APPENDIX III. "Demand for Commodities is not Demand for Labour" versus The Doctrine of "Derived Demand"

APPENDIX III " DEMAND FOR COMMODITIES IS NOT DEMAND FOR LABOUR" VERSUS THE DOCTRINE OF " DERIVED DEMAND" JOHN STUART MILL'S celebrated proposition that" demand for commodities is not demand for labour" 1 is to the present day one of the most disputed theories of economics. It was the fourth2 of his fundamental propositions respecting capital and is closely connected with the first of these propositions that " industry is limited by capital". The idea underlying both these statements goes back at least as far as Adam Smith, who expressed it by saying that " the general industry of society never can exceed what the capital of society can employ".3 In the writing of Bentham the formula that "industry is limited ?y capital" became almost the leitmotiv, and it was of course familiar to all the members of the classical school of economists. When finally J. S. Mill explicitly stated his fourth proposition, which is more particularly the subject of this appendix, it was little more than a corollary of the first, which he had taken over from his predecessors, and of course closely connected with the wage fund theory. But like the 1 J. S. Mill, Principle8 of Political Economy (ed. Ashley), Book I, chap. v/9, p. 79.

2 The "second fundamental theorem regarding capital" is that capital is the result of saving, and the third, in its more complete formulation, that "capital is kept in existence from age to age not by preservation, but by perpetual reproduction: every part of it is used and destroyed generally very soon after it is produced, but those who consume it are employed meanwhile in producing more" (ibid. p. 74). It will be noticed that we are prepared to defend all four propositions and object only to what appears to us the erroneous conclusion drawn from the third that, when people" turn their income into capital, they do not thereby annihilate their power of consumptioI)., they do but transfer it from themselves to the labourers to whom they give employment." (See above, p. 273.) 3 Wealth of Nations (ed. Carman), Book IV, chap. ii, vol. i, p. 419. 433 2') 434 Appendix I I I latter it was almost immediately assailed,! and has ever since been the butt of attack and even ridicule by a long list of eminent economists from Jevons 2 to E. Cannan: 3 and J. M.

Keynes.' It has, however, always had its defenders, including Marshall 5 and particularly Wicksell,6 and Leslie Stephen even described it, as Mr. Keynes has recently reminded us, as " the doctrine so rarely understood, that its complete appre hension is, perhaps, the best test of an economist ".7 That in more modern times the doctrine has suffered a marked eclipse is mainly due to the fact that the modern subjective theory of value was erroneously thought to have provided an effective refutation. This modern view of value taught, of course, and nObody can seriously quarrel with this general proposition, that the value of the factors of production is based on the utility of their products and that in this sense it can be said to be "derived" from the value of their products. In so far as this idea was used to explain why the value of particular factors of production changed relatively to that of others, it provided indeed an extremely important key to the solution of problems which had puzzled many earlier generations of economists. And in general it may be said that in so far as the theory flf the kapitallose Wirtschaft is concerned the principle is valid with out restrictions.

It was thought, however, that the application to an economy using extensive capital equipment not only did not diminish 1 The fullest adverse criticism of the four propositions known to the present author is to be found in A. Musgrave, Studies in Political Economy (London, 1875), pp. 55.102, and S. Newcomb, Princip~8 of Political Economy, New York, 1886. 2 See particularly Jevons' Principles of Economics (1905), pp. 120· 133. 3 Theories of Production and Distribution, p. 381. • J. M. Keynes, 1936, p. 359. 6 Principle8, p. 828. • K. Wicksell, Wert, Kapital und Rente (1893), p. 67: "Es bestatigt sich hier der bekannte Satz von J. S. Mill (dem er freilich selbst eine ganz ungehiirige Ausdehnung gab), dass die Nachfrage nach Gutem nicht mit Nachfrage nach Arbeit identisch ist "; and Lectures, vol. i, p. 191: " Broadly speaking, even if not in detail, we must recognise the truth of Mill's weIl·known principle that demand for commodities is not the same as demand for labour - unless it results in the accumulation of capital."

7 Hi8tory of English Thought in the Eighteenth Oentury, p. 297.

Derived Demand 435 the significance of the principle but even increased it. The simple "principle of derived demand" became the basis of the so-called "acceleration principle of derived demand", based on the idea that in a system using highly capitalistic methods of production any increase in final demand would give rise, not only to-an equal increase in the demand for factors but to a much greater increase in the latter, since in order to satisfy the increased final demand it would be neces sary to build up, within a short period, all the additional capital equipment required to produce the additional output. In so far as this argument is applied to the demand for a particular product and its effect on the demand for the factors from which it is produced, there is still little to object to. The meaning and validity of the argument become, however, much more questionable as soon as it is applied, as it immedi ately was when used in the theory of the trade cycle, to the relation between the demand for consumers' goods in general and the demand for factors of production in general. In its original form, based on the modern utility analysis of value, the argument is clearly not capable of this extensiqn. In fact it is difficult to see what meaning we could attach to the statement that an increase in the value of consumers' goods in general would lead to a similar increase in the value of the factors of production in general, since this would imply that the aggregate value of all goods taken together has increased - a statement which in terms of the modern utility analysis would clearly have no meaning.

Before we proceed further, however, it will be advisable to restate Mill's proposition in a form which leaves no doubt about its exact meaning. In the first instance it is probably clear from that use to which the doctrine has been generally put that we are entitled, as we have already done, to sub stitute consumers' goods for "commodities" and that the " demand for commodities" will have to be described, not as a simple quantity, but as a demand schedule or curve describ- . ing the quantities of consumers' goods that will be bought at different prices. Secondly, the test of whether demand for con sumers' goods" is " demand for labour (or, we may say, demand for pure input) must clearly be whether a rise in the demand curve for consumers' goods raises the demand curve for pure input (and whether a lowering of the former lowers the latter), 436 A ppendix I I I or whether a change in the demand for consumers' goods causes no' change in the same direction or perhaps even a change in the opposite direction to the demand for pure input.

It remains to decide in terms of what we are going to measure the two kinds of demand. And it will presently be seen that this decision is indeed crucial for the solution of our problem. If we decide to measure demand in terms of money, the problem will clearly be indeterminate unless we make further assumptions with regard to the effect of a change in final demand on expectations of future prices and on the supply of money. Circumstances are clearly conceivable in which an increase in final demand will bring about an in crease in the demand for labour (in terms of money) many times its size. This indeed is the case which is treated as the normal one by the" acceleration principle of derived demand". If, on the other hand, we decide to measure demand in real terms, as we clearly ought to do so long as we treat the proposition as one of pure theory, it will quickly be seen that the opposite proposition becomes almost a pure tautology. An increase in the demand for consumers' goods in real terms can only mean an increase in terms of things other than consumers' goods; either more capital goods or more pure input or both must be offered in exchange for consumers' goods, and their price must consequently rise in terms of these other things; and similarly a change in the demand for labour (i.e. pure input) in real terms must mean a change of demand either in terms of consumers' goods or in terms o~ capital goods or both, and the price of labour expressed in these terms will rise. But since it is probably clear without further explanation that if the demand for capital goods in terms of consumers' goods falls, the demand for labour in terms of consumers' goods must also fall (and vice ver8a), and that if the demand for labour in terms of capital goods rises (or falls) it must also rise (or fall) in terms of consumers' goods, we can leave out the capital goods for our purpose and conclude that an increase in the real demand for consumers' goods can only mean a fall in the price of labour in terms of consumers' goods, or that, since an increase in the demand for consumers' goods in real terms must be an increase in terms of labour, it just means a decrease in the demand for labour in terms of con sumers' goods.

Derived Demand 437 We see, therefore, that if we treat the problem in real terms and in its simplest forms, an increase in the demand for con sumers' goods not only does not increase but actually decreases the demand for labour. And we obtain of course the same result if we approach the problem more specifically from the point of view of the theory of capital. From this point of view the real demand for labour will depend on its marginal productivity, which in turn will increase and decrease with the " supply of capital", that is with that part of the total available resources which people in general do not want to consume currently but devote to production for the future. Any increase in the share of the resources at their command which they devote to current consumption, any increase in the demand for consumers' goods, therefore means a decrease in the supply of capital and consequently a decrease in the pro ductivity of labour and the amount of labour that will be demanded at any given real wage.

The doctrine still retains its validity, in so far as the effect on the real demand for labour is concerned, if we merely introduce money into the picture but assume an equilibrium position in which the supply of all factors equals demand (i.e. in which there are no unemployed resources). The mechanism by which in such a system an increase in final demand will decrease the demand for labour is somewhat more complicated, but still fundamentally the same. It is easiest to show if we assume that the increase in the demand for consumers' goods occurs in a system which before has been in stationary equilibrium - although the argument applies also when this condition is not satisfied. We shall assume that the initial increase in demand is brought about by a net increase in total money expenditure (involving either dis hoarding or an increase in the quantity of money), since otherwise the increase in expenditure on consumers' goods would simply mean a simultaneous decrease in the outlay on factors of production (mixed input). Such an increase in the monetary demand for consumers' goods will in the first instance bring about a rise in the prices of consumers' goods which undoubtedly will to some extent be transmitted to the demand for pure input. But for obvious reasons, discussed fully above in Chapter XXVII, the money price of pure input and of labour in particular can (under the conditions of full 438 Appendix III employment assumed) never rise in full proportion to the rise in final demand, since some part of the available output will have to be used to satisfy the additional new demand and the real remuneration of the pure input will have to be reduced by the amount of this new demand, that is, real wages will fall. It has been shown in the chapter just referred to how in turn this fall in " real wages" will lead to such a reorganisa tion of production as to reduce the marginal productivity of labour (and pure input generally) all round (by using it in combination with proportionately less capital) so that with the lower real wages a new equilibrium will be reached. This lower real wage will now be the only wage rate at which, with the reduced supply of capital (or, what amounts to the same thing, the increased urgency in the demand for consumers' goods), the whole supply of labour will be employed. If in these conditions labour should insist on unchanged real wages and succeed in raising its money wage accordingly, the result can only be that less labour than formerly will be employed.

The situation will, of course, be different if at the pre existing level of wages and prices supply exceeded demand, and an increase in final demand makes it possible immediately and proportionately to increase output by employing formerly unemployed resources of all the kinds required. In this case, and in this case only, an increase in final demand will lead to a proportionate increase of employment; and this effect will of course be limited to the period during which such unempioyed reserves are available. There will of course be intermediate cases where, although there may not be unemployed resources of all kinds available, there will be sufficient reserves in exist ence of a number of the .more important kinds of input to make it possible to increase output, although not in pro portion to the increase in final demand, yet to some extent. In this case a very slight reduction of real wages may be accompanied by a very considerable increase in employment.

In both these cases the "principle of derived demand " will approximately apply if money wages can be assumed to be given and constant, because the effect of an increase in final demand will here not dissipate itself in an increase in the prices of output and - to a lesser extent - input, but can bring about an increase in employment at more or less unchanged prices.

Derived Demand 439 That under conditions of under-employment the general principle does not directly apply was of course wei: known to " orthodox" economists, and to J. S. Mill in particular. In his exposition the statement that "industry is limited by capital ", on which, as we have seen, the proposition under discussion is based, is immediately followed by the further statement that it " does not always come up to that limit ".1 And few competent economists can ever have doubted that, in positions of disequilibrium where unused reserves of resources of all kinds existed, the operation of this pripciple is temporarily suspended, although they may not always have said SO.2 But while this neglect to state an important qualification is regrettable and may mislead some people, it involves surely less intellectual confusion than the present fashion of flatly denying the truth of the basic doctrine which after all is an essential and necessary part of that theory of equilibrium (or general theory of prices) which every economist uses if he tries to explain anything. The result of this fashion is that economists are becoming less and less aware of the special conditions on which their arguments are based, and that many now seem entirely unable to see what will happen when these conditions cease to exist, as sooner or later they inevitably must. More than ever it seems to me to be true that the complete apprehension of the doctrine that" delnand of commodities is not demand for labour" - and of its limita tions - is " the best test of an economist ".

1 Principles, Book I, chap. v/2 and table of contents (ed. Ashley), pp. 65 and xxxiv. Mill is mainly concerned with the case where there is not as much labour available as might be employed with the existing capital, but although this case looks very different froIn those with which we are now concenled, it is not really so different from the case of artificial scarcity caused by labour refusing to work for less than a certain wage. 2 As was clearly done, to mention only the leading representative of a school that is often accused of overlooking this, by Professor L. v. Mises. See his Geldwert8tabili8ierung und Konjunkturpolitik (1928) p.49.