The previous analysis of the effect of the reservoir transactions was confined to the effect on the goods markets. We will now follow the money purchasing power stream a little farther and see what effect the ebb and flow of the stream has on the production end of the mechanism. In the first place it should be noted that the stream of money flowing from the goods market is exactly equal to that which enters. The price paid by the purchaser is the same as that received by the seller. Again we are looking at two aspects of the same thing. The reservoir transactions, which change the flow of money to the goods market, therefore cause a similar change in the flow from the goods market to the production market. Between the two markets, however, there is another set of reservoirs. Money may be stored by producers, and later used for production purchasing (buying of labor, materials, or services of capital) just as it may be stored for delayed consumer purchasing. Producers may draw from credit reservoirs, and so on. Thus the flow coming in to the production market is not the same as that which left the goods market, but is modified by the net result of these producer money reservoir transactions. The money purchasing power entering the production market is that created by production plus the net result of the transactions affecting both the consumer and the producer reservoirs.
The relation of production in terms of money to production in terms of the volume of goods produced is the production equivalent of the goods market price (or simply “market price,” as we will usually call it where the meaning is clear from the context). It is the quantity, which has already been designated as production market price, or production price. It might also be called “cost of production,” but a different name is being used to emphasize the analogy with market price and to avoid confusion with other definitions of the cost of production that include some different elements.
It will be noted that this concept of production price defines the price in terms of payment per unit of goods output rather than in terms of payment per unit of inputs such as labor and the services of capital. Inasmuch as the average productivity per man-hour is practically fixed from a short-term standpoint, the two methods of expression are almost equivalent, and the use of the output basis has some very important advantages. It not only puts all of the production costs on a commensurable basis, so that we can combine the costs of labor, interest, taxes, etc., but, even more significantly, enables us to make use of the equality between production price and normal market price that is a consequence of Principle VII.
As matters now stand, an endless series of debates rages over questions concerning the effect on the market price level of various actions that change the cost of production: wage increases, higher business taxes, etc. Such problems are greatly simplified by our finding with respect to the price equivalence in the two markets, since the question as to what effect a specific action in the production market will have on prices in the goods market now reduces to the much less complex question as to what effect the action has on the production price itself. The purchasing power analysis shows that any increase or decrease in production price that is not offset by reservoir transactions is promptly and inevitably followed by a corresponding increase or decrease in the market price level.
The items entering into the production price are well defined, and no particular question arises at this point with respect to any of them except profits. For purposes of this present work profits are included in production price in the amounts currently earned. To arrive at the total production price of the goods produced today, we add today’s wages, today’s taxes, today’s interest, etc., to today’s profits. This is not a distortion of the picture to fit a pre-conceived theory; it is a true representation of the manner in which modern business operations are actually carried on. If a decline in the price level occurs so that the goods produced today are ultimately sold at a lower price than in now contemplated, we will not go back and alter the books to reduce today’s profits. We will show the price reduction as an inventory adjustment when the change occurs. Not that these bookkeeping transactions are important in themselves; they are significant because they indicate the basis on which economic actions have been taken. During the interim these funds have been treated as profits. They may have been carried to reserves, they may have been disbursed as dividends, they may have been invested in capital goods, or they may have been otherwise used, and the economic life of the community has been influenced accordingly. We cannot retrace our steps and cancel out all that has occurred.
The economic policies and actions of today are predicated on the conditions existing today and our estimates of prospects for the immediate future. It is useless to look back at the past, and we cannot look forward into the distant future with any degree of certainty. The great majority of producers, moreover, have no reserves of any consequence. If today’s income fails to meet today’s outgo, there is no option. This outgo must be reduced or there is no tomorrow. Even if the producer feels reasonably confident that the tide will soon turn, he must still conform to present conditions. He cannot pay out what he does not have, and the gates to the credit reservoirs are closed to him as long as present operations are unprofitable.
The producers’ ability to make the necessary reductions in expenditure is a result of the fact that the production market is subject to control, fully insofar as volume is concerned, and to a lesser degree with respect to price. Here the production market differs very decidedly from the goods market. The latter is completely uncontrolled, except for the little that can be accomplished by means of the goods reservoirs, not because of any failure to set up such controls, or any lack of willingness to do so, but because control by the producers is impossible. They establish the normal price level by the wage rates they pay, but they have no influence over the amount of money stored in the reservoirs, or withdrawn from storage, by the consumers, hence they cannot control the flow of money purchasing power to the markets, and the volume of goods produced has been determined in advance of the marketing process. Since they cannot control either of these two elements, average market price, the quotient of the two, is also beyond their control.
At the production end of the mechanism the situation is different in two respects. First, and most important, the production market transaction precedes the production process, and the producer therefore has almost complete control over the volume of goods produced. He can buy enough labor to operate his plant at full capacity, or he can limit his operations to any fraction of capacity, even to the extent of closing down completely. This control over volume also gives him control over total production expenditures, and it enables him to influence production price (unit costs) to an extent that depends on how many fixed commitments for wages, interest, etc., he is operating under. A second difference is that the reservoirs in the circulating money stream between the goods market and the production market (the producer reservoirs) and the reservoirs of goods (inventories) are under the control of the producers, and they are deliberately handled in a manner, which conforms to production market conditions and helps to maintain control over this market.
In its role as a producer, serving other producers and the consumers, government has the same functions in the economic mechanism as a private enterprise. It may produce finished goods. Or it may act as a producer of services, performing some of the intermediate or auxiliary steps in the production process, in the same manner in which a bank or a railroad operates, and making a charge against the producers or consumers receiving the benefit of these services. The principal difference between the government and private production is that the charges made to the individual producers and consumers are less directly related to the services rendered than is customary in private business practice. This separation between the benefits derived and the costs assessed has some important economic effects that will be discussed at the appropriate points in the pages that follow, but in the meantime it should be understood that wherever reference is made to producers in general, the government is included to the extent that it participates, as a producer, in the activities under consideration. In market transactions, the government may act as an agent of the consumer, levying taxes on the consumer and using the funds so obtained in the goods market for the benefit (presumably) of that consumer.
Thus in considering the general economic relations it is unnecessary to treat the government as a separate entity. However, for some special purposes the distinctive methods by which the government assesses the cost of its services against the recipients will have to be taken into consideration. In analyzing the production price (cost of production), for instance, all elements of cost can ultimately be reduced to payments for labor and the services of capital. The costs incurred by the government are no exception, but the mechanism whereby these costs are attached to each item produced is so different for government services that separate treatment is required. In such an analysis, therefore, we will regard the total costs as being made up of labor costs, costs of the services of capital, and taxes.
At this point it will be helpful to introduce another simplified economic concept analogous to the isolated worker-consumer, Robinson Crusoe. The complex modern economic organization has aspects, which permit some individual workers or consumers to do many things which all workers or consumers are unable to do, and because of the mass of detail which confuses the issues it is often difficult to recognize the limitations that apply to the situation as a whole. An examination of these phenomena as they would exist in a Crusoe economy is therefore very helpful inasmuch as Crusoe, as an individual, is limited not only by the restrictions which apply to individuals in the modern economy, but also by the restrictions which apply to the total of all individuals. There are aspects of the modern economies, for instance, which permit some consumers to get something for nothing by means of government subsidies of one kind or another, by gift, theft, or otherwise, but it is easy to see that Crusoe cannot get something for nothing. He gets only what he produces, no more, no less, and this helps us to realize that something for nothing is prohibited by a decree that we cannot circumvent, and that we can give one individual something for nothing only by giving some other individual nothing for something.
A very similar situation exists with respect to the producers; that is, the modern economic system is so organized that one producer, or some producers can evade certain of the limitations that apply to all producers as a whole. Here, again, the mass of confusing detail that surrounds the pertinent facts often makes it difficult to recognize the true position of producers as a whole. The very essence of the competitive system, for example, seems to lie in the wide variation of profits between the most efficient and the least efficient producers. It is therefore hard for most observers to accept the fact that the net profits accruing to all producers are in total determined by the interest rate, even though it is conceded by practically everyone that for the last hundred years or more (the whole of the time for which adequate records are available) average profits have actually remained at essentially the same level as interest, and those who have studied the situation theoretically almost invariably admit that such a relationship must be maintained because of the mobility of capital which permits it to be diverted from one use to another if there is a gain to be made by so doing.
In order to help clarify the relations applicable to producers as whole in the same manner that the Crusoe concept illuminates the true economic position of the worker-consumer, we will visualize an isolated producer somewhat similar to the isolated individual typified by Crusoe. For this purpose we will assume the existence of a self-contained economy in which all production that would ordinarily be handled by many individual producers, including the production services normally performed by the government, is handled by a single producer that is subject to the same requirements and limitations that are placed on producers as a whole in our present-day individual enterprise economy. On this basis, the single producer must obtain all labor and capital services from individual suppliers, it must compensate them at the current rate of interest, and it must disburse all of its income to these suppliers of labor and capital services, either actually or constructively, so that the long run result to the producing enterprise is zero. To enable examination of the basic processes of the economy without the confusion that is introduced by temporary reservoir unbalances in one direction or the other, we will also assume that in this economy a control is exercised over the reservoir transactions to keep the net balance of input and output at zero.
Like Crusoe, this isolated producer is hypothetical, but again like Crusoe, it is definitely possible; that is, a Crusoe could exist, and so could such an isolated producer. Thus in examining economic activity from these highly simplified viewpoints we are not dealing with imaginary situations; we are dealing with normal economic life stripped down to the bare essentials.
Control of the reservoir transactions to maintain a balance between total input into and total output from the money reservoirs, as assumed for purposes of the analogy, is not only entirely possible in actual practice; it is definitely essential for economic stabilization. In this respect, therefore, a stabilized economy will operate in the same manner as the economy of the isolated producer. In application to the existing uncontrolled situation, use of the concept of the isolated producer is a way of employing the method of abstraction, one of the very useful tools of science. When we are considering the effects of a price change, for example, an examination of the results that can be seen to follow from such a change in the economy of the isolated producer tells us just what the price change itself accomplishes in the existing economy, not the results of the price change plus some reservoir transaction, the kind of a result that emerges from the usual analysis.
The concept of the isolated producer is particularly helpful in bringing out why, as has been stated, the producer has almost complete control over the production market. If we examine the economy of the isolated producer, we find that the total of the payments which he makes for labor and the services of capital (the money purchasing power leaving the production market) necessarily equals the total purchasing power used for buying goods (the money purchasing power entering the goods market), and it also equals the total income of the producer from the sale of goods (the money purchasing power flowing back from the goods market to the production market). These equalities hold good irrespective of the volume of production or the production price (Principle VI), and it therefore follows that the producer can vary either the price (in money) or the volume up or down without affecting the ability of consumers to buy its goods and without affecting the relation of its income to its expenditures. (Changes in production volume would have a material effect on the ability of consumers to buy the volume of goods that they want, but that is a different matter that has no bearing on the issues that we are now considering.) The composite situation of all producers in an individual enterprise economy, when reservoir transactions are in balance, is identical with that of the isolated producer in its economy, and the foregoing conclusions are therefore equally applicable to the composite of these producers.
Current thought in the economic profession recognizes the ability of the producers to control volume, but regards the establishment of production price as a part of the same process, which determines market price. As explained by Samuelson, “The many inputs and output markets are connected in the interdependent system economists call general equilibrium.”
In this general equilibrium, market prices and production prices (costs in terms of money) mutually determine each other. Wicksell tells us that “The prices of the factors of production… are necessarily determined in combination with the prices of commodities in a single system of simultaneous equations.”64 Schumpeter expresses the same point in his statement that “incomes evidently ‘determine’ prices in the same sense only in which prices ‘determine’ incomes.”65
This is a serious mistake, one which has had a highly detrimental effect, not only on the actual performance of the economy, but also on the emotional atmosphere in which the dealings between the various segments of the economy are carried on. The fact that this erroneous and costly conclusion is such a direct consequence of the prevailing economic theories that it can be freely characterized as “necessary” or “evident” is a clear indication of the fundamental flaws in these current theories. The concept of the circular flow of economic activity, which is orthodox doctrine today, is one of the principal factors that has turned the thinking on the subject of price determination into the wrong channels. In a circular path there is no beginning and no end; all points along the way are equivalent. If this were a true picture of the economic flow, the viewpoint expressed in the foregoing quotations would be correct. Prices would then determine incomes in the same manner as incomes determine prices, just as the economists contend, and the problem would then be to locate the originating influence. But the main stream of economic activity is not circular, and hence all conclusions based on the assumed circularity are wrong.
As pointed out in Chapter 8, the main stream of the economy always flows in the same economic direction. Irrespective of the type of economic organization in vogue at the moment, this stream is originated by producers, flows to consumers, and passes out of the system at that point. The production market, the market in which the modern producer buys labor and the services of capital, is located ahead of the production process in this main stream, and neither production volume nor production price has been established at the time the market transaction is initiated. The volume of production can therefore be set at any level for which sufficient labor and capital are available, and wages can be set arbitrarily.
The price and volume thus established determine the rate of flow of the circulating medium at the production end of the system. If the reservoir transactions are in balance, this is the rate of flow throughout the auxiliary purchasing power circuit. It follows that since the goods market is located downstream of the production process and the reservoirs, both the volume of goods and the flow of money purchasing power have been fixed in advance of the goods market transactions. The average market price is therefore the quotient of two fixed quantities, and it cannot be arbitrarily changed. Temporary and limited price changes can be accomplished by means of reservoir transactions, unless the net total of those transactions is controlled to prevent such changes. Otherwise, market price must conform to production price. In this normal situation, the prices paid by the producer in the production market determine the prices that the consumer must pay in the goods market.
In order to get a more detailed picture of the operation of the markets, let us now examine the reaction of the production market to various possible economic changes, by means of the general economic equation. If money is withdrawn from a consumer reservoir, increasing the flow to the markets, the initial effect is to draw upon producer’s stocks (goods reservoirs), increasing market volume without any change in the market price.
The increased flow of money purchasing power cB passes on to the producer. In case he uses the higher rate of income entirely to increase the volume of production, the production market equation will become the same as the new goods market equation, and equilibrium between the two markets will be reestablished at this higher rate of production without any change in the price level. Some producers, however, will be either unwilling or unable to increase volume. When their inventories get low they will increase prices and take a larger profit. The goods market in this case becomes
The production market follows suit, and the system reaches a new equilibrium at a higher price instead of a larger volume. As a large number of producers are involved, with many variations in policies and operating conditions, the actual result in practice will be somewhere between these two limits. If we represent the modifying factors applying to V and P by y and z respectively, the final equation for both markets is
Expressing the foregoing in words instead of symbols, we have
Any net flow of money from the consumer reservoirs to the purchasing power stream, or vice versa, causes a corresponding change either in production volume, production price, or both.
Changes in the producer money reservoirs have the same effect as those involving the consumer reservoirs, except that they act on the production market first and then on the goods market. As already noted, however, these transactions, which have a direct effect on the status of the individual producers, are more subject to intelligent control than the practically blind consumer reservoir transactions. For this reason, withdrawals from the production reservoirs are generally directed toward economically desirable ends, and they constitute a stabilizing factor in the general economy. Unfortunately, from this standpoint, these reservoirs are small compared to the huge consumer reservoirs.
The magnitudes of the factors y and z depend on the current business situation, varying between the limits of one and c. At the bottom of a depression, for instance, when profits are at the vanishing point, or in a sharp decline when producers fear that they will soon disappear, there is no incentive to increase volume. Twice nothing is still nothing. So all of the increase represented by the factor c goes toward bringing profits back to life.
Some observers have commented that business cycles swing up and down with a high degree of regularity as long as the downswing does not pass a certain point, just as a ship might roll to a certain extent with the waves. Beyond that point the ship would capsize, and could not be righted again without considerable difficulty. Similarly, it has been noted that when a recession passes a certain point it becomes a full-fledged depression, and the task of turning the tide is greatly magnified. The foregoing explanation shows why this is true. As long as profits do not fall, or threaten to fall, below a reasonable minimum level, any improvement in the money flow to the producers is promptly reflected in increased volume as well as in higher prices, but beyond this point no volume benefit results.
Near the top of the upswing there is plenty of incentive to increase production, but exhaustion of the available labor supply interposes an upper limit. From here on, the factor y is unity, and the entire force of any increase in money flow relative to the production price must be absorbed in price increases.
Sooner or later the reservoir flow reverses. The money purchasing power flowing to the markets and from there to the producers drops below the equivalent of current production cost. Now there is no longer enough producer income to enable paying the same prices in the production market for the labor and capital services that are required in order to continue production of the same volume of goods. If the producers have available reserves in their money reservoirs that can be used for this purpose, both price and volume may be maintained for a limited period of time in the hope of another reversal of the trend. Unfortunately, these reservoirs are relatively small. They amount to no more than a drop in the bucket if the recession is a sharp one. If the inflow into the consumer reservoirs continues the time eventually arrives when either production volume or production price must be cut.
But most of the components of production price do not want to come down. Rents and interest are extremely resistant to any modification. Wages can be reduced only against very strong pressure for the maintenance of existing levels. Only profits are vulnerable. It is rather ironic, in view of all of the criticism that is directed at business profits, that the owners of venture capital are the only participants in the production process who regularly take a cut in their “wages” in order to maintain the volume of production. The cut is involuntary, of course, but it is nonetheless a reality. Some businesses do attempt to maintain their rate of profit, and curtail production as soon as sales drop off, but other producers by choice, or by necessity, conform to the change in the general price level to keep their volume up, and the initial decrease in income is offset principally by a reduction in the rate of profit. Thus, by reason of the non-uniformity in business policies, production price and production volume decrease together in the early stages of the decline, as the flow of money to the producers drops. Again the new equation is
Although a volume reduction is the equivalent of a price reduction from the standpoint of bringing expenditures into line with income, it does not protect profits. In fact, it usually makes matters worse, as reducing volume below the normal level generally raises the cost per unit, and thus increases other components of production price at the expense of profits. Furthermore, the new equality between income and expense is only temporary, as the reduction in volume also reduces income. As the recession continues, therefore, profits decrease irrespective of the policies that are followed, and finally one producer after another reaches the zero profit level. From here on these producers must either negotiate cuts in some of the other components, or they must close their doors.
Some, particularly the stronger companies, are able to force wage reductions, or even gain concessions from the bondholders or other creditors, but many others are reduced to bankruptcy. The number of business failures increases substantially in every recession, and reaches very serious proportions during major declines. Since the competitors are not expanding under these conditions, the failures represent a decrease in production, over and above the decreases that are taking place in the volume of goods produced by those enterprises that do manage to survive.
The lack of symmetry in the upward and downward swings of the cycle, which concentrates the effects mainly on price in the upswing and mainly on volume in the downswing, is generally recognized by economic observers. “Expansions act partly on physical volume and employment and partly on money scales of prices and wages,” says J. M. Clark. “Contractions, owing to the ‘ratchet action’ of an economy in which wages and prices resist downward movement, act more predominantly on the physical volume of production and employment.”66 This is why recessions, even if relatively moderate, always create unemployment (under existing conditions, where it is not realized that employment can be maintained by purely employment measures independently of the business cycle), while a moderate amount of inflation may not have any material effect on employment.
It is important to note that there is no force tending to restore previous conditions after a price or volume change takes place. The economy simply stabilizes at the new levels. As has been brought out, the system is stable at any level of production and at any price level, as long as there is no net change in the reservoirs. Hence if a reservoir withdrawal causes an increase from volume V and price P to volume yV and price zP, the system stabilizes at yV and zP. A return to V and P does not take place unless there is a reservoir input equal in magnitude to the previous withdrawal, or the producers take some voluntary action to change volume or price. It is unlikely that they will increase or decrease production volume except to meet the requirements of the market, but they may have occasion to make voluntary changes in either the production price (that is, in wages) or in the market price. (The term “voluntary” refers to changes that are not dictated by market behavior. They may not be entirely free from coercion of some kind). We will now examine the results of such voluntary actions.
First, what happens if money wages are increased? It is usually assumed that the increase is secured at the expense of the owners of the business enterprises. This is not correct because, as brought out in the discussion of profits, the cost of the services of capital is determined by factors independent of other business costs. But even if it were true, the wage increase would have no effect on the general economy, except that some purchasing power would be transferred from one group of consumers to another. As all consumers are at the same economic location, neither the price level nor the volume of production would be affected (Principle IV).
It is true that the normal economic relationships are subject to temporary modification until the fundamental economic forces have had time to overcome economic friction, and many of those who recognize that wage increases must be reflected in the market price level sooner or later have felt that the wage earner would gain an advantage in the interim while the adjustments were taking place. But even this transitory gain does not materialize because the wage increases add to the flow of money purchasing power immediately. The salient point here is that it is the wage increase itself—that is, the addition to the flow of money purchasing power—that causes the rise in the general price level. Whether or not the particular enterprises that pay the higher wages raise their own prices to compensate for the additional costs is immaterial. If the prices of their products are not raised, the prices of some other products must be. The general price level must go up enough to absorb the additional money purchasing power.
In terms of the general economic equation, the higher wages increase production price from P to fP. This pushes money purchasing power up to fB, and the new production market equation is
The increased flow of purchasing power fB received by the workers passes on the the goods market and, not being counterbalanced by any increase in the volume of goods, increases market price to fP. It then continues on to the producers and restores the inflow of money into their treasuries to an equality with the larger outflow to the production market for the purchase of labor and the services of capital. The net result is therefore nothing but an equilibrium at a higher price level.
Arbitrary increases or decreases in wage rates have no effect on the volume of production or the ability of consumers as a whole to buy goods.
There is much reluctance these days to accept any contention that an increase in money wages necessarily involves a corresponding increase in prices, because this conclusion interferes with many popular and attractive schemes for lifting ourselves into prosperity by our bootstraps, but the purchasing power analysis shows that it is true nevertheless. Any net increase in the amount of money purchasing power available to consumers by reason of a wage increase is promptly and inevitably counterbalanced by an increase in the market price level, and there is no gain to the economy as a whole.
This is not an argument against high money wages. It merely establishes the fact that high money wages have no beneficial economic effects. They do not improve the ability of the consumers to buy goods, nor do they have any effect toward increasing the volume of production. This analysis therefore refutes the contention that raising wages can improve economic conditions, and it also exposes the futility of the recurrent agitation for higher wage rates as a means of “increasing purchasing power.” Adjustments of money wages upward or downward do not alter the total real purchasing power (the ability of consumers to buy goods) in the least; any gain that one group may make is offset by a loss to all other persons who work for a living, or who have funds invested on a fixed income basis—in pensions, bonds, life insurance, annuities, mortgages, etc.
Outside of the rather serious inequities that develop between the individuals who are benefited and those who are harmed by the changes, and a certain amount of business dislocation during the process of adjustment, wage increases do neither good nor harm to the domestic economy as a whole. (The effect on foreign trade will be discussed in Chapter 16.) Those enterprises that are able to resist the pressure for wage increases the longest will gain at the expense of those who raise wages first, but the general average of business volume and profits will remain unchanged.
Whether there are other, non-economic, grounds on which arbitrary wage increases can be justified is another question. There may possibly be some psychological value in high wages that is absent in low prices, even though they amount to the same thing. But this is beyond the scope of economic science. If it is within the bounds of economics at all it belongs to the sociological branch of the subject. There is, of course, ample justification for whatever wage increases are required to keep the price level unchanged as productive efficiency improves, since falling prices create the same kind of inequities as rising prices, but this applies only to the general price level, not to the prices of individual items. If the inequities are to be removed, some systematic method of distributing the wage increases among all segments of the economy will be necessary.
The analysis shows that economic stability is independent of the money wage level. Both prices and volume of production (employment) can be stable at any wage level. This is, of course, in direct conflict with orthodox economic thought, which holds, as J. R. Hicks puts it, that “A raising of wages above the competitive level will contract the demand for labor, and make it impossible to absorb some of the men available.”67
Several factors have contributed to getting economic thought this far off the track. The most important of these, reliance on an erroneous theory of wages, will be discussed in Chapter 18. The influence of the equally erroneous circular flow concept has already been mentioned. Then, too, supply and demand considerations have been introduced into this situation where no change in real quantities takes place, and supply and demand theory does not apply. Another factor that has had an effect on economic thinking is the fact that unemployment by reason of threatened business failures during recessions and depressions can be—and frequently has been—avoided by wage reductions. On first consideration this seems to confirm the hypothesis that there is a relation between the amount of unemployment and the wage rates, and the experience is generally so interpreted, but the analysis in this work shows that the absolute level of wages has no significance in this connection. It is wage flexibility that is helpful in recessions.
When there is an input into the consumer money reservoirs so that the money purchasing power entering the markets drops to cB (where c is a fraction), the income accruing to the producers also drops to cB. The original volume of production V can then be maintained only if production price can be reduced to cP. Since wages constitute the largest component of production price, no substantial reduction in P, beyond that accomplished by eliminating profits, can take place without a cut in wages, and if there is no wage flexibility the producers must cut volume, thereby creating unemployment. Ability to cut wages below whatever level existed before the recession is therefore an employment-preserving factor when recessions occur, but this does not mean that there is any significance in the absolute level of wages either before or after the reduction, nor does it mean that a reduction of wages would increase employment under conditions in which no deflation is taking place. As expressed in Principle XI, arbitrary decreases in wage rates (that is, decreases not made in response to some special market situation such as the one that we have just been discussing) have no effect on the volume of production, and therefore no effect on employment, which in the short run situation is a function of production volume.
An increase in business taxes has the same effect on the general operation of the economic system as an increase in wage rates. In the use of tax money, the government acts as the agent of the consumers (the general public). Higher business taxes therefore increase the total amount of money purchasing power available for consumer spending, just as a wage increase does, even though the additional money does not go directly into the hands of the individual consumers. The amount of money flowing to the markets is thus increased without any change in the production of goods. This raises the general price level, and increases the income of the producers by the amount required to offset the additional cost.
We next turn to the other side of the picture, the market price. Here we find that the producer has only a comparatively narrow margin for voluntary action. He cannot raise prices relative to the general price level without losing business and consequently reducing his profits. He cannot cut prices relative to production costs without reducing the rate of profit per unit. Furthermore, unless he has a cushion in the form of substantial reserves, the average producer must stay within the zero profit limits either way; he cannot afford to operate at a loss. Under normal conditions, this producer will attempt to establish prices which, in the long run, will give him the maximum total profits, a compromise between the greatest possible volume of business and the maximum possible rate of profit per unit.
We are interested now in determining the reaction of the economy in general if the producer is induced by external pressure to modify his normal policy and reduce his prices to some lower level. While this will have a prompt effect on the profits as shown on the books of the enterprise, the disbursements to the suppliers of capital will not be altered immediately, and the flow of purchasing power from production to the markets will therefore remain unchanged for the time being. This means that the average market price level likewise remains constant, and the only effect of one producer’s arbitrary reduction in price will be that some other producer’s price goes up. In all probability the futility of the action will soon be recognized and the original price will be restored.. If not, dividends will have to be cut, and since they constitute money purchasing power in exactly the same manner as wages, the total purchasing power generated by production will drop from B to fB, where f is a fraction. Market price will necessarily conform, and the new economic equation will then be
No change in production volume has occurred. The price level in terms of money has dropped, and some purchasing power that been transferred from owners of capital to other consumers, but the real price level, the cost of goods in terms of labor, is unchanged, and there has been no benefit to the general economy. Furthermore, the gains that are made at the expense of the suppliers of capital services cannot be other than transient, as a continual replacement of capital is necessary in order to enable continued production, and a diversion of earnings away from the suppliers of capital would inevitably dry up the capital supply and destroy the enterprise. We therefore arrive at the conclusion that it is sound policy for the producer to adapt his prices to the general market price level, so far as he is able, but that arbitrary changes made irrespective of the general price level, or in an attempt to influence that price level, accomplish nothing.
This principle is in direct conflict with current economic thinking based on supply and demand theory. As brought out in the preceding pages, however, that theory is not valid in application to the economy as a whole. This is another place where the concept of the isolated producer, Crusoe & Co., can be of considerable assistance in clarifying the situation, as the validity of Principle XII is readily verified by examination of the effect of price changes in the economy of this isolated producer.
As matters now stand one of the greatest contributions that could be made toward economic understanding would be to obtain a general realization of the fact that the market price level is a resultant, not a quantity that can be manipulated by government controls or by the pricing policies of the individual producers. The general price level is determined by the rate of compensation paid to the suppliers of labor, by the business tax and subsidy rates, and by the rate at which money purchasing power is being stored or withdrawn from storage in the reservoirs, and it cannot be changed except by measures which alter one or more of these determinants. So-called “price control” is nothing but a delusion. The general level of prices can be prevented from rising by prohibiting, or limiting, wage increases, or by forcing diversion of excess money into the reservoirs, but any price control is effective only to the extent that it accomplishes one or both of these results. The direct “price fixing” that is so often resorted to in emergencies is futile; holding down some prices simply means that others must go up. Holding down all prices by direct action is simply impossible—so hopeless that no one even tries it.
Attempts by business enterprises to influence the general price level by their pricing policies are equally futile, but unfortunately the economic profession has not been able to get a clear enough view of he situation to recognize this fact. Galbraith, for example, asserts, “Yet it is plain that a firm that advances its prices after a wage increase could have done so before.”68 What he fails to see is that before the wage increase their prices could be increased only at the expense of some other producers, who must then reduce their prices, since the total money purchasing power available for buying all goods remains unchanged. This would, or course, initiate a competitive round of repricing, which would react against the original producer. After the wage increase, the producer that granted the increase can increase his prices without any effect on the price situation as a whole, inasmuch as the additional money purchasing power required to pay the higher price is provided by the increased wages.
Where the wage increase applies only to a single producer and not to his competitors, it is not possible for that producer to offset the full amount of the increase by raising his prices, as this would result in too much of a loss of business. In this case the inevitable increase in the general price level is spread out over the entire economy. But where wages are established on an industry-wide basis, all of the direct competitors are affected equally, and here a price increase to compensate for the added costs leaves both the competitive situation within the industry and the price equilibrium in the rest of the economy unchanged. The error in Galbraith’s appraisal of the situation is particularly obvious when we look at the economy of the isolated producer. It can easily be seen that this producer, as we have defined him, cannot increase his prices before a wage (or other cost) increase, and must do so after a cost increase of any kind.
The foregoing pages portray the producer (the employer) in quite a different role in the general economy than the commanding position, with respect to wages and prices, in which he is commonly visualized. By his economic actions, the individual producer may influence his own status very materially, and that of his employees as well, but whatever benefits may be accomplished by manipulation of wages and prices are merely differential gains realized at the expense of other producers or other workers. As the analysis shows, no arbitrary actions in these areas can alter the real price levels, either the real wage level, the average wage in terms of the amount of goods that it will buy, or the real market price level, the average price of goods in terms of the amount of labor required to buy them. Any reduction that the producer makes in his own price will not reduce the general price level, and any wage increase that he may grant will not increase the total real income of consumers (their ability to buy goods).
The really significant actions of the producer, from the general economic standpoint, are those that he takes to increase the efficiency of the productive process. As stated earlier, the results achieved by any economic system, or organization, are mainly determined by the extent to which the producing units are allowed and encouraged to carry out this primary function of controlling and increasing productive efficiency. To complete the present discussion, we will now take a look at the effect of an increase in productivity as seen in terms of the general economic equation: P = B/V.
According to Principle IX, an increase in production volume at a constant rate of productivity does not change the price level, as the increase in volume from V to aV is accompanied by a corresponding increase in the payments to the suppliers of labor and capital services, which raise B to aB. The quotient aB/aV is still P, the original price level. However, if the larger volume is attained by means of greater productivity, the payments to the suppliers of labor and capital services do not increase, and purchasing power remains at B. The economic equation is then
The market price thus drops in proportion to the increase in production volume. As indicated in the preceding discussion, there are some advantages in maintaining a constant price level, and this could be accomplished by increasing money wages by the equivalent of the increase in productivity. The result is
This equation is identical with that which results when the increase in volume is accomplished by employing more workers, but in the latter case the additional purchasing power is shared by the additional workers, and the average income of the original workers remains at B. However, if the increase in volume is attained by greater productive efficiency, the total money purchasing power aB goes to the original workers and their average income is raised from B to aB. The increase in productive efficiency thus accomplishes the kind of a true gain in the ability of the workers to buy goods that cannot be attained by any kind of juggling of the money labels attached to either wages or goods.
Now let us review the contents of this chapter. The question at issue has been: Can we put our finger on the factor that determines whether general business conditions are good or bad? The answer is: Yes, we can. Business is good if the money purchasing power resulting from production is all flowing to the goods markets so that there is sufficient return from sales to pay all of the costs of production, including profits in satisfactory amounts. Business is not good if some of this money purchasing power is being drained off because money is flowing into the reservoirs; that is, accumulating in the banks, or being withdrawn from circulation. In this case the money income of business enterprises is not sufficient to take care of all of the costs. Efforts to reduce these costs by cutting wages or laying off workers may save some individual enterprises, but they are fruitless so far as the general economy is concerned, as they merely cut the total income of all businesses that much more. Business is more than good, it is booming, if money is being withdrawn from the reservoirs and used in the markets, because then the money income from sales is greater than the cost of production.
But the prosperity during the boom is costly in the long run. Sooner or later the money reservoirs must be replenished, and then we have a depression, at least the less severe kind of a depression that we call a recession. From the very nature of the rise, it must inevitably be succeeded by a fall. The only stable condition—the only one that can be permanent—is a condition of balance where reservoir input and outflow are equal, and business income is therefore in equilibrium with the costs of doing business. The answer to the problem of stability is to take appropriate actions that will offset the erratic buying habits of the consumers and government agencies, and will maintain this balance.
As long as such a balance exists, a general increase in wages or in business taxes will have no adverse effect on business enterprises. Market prices will rise enough to absorb the increase in money purchasing power, the increase will pass on to the producers, who will then be back in the same relative position as before the cost increases. The price increase is inevitable and inescapable; it will take place regardless of what business enterprises want to do about it—even if they try to hold it back. The reverse is also true, as experience during depressions has demonstrated. The producers cannot keep the market from adjusting itself to a falling purchasing power flow. If they keep their prices up in defiance of a falling market trend, they cannot sell their goods. If they hold their prices down in defiance of a rising market trend, they merely raise the prices of other goods, for the general average of prices is fixed by the relation of the money entering the markets to the goods production volume.
Efficient operation of the economic system to attain the results that we want is not the complicated and difficult task that we have been led to believe. It is difficult for those who want to “reform” the system to conform with their own ideas, but if we address ourselves to the specific task of eliminating the cycle of booms and depressions, and leave the “reforms” to the reformers, there are no serious obstacles in our path. Later in this volume it will be demonstrated that there are many practical methods of accomplishing the stabilization of the money reservoirs that is the primary requisite for permanent prosperity. These measures do not involve alteration of our economic institutions, or reconstruction of our people; they merely provide the means whereby intelligent control can be applied to the system that is now in operation.