as
the investment in it is increased, partly because the prospective yield will
fall as the supply of that type of capital is increased, and partly because, as
a rule, pressure on the facilities for producing that type of capital will cause
its supply price to increase; the second of these factors being usually the more
important in producing equilibrium in the short run, but the longer the period
in view the more does the first factor take its place. Thus for each type of
capital we can build up a schedule, showing by how much investment in it will
have to increase within the period, in order that its marginal efficiency should
fall to any given figure. We can then aggregate these schedules for all the
different types of capital, so as to provide a schedule relating the rate of
aggregate investment to the corresponding marginal efficiency of capital in
general which that rate of investment will establish. We shall call this the
investment demand-schedule; or, alternatively, the schedule of the marginal
efficiency of capital.
Now it is obvious that the actual rate of current investment will be pushed
to the point where there is no longer any class of capital-asset of which the
marginal efficiency exceeds the current rate of interest. In other words, the
rate of investment will be pushed to the point on the investment demand-schedule
where the marginal efficiency of capital in general is equal to the market rate
of interest.{N-ch11-1}[1]
The same thing can also be expressed as follows. If Q