The Economics of Industrial Society

This book is a stimulating and original introduction to the economics of industrial society. It is intended for use as a student text, but will also be of interest to all those - whether students or teachers - looking for new ways of understanding the economic problems of industrialised countries. It provides an effective critique of current economic theories, and develops an original model of the economics (whether neo-classical, Marxist, or Keynesian) of modern industrial society. Throughout the book the analysis is oriented towards the solution of problems in the real world, and towards explaining the operation of economic institutions in different countries. The work looks at the way individual markets operate, the determination of foreign exchange rates, the problem of unemployment, and the fiscal and monetary policies needed to tackle unemployment. The standard text book approach does not allow for the different types of market that exist. For the main agricultural and mining products there are commodity exchanges, whereas no such markets exist for the products of manufacturing industry. The way in which prices are determined will vary considerably depending on whether or not a commodity exchange exists. This means that the price mechanism will not be uniform for every single commodity. This book analyses the case of an industrial country entirely dependent on other countries for its raw materials (agricultural and mining products). The prices of these raw materials are determined on the commodity markets of the exporting countries; and it is only after passing through the filter of the exchange rate that they will exert an influence on the prices of manufactured products. For that reason foreign exchange rates play a significant role in the theory of production. Furthermore, this book follows Marx and Keynes in refuting Say's Law, which states that a state of general overproduction is impossible. (In this sense the book is anti-neoclassical.) Investment is not determined by savings, but is determined independently of savings, either autonomously or according to certain investment functions, and is dependent on the operation of financial markets. This book therefore attempts an integrated analysis of the real economy and the money economy. In an economy for which Say's Law does not hold true, there will inevitably be no automatic full employment. For that reason this book discusses thefiscaland monetary policies available to help reduce unemployment. It also considers stagflation and the Wicksellian cumulative process, making clear their mechanisms. Throughout, the mathematical analysis is kept simple, and wherever possible diagrams are used so that the argument will be intelligible to those new to the subject.

The economics of industrial society

The economics of industrial society MICHIO MORISHIMA Translated by DOUGLAS ANTHONY, JOHN CLARK, and JANET HUNTER

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British Library Cataloguing in Publication Data Morishima, Michio The economics of industrial society. 1. Economics I. Title 330 HB171 ISBN 0 52126700 5 hard covers ISBN 0 52131823 8 paperback

Transferred to digital printing 2002

BS

Contents

Preface

page

Introduction 1 Which economics? 2 The outline of this book

vii 1 5

PART ONE THE FORMATION OF PRICES 1 Markets and the price mechanism 1 How are prices determined? 2 The structure of auctions 3 Formulations of economists 4 The existence of equilibrium 5 Determining production prices 6 Two types of market economy 2 The function of exchanges 1 The multilayered structure of market economies 2 Interrelationship of demands and supplies within a single exchange 3 Price repercussions amongst substitutive goods 4 Price repercussions between different exchanges 5 Futures markets 3 Fixing product prices 1 More on the full-cost principle 2 The period of production and hedging 3 Equilibrium production prices and their movement 4 The traditional theories: the marginal productivity theory and the labour theory of value 5 How should we treat the traditional theories of the firm?

13 15 21 23 25 32 38 39 43 53 61 68 72 78 83 95

vi

Contents

4 Determination of foreign exchange rates 1 The century of internationalism 2 The effects of fluctuations in foreign exchange rates 3 How exchange rates are determined (I) 4 How exchange rates are determined (II) 5 Changes in exchange rates 6 The futures market

99 105 112 118 122 128

PART TWO THE WORKING OF THE NATIONAL ECONOMY 5

The modern industrial society 1 An outline of the model 2 The structure of the model (I) 3 The structure of the model (II) 4 Equilibrium in real commodity markets - the principle of effective demand 5 The structure of the financial sector 6 Equilibrium on financial markets - the determining of the interest rates 6 Is full employment possible? 1 The labour market 2 Labour unions 3 Unemployment (I): Marx 4 Unemployment (II): Keynes and the classical school 5 Wages and unemployment 6 Labour and machinery 7 Fiscal policy 1 The investment multiplier 2 The effect of fiscal expenditures 3 The effects of a reduction in taxation 4 The multiplier effect of balanced budgeting 8 Monetary policy 1 Credit and business stimulation 2 Deflation and inflation 3 The roles of the central bank and the exchange stabilization fund 4 The Wicksellian cumulative process

135 140 147 152 160 167 177 183 188 197 204 212 221 231 237 243 251 257 262 271

Additional notes

281

Exercises

293

Index

299

Preface

This book has been written as an introductory economics textbook for first or second year students, but it is also intended to be used on occasions as a textbook for courses on the principles of economics for third or fourth year students, and as a supplementary reader for private study by MSc students. Furthermore, at the risk of setting my hopes too high, I hope it will also be of interest to fellow economists. The content of this book does, in fact, reproduce the content of the lectures which I have been giving to first year students at the LSE for several years now. Many of these students come to us having already studied 'A' Level economics in the sixth form, and the proportion of our students who have done this has recently been showing a marked increase. It is therefore desirable to present to them lectures with a higher-level content than 'A' level economics - often P. A. Samuelson's Economics and R. G. Lipsey's An Introduction to Positive Economics, for example - or at least lectures which do not just repeat the content of such works. This book marks my supply in response to this sort of demand. The approach of this book differs to a considerable degree from standard economics. If one really wishes to study economics at the present time one has to pay assiduous attention to consumer theory and the theory of the firm, dependent on the concepts of the marginal rate of substitution and marginal productivity respectively. That students should acquire 'the habit of rigorous thinking' through this kind of learning process is obviously an extremely good thing, but the rigour emphasized by these theories is no more than a geometric (or mathematical) rigour. All historical exactness or fidelity to the facts is either made light of, or totally disregarded. We should, of course, be pleased that economics has increasingly 'progressed' towards an exact logical composition, but it is regrettable that this has resulted in at least one of the most important divisions of economics ending up as a grandiose philosophy seeking to find out the logical implications of the pursuit of utility maximization on the part of vii

viii

Preface

the individual and profit maximization on the part of the firm - what we might call a philosophy of freedom. In this book such theories as these are not discussed at all. The theorem of the realization of a Pareto optimum in a situation of competitive equilibrium has entirely been ignored. The same is true of the equation for consumer behaviour - income effect and substitution effect - and of the marginal productivity theory; they have either been disregarded or accorded only the barest mention. Instead this book attempts to analyse the price mechanism in accordance with reality and at the same time to introduce students directly to the major problems of economics - i.e. an analysis of the way in which the real economy operates and the best way to bring about a change in direction in this operation. For an analysis of such problems as these a high-level consumer theory is quite unnecessary, as this book makes abundantly clear. What is more important is a knowledge of historical experience and the observation and formation of the way in which actual institutions work. As is stated in the introduction, the operation of the economy in 'middle-ranking' industrial nations such as Britain, Japan, Germany and Italy, differs from its operation in large-sized' industrial nations like the United States. Medium-sized nations have to be dependent on other countries for their raw materials, therefore have to export in order to raise this capital. Hence foreign exchange problems occupy a pivotal place in production theory, and friction - or, in the very worst cases open conflict - arises between financiers and industrialists regarding whether the exchange rate should be high or low. Such problems as these are not matters of life and death for the large industrial nations which can be more or less self-sufficient, and where imports and exports are very small in proportion to GNP, but for the medium-ranking industrial countries they are of primary importance. I therefore believe that we should have for these medium-sized nations economic theories (and textbooks) different from those we use in the case of the United States, and this book is my own first step in the direction of the quest for this kind of theory. For that reason I would like to recommend it not merely to university students but also to those who have already graduated and who now find themselves surrounded by the operation of the 'real economy'. I suspect, however, that one part of the second section of the introduction to this book will be difficult to understand, not merely for students but also for those who have gone through economics courses. Should this be the case, I hope that although the reader may have encountered in the introduction passages which are difficult to under-

Preface

ix

stand, he or she will not stick at that point but read on to the end of the book and then afterwards reread the introduction. It is likely to be a good deal easier the second time around. I have explained further in the Additional Note about those topics which are dealt with in normal textbooks but which here are either disregarded or given scant attention. Although based on my lectures at LSE, this work was first published by Iwanami Shoten for Japanese readers, which accounts for the large number of examples taken from the case of Japan. For the English translation I am indebted to the efforts of D. Anthony, J. Clark and J. Hunter and would like to express my gratitude to them. March 1984

MICHIO MORISHIMA

Introduction

1 Which economics?

The variety of economics There are, fortunately or unfortunately, a large number of schools within economics. Each school possesses its own particular theories, hence there is a great diversity of economic theories. They can be roughly classified into such schools as, for example, classical economics, neoclassical economics, Marxian economics, and Keynesian economics, but these can then be further classified into sub-schools such as the neo-Ricardian, neo-Marxist, neo-Keynesian and even neo-Austrian. On top of that we have institutional economics, the historical school as well as power school of economics. There are, in effect, a galaxy of plausible theories, but they all aim to analyse and explain the capitalist economy, so very few economists indeed even think that these theories can be used to shed light on socialist economies. What is needed for this is a quite separate theory. Similarly, when considering a capitalist economy which incorporates a relatively high degree of planning the theory of competition used for the free enterprise system cannot possibly be applied without substantial modifications. It is taken as a matter of course that for analysing different systems different theories must be used. This approach is regarded as the common sense one by economists of socialist countries. No one is likely to believe, for example, that the theory used in analysis of the Soviet Union will, just as it stands, be appropriate to Poland, Yugoslavia or China. Among economists in capitalist countries, however, you are unlikely to find many opportunists who make assertions along the lines of 'Classical theory is the most valid for country A, Marxian theory for country B, and Keynesian for country C ; if an economist is a Marxist then that economist is likely to claim without any flexibility that Marxian economics is the correct theory for all capitalist countries: the United States, Britain, Japan and so forth. And in that respect neoclassical economists and Keynesians are no 1

2

Introduction

different from their Marxist counterparts. They remain loyal to the theory in which they themselves believe and are convinced that the real capitalist economy must in each and every respect operate in the manner prescribed by their theory.1 When looked at closely socialist economies differ tremendously from one country to another and possess considerable individuality. Free enterprise economies likewise are not completely uniform. The real economy is not managed by an abstract ethereal being known as Homo economicus. Countries may share a capitalist economy, but their historical experience and cultural traditions differ, and the lives, beliefs and modes of behaviour of their people are certainly not the same. Not only that, but the methods and attitudes of organizations such as companies, banks and labour unions are quite different. They encounter, as a result, very different problems. The problems of wage differentials between large and small enterprises and of unpaid family employees, for example, which have been more or less solved in Britain, remain very severe difficulties in Japan. Furthermore each of these countries can also react in a different manner to the same stimulus. Where the difference in reaction is not more than a matter of degree it is possible to handle these economies with models of the same type using 1

Lionel Robbins' famous definitions of 'economic' was probably connected with the establishment of this sort of conviction. According to Robbins economics is the branch of learning which is concerned with the allocation of scarce resources among the various aims competing with each other for them. Those who define economics in this way as the study of the management of scarce resources are likely to consider that the most efficient way of administering these resources will be the same in any country. They therefore usually tend to regard neoclassical theory as the most appropriate scholarship to teach this kind of means of management, and apply it to all countries, on occasions even to the Soviet Union. Hence the conviction that neoclassical theory, and neoclassical theory alone, is the true economics. (This is the sort of reason why many Western economists have ended up by subscribing to Kantorovich's theory of production planning as one element of neoclassical theory.) My own tacitly adopted definition of economics is different: It is that economics is the branch of learning which concerns itself with elucidating how the elements of the material life of the people of a country compete with each other, and how they are mutually interdependent. Therefore whenever people are directly confronted by some difficulty relating to the management of their material lives, economists are under an obligation to look into how that particular problem can be removed. In view of the fact that the way in which the material lives of the people are related to each other differs from system to system, and the difficulties which crop up also differ according to system, the content of economic theory may also be expected to differ accordingly. In considering matters of policy, there are frequent cases where the conclusion is unavoidable that a difficulty cannot be dealt with without changing or amending the system, so it is essential that whatever their country economists should be guaranteed a wide measure of freedom to criticize the system. Robbins, L., An Essay on Nature and Significance of Economic Science, 2nd edn., London, Macmillan, 1949; Kantorovich, L. V., 'Mathematical Methods in the Organization and Planning of Production', (1939), Management Science, 6, pp. 366-422.

Which economics?

3

different numerical values for the coefficients (parameters) constituting the framework, but where the reactions are qualitatively different they have to be analysed using quite separate models. As the peculiarities of each economy become more and more well-defined we become more and more dissatisfied with these ready-made, conventional models - be they neoclassical or whatever - and the development of more appropriate models becomes a matter of primary concern to economists. Large, medium-sized and small industrial countries In this book we shall leave aside completely the differences in the characters of the people and the disparities in their cultural traditions, and instead classify economies quite simply according to scale, dividing them into three groups: large, medium-sized and small.2 Large capitalist countries will be deemed to mean countries such as the United States which are rich in natural resources, which are more or less selfsufficient, having virtually no dependence on any other country, and whose economies can develop any industrial sector that should be necessary. Countries whose land area is small and which are perforce dependent on other countries for many of their industrial raw materials and fuel are designated 'medium-sized industrial nations'. These countries, however, are by no means small, and are strong enough to be able to develop domestically all sectors of industry. The ratio of the volume of raw material imports to the level of production of manufacturing industry was in the case of the US A in 1977, 2.5%. The same figures for 1978 for Britain, Italy and Japan were 12%, 10% and 9% respectively, so these three countries are classed medium-sized industrial nations in our sense of the term.3 The same year thefiguresfor West Germany and France were 5.6% and 6.6% respectively, so these countries, too, can be said to demonstrate a marked 'medium-sized' tendency in comparison with the United States. Moreover in our 'medium-sized nations' the agriculture and mining sectors are weak, with the amount of production of these sectors comprising only a very small percentage of total GNP. In the case of both Britain and Japan these percentages in 2

3

The ethos of a people frequently governs their destiny. For discussion of this problem, see my Why has Japan 'Succeeded'?, Cambridge University Press, 1982. To obtain these figures imported fuels should, strictly speaking, be included. However, since many imported fuels are consumed outside the industrial manufacturing sector very detailed statistics are needed for any calculation of the proportion of the price of the products of manufacturing industry accounted for by imported raw materials and imported fuels. If we here for the time being regard all imported fuel stuffs as being used by manufacturing industry the figure comes to 16% for the USA, 26% for Japan, 30% for the UK, 16% for Germany, 24% for France and 31% for Italy, providing us with almost the same conclusion as the text. (Figures relate to 1977 for the USA, 1978 for the other countries.)

4

Introduction

1978 were 4%; for West Germany, France and Italy the figures were 7%, 9% and 12% respectively, so that both Britain and Japan can be said in this respect to be archetypal 'medium-sized' nations. Of the other three, however, both France and Italy have fairly sizeable agricultural sectors and in this sense cannot be regarded as typical of 'medium-sized industrial nations'. Small industrial countries are unable to produce all industrial commodities. Some of them may be unable to produce capital goods, and have to purchase machines from abroad, while others may be unable to produce certain kinds of consumer goods and have no choice but to import these consumer goods from other countries to satisfy demand from the people. In as far as its population is small, a small-sized country will not possess the labour force adequate for the domestic production of all kinds of industrial products, so such small countries are likely to be forced into the position of 'small industrial countries'. However, there also exist countries, which, while they may be sizeable in terms of population, cannot, for reasons such as the low level of education, develop those sectors of industry which require particular skills. Some industrial countries in the process of development become 'small industrial countries' for this reason, and many of these countries may easily before long become 'medium-sized industrial countries' if the opportunity offers. Some may even progress to become 'large countries'. Model for countries lacking natural resources In this book I intend to try to analyse those countries we have defined as 'medium-sized industrial countries', and in an effort to reach greater clarification of the concept of a 'medium-sized country' I shall venture to make a somewhat bold abstraction along the following lines. Let us consider the case of a country which possesses no natural resources whatsoever of its own. There exist, therefore, no agricultural sector and no mining sector. This country's industry, however, is capable of producing sufficient goods - both in the consumer goods sector and in the capital goods sector - to satisfy the demands of its people. It therefore imports no finished industrial goods from any other country. However, these industrial sectors require raw material and fuel. A country with no natural resources of its own has no choice but to import such raw materials and fuel from elsewhere. Given that imports of this kind are unavoidable this country is going to have to export part of its industrial production to pay for its imports. The problems of earning through exports such-and-such an amount of foreign currency, and of how much foreign currency will be necessary to purchase imports, i.e.

The outline of this book

5

the problem of trade receipts and disbursements, is a significant matter, literally one of life and death, for the country. Should the foreign exchange rate change the cost of imported raw materials and fuel will also change, thus influencing the costs of production of industrial goods and hence their price. In this way, in a country lacking in natural resources, industrial production (which is the same as that country's total national production) is directly linked to the exchange rate. Since there is no agriculture, foodstuffs have to be imported from other countries, but in our no-resource country there will be no importing of agricultural products for immediate food use. Despite this there is unlikely to be any shortage of food, because according to our model one section of the consumer goods production sector, that manufacturing tinned goods, has as its raw materials imported agricultural and marine products and supplies the people with these tinned goods. Clearly this kind of model is a distorted one, one which represents in an utterly deformed way the realities of a medium-sized industrial country. Nevertheless this kind of crude abstraction is absolutely imperative if we are to reveal the essentials of the economy which we have selected as the object of our analysis. Just as the twisted faces drawn by Picasso expressed very well the individuality of their subjects so in science does one gain a more precise grasp of the real fundamentals by exaggerating one side of the reality through abstraction and eliminating completely the other side. In this work we will not be concerned with the other sizes of industrial country, but if, while studying the theory of 'medium-sized industrial countries' we bear in mind the question of how to reach a model for the large and small industrial countries, then this will develop our ability to conceptualize. 2 The outline of this book Part one: The theory of prices

This work is divided into two main parts. Part One discusses the way in which prices are determined. Ordinary textbooks tend first of all to state that a price is determined at the point where the demand curve and the supply curve intersect, and then move on to an explanation of each of these curves (expounding the utility or indifference-curve theory of consumer demand and the theory of firms based on the principles of profit maximization; these theories yield the demand curve and the supply curve, respectively). However, this means of determining prices fits only one group of goods: agricultural, forestry and marine products, and some minerals. The prices of many industrial products are not

6

Introduction

regulated by the market so as to equate demand and supply; prices have already been decided at the factory at the time of shipment, and the amount of shipment is regulated according to the volume of demand. Of course even when the price is determined in this way by the supplier (the factory) there is frequently price competition between suppliers, competition which is in some cases so fierce that it can be more appropriately termed a 'price-war', and there is no question of such price competition being a revision of prices to regulate supply and demand. It is aimed at bringing down competitors. Any equating of the supply and demand of these goods is achieved not by price regulation but by regulating the quantity available (the volume of shipments). On top of this the foreign exchange rate is determined by the dealers of the various banks according to particular formulae. Furthermore in the real economy wages are not determined by the congruence of supply and demand, being bid up and down in the manner described by the textbooks. In short, in the real economy the price of each good is decided according to a number of formulae, and the first half of this book will attempt to explain the manner of determining the prices of those goods which have the greatest bearing on our 'country without natural resources'. Discussion will include the means by which the prices of agricultural, forestry, marine and mining products which constitute the raw materials of our industrial sector, are determined on the (foreign) commodity markets; the nature of the full-cost principle which supplies the formula by which each factory decides on the price of its products; and how the exchange rate is determined on the international interbank market. Discussion of the labour market and the financial markets will be reserved for Part Two of the book. Part two: Say's Law and the principle of effective demand In Part Two we will discuss the circulation of both goods and currency. Since our country without natural resources has no agriculture no landlord class need be considered. The people make their living as workers, entrepreneurs or capitalists, or if they are unable to become any of these they become unemployed. The entrepreneurs are distinct from the capitalists. It is the capitalists who supply the capital for the enterprise, and the entrepreneurs who are responsible for its direction and management. Cases where capitalists are at the same time entrepreneurs are, of course, quite frequent, but in view of the fact that there are countless capitalists who despite contributing capital have no role in planning or management, and because there are also large numbers of entrepreneurs who possess no capital at all - or hardly any - and carry on their business with loans of capital from elsewhere, entrepreneurs

The outline of this book

7

and capitalists must be kept distinct from each other. Enterprises normally raise funds through the issue of stocks, but we shall assume here that funds are raised through the issue of (fixed-interest) debentures. Hence the capitalists who finance the enterprise are rentiers. There are in economics two fundamentally conflicting methods of thought. The first of these takes the view that overproduction is impossible when the economy is taken as a whole, that is to say if the total volume of production pxXx + p2X2 is decided then a total demand in accordance with this level will always be generated.4 The second is the view that it is total demand which determines the total volume of output, and not vice versa. The former is called Say's Law, and the latter the principle of effective demand. Ricardo, who dominated the field of economics up to the first half of the nineteenth century, recognized Say's Law, so this law was called by Keynes the postulate of the classical school.5 Since such a postulate is necessary for general equilibrium to be achieved, theorists who believed in general equilibrium, including Walras, subscribed to Say's Law, but from the midnineteenth century, scholars denying the validity of Say's Law began to appear, for example Marx and his disciples. The ideas of these opponents of Say's Law eventually bore fruit in the form of Keynes' principle of effective demand.6 The basic theme of the history of economics over the century preceding the publication of Keynes' General Theory can be regarded as the attempt to overturn the world of Say's Law (Ricardian economics) and to construct a system not governed by this law (Keynesian economics). This book is written from the standpoint of the principle of effective demand, but before coming down conclusively on the side of this principle I shall explain briefly what I regard as the deficiencies in Say's Law. Any decision on the level of output involves a decision on the wages to be received by workers and the income of entrepreneurs, and these individuals all consume part of their respective incomes, and save the remainder.7 If it can be always guaranteed that investment will be 4 5 6

7

Xx is the volume of production of consumer goods, X2 the volume of production of capital goods. px and p2 are their respective prices. Keynes, J. M., The General Theory of Employment, Interest and Money, London, Macmillan, 1936, p. 26. Walras' position is an ambiguous one. In the text of his Elements of Pure Economics (translated by W. Jaffe, Richard D. Irwin, Inc., Homewood, Illinois, 1954), he clearly refutes Say's Law, while affirming it in his mathematical model. Any denial of Say's Law in his mathematical model would have amounted to a recognition that such a thing as a situation of general equilibrium, far from coming into being, did not generally exist. (M. Morishima, Walras' Economics, Cambridge University Press, 1977, pp. 70-122.) Concerning Marx see his Theories of Surplus Value, part II, London, Lawrence and Wishart, 1969. See Additional Note a.

8

Introduction

equal to this volume of savings, then the total level of production will always be equal to the sum of the total amount of consumption plus the volume of investment, i.e. to the total level of demand. Hence Say's Law will operate.8 Overall surplus production is not possible; if there is overproduction in industries producing consumer goods there is bound to be underproduction in capital goods industries.9 In this way in order for Say's Law to take effect the amount of investment generated must be equal to the total amount of savings, regardless of the prescribed level of the total volume of output. This, however, is quite simply impossible. The decision on whether to invest rests with the entrepreneur, and neither the workers nor the rentiers have any part in it. When total production is at a high level the total volume of savings is accordingly high, so savings can without any problem exceed investment. Conversely when the volume of output is small total savings will be less than total investment. This being the case there is no question of total savings equalling investment at every level of total output. It will be no more than a case of savings equalling investment by chance at a certain level of total output. This stipulated value of output is known as the equilibrium output value, and since any volume of production differing from the equilibrium value generates savings which are either greater or less than investment, then overall overproduction and underproduction are very possible.10 It is this that serves to negate Say's Law. The entrepreneurs' investment decisions are devoid of any mechanism which might enable them to revise their investment plans to invest at exactly the same level as that reached by savings at any time, whatever the volume of output may be; they also lack any flexibility which might produce this kind of revision. Conversely, in the real economy the amount of production accords with the amount of investment decided on by entrepreneurs. In this manner production is carried out on a scale which will produce the I2 is the volume of demand for investment, p2l2tne amount of investment funds. Should this amount of investment always be equal to savings, the result will be e (*) PxXx + p2X2 = Pl(D? + D 1 + D[ + El + Gx) + p2(I2 + E2 + G2) according to the (t) formula given in the Additional Note a. That is to say the total amount of production equals total demand. y Formula (*) in note (8) can alternatively be written px[Xx - (D? + D\ + D[+El + Gx)] + p2[X2- (I2 + £ 2 + G2)] = 0 (**) If the part within the first square brackets has a plus value (i.e. surplus production of consumer goods), then the formula within the second square brackets has a minus value (i.e. underproduction of capital goods). 10 If S>I then the left side of the formula (**) in note (9) has a positive value, so the sections within both the first and second square brackets are together likely to assume a positive value, hence giving rise to general overproduction and contradicting Say's Law. 8

The outline of this book

9

equilibrium value of output, but production of this sort of scale is not necessarily such as will result in full employment among workers. At times when entrepreneurs are not particularly keen to invest the equilibrium amount of production will be small, and unemployment is, as a result, unavoidable. Under Say's Law there are no obstacles to full employment. As long as production is carried on at the level necessary to realize full employment, then investment will adapt itself so as to equal the appropriate level of savings, and supply and demand are balanced at the full employment level of output; neither overproduction nor underproduction will exist. In an economy where Say's Law does not operate insufficient investment becomes an obstacle to full employment. And in an economy where the inclination to invest is insufficient the government must either positively generate demand to remove this insufficiency, or in some way encourage financial agencies into stimulating the desire to invest. Hence fiscal and monetary policy will constitute the main topic of Part Two of this volume, and there will also be some discussion of problems related to dealing with the ill effects of these policies (such as deficit financing, inflation, and stagflation). The approach adopted by this book This book is both theoretical and analytical, so mathematics is frequently utilized. The mathematics is, however, not difficult, and the level of knowledge attained with O-level mathematics is adequate for an understanding. My own belief is that economics is not a single pure science, but a grand integrated body of knowledge. Therefore in order to gain an understanding of economic theory it is not enough merely to be conversant with the mathematical framework of the theory. There must also be some considerable knowledge of the social, institutional and historical foundations of that theory. Any attempt to disregard this social, institutional and historical background, and to consider and examine economic theory as no more than formal logic and chains of mathematics, cannot possibly be the right way to study economic theory. At appropriate junctures in this book, therefore, pages are devoted to the explanation of economic systems and attempts made to consider matters from an economic history standpoint. I am under no illusions that such discussions are adequate, but I have adopted this sort of approach here in the hope of persuading the readers of this book that economics is an integrated science. It expresses my own antipathy towards the way in which theoretical economics has become no more than a mathematical skeleton.

PART ONE

The formation of prices

Markets and the price mechanism

1 How are prices determined?

Views of the academics Let us first consider the views of two representative scholars, Marx and Walras. The former, Marx, considers that the prices of goods are determined 'by competition between buyers and sellers, by the relation of demand to supply, and of desire to offer'.1 He says that The same commodity is offered by various sellers. With goods of the same quality, the one who sells most cheaply is certain of driving the others out of the field and securing the greatest sales for himself. Thus the sellers mutually contend among themselves for sales, for the market. Each of them desires to sell, to sell as much as possible and, if possible, to sell alone, to the exclusion of other sellers. Hence, one sells cheaper than another. Consequently, competition takes place among the sellers, which depresses the price of the commodities offered by them. But competition also takes place among the buyers, which in its turn causes the commodities offered to rise in price. Finally, competition occurs between buyers and sellers; the former desire to buy as cheaply as possible, the latter to sell as dearly as possible. The result of this competition between buyers and sellers will depend upon how the above-mentioned sides of the competition are related, that is, whether the competition is stronger in the army of buyers or in the army of sellers.2

Of course, since in the real world friction exists, actual prices do not necessarily coincide with equilibrium prices. Nevertheless Marx thought that 'the study of such frictions, while important to any special work on wages, may be dispensed with as incidental and irrelevant in a general analysis of capitalist production'.3 That is to say, as a rule Marx took prices to be equilibrium prices. Orthodox economists are completely at one with Marx from this standpoint. Walras for example, writes as follows 1 2 3

Marx, K., Wage, Labour and Capital in Karl Marx and Frederick Engels, Selected Works, London, Lawrence and Wishhart Ltd., 1978, p. 76. Ibid, p. 76. Marx, Capital (Volume III), Moscow, Progress Publishers, 1966, pp. 142-3.

13

14

Markets and the price mechanism

As buyers, traders make their demands by outbidding each other. As sellers, traders make their offers by underbidding each other. The coming together of buyers and sellers then results in giving commodities certain values in exchange, sometimes rising, sometimes falling, sometimes stationary. The more perfectly competition functions, the more rigorous is the manner of arriving at value in exchange. The markets which are best organized from the competitive standpoint are those in which purchases and sales are made by auction, through the instrumentality of stockbrokers, commercial brokers or criers acting as agents who centralize transactions in such a way that the terms of every exchange are openly announced and an opportunity is given to sellers to lower their prices and to buyers to raise their bids. This is the way business is done in the stock exchange, commodity markets, grain markets, fish markets, etc. Besides these markets, there are others, such as the fruit, vegetable and poultry markets, where competition, though not so well organized, functions fairly effectively and satisfactorily. City streets with their stores and shops of all kinds - baker's, butcher's, grocer's, tailor's, shoemaker's etc. - are markets where competition, though poorly organized, nevertheless operates quite adequately. Unquestionably competition is also the primary force in setting the value of the doctor's and lawyer's consultations, of the musician's and singer's recitals, etc. In fact, the whole world may be looked upon as a vast general market made up of diverse special markets where social wealth is bought and sold. Our task then is to discover the laws to which these purchases and sales tend to conform automatically. To this end, we shall suppose that the market is perfectly competitive, just as in pure mechanics we suppose, to start with, that machines are perfectly frictionless.4 The market So then, what is a market? In economics a market is both the place where transactions (exchanges) are carried out, and the arrangements for exchange, or the organization through which buying and selling take place. As Walras points out, whilst there may be loose arrangements, there may also be elaborate organizations regulated by law which are completely systematized (such as the various types of exchange, etc.). Since goods and goods (or goods and money) are exchanged in the market, an exchange ratio, that is a price, will be fixed there. For example, if 20 yards of linen are exchanged for 2 coats, the price of a coat in terms of linen will be their exchange ratio, that is one coat: 10 yards of linen. In the everyday economy, goods are not normally exchanged for other goods but for money, and so the price of goods will be their exchange ratio with money. Thus the price expressed in terms of pounds will be 1 coat for a certain number of pounds. In broad terms three markets may be distinguished: commodity 4

Walras, Elements of Pure Economics (translated by W. Jaffe), Homewood, Illinois, Richard D. Irwin Inc., 1954, pp. 83-4.

The structure of auctions

15

markets, markets for factors of production, and security markets. Commodity markets may be further divided into consumer goods and producer goods markets (machinery, buildings, raw materials, etc.), while the market for factors of production may be broken down into the labour market and the market for land. Security markets are markets for shares, for bonds, and so on. Markets for factors of production must be handled cautiously because of the important role of human, social, and historical factors, and therefore we shall treat them separately below, and continue our explanation mainly in terms of commodity and security markets. 2 The structure of auctions Cross-trading

There are three kinds of transaction method; cross-trading or negotiated transactions, trading by bid or tender, and competitive trading. In cross-trading there is a transaction as long as the seller (supplier) and the buyer (demander) agree on a price. Suppose that there is a clothes shop A which would like to sell a coat at £16.00, and an individual B who would like to buy it at £16.00, with C who would buy it at £14.00, and D who would buy it at £12.00. Because agreement is soon reached between A and B on price, in cross-trading, a coat will quickly be sold from A to B. With the next coat it seems more likely that agreement will be possible with C rather than D, and so A may well first approach C. In this case too, so long as either A or C, or both, are not prepared to make some concession no agreement will be reached; but if A is intent on selling and C is similarly intent on buying, a second cross-trade will probably be achieved at £15.00 between A and C. Thus, with cross-trading similar coats may be exchanged at different prices on the same day. However, B may complain at this point. Having just bought from A at a price of £16.00, when B hears that A later sold to C at £15.00 he is likely to return to shop A and stubbornly negotiate to get the price of the coat he bought down to £15.00. In order to avoid such disturbances not only must there be agreement achieved on price between individual sellers and buyers who cross-trade, but amongst all the sellers and buyers. The tender system and competitive trading are arrangements for achieving high levels of agreement and for establishing a single price for each good. That is, the law of indifference is realized. Trading by tender With trading by tender, there are both tenders for buying goods and tenders for selling, and it is the latter in particular which is called an

16

Markets and the price mechanism

auction and is carried out periodically at a specified place. Examples of the former are as follows. (1) Where the State and regional public bodies procure construction work, the contents of the work are publicly announced. The construction companies having estimated the costs, the government office as a rule entrusts the company which presented the cheapest estimate with the work. (2) In ordering the construction of new ships, too, contracts are made according to the same formula. And (3) where there are several different methods of manufacturing the same product the 'tender formula' will be employed to determine which method of production will be adopted and which rejected. That is, the cost of the respective methods of production will be estimated, and the least-cost method will be adopted. Auctions often take place in the selling of antiques and luxury residences. But there is no set method for these, and there are various types, such as the British type and the Dutch type. In the British type the buyer bids up gradually from a low to a higher price, whilst in the Dutch type he bids down from a higher to a lower price. Let us now sell two coats at auction. Let A be the seller and B, C and D the three buyers. As in the previous example, suppose that B will buy 1 coat up to a price of £16.00, and C and D respectively will buy 1 coat each at £14.00 and £12.00. Firstly, in the British type, the auctioneer may well propose a low price, such as £11.00 for example. At this price B, C and D all signal their intention to buy, so with a demand of 3 but a supply of 2 the price will be bid up. When the auctioneer raises the price in units of £0.10 and it reaches £12.10, D will drop out, the demand will be 2 and will be equal to the supply. That is, in the British type of auction £12.10 is the equilibrium price. Since both B and C will have bought at the same price neither should have any complaint, and D too will have no reason to complain since he has given up trading. Since B was happy to buy up to a price of £16.00 he will congratulate himself that he has bought cheaply; and C too, who would have bought up to £14.00, may well think that it was not a bad bargain. (The total amount by which the purchasers have profited is called the consumer's surplus, and is, (£16.00 - £12.10) + (£14.00 - £12.10) = £5.80.) The Dutch type of auction goes as follows. The auctioneer suggests a high price, for example £17.00. There is no buyer and the price is bid down. At £16.00 B will begin to demand it, but there will still be an excess supply, and the price will be bid down further. When it eventually reaches £14.00 the demand will be 2 and will equal the supply. The equilibrium price in the Dutch type of auction is £14.00 and of course the consumer's surplus is £2.00. Thus even with auctions, when the type differs the equilibrium value

The structure of auctions

17

attained will not necessarily be the same. However, it differs from cross-trading in that in an auction all the buyers are treated equally and all transactions trading between B and A, and between C and A are carried out at a uniform price. Auctions are transactions at a uniform contract price and establish the rule of one price for one good. There may, however, be some readers who think that because in an auction seller A will supply 2 coats regardless of the price proposed, the inclinations of A are absolutely ignored. However, A will not sell a coat at any price simply at the behest of the buyers. For example, if the price were above £15.00 A may certainly want to sell, but beneath that price he may not want to; and at a price of exactly £15.00 he may be indifferent between selling or not. But in order to have the inclinations of the seller reflected in the bargain, the rules of the auction given above should be slightly amended. That is, A entrusts the sale of 2 coats to the auctioneer and when the auction starts sits among the buyers. Whilst the price is not one at which A wishes to sell, A should be permitted to indicate his intention to buy back the 2 coats. Therefore when the price is less than £12.00, the total demand will be the 3 coats B, C and D wish to buy and the 2 coats A bids for, making 5 coats in all. With this demand the price will be bid up. Where the price is £12.10-£14.00 total demand will be 4 coats, where it is £14.10-£14.90 demand will be 3 coats, falling to 1 coat at £15.10-£16.00. Since the supply is 2 coats the price will be bid up to £15.00. At £15.00 one coat will be sold to B, and the remaining coat will be left unsold. This means that if the price is lowered to £14.90 A will buy up the total supply at that price and so B's demand will be an excess demand. Therefore price will be bid up. The price of £15.00 is thus equilibrium price, and one coat remains unsold at equilibrium. But because it does not matter to A whether he sells or not at that price he will be content to withdraw. Exchanges The competitive trading which is carried out at commodity and stock exchanges has expanded and reinforced the bid or tender system or auctions at auction houses, so as to enable many suppliers and demanders to participate at the same time. Exchanges are not public places in the sense that anyone can transact directly there. Transaction must be through a broker approved by the exchange; but once having commissioned a broker anyone can engage in transactions, and so the organization is a semi-public one. Thus, whilst only a limited number of brokers have access to the exchange, an unlimited volume of business can be handled.

18

Markets and the price mechanism

There are various kinds of competitive trading. For example, prices were determined as follows in the settlement-trading market of the pre-war Tokyo Rice Commodity Exchange. In Table 1, let us assume that A to H are the eight brokers and that they came to the exchange with orders to sell or buy as shown in the Table. Carte blanche here means that they do not specify the price; an order to sell 300 bushels of standard rice (or to buy 400 bushels) at the market price, whatever it was, would be a carte blanche order. The opposite of this is a stop or limit order which is to sell or buy at a specified price. For example, B has orders to sell 300 bushels if the price is £10.00 or above, and F has orders to buy 100 bushels if the price is £13.00 or below. Table 1. Sample rice exchange orders Seller

Price

Quantity

Buyer

Price

Quantity

A

Carte blanche £10.00 £11.00 £12.00

300 bushels

E

400 bushels

300 bushels 200 bushels 100 bushels

F G H

Carte blanche £13.00 £12.00 £10.00

B C D

100 bushels 300 bushels 300 bushels

In the competitive trading process the price will change, but because it is impossible for it to be made to change continuously in infinitely small units, let us assume that it changes in discrete, minimum units of £1.00 (one pound). If finer adjustment is necessary, it might be adjusted in 50-pence or 10-pence units. The minimum unit is decided by the statutes of the exchange. Simulation of competitive trading Let us now handle the demand and supply of Table 1 according to the practice of the Tokyo Rice Exchange. When competitive trading begins, first carte blanche orders to buy and sell are transacted. In our example, the carte blanche order to buy is 100 bushels in excess of demand, and the convention is that these 100 bushels will be transacted at the lowest price (at £10.00, 100 bushels will be supplied from the 300 bushels B intends to supply). Where there is an excess supply on carte blanche ordering, this excess is transacted at the highest demand price. Buyers and sellers who have struck a bargain slap each other's hand to indicate the fact, and the exchange's book-keeper will record who sold or bought how many bushels. However, he will not record the price at which the bargain was struck.

The structure of auctions

19

In the market, however, B still wants to sell his remaining 200 bushels at £10.00. When we look over to the demand side, F, G and H still want to buy 100, 300 and 300 bushels respectively at £10.00, and thus there is an overall demand of 700 bushels in total. Of this, H's demand for 300 bushels will be withdrawn if the price goes above £10.00, G's demand for 300 bushels will disappear if it goes above £12.00; but as long as no seller is found F will stay in the market until his price of £13.00 is reached. Accordingly, the course of competitive trading will be different thereafter according to which of F, G or H, B transacts with. Competitive trading consists of transactions through a single agreed price, and transactions made in the course of the auction are all settled at the final price (equilibrium price). Even if H were to transact with B at the price of £10.00, should the price go above £10.00 H must pay B the higher figure. That is, even though it was H's intention only to buy rice at £10.00 per bushel he will have bought rice at a price above £10.00. In order to avoid such a mistake, H must be permitted to resell (without cost) the rice he has bought from B. If B transacts with H and the price then goes above £10.00, H will immediately resell; but when B transacts with G or F they will not resell what they have bought until the price rises to £12.00 and £13.00 respectively. Since the way in which resale orders appear differs, the course of competition trading thereafter depends on whom B transacts with now. Let us suppose that B has struck a bargain with H. Since only 200 bushels remain of B's supply, even after buying from B, H will probably continue waving his hand shouting 'buying 100 bushels at £10.00'. Since the total supply at £10.00 has already come on the market there will be no supply to satisfy the demands of H, F and G who remain on the floor of the exchange. However, if the price were to rise to £11.00 C will want to sell 200 bushels. Yet at £11.00, H's demand (100 bushels) would disappear from the floor; but because F and G still want to buy it is possible these bargains will be struck between C and F or G. Whilst the total demand is for 400 bushels and the new supply is only the 200 bushels of C, there is also the resale from H. That is, H has already bought 200 bushels at a price of £10.00, but since he has no intention of buying a single bushel at a price of £11.00, as soon as it reaches £11.00 he has to cancel the order he made earlier. As explained, in order to do this H must resell the 200 bushels he has already bought in order to offset past purchases. Total supply is now 400 bushels, including the supply from this resale. This is equal to total demand and bargains will be made between C, H and F, G

20

Markets and the price mechanism

at the price of £11.00. This fact will then be recorded by the exchange's book-keeper. On the floor of the exchange, D waves his hand shouting 'selling 100 bushels at £12.00', and H shouts 'buying 300 bushels at £10.00', but there is no longer anyone in the market who will buy at £12.00 or sell at £10.00. This is because B who wished to sell at £10.00 and F and G who were prepared to buy at £12.00 and £13.00 respectively, have already completed their selling and buying under the preferred conditions of a price of £11.00. If the price is £11.00, D and H cannot complain at not selling or not being able to buy. Thus £11.00 is the price (equilibrium price) which none of the traders then present in the market have any objection to. When he judges an equilibrium price has been achieved, the watchman hits a clapper and declares that competitive trading is over. The equilibrium price governs all transactions and has established the rule of one price for one good. Prohibition of disorderly bidding The above simulation of competitive trading in the Tokyo Rice Exchange followed the rules and normal practice of Exchange. That is, as long as there are outstanding orders to buy at a given price, it is forbidden to put in a selling bid at a lower price. Conversely, whilst selling orders are not completely exhausted at a given price it is not permitted to put in a buying bid at a higher price. To allow these practices would be to condone conduct inimical to the orderly working of the market. When there are outstanding orders on the market to buy at a given price /?, and sellers had in any case been prepared to sell at a price lower than p, it is only commonsense for them to sell at p. Not to do so, and to try to sell at a price lower than p would be disturbing. Similarly, when there are outstanding orders on the market to sell at a given price/?, and buyers had in any case been prepared to buy at a price higher than /?, it is commonsense to buy at p. Not to do so, and to try and buy at a price higher than/7 would be equally disturbing. Bidding in contravention of these normally accepted conventions with regard to transactions is known as 'disorderly bidding' and is prohibited. Therefore, the only bids that can be lodged when outstanding bids to buy remain on the market (an excess demand) are bids to sell at a higher price. Similarly, the only bids permitted when outstanding offers to sell remain on the market (an excess supply) are bids to buy at a lower price. In fact, the reason why, in the above simulation of competitive trading, the price rose from £10.00 to £11.00 was because of the rule of the Exchange whereby offers to sell at £11.00 come into consideration because there are outstanding bids to buy at £10.00. That is, under this

Formulations of economists

21

rule, if there is an excess demand (supply), the price will rise (fall). The competitive trading mechanism is merely a kind of 'social computer' which eventually discovers equilibrium prices by adjusting prices according to this formula. 3 Formulations of economists

Demand and supply curves How then do economists analyse equilibrium prices? Economists say that prices are determined where the supply and demand curves intersect, but in our example of an exchange, how can we depict the demand and supply curves? Let us begin with the supply curve. Because the only supply will be from carte blanche sales when the price is less than £10.00, total supply is 300 bushels. At a price of £10.00, B will try to sell 300 bushels, which together with carte blanche sales will make a total supply of 600 bushels. At £11.00 B will, of course, continue to supply, and when we include the 200 bushels from C who now joins in the selling, total supply will be 800 bushels. At and above £12.00, supply will be 900 bushels. This is shown graphically in the series of black dots of Fig. 1, which places price on the vertical axis and quantity on the horizontal axis. Because price changes at discrete intervals in £1 units, even if we join the black dots in a line there will be no meaning to the spaces between neighbouring black dots. In our case the series of sporadic black dots makes up the supply curve, but in economics we usually consider that price changes continuously, and we show the supply curve by means of a continuous curve. The demand curve can also be derived from Table 1 by a similar procedure. At prices above £13.00 there is only carte blanche demand and therefore total demand will be 400 bushels; but at the price of £13.00 the 100 bushels of F demands are added (total demand equals 500 bushels). At £12.00 there will be G's demand as well (total demand 800 bushels). Since there is no new demand at £11.00, total demand will be 800 bushels as before, but at £10.00 H's 300 bushels will be added and total demand will be 1100 bushels. Thereafter there will be no change in total demand even if the price were to fall further. The series of hollow circles represents the demand curve. As is clear from Fig. 1, because a black dot and a hollow circle coincide at the price of £11.00, this is the price which equates demand and supply, and is therefore the equilibrium price. In order to arrive at such a price competitive trading began at £10.00, but an excess demand arose at that price. In order to satisfy this excess demand we should mobilize extra supply; for that purpose we should inquire into how the supply will be forthcoming at prices above

22

Markets and the price mechanism £'s 15 14 13 12 11 10

300

600

900

1200

Bushels

Figure 1

£10.00. When bargains were struck at a price higher by one unit according to our 'market conventions', there was an increase in supply of 200 bushels (from C), and the elimination of 300 bushels of demand (from H). Thus 500 bushels of excess demand were eliminated from the market. The price adjustment function So economists explain the mechanism of price determination, via competitive trading as follows. Let the total demand for rice be £>, the total supply be S and price be/?. Because D and 5 depend on/?, we have D = F(p) and 5 = G(p). The changes in D in response to changes in p depict the demand curve, and the changes in 5 give the supply curve. The equilibrium price p° will be determined by the intersection of the two curves. That is F(p°) = G(p°)

(1)

When the price is/?, if there is an excess demand (F(p) > G(p)) the price will rise (p > 0); and if there is excess supply (F(p) < G(p)) the price will fall (p < 0). Here p shows the extent to which price p changes at a given moment in the course of competitive trading. (To put this in more detail, when we take t as the parameter which shows the progress of competitive trading p shows the rate of change of p with respect to t,

The existence of equilibrium

23

dp/dt.) When demand and supply are equal (F(p) = G(p)), price will cease to change (p = 0). Following Samuelson, economists write the relationship between the degree to which price changes (whether positive or negative) and the volume of excess demand as follows p = H(E(p)) where E(p) = F(p) - G(p) and //(0) = 0

(2)

This is called the price adjustment function, and it is 'market conventions' which sustain this type of price adjustment mechanism. 4 The existence of equilibrium

No trading In our simulation the seller D did not participate in any phase of competitive trading. For this reason there may be those who consider perhaps that D has no relationship with the equilibrium achieved; but D is in fact one of those who uphold this equilibrium. This can be shown as follows. We assumed in the previous example that D would sell 100 bushels of rice at £12.00, but let us now suppose that D changes his mind and tries to sell at £11.00. On this assumption competitive trading would have proceeded as follows. Firstly, carte blanche selling and buying will take place and 300 bushels will be sold by A to E. E's remaining demand for 100 bushels will be met by agreeing a sale with B at £10.00. The further 200 bushels which B wishes to sell will be sold to meet the demand at the price of £10.00 (to H, for example). At £10.00 there will be excess demand because there will also be F's demand (100 bushels), G's demand (300 bushels), and H's demand (100 bushels). According to the market conventions sales at £11.00 will be sought after. (Up to this point the situation is exactly the same as in the previous simulation.) At £11.00, not only will C and D supply 200 bushels and 100 bushels respectively, but there will be an addition to supply of 200 bushels because H will cancel the purchase of the 200 bushels he made earlier and resell them. Therefore the total supply will be 500 bushels. On the other hand, at a price of £11.00, demand will total 400 bushels with F wanting 100 bushels and G 300 bushels. Suppose that the 200 bushels supplied by C and the 200 bushels re-sold by H are now sold to F and G, and D's supply remains unsold on the market. According to 'market conventions' price will be forced down to £10.00. If the price goes down to £10.00, D's sales will disappear from the market because he does not want to sell below £11.00. However, C, who does not want to sell at £10.00, has already disposed of his supply when

24

Markets and the price mechanism

the price was £11.00, and therefore he must buy back the 200 bushels he sold, now that the price has fallen again to £10.00. Further, amongst the buyers H has once bought but then resold what he bought. Thus he is in the same position as if he had not bought at all. H will accordingly appear as a buyer of 300 bushels and hands will be waved and bids made on the floor of the exchange for a total demand of 500 bushels. On the other hand, the supply will be zero. The price will be pushed up once more to £11.00. Thus when D sells 100 bushels at £11.00 the price will permanently oscillate between £10.00 and £11.00 and an equilibrium price will not be established. The market's watchman declares 'No Trading', and all deals made in the process of competitive trading up to then are cancelled. It is clear from this that the reason why equilibrium was established at £11.00 in the previous simulation was because D did not sell at £11.00, but attempted to sell at £12.00. Thus, because of this kind of supply schedule being assumed for D, he did not take any part in competitive trading, and it was this very lack of his activity which produced the equilibrium. That is to say, equilibrium is the product of the collective operations of all the buyers and sellers, who have gathered in the market, irrespective of whether they are active in the market or not. Multiple equilibria Thus D plays an important role in that he allows an equilibrium to exist and causes it to be established. Moreover, depending upon his supply schedule, not just one but several (say two) equilibria are possible. In order to see this, let us assume that in Table 1 D will only supply 100 bushels when the price is £13.00 and not £12.00. In this case the black dot corresponding to the price of £12.00 will move leftwards by 100 bushels and coincide with the circle at that height. That is, both £11.00 and £12.00 will be the equilibrium prices with D's new supply schedule, and which equilibrium price is established will depend upon what price competitive trading starts from. The following series of deals will bring about a new equilibrium price of £12.00. Hitherto carte blanche selling and buying first took place, and according to the common practice of the Tokyo Exchange the 100 bushels of excess demand left over was met from B's supply at the lowest price (£10.00). Let us now assume that the rules have been changed so that this left-over demand has to be met out of the supply which is forthcoming at the maximum price of £13.00. At this price B, C and D are all ready to supply (total supply is 600 bushels), and the 100 bushels of carte blanche demand together with F's demand for 100

Determining production prices

25

bushels at £13.00 will be met from amongst the supply forthcoming from B, C and D (say C and D, for example). Since 400 bushels of supply will not be taken up and will remain in the market, price will be lowered by 1 unit in accordance with 'market conventions', and demand at £12.00 will be forthcoming. G will demand 300 bushels at £12.00, and in order to cancel the transaction in which he sold when the price was £13.00, D will try to buy back 100 bushels. For this reason total demand is 400 bushels, whilst on the other hand supply consists of B's 300 bushels and C's 100 bushels, given a total of 400 bushels (C has already sold 100 bushels when the price was £13.00). At £12.00 supply and demand balance, and both are cleared off the market. That is, equilibrium has been achieved. Thus, where several equilibrium prices exist, competitive trading will converge on a low equilibrium price where it began at a low price, and on a high equilibrium price where it began at a high price. There are cases where the price from which trading begins is determined by the rules and conventions of the exchange; but there are also exchanges which leave this opening price to the discretion of the market's auctioneer. In either case, exchanges are the most powerful kind of organization for discovering and disseminating equilibrium prices. However, situations may exist where, even with such an organization, trading must be abandoned, with the cry of 'equilibrium price not achieved', because of the state of demand or supply; also it may be unavoidable that because of the rules of the exchange low (or high) equilibrium prices are consistently established. Despite this, however, exchanges produce, in normal circumstances, agreements which satisfy all those who have put in orders to buy and orders to sell, irrespective of whether or not they all are actually able to buy or sell on the market. In this sense the exchange must be seen as an extremely important mechanism which contributes greatly to the democratic management of the economy. 5 Determining production prices Commodities without an exchange However, it is impossible to provide this kind of exchange for every kind of commodity. Shares, public bonds and corporate debentures apart, exchanges are restricted to some of the products of agriculture and forestry and their processed products (such as grains, beans, potatoes, cotton, coffee, cocoa, wool, eggs, meat, rubber, bean wastes, sugar, wood, plywood etc.). They also exist for textiles (cotton yarn, silk thread, rayon yarn, rayon staple etc.), and for mineral products (gold,

26

Markets and the price mechanism

platinum, silver, copper, tin etc.). No exchanges where prices are determined exist for most manufactured products (automobiles, electrical products, furniture etc.) or for services (railways, hotels, films etc.). Even with commodities for which there is an exchange competitive trading does not necessarily take place, for there are commodities where only cross-trading is carried out even in exchange. Competitive trading where many suppliers compete with each other could not take place unless they all supply a commodity of very similar quality. Where quality is difficult to standardize (as with commodities such as silk cocoons and wool) each lot must be graded individually and its own price fixed. Consequently, only trading by bid or tender will be carried on, and not competitive trading. Furthermore, even for commodities which have an Exchange, not all transactions take place at the exchange. Besides cross-trading which goes on over the counters of shops, wholesalers form associations and gather periodically at a pre-determined place and sell these commodities by bid or tender. This sort of market can be called a 'quasi-exchange'. At a fully-fledged exchange sale or purchase can only be made through a recognized dealer; but in a quasi-exchange there are no restrictions on buyers, whether they be organized traders or individuals acting on their own behalf, who can come and go freely. This is despite the fact that suppliers are limited to the very wholesalers who organized the 'quasiexchange'. In any case, strictly supervised competitive trading only handles a part of the demand for an extremely small number of commodities, and the effectiveness of the competitive trading price mechanism is correspondingly partial and local. Of course, where an Exchange has been established for a particular commodity, transactions outside the exchange will rarely be carried out at prices very different from the equilibrium price determined in the Exchange. Price fixed within the Exchange will affect transactions outside to a greater or lesser extent. When the demand and supply in the exchange is an unbiased sample of the demand and supply of that commodity in the country in general, there can be little objection to treating the equilibrium price established in the Exchange as closely resembling the equilibrium price in the country at large. However, for commodities for which there is no exchange this method of approximation cannot be established. In considering how the prices of commodities with no exchanges are decided, it would be hasty, superficial, and dangerous to consider - without examining what actually happens and by analogy with transactions within exchanges - that prices will be established for those commodities which satisfy all the parties to the transactions.

Determining production prices

27

The full-cost principle5 How are prices decided in the case of manufactured products? Let us suppose for the sake of simplicity that factories produce only one kind of product. The factory computes a standard price by adding fair profits at a fixed rate to production costs. Production costs per unit of product are made up of (1) raw material costs, (2) fuel costs, (3) power costs, (4) the cost of chemicals, (5) the cost of tools, (6) water costs, (7) wages, (8) depreciation costs, (9) management costs, (10) various miscellaneous costs, and so on. If volume of production is very small, costs per unit product will be high; conversely, if the volume of production is extremely large, and the factory must mass-produce beyond its capacity, costs per unit will also be comparatively high. Therefore the production costs c per unit product will be a function of the factory's output x; where x is small c will be large, and with increases in JC, c will at first decline but will then increase (when it exceeds the capacity of the factory). That is, c will describe a U-shaped curve as x increases (we call this the average cost curve). Costs c increased by a fixed rate will be the price of the good (this fixed rate m is known as the net mark-up rate), and the part marked up will form the profit per unit of output. Price determination by this method is known as the full-cost principle.6 Thus in order to determine price p, c has to be determined, and for c to be fixed x must be determined. Since it takes a certain length of time to produce a product, those who run the factory must either produce only that amount for which they have received orders, or they must produce in anticipation of a volume of demand gauged through market research. Where output is small, production will be to order (for example, in the case of ships and special machinery); but with mass production it is impossible to take orders individually, and production must be by estimate. 5

6

On the full-cost principle see for example: Wilson, T. and Andrews, P. W. S., Oxford Studies in the Price Mechanism (Oxford: The Clarendon Press, 1951), which includes inter alia, Hall, R. L. and Hitch, C. J., Trice Theory and Business Behaviour'. Going back further Kalecki, M., Essays in the Theory of Economic Fluctuations (London: George Allen and Unwin, 1939) may be considered a pioneering study on the full-cost principle. See also Wiles, P. J. D., Price, Cost and Output (New York: Frederick A. Praeger, 1963). Among the ten items which make up the costs of production, the sum of (1) to (7) are known as prime costs c', and the sum of (8) to (10) are the indirect costs c". Because it is difficult to assess c" it is usually taken as a proportion of prime costs c' at a prescribed rate m", i.e., c" = m"c'. Thus c = c' + c" = (l + m")cf. Because price is determined according to p = (1 4- m)c, we can write p = (1 -I- m) (1 + m")c' = (1 + m')c', where m' is usually called the mark-up rate. Obviously there is a relationship between it and the net mark-up rate m: 1 + m = (1 + m')/(l + m").

28

Markets and the price mechanism

Where production is estimated in this way, output which is actually sold (xa) will not necessarily be equal to the estimated sales (xe)J When they are equal the factory will make its forecasted profits; but where some production estimated in this way is left unsold (that is, xe>xa), profit will be less than was forecast, and in the worst case profits may even be negative. That is, the factory will make a loss. If the factory is just about to go bankrupt it might hold a bargain sale of its products.at auction, as in the example of the sale of coats at the beginning of this chapter. Let us assume that a demand for 200 coats has been forecast, and that the price of producing a coat is £16.00 (cost + mark-up). Since demand depends on price it will be necessary to revise the initial forecast if £16.00 is too high. However, we will assume that the clothing firm judges it can sell 200 coats if the price is £16.00, and that 200 coats have been produced. However, in reality it transpires that there are orders for only 150 coats at £16.00 and 50 coats remain unsold. The company now has two choices. The first is to lower the price and sell off the 50 coats, and the second is to leave the price as it is and dispose of the remainder in the future. Where it adopts the first method people who have already bought the coats at £16.00 will complain; or else they may say nothing but lose their faith in the company. Thus even if the first method is beneficial to the company in the short term it will not be adopted other than in an emergency situation such as when it 'shuts up shop'. Instead it is likely to adopt the second method, which is to maintain its price, add the unsold goods to the future supply, and at the same time reduce its future output. Even in the converse case where demand is higher than the output it produces, price may not be raised as it would be under competitive trading. The 200 coats produced will steadily be sold off at £16.00 to the waiting buyers, but when the firm has sold about 150 coats it may well come to realize that 200 coats will be insufficient to satisfy total demand. Yet in this case too the company may not try to discourage demand by increasing the price. Instead it may either mobilize stock from the warehouse, or if it has no stock will simply declare 'sold out' and apologize to its customers. It is clearly advantageous to the company to raise its price and adjust overall demand to 200 coats rather than discard demand, but in real life managers and merchants do not behave 'rationally' as depicted in economic textbooks. They are more mechanical and bureaucratic than one would expect. Also, by sticking to the 7

We will discuss in Chapter 2 the way in which the estimated output xe is determined. Here, however, we shall treat it as if it has already been determined.

Determining production prices

29

price they first decided upon they feel they are keeping faith with their customers. Thus in the market for mass-produced, manufactured products demand and supply are regulated by the volume of output let onto the market rather than by price. Where production exceeds demand the volume of stocks increases, and accumulated stocks are discharged onto the market where there is an excess demand. Through adjusting stocks in this manner demand will usually be satisfied, apart from when there is an exceptional shortage of goods. Despite the fact that most manufactured products are sold by cross-trading rather than competitive trading, the principle of one price for one commodity is established for them, because each supplier will continue to sell them at an unchanged price as long as he is able to do so by adjusting stocks of his products.

Price competition under the full-cost principle If there is excess demand (supply) the price will rise (fall), so that buyers who cannot go to high prices will be eliminated (as will suppliers who cannot accept low prices). This form of competition via competitive trading is the basic conceptual formula of economists, and it has been widely disseminated and become accepted as common knowledge. On the other hand, under the full-cost principle - in which excess demand (supply) is eliminated by adjusting the quantity supplied and exerts no pressure on price - we may ask how are buyers and sellers induced to compete, and in what way are they eliminated from the market? To begin with the production costs of firms are not all the same. Even with the same company, each factory is located in a different place, uses different machines, and there are differences in the skill of the workers. Consequently, if the mark-up rate is given, differences in costs will produce differences in price. If there is no difference in the quality of companies' products buyers will, whenever possible, try to buy at the cheapest prices. Therefore high-priced products can survive only for the short period it takes for the information to circulate amongst buyers that their price is high. Even under the full-cost principle competition requires that there be one price for any given commodity. Therefore, factories and companies with high costs have to be content with smaller net mark-up rates, and rates will differ to an extent which reflects the differences in costs. If we take the profit per unit of production as TT, the costs of production as c, and the prices as /?, it follows from the formula for the full-cost principle p = c+ 77=(l + 7r/c) c = (l + m)c

(3)

30

Markets and the price mechanism

that those companies and factories with a high c must have a low net mark-up rate m (that is profit per unit of cost incurred TT/C will be low). Otherwise they will lose out as a result of price competition. Moreover, even if they can afford to tolerate a low mark-up rate for a while, they will soon fall into financial difficulties because funds must be used in the most effective manner; obviously, no lender will be interested in companies with a poor mark-up rate. The result is that such companies will have to reduce their output, and will be caught in a vicious circle where they lose the benefits of mass production and their costs of production rise more and more. In the end factories and companies whose efficiency is low will be closed down and their output will be eliminated from the market. Thus during the second stage of competition there will be a single, uniform cost of production for any given commodity. With a single price and a single cost of production per commodity, there will also be one mark-up rate per commodity. Moreover, if the mark-up rate differs amongst commodities it is unlikely that funds will flow in the direction of products with a low mark-up rate. Thus factories which produce these products will eventually get into financial difficulties. Thus in the end the mark-up rate must be the same for all products. In this way the principle of one mark-up rate for one commodity, and the tendency to uniformity in mark-up rates amongst all commodities, are both the outcome of funds flowing in the direction of efficient firms as a result of the calculation of economic self-interest. Competition under the full-cost principle does not stop at that point. Buyers do not necessarily buy commodities directly from the factory for there may be shops and stores of various sizes between them and the factory. There are corner shops, department stores, supermarkets, and consumer cooperatives, and small shops will buy in goods through small regional wholesalers, and the latter will buy in through large national wholesalers. The more stages there are in the distribution process, the higher will final retail prices be as the operating costs and the profits of each shop and store are added on, and the power to compete will be successively weakened. The necessity to compete may well eliminate an excessively complicated and roundabout distribution process. 8 Let us now compare the following as three of the simplest routes for getting consumer goods to their purchasers: (i) from factory direct to consumer; (ii) from factory to consumer via small retail shops, (iii) from factory to consumer via supermarket, chain store, or consumer coopera8

On the revolution in distribution due to the advent of supermarkets, see for example Zimmerman, M., The Super Market: A Revolution in Distribution, McGraw-Hill, 1955.

Determining production prices

31

tive. Since sales costs are a constituent part of total costs of production and depend more on how much is bought at one time rather than on the volume of output, the actual sales costs which are incurred and charged when goods are sold to large purchasers will be noticeably lower than the estimated average sales costs which are included in the price according to the full-cost formula. It is therefore usual for factories to sell to large purchasers such as supermarkets, chain stores, consumer cooperatives etc. at far lower prices than to individuals and small retail outlets. Thus if supermarkets and the like buy in quantity and economize on the costs of acquiring their goods, they will be able to sell at a much lower price than the corner shop. In some cases, they can even sell at retail prices which are much cheaper than those recommended by the factory. With rationalized and simplified block-purchasing and sales methods as their main weapon, supermarkets and the like have begun to meet the challenge of the very small retail outlets in the price war and ultimately defeated many of them. Most of those who work in small shops are either the owners themselves or members of their families, and the proportion of ordinary employees is extremely small. Consequently, their sales costs depend largely on how the owner costs his own labour and that of his family, and thus to some extent they are arbitrary and flexible. Small shopkeepers and their families have fought back by contenting themselves with very low incomes but there are limits to these tactics. Most of them will ultimately go under. That is, there are price wars even under the full-cost pricing principle, and as a result only the most economic distribution channels will survive and the rest will go to the wall. However, it must be remembered that price-cutting did not occur because of an excess supply of the commodity. Even if the lines they were interested in were selling smoothly and without hitch, the supermarkets would still devise some sales method which undercut their competitors and allow them to increase their share of total sales.9

9

There are, in addition, commodities whose prices are determined neither by the full-cost principle nor in a competitive trading market. There were for example taxis and rickshaws in the late 1920s in Japan. Because the price was decided by negotiation between the driver or rickshaw man and the client, it was a cross-transaction, and the price depended a good deal on who was more skilful at negotiating. Therefore the principle of one price for one good did not hold true. In that case, however, if the driver proposes a high price the client will summon another taxi, and if the client persists in offering an extremely low fare the taxi will seek other clients. Where there is excess supply, that is many empty cars, the position of the clients will strengthen and the price will fall; but where there is an excess demand, that is where there is a long line of clients waiting for taxis, the drivers will resolutely press for higher fares.

32

Markets and the price mechanism

6 Two types of market economy Neoclassical economists and Keynes Thus almost all manufactured industrial product prices are determined according to the full-cost principle, while the main agricultural, forestry and fishery products, together with some mining products, have exchanges where competitive trading takes place. The full-cost principle and competitive trading are very different price fixing mechanisms, and the character, physiology and dynamics of the whole of a national economy will differ according to whichever of the two mechanisms predominates. Since neoclassical economics (or so-called Walrasian economics) assumes that all commodities are exchanged via competitive trading, it will be effective in analysing economies where the competitive trading mechanism predominates. On the other hand the Keynesian-type of economics in the form developed by Kalecki10 can be seen as taking prices to be fixed by the full-cost principle. Therefore this type of economics is appropriate for analysing economies where manufacturing industry predominates. In what follows we shall refer to the pure model where the prices of all commodities are decided by competitive trading as flexprice economies or neoclassical-type economies. We shall call economies where the price of all commodities is decided by the full-cost principle fixprice economies or Keynesian-type economies (strictly speaking, Kalecki-Keynes type economies), since prices are fixed independently of the excess demand for the commodities once costs are determined. Real economies fall between these two extremes, being mixed forms of flexprice and fixprice economies. We can calculate the degree to which real world economies are mixed by measuring the ratio of the value of output produced in the flexprice sector to the value of output produced in the full-cost sector; or roughly by the ratio of the value of the output produced in agriculture, forestry, fisheries and mining to the value of the output produced in manufacturing. If we compute this ratio for 1960 and 1973 by country as in Table 2, we see Britain and West Germany are fixprice economies nearest to the pure type. Japan and Italy in 1960 were still provided with fairly large flexprice sectors, but rapidly became fixprice types between 1960 and 1970. 10

See for example the previously quoted work by Kalecki and also Kalecki, M., Theory of Economic Dynamics: An Essay on Cyclical and Long-Run Changes in Capitalist Economy, London: George Allen and Unwin, 1954. We are below interpreting Keynes' theory along Kalecki's lines in spite of the fact that Keynes' own theory of the firm and his theory of prices are both neoclassical.

Two types of market economy

33

Table 2. The ratio of the value of output of agriculture, forestry, fisheries and mining to the value of output of manufacturing (unit: %)* Year

Japan

America

Britain

West Germany

France

Italy

1960 1973

57 25

23 24

19 13

20 16

31 24

58 37

* Computed from World Bank, World Tables 1976.

Table 3. Ratio of the value of agricultural output to manufactured output (unit:%)* Year 1789/1815 1801 1825/1835 1841 1860/1869 1872/1882 1896/1900 1901 1907 1913 1919 1929 1939 1949 1959 1969

Britain

Germany c

France

Italy

250 139 200 65 133

275'* 140

46 15 18

214* 95*

51 16° 13 13* 15 10 8

33 23« 15 9

30Q

(1) (2)

Expression (2) is obtained because in Fig. 3a the point p" lies to the

46

The function of exchanges P2

Pi Figure 3 a

Pi Figure 3b

47

Price repercussions amongst substitutive goods

P2

(a)

(c)

Pi

Figure 4

left of the El = 0 curve where Ex is always positive. However, (2) contradicts Table 5. Since the last column of the table states that Ex must decrease when prices increase proportionally, when prices change from p to p", Ex will decrease from 0 to a negative value, and at point p" we should get £i 0 in zone (b), Ex < 0, E2 > 0 in zone (c) and Ex < 0, E2 < 0 in zone (d). In well-organized markets prices are regulated by the relative magnitude of demand against supply. That is, competitive trading takes place in accordance with the rule that the price of a good rises where demand exceeds supply (excess demand is positive), and falls in the reverse case. Accordingly, px will rise and p2 fall in (a). In this zone therefore, the arrow which shows the direction of the price change will point down to the right. Similarly, the arrow will be upward pointing to the right in zone (b), upward pointing to the left in zone (c), and downward pointing to the left in zone (d). p2 will be unchanging at the boundary of (a) and (b) but px will rise there and the arrows will in consequence point horizontally to the right. For the same reason the arrows point horizontally to the left at the boundary of (c) and (d), straight upwards at the boundary of (b) and (c), and straight downwards at the boundary of (a) and (d). In this way we may obtain the graphical arrangement of the arrows shown in Fig. 5.6 We may compare this figure with a maritime chart which shows the flow of ocean tides. At whichever point on the ocean a piece of driftwood floats it will ultimately float to the general equilibrium point/?0, given that such ocean currents exist. That is, competitive trading will reach p° and cease. Hicks' Law of prices Lastly let us consider how the general equilibrium point is affected when there have been additional carte blanche orders for a given good, for example white sugar. Since a fixed quantity of white sugar will be bought - for example 100 units - whatever the price, the original points where Ex = - 100 will become new partial equilibrium points (that is, the points where Ex +100 = 0). Since the new partial equilibrium curve for white sugar must be located within the zones (c), (d) where excess demand was originally negative, the partial equilibrium curve will move right as in Fig. 6. AEX in this figure indicates the volume of additional carte blanche orders for white sugar. In Fig. 6, p° is the old general equilibrium point and/?1 the new one. 6

See Additional Note c.

49

Price repercussions amongst substitutive goods Pi

X \

\1 I/ \

0

\

x P\

Figure 5

£•,=0

0 Figure 6

P\

50

The function of exchanges

We may obtain the following three propositions if we compare the two: (i) the price of white sugar will rise (that is, p\>P\)', (ii) the price of yellow sugar will rise too (that is, p\ >pi)\ and (iii) the ratio of the price increase for yellow sugar will be lower than that for white (that is, Pi/p^Pi/Pi)Laws (i) and (ii) are self-evident from Fig. 6, but to obtain (iii) we should join p° and p1 respectively to the origin O and compare the two price lines. The respective slopes of these lines show Pi/Pi andpl/pl* a n d the figure indicates that/^/p? >P2/p\- Therefore as (iii) states it must be that/?}//?? >pl//?§. The above was premised on the fact that there are two kinds of goods, but this assumption is not indispensable to our deriving these conclusions. However many kinds of goods there are, that is, where there is an exchange divided into many sectors where competitive trading takes place for a single good in each, and in the exchange as a whole competitive trading for many goods takes place simultaneously and in parallel, we may obtain the same conclusion notwithstanding the number of goods as long as there exists the sort of dependency of excess demand on prices as is shown in Table 5.7 Firstly, the general equilibrium is necessarily stable (that is, the flow of prices created by excess demand in the end carries the market to a state of general equilibrium). Secondly, where excess demand for one good increases (i) its price will rise, (ii) the prices of all other goods will rise too, and (iii) their rates of increase will not be as great as that for the good whose demand has increased. These three laws of price changes are called Hicks' Three Laws after their discoverer, and are the most fundamental laws of prices obtainable with regard to the competitive trading mechanism. From the previous session to the next Let us suppose that after the session for white and yellow sugars has ended in our exchange, competitive trading now takes place for medium white and brown sugars. Let medium white sugar be the third good and brown sugar the fourth, and let their respective demand, supply and 7

Where for example there are three goods, Table 5 may be expanded as follows; however, a is the parameter which shows the proportional changes in pl9 p2, Py Rise in Pi

Effect on E2 £3

Pi

P3

Price repercussions amongst substitutive goods

51

price be D3, S3, p3 and D4, S4, /?4. Because medium white and brown sugar are substitutes, there is no objection to our considering what we have said before about white and yellow sugar as being perfectly true as it stands for them too. A general equilibrium which equates both demand and supply for medium white and brown sugars is possible, and moreover it is a stable equilibrium. That is, from whatever price set competitive trading commences, a general equilibrium price set will be discovered sooner or later and competitive trading will end at that point in time. This will be so as long as the exchange teller adjusts prices according to the rules (that is, as long as he adjusts prices according to a formula whereby he raises prices if there is an excess demand for the respective commodities and lowers them if excess supply arises). Hicks' Laws will also hold. That is, if the demand for either medium white or brown sugar increases not only will the prices of both rise, but the rate of price increase for the sugar whose demand has increased (for example, medium white sugar) will be larger than that for the other (brown sugar). However, we must not forget that apart from this the following price repercussions exist. The increase in the demand for white sugar (or yellow sugar) will affect the prices of medium white and brown sugars. Not only are these two kinds of sugar now in session mutually substitutable, they are also substitutable for the goods (white and yellow sugars) whose trading session has already ended. If the demand for white sugar increases the prices of both white and yellow sugars will rise (according to Hicks' Laws), and therefore due to the substitutability between these sugars and medium white or brown sugar demand will switch over from white and yellow to medium white and brown sugars, and the demand for the latter two will increase. The result will be that the prices of medium white and brown sugar rise. (In Fig. 7, E3 and E4 are the partial equilibrium curves for medium white and brown sugars when there is no increase in the demand for white sugar, and £3 and E\ are their partial equilibrium curves after an increase in demand for white sugar. The new general equilibrium point is located to the above right of the old one, and therefore the prices of medium white and brown sugars will both increase.) Thus effects of the increase in demand for white sugar will continue to be present in the exchange after trading in white sugar has ended. That is, the increase in the demand for a good will not only force the prices of that good and all others traded in simultaneous sessions to rise, it will also force the prices of all goods traded in that exchange in sessions thereafter to rise. What then is the relationship between the rate of increase in the price of medium white or of brown sugar and that for white sugar which was

52

The function of exchanges PA

E*

Figure 7

the epicentre of these price changes? Let us assume that excess demand for medium white and for brown sugar changes as in Table 5', in order to make possible a comparison of the rates of price increase. In this table, /3 is a parameter which shows that proportional changes have taken place not only in /?3, /?4, but also in pu p2. That is, if p increases, then/?!, /?2, /?3, /?4 will all have simultaneously increased proportionally, and a decrease in j8 shows a proportional fall in each of them. When these four prices change in proportion no substitution will occur amongst the four kinds of sugar because the price of any one of them will not be comparatively cheaper or more expensive compared with the others. But because these sugars will be comparatively cheaper or more expensive compared with other goods, the excess demand for medium white and brown sugars will probably be affected. The last column of Table 5' shows that where the four prices have increased in proportion both medium white and brown sugars will be more expensive when compared with goods other than white, yellow, medium white and brown sugars, and as a result the excess demand for them E3, EA will decrease. Given these interrelationships of excess demand, we can prove that

Price repercussions between different exchanges

53

Table 5'

Rise in P3

PA

Effect on EA

Hicks' Third Law of Price Repercussions does hold for medium white and brown sugar: An increase in the demand for white sugar gives rise to an increase in the prices of both medium white and brown sugar at rates lower than the rate of increase in the price of white sugar itself. (We are not herewith involved in the proof of this proposition, which is left to the reader.) It can also be shown that an increase in the demand for white sugar raises the prices of both medium white and brown sugars less if trading of these kinds of sugar takes place after the session for white and yellow sugars has ended than they will if the four are traded simultaneously. 4 Price repercussions between different exchanges

Arbitrage dealings and equalization of prices As we have seen above, an increase in the demand for white sugar not only pushes up the price for yellow sugar which is competitively traded for at the same time as white sugar; after completion of competitive trading in white sugar it also operates to push up the prices of other commodities traded on that exchange (medium white sugar, brown sugar, etc.). Thus, throughout the goods traded in the same exchange there would prevail a 'co-variational' relationship among their prices. That is, all prices determined in a single exchange tend to fluctuate in the same direction; either they all rise together or fall together. What then are the price repercussions which are transmitted between different exchanges? In the actual economy there are many markets (sugar, coffee, cocoa, silk yarn, cotton yarn, wool and other exchanges etc.), and there may not be just one market in each economy for each commodity: several can exist (like the Tokyo Sugar Exchange, the Osaka Sugar Exchange, etc.). In the above analysis of price effects within the same exchange we tacitly suppose that the exchange was cut off from the outside and turned into a secret chamber; that is, there was noflowof information between exchanges and events which occurred in

54

The function of exchanges

one exchange or were in the process of occurring were never made known to other exchanges. But in reality the communications between exchanges are very close, and since dealers have information sent to them all the time by telephone from all parts, price repercussions are not confined within a single exchange. Where transmission of information is immediate there is unlikely to be any difference in competitive trading simultaneously taking place whether it is happening within the same exchange or in a different exchange. We shall assume in what follows that the transmission of information is perfect (information is transmitted costlessly, immediately and accurately), and will analyse what kind of price repercussions occur between various goods in competitive trading which simultaneously takes place in different exchanges. Let us first consider the case where competitive trading takes place for the same goods at the same time on two exchanges (for example, the sort of situation where competitive trading goes on at the same time for white and yellow sugar in both Tokyo and Osaka). As we have already seen, if the demand for white sugar increases in the Tokyo Exchange the prices of white and yellow sugar will increase in Tokyo. But there will be no change in the Osaka prices if this price information is not transmitted there. Yet if the exchange of information between the two exchanges is perfect and the Tokyo prices are communicated minute by minute to Osaka and vice versa, a large flow of demand and supply will occur between Tokyo and Osaka. That is to say, if it is known that the Tokyo price for white sugar is higher than the Osaka price, suppliers in Osaka will not sell there but will try to sell in Tokyo, and buyers in Tokyo will probably stop buying in Tokyo and try to buy in Osaka. (We shall assume the cost of transporting white sugar between Tokyo and Osaka can be ignored.) Nor is this all. Arbitrage dealing will occur - that is transactions for profit which result from the margin between buying cheap in Osaka and selling dear in Tokyo.8 Thus when Osaka supply flows to Tokyo and Tokyo demand flows to Osaka, excess supply will be created in Tokyo and an excess demand in Osaka, the Tokyo price will fall, and the Osaka price will rise. If, as a result of such price fluctuations, the price of white sugar becomes higher in Osaka than Tokyo, the flow of supply and demand will reverse direction. Supply will increase in Osaka and demand in Tokyo; the price in Osaka will fall and that in Tokyo rise. Such price 8

Earlier works concerning the problem of arbitrage includes Cournot, A., Research into the Mathematical Principles of the Theory of Wealth, New York: Macmillan, 1887, Chapter 3.

Price repercussions between different exchanges

55

fluctuations will continue until the price in Tokyo and Osaka are balanced. That is, where Tokyo information can be obtained without cost in Osaka (or the converse) and where transportation costs for sugar between Tokyo and Osaka are zero, prices in Tokyo and Osaka will be absolutely equal. Common national prices will thus be formed, and such prices will also, to a certain extent, be effective outside the exchanges. It is indeed true that the exchange of information between exchanges and the outside will not be as close and rapid as it was between exchanges. However, those who transact in rather large quantities even though outside the exchange will be bound to take account of the price within it. Thus if the price on the exchange is cheaper than that outside it, buyers outside the exchange may well try to buy sugar on the exchange rather than buy outside. Conversely if the price on the exchange is higher than that outside, suppliers outside the exchange will try to sell within the exchange. Therefore, the price formed at the exchange will not only be binding upon trading within the exchange but also regulate large-scale trading outside it. The formation of prices which have such broad controlling power is a result of the cheapening of transportation costs and of the costs of obtaining information. Before the nineteenth century, the exchange of information and means of large-scale transportation were undeveloped, and markets in separate areas were little interested in each other because the costs of obtaining information were so high. Even if traders paid a lot to obtain information and were aware of price differentials, transportation costs were too high to realize a profit from such price differences. The result was that regional markets were isolated. However, by the twentieth century, especially after the Second World War, both communications and transportation technology made great advances. Telegrams, telephones, radio, television and computers were developed, reliable information became obtainable at low cost, and along with this automobile highways were built, container transportation spread, and the efficiency of truck transportation greatly improved. The area within which goods circulated expanded to a national and to a world-wide scale, and in response prices are equalized not only nationally but also internationally. Effects on exchanges for substitutive goods Let us next consider the effects of an increase in demand which has developed on an exchange for a certain commodity (say coffee) upon another exchange where its substitutes (say cocoa) are dealt with. If transmission of information between the exchanges is as rapid and accurate as it is within an exchange, even if the coffee exchange and

56

The function of exchanges

cocoa exchange are independent organizations, both commodities will be transacted just as if they were on one fictional, composite 'coffee and cocoa exchange'.9 All kinds of coffee and cocoa will be transacted for at this 'composite exchange', and all these goods will be mutually substitutable. Thus the analyses in section 3 of this chapter are applicable exactly as they are to this composite exchange too. That is, if the demand for Brazilian coffee increases its price will rise (Hicks' First Law). At the same time not only will the prices of other coffees rise, the price of cocoa will rise too (Second Law). Furthermore, the extent of the increase of these prices will not be as great as that for Brazilian coffee (Third Law). Effects on exchanges for complementary goods Where information is transmitted perfectly between two exchanges which deal in complementary goods (for example, coffee and sugar), the two exchanges can be regarded just as if they were two sectors of one composite exchange, as was the case with the substitutes, coffee and cocoa. Whilst these two exchanges can be said to be organizationally independent they are functionally integrated. In normal cases, transactions for similar commodities take place on the same exchange and so all of the commodities handled are substitutive goods, but exchanges also exist which handle complementary goods, such as the New York Coffee and Sugar Exchange. Therefore, though we proceed with our analysis by means of the idea of a fictional, composite coffee and sugar exchange, we cannot be criticized for divorcing ourselves altogether from reality. Let coffee now be commodity 1 and sugar commodity 2, their excess demands be Eu E2, and their prices be pu p2. \ip\ rises, demand for coffee will decline (supply will increase) and because the demand for its complement sugar will also probably decrease in response, it can be assumed that the rise in/?! will bring about a decrease in Ex and E2. With px on the horizontal axis and p2 on the vertical axis, we can draw the partial equilibrium curves for coffee and sugar on the plane with these two axes. The curves will decline to the right as shown in Fig. 8. If we now move horizontally to the right from point a on the partial equilibrium curve for coffee and reach point ft, for example, the volume of excess demand for coffee will be negative because the price of coffee is rising. To return it to zero we must move perpendicularly down from point b to point c, for example. This is because the excess demand for 9

As an outstanding concrete example of a composite exchange we have the New York Commodity Exchange Center. This incorporates the New York Mercantile Exchange, the New York Coffee and Sugar Exchange, the New York Cotton Exchange and COMEX (Commodity Exchange Inc.).

Price repercussions between different exchanges

0

57

Pi

Figure 8

P7

0

Pi

Figure 9

Pi

Figure 10

coffee will increase when the price of sugar falls. (By the same reasoning, the partial equilibrium curve for sugar will also fall downwards to the right.) When we draw the two partial equilibrium curves on the same figure

58

The function of exchanges

we obtain Fig. 9, but the partial equilibrium curve for coffee is not necessarily the more steeply inclined as in the figure, so it is also possible for the partial equilibrium curve for sugar to be steeper as in Fig. 10. Each partial equilibrium curve divides the price plane into two. On the side nearer to the origin excess demand for the good is positive, whilst on the side furthest from the origin it is negative. By the rules of the market if excess demand for a commodity is positive its price will rise, and if it is negative the price will fall. Therefore we can draw small arrows which show the direction of price changes on the price plane once we are given partial equilibrium curves. Thus when we join up these arrows we may obtain a flow diagram of price movements. As we soon understand if we take a little care to confirm it, where the slope of the partial equilibrium curve for coffee (commodity 1) is steeper than that for sugar (commodity 2) (as in Fig. 11), the flow will be towards the intersection of the curves (the general equilibrium price set p°) and p° will be stable, but where the slopes of the curves are in the converse relationship (as in Fig. 12), clearly prices will ultimately be pushed further away from/? 0, as long as they do not drift along on one of the special currents (a or a1). That is to say, p° is unstable (more precisely, p° is a saddle point). Where general equilibrium is unstable it will not be possible to establish general equilibrium prices by competitive trading unless by great good fortune the prices are initially set at a point on a or a'. Prices will never reach the general equilibrium point and continue to fluctuate limitlessly, the teller will eventually have to declare 'no trading' and the session must halt. Therefore, whilst we shall assume below that equilibrium is always stable, we must recall that, as in Fig. 12, complementary goods can be a cause of instability. If demand for coffee increases its partial equilibrium curve will move to the right. Since we are assuming that equilibrium is stable, the slope of the partial equilibrium curve for coffee will be steeper than that for sugar. Therefore, as shown in Fig. 13, the new general equilibrium price p', after an increase in demand, will be located to the right and below p° which was the price set before the increase. That is, the increase in the demand for coffee will increase the price of coffee and push down the price of its complementary commodity, sugar. Substitutes for complements are complements Such results will be obtained however many kinds of commodities are transacted at the two exchanges. If for example, Arabica coffee and Robusta coffee are traded at the coffee exchange, and white, yellow and brown sugars at the sugar exchange, an increase in the demand for Arabica coffee will force up the prices of both Arabica and Robusta

59

Price repercussions between different exchanges

Pi

0

Pi

Figure 11

P2

P\ Figure 12

60

The function of exchanges

0

Pi

Figure 13

coffee, and force down the prices of white, yellow and brown sugars (given that the general equilibrium for coffee and sugar is stable). This case can be further extended to where there are more than two exchanges. Let us now suppose that there are four exchanges for coffee, cocoa, sugar and honey and that information is rapidly and accurately transmitted amongst them. With such perfect information there is no need to consider the exchanges as functionally independent organizations, and there is also no obstacle to proceeding with the analysis as if there were a composite coffee and cocoa exchange and a composite sugar and honey exchange. Only substitutes are transacted at the respective composite exchanges and relations between the two exchanges are complementary. That is, the relation between one commodity on the integrated coffee and cocoa exchange (say, Arabica coffee) and one commodity on the integrated sugar and honey exchange (say, white sugar) is one of complementarity; but in addition the relationship between any other good in the coffee and cocoa exchange which is a substitute for Arabica coffee (say, cocoa) and white sugar is also one of complementarity. That is, a substitute for Arabica coffee is a

Futures markets

61

complement of white sugar, which is itself a complement of Arabica coffee. Similarly a complement (Arabica coffee) of white sugar, which latter is a substitute for the No. 1 honey which is traded in the sugar and honey exchange, is a complement of No. 1 honey. The mesh of transactions which knit together the composite coffee and cocoa and the composite sugar and honey exchanges in this way satisfies the relationships that substitutes of complements are complements, and the complements of substitutes are complements.10 As long as such relations are satisfied, there is no difference in relations between the two integrated exchanges are compared with relations between the single coffee exchange and the single sugar exchange. That is, an increase in the demand for the Arabica variety of coffee forces up the prices of all kinds of coffee and cocoa, and forces down those of sugar and honey. The law that the prices of substitute goods move in the same direction and those of complementary goods in opposite directions is thus not only correct within exchanges but also between them, given perfect circulation of information and the stability of the general equilibrium of coffee, cocoa, sugar and honey. 5 Futures markets Sham buying and speculation We implicitly assumed above that transactions are made for actual goods. That is to say, within a short period after the completion of competitive trading, for example within five days, the contracted transaction must actually be implemented. Consequently, the seller must actually be in possession of the goods and the buyer must also have sufficient money to pay for them. Or else the seller must make preparations to hand over the goods within a few days, and the buyer must dash about raising the money. Then if they fail in this the transaction will go by default, and the defaulter will be forced to incur painful sanctions. In actual exchanges, however, transactions take place in futures goods in addition to actual goods, and the former predominate in the 10

This kind of system satisfies the following relationships too: (i) 'substitutes of substitutes are substitutes'; (ii) 'complements of complements are substitutes'. For example, cocoa, which is a substitute for Robusta coffee whose substitute is Arabica coffee, is itself a substitute for Arabica coffee; and honey, which is a complement of cocoa whose complement is white sugar, is a substitute for white sugar. On the stability of such a system and the laws of price changes under it see, for example, Morishima, M., 'On the Laws of Change of the Price-System in an Economy which Contains Complementary Commodities', Osaka Economic Papers, Vol. 1,1952, and Morishima, M., 'A Generalization of the Gross Substitute System', The Review of Economic Studies, Vol. XXXVII (2), April 1970.

62

The function of exchanges

break-down of total transactions. Futures transactions are those where it is unnecessary to deliver the goods immediately on contracting a deal (or to do so within a few days). Instead they may be delivered and accounts settled on a fixed day after quite a margin of time (at the end of the month or of next month, or six months later). The time limit by which futures must be delivered and the deal implemented is known as the 'terminal month' or the 'delivery month'. Normally at the exchange futures transactions take place in parallel for terminal months of different lengths, but there are limits to the length of period for transactions in futures (these differ according to country, exchange and commodity, short terms normally being of three months and long terms being up to 24 months), and the number of sessions for transactions in futures in a given day is determined in relation to the length of term. For purposes of simplifying the explanation of trading in futures let us assume the longest terminal month is three months. We call transactions where delivery must be made at the end of the current month 'current month delivery', or 'month end delivery (options)' and those which must be accepted at the end of the next month, or at the end of the month after 'intermediate delivery' and 'future delivery' respectively. Sessions for transactions in the three types of futures take place for the commodities (for example, wheat) on the exchange. Since there is a gap in time between contract and delivery there is no need for the seller to hold the actual goods (actuals), nor for the buyer to have the cash for them. Where futures transactions have a terminal month which is a long way ahead (for example, transactions in 12-months' wheat), no sellers are likely to have the actual goods. Therefore much sham takes place in futures without the actual goods to back the transactions. 11 However, where there is false selling (let us suppose an individual A sham-sells commodity M on the intermediate delivery market), A does not have the actual goods (actuals or physicals) to deliver to the buyer of M at the next month end. Therefore, there would be default on the contract so that A must in the period from the day the contract was made until the end of the next month, repurchase M, at least by the same volume as the sham sale either this month on the intermediate delivery market or next month on the current month delivery market. However, a buyer like A does not purchase and take deliveries of the commodity M with a view to using or consuming it. A will re-sell M by the terminal month. (In fact, in the present example A has already re-sold before purchasing.) This is the way 'sham' transactions occur in the futures market, but 11

See Additional Note d.

Futures markets

63

since 'sham' transactions will all be cancelled by the corresponding repurchase or resale on the day when accounts are settled what remains after cancellation is the buying and selling of actuals (physicals), and therefore the delivery of actual goods will take place without let or hindrance. People who engaged in 'sham' trading on the futures market will have no need to pay the whole of the purchase price, needing only to pay the difference between the buying and selling price. That is to say, transactions in futures are dealings in margins or differences. Those who bought high and sold low will have made a loss, conversely profits may be obtained by 'sham' trading. Consequently, able people who are perfectly capable of figuring out future price changes are certain to make a profit in the futures market, so long as prices continue to fluctuate. Moreover almost no capital is required to make such a profit. Therefore those confident that they can forecast the movement of futures prices gather in the market for futures which is the site for their speculative activities. They do not come to the market with a view to commodities but with a view to prices. However, because they need to know about the situation as regards production, consumption, the environment (movements in domestic and international politics, the weather, etc.), the activities of large speculators and so on in order to formulate accurate forecasts, all kinds of information gather in futures markets, and the exchange becomes a kind of information centre. Those who deduce correct forecasts from this information make a profit, and those who err in forecasting make a loss. Hedging Depending on the exchange and the commodity, sham trading in futures takes place every day in many times more than the actual quantity of goods delivered, sometimes several hundred times more. Yet those who activate the futures market include not only the speculators prepared to take the risk and who are dreaming of a quick killing. In addition to them, producers, wholesalers, importers, etc. appear in the market as sellers or buyers and trade for the purpose of 'hedging' to reduce risk even though it is impossible to avoid it completely. Let us consider the example of wheat. Wheat (winter wheat) is sown in late autumn or early winter and harvested in early summer of the following year. It goes without saying that the size of the harvest will depend on the weather. There will be a good crop if it is favoured by the weather, and bad weather will produce a poor crop. Thus with a good crop wheat will be cheaper, and when there is a poor crop the price will rise. Farmers will thus be haunted by violent fluctuations in income according to their luck, but up to a point they can stabilize their income

64

The function of exchanges

by using the futures market. For example, if they sell about half the average annual crop on the futures market some months before harvest they have no need to fear a collapse in price below the present selling price for the part of the harvest already sold. If the harvest is good they will only have to sell off cheaply what remains from the harvest. That is, farmers will have been able to halve the damage from the crisis caused by a good harvest by using the futures market. Similarly, if wheat importers sell part or all of what they import on the futures market, they will be able partially or wholly to avoid the damage of a fall in prices which might arise from an excess supply when imports actually arrive on the market. Conversely, however, where prices rise, farmers' incomes will be less because they will not be able to enjoy the benefit from the price increase in respect of that part of the harvest they have already sold. Thus if they sell off on the futures market they lose tfie chance of a large income, but in return they reduce the risk of having to be satisfied with a very small income. That is, futures markets serve the purpose of stabilizing farmers' incomes. Role of futures markets In the exchanges, for each commodity handled, there are, as a rule, a spot market and futures markets with different terminal months. Because today's wheat is substitutable for wheat at the end of the month or the end of the next month or the month after that, there is a relation between the futures prices and the spot price, and the former cannot diverge too far from the latter. Thus the spot price will rise when the demand for spot goods now increases, and the futures price will probably rise along with it. It is moreover unlikely that the futures prices will be boosted out of balance. Let the current delivery price of a certain commodity at a certain point of time t be pu the intermediate delivery price be /?2? a t a given time t' later in the same month let them be respectively p[ and/?2. If it is expected that the intermediate delivery price in terms of the current delivery price at t is higher than the corresponding price at t', i.e., if the inequality

P\

Pi

is expected to hold, then people will sell s2 of the high priced intermediate delivery and buy dx of the cheap current delivery; then later when a cheaper relative price is established they buy back s2 of the

Futures markets

65

intermediate delivery (d2 = s2) and re-sell dx from the current delivery (s[ = dx). It is obvious that from such transactions a surplus of m = [p[s[ ~pidx] + \p2s2-p'2d'2] will be obtained. If we take du s2 such that pxdx = p2s2, then m=p[s[-p'2d'2=P-±pxs[-P-±p2d'2 P\ Pi But since dx = s[, and s2 = d2, we have pxs[ =p2d2 so that

1

Pi

Therefore when the above inequality for relative prices is established the surplus m is positive. That is, sham trading on the current and intermediate delivery markets, together with the re-selling and buying back at a later date which cancels it out, will produce a profit. Such combinations of transactions are called arbitrage over time, and since intermediate delivery goods will be sold due to arbitrage, p2 will fall; px will rise because current delivery goods will be bought due to arbitrage. As a result the relative price ratio of futures will rapidly equalize, and soon proper relative prices will appear. Not only will this be so but changes in the futures prices px, p2, are also likely to be appropriate ones. As we have already said, there are many speculators active in the futures market. If they foresee that in future px or p2 will suddenly rise, they will buy in before px, p2, actually begin to rise. Then, since they will re-sell what they have already bought in order to profit from the difference in the prices, when the price at last does begin to rise violently, the price will in fact not increase as much as had been forecast. Similarly, where a violent fall in prices is forecast, the speculators will soon begin to sell out. But because they will buy back to profit from the price margin when the price at last does begin to fall violently, the price fall will be moderated through their support. With commodities whose supply fluctuates seasonally like agricultural products, prices will fall in the harvest period and rise out of season; but when a futures market is established the price equalization function of speculative dealings and hedging will start to work and very much reduce the extent of rises and falls in the prices of agricultural products. Futures markets have the internal capacity automatically to normalize prices in this fashion, but besides this exchanges additionally set an

66

The function of exchanges

Pc -

Pa

upper and lower limit to fluctuations in pu p2, and thus to prevent the overheating or overcooling of the markets.12 Lastly, futures markets have the capacity to put into circulation a larger volume of actual goods (actuals) than spot markets. Let us assume that the demand and supply curves for actual goods are represented by DD' and 55' respectively, as in Fig. 14. Where speculation and hedging are not allowed and the demand and supply for the actuals directly balance each other on the market, price will take on a value (for example p°) between the two end points, S and D of the curves, and both demand and supply will be zero, as the figure shows. However, in the futures market where speculation and hedging may occur, the demand for actual goods qa and what speculators sell may correspond at price pa. If that is the case, speculators must later buy back what they sham-sold and therefore they will once more appear in the futures market and look for sellers. New sellers will also appear later on than this in the market in order to repurchase. They will buy back 12

In futures markets it is not permitted to fix prices during that day which exceed the upper or the lower limit.

Futures markets

67

that part qb at price pb from suppliers of actual goods, buy back the remainder qa - qb at price pc from other suppliers of actual goods. At the end of the terminal month, qa of actual goods will be delivered from the suppliers with actual goods to the buyers of actual goods. The two speculators who have intervened in the course of this process will buy back all that they sham-sold and must pay the difference. That is, through the intervention of the speculators and by their loss, a quantity qa of actual wheat has come into circulation. That is, in the futures market demand can meet supply smoothly because of speculators' intervention, which results in the circulation of a large volume of real goods.13 15

In this case speculators will suffer a loss, but in other cases they may make a profit. Even if exchange does not take place in a real-goods economy as a consequence of the fact that buyers of goods and sellers of goods confront each other who are neither of them prepared to make a loss, the circulation of goods will begin if there are amongst them speculators who are prepared sometimes to make a loss and sometimes a profit.

Fixing product prices

1 More on the full-cost principle The average cost curve As indicated earlier, the prices of most industrial products are not fixed in the market (exchange) so as to equalize supply and demand; they are set by the enterprise itself. In order to obtain a profit the enterprise will mark up average production costs to get the product price per unit, but the mark-up ratio has to be a reasonable one. We will discuss later what constitutes a reasonable rate; we will assume for the present that the entrepreneur already has a generally accepted idea of what it should be. Thus the problem of price-fixing rests entirely on how to estimate average costs. Costs are classified into fixed costs which do not increase even though the volume of output increases, and variable costs which increase and decrease with the volume of production. Variable costs may be further subdivided into proportional costs which vary in proportion to the volume of production and non-proportional costs which do not. The latter are of two kinds; those which vary less than proportionally, and those which vary more than proportionally. Fixed costs are interest and depreciation costs on fixed capital, rents and remuneration to employees not engaged directly in production directors, executives, technicians, watchmen, porters etc. However, most raw material costs and the wages of labour are proportional costs. Power costs, fuel costs and maintenance costs of buildings, machines and tools etc. are all non-proportional costs, and they vary less than proportionately while the volume of production is small; but should production reach such a high level that machines are inevitably driven to their limits then it is likely that they will vary more than proportionately with output. Various operating costs such as sales and purchasing costs will be unchanged while the volume of production is low, and will vary less than proportionally when it is high. Taxes and rights' fees for patents, copyright and such-like will depend on the tax system and on 68

More on the full-cost principle

69

rights' transfer contracts, or else may be invariable in some cases and variable in others. In the normal event wages, which are also proportional costs, may have to have an overtime allowance added to them where production is the result of labour working overtime. Thus as the proportion of output produced in overtime rises, wages rise more than in proportion with output. In any case, it goes without saying that fixed costs per unit product will decline with an increase in production, and that proportional costs per unit product will not change. As against this non-proportional costs per unit product will tend to decrease while the volume of production is low, but will begin to increase per unit if the volume of production is high and exceeds the capacity of the factory. Therefore, having added up all these different kinds of costs we find that average costs will decrease initially with an increase in output, but ultimately will increase. Even after average costs have started to rise, only a part of nonproportional costs will initially increase more than proportionally, but thereafter most non-proportional costs will gradually start to increase more than proportionally. If we measure output along the horizontal axis and average costs along the vertical axis, we will obtain a U-shaped curve. Fixed costs per unit product will decrease rapidly while the volume of production is low but rising; but when the product is produced in large quantities the variation in fixed costs will gradually get smaller. Therefore, in the case of products which are produced in large quantities and fixed costs are not large compared with proportional costs, changes in fixed costs per unit product due to changes in the volume of production can practically be ignored. On the other hand, average costs will begin to rise markedly when production is pushed beyond the capacity of the factory; and as long as production is not carried on at such an exceptionally high level average costs will be more or less unchanged with respect to changes in output. For example, where total fixed costs are £8000 and proportional costs per unit-product are £3.90, average costs will be £4.00 with an output of 80000 units. However, if output were 40000, average costs would be £4.10, and if output were 160000 units they would be £3.95, and so average costs will be practically unchanged. That is, the average cost curve for this factory will describe a U-shape with an almost horizontal bottom over a broad range of output from 40000 to 160000 units; and as long as the volume of production remains within this range average production costs may be easily determined, and thus the price of product marked up at the mark-up rate may also be easily fixed. They will be practically unchanged over a broad range whatever happens to the volume of output.

70

Fixing product prices

The estimated demand curve What happens where the volume of production is estimated to be extremely small? Let us consider the above arithmetical example as referring to the production of books. Paper and binding charges are proportional costs, editorial costs and typesetting charges are fixed costs. Printing costs will be non-proportional costs which increase less than proportionally, but we shall ignore them in our arithmetical example along with certain other costs such as advertising and sales costs. Now where the book has a very general appeal and estimated sales are more than 40000, average costs will be about £4.00, and mark-up at a rate of 25% may be fixed at a retail price of £5.00. But where the book is specialized and estimated sales are only 1000, average costs will be £8000/1000+ £3.90 = £11.90, and the retail price may be £14.88. The price of the book will thus depend first of all on whether it is of general appeal with a large expected estimated demand, or whether it is a specialist book with only a small expected demand. In the former case there will be almost no difference in the price even if expected demand changes, but in the latter case there will be a wide margin of difference in the price according to how demand is estimated. For example, where expected demand is only 500 books, average costs will be £19.90 and the retail price will be £24.88 (given that the mark-up rate in each case is 25%). That is to say, the price of commodities with a small output which does not reach the long flat bottom of their respective U-shaped average cost curves will depend a great deal on the size of expected demand. There is another situation where the size of the expected demand greatly influences the determination of the price. This is where fixed costs are very large compared to proportional costs. In the previous example, fixed costs were £8000 in total, and fixed costs per unit product were £0.04 where the factory produced to the limit of its productive capacity, which is 200000 units. This figure is extremely small in comparison with proportional costs of £3.90 per unit product, with the result that average production costs were virtually unchanged over a broad range of output from 40000 to 200000 units. However, if in the arithmetical example the fixed costs were £800000 (given that the productive capacity of the factory was still 200000 units as before), the fixed costs per unit product would be £4.00 at the capacity level of production and would thus be comparatively high compared with proportional costs of £3.90. So we would no longer be able to ignore changes in fixed costs per unit product which accompany changes in the volume of output, and we would only be able to regard average costs as fixed with regard to a volume of output in the range of from 185 000 to

More on the full-cost principle

71

200000 units. That is, if fixed costs are large compared with proportional costs the flat part of the U-shaped average cost curve will be shorter. Therefore, there is a high probability that expected demand will not fall within that range; and if it does not, average cost and so price will be elastic with respect to expected demand. How then will prices be fixed in these cases? That is, where products have a very short horizontal section to their average cost curves; or, as with specialized academic books, there is a long horizontal section to their average cost curve but an extremely limited demand. In these cases the firm will estimate demand and read off its average costs from the cost curve which corresponds to a volume of output that equals the estimated demand. It will next add a mark-up at the mark-up rate and thus set the price of the product. But demand depends upon price, and so the price which is calculated on the basis of the expected demand must be completely consistent with the price the firm had in mind when it made its estimate of likely demand. We can easily confirm whether the price the firm sets is consistent or not by drawing in the expected demand curve on the diagram of the average cost curve.1 Figure 15 shows a part of the U-shaped curve which includes a mark-up m on average costs c(x) (that is (1 + m)c(x)), and an expected demand curve DD' which slopes downwards to the right. That is, when the price is px the firm can expect a demand of xu and if it produces only xx it can sell its product at price p2. But if the price is p2, the enterprise can expect a demand of x2, and can sell output x2 at a price lower than p2. At both the points xx and x2 the price the firm had in mind when it estimated the demand for its product and the price which it sets on the basis of that expected demand are not the same. Therefore the prices the firm sets at these points are not consistent prices. Only at the point where the estimated demand curve intersects the curve of supply price (1 4- m)c(x) - points x and x' in the figure - will the prices set by the firm be consistent. As the figure shows two consistent prices normally exist, but where the curve of expected demand is twisted more than three can exist, and indeed an unlimited number can exist in extreme cases. In these cases 1

The expected demand XA of firm A will depend not only on the price p of the product, but also on the expected demand XB for the competitor B. That is, XA = fA(p, XB). Similarly, XB =fB(p, XA), and the curve of expected or estimated demand in Fig. 15 is obtained from the two. Thus, or p = hA(XA) Not only isfA a subjective estimate made by A , / f l is also A's subjective estimate of what B will probably estimate. At the same time B too may well derive p = hB(XB) from his own subjectively estimated curves. A similar situation arises when there are more than two competitors.

72

Fixing product prices P

Pi P2

0

x

xx

x2

x

D

x

Figure 15

which price is selected will depend completely on the policy the firm follows and one probable criterion for the selection is the size of the profit anticipated. Since it can be shown that the larger is the volume of output the larger will be the profit,2 and if the points x, xf, x", etc. are points where consistent prices can be set, then profit will be at a maximum at the point where the x is largest from among these JC'S. In the case of Fig. 15, the profit at x is larger than that at x'. The enterprise will set a price p for its product and anticipate a demand of x? 2 The period of production and hedging

Re-assessment of costs of production Let us divide goods into three groups. The first group consists of goods whose prices are set according to the full-cost principle; the second 2 3

Profits will be mc(x)x when the volume of output is x. Since total costs c(x)x will increase when x increases, the larger JC is, the greater the profits will be. Where the actual volume of sales does not accord with the expected one an enterprise can go without altering the price of its products, by either foregoing the surplus demand or carrying over the excess supply to the future. However an enterprise must as far as possible avoid this kind of situation. An enterprise must therefore set the price of its products so as to have it as consistent as possible. Furthermore, as maintained by the neoclassical school, even where an enterprise has fixed its margin so as to maximize profit, if other enterprises are selling their products at a lower margin, that enterprise will have no choice but to change to prices with a lower mark-up rate. In this way the mark-up rate is pushed down to where prices are at the minimum. See the discussion later (p. 88 ff.) on price competition.

The period of production and hedging

73

consists of goods where prices are set by competitive trading, and the third group consists of labour and land. The determination of prices of goods in Group II was considered in detail in Chapters 1 and 2. We will explain later how prices for goods in Group III, wages, are set, while land problems and therefore, rents, are ignored throughout the book. In what follows here we shall go into some detail concerning the way prices of goods in Group I have to be determined, assuming the prices of goods in Groups II and III are given. The prices of goods in Group I will be set according to their respective average costs of production, but they are often themselves used as producer goods or in the production of other Group I goods, as for example with paint and electric cables etc. Consequently, a part of the production of goods in Group I will depend on the prices of some other goods in the same group. That is,firmstake the current prices of Group I goods as given, evaluate their respective average costs, mark up the average costs so decided by a mark-up rate, and thusfixthe prices of the various goods in Group I. However, prices set in this way are not necessarily equal to the prices of Group I goods which were used at the time when average costs were assessed. Therefore, the assessment of average costs must be corrected using the new prices. Thus as a result of this re-assessment firms will have to revise their production prices. Revision of prices brings about a further re-assessment of costs, and this latter produces a further revision of prices. Such 'iteration' may well continue until prices calculated from marked-up average costs are equal to the prices used for the assessment of average costs - that is, until a consistent price system is obtained. Once such a state is reached 'iteration' will cease; further revisions of prices will not take place and therefore the consistent production prices arrived at will be equilibrium production prices. The speed with which equilibrium prices are established rests on the degree of sensitivity with which firms react. As long as the firm is rational it will always assess its costs on the basis of current prices, and must always revise its production prices in response to changes in these; but since it requires extraordinary effort constantly to carry out these 'iterative calculation operations', firms often tend to be negligent or remiss in doing them.4 Thus current production prices are not necessarily 'consistent prices', and will merely be 'interim prices' which have 4

Price revision tends to be slow in socialist societies in particular. They are afflicted by the long sequence of time-consuming bureaucratic procedures for price revisions and by the bureaucratic way of thinking which considers that to revise prices for any reason whatever is to confirm that an error has been made by the authorities. The planning bureaucrats thus prevent achievement of equilibrium prices (that is, the establishment of appropriate and fair prices).

74

Fixing product prices

stopped short somewhere along the endless chain of repeated iterative calculation needed to reach equilibrium prices. Yet if we were to assume that firms are enthusiastic enough in re-evaluating their costs, then we should have current prices which are quite close to equilibrium production prices, even though they are only 'interim' prices. Cost assessment and the current prices assumption The above explanation is implicitly premised on the fact that each cost item is assessed at its price prevailing at the time when firms fix their product prices. However, since in reality time is required to produce things, the input of producer goods into the production process must be made before products are completed and put on sale. The prices required to obtain producer goods of this sort are not the same as the prices of producer goods at the time when product prices are determined. Therefore, costs which are assessed on the basis of current prices will differ from actual costs incurred in the past for the production of the relevant goods. Such a way of assessing costs would seem to be irrational at first sight but it can be rationalized if we reason as follows. Firms have stocks of producer goods, and at time t0 they will withdraw them from stock and inject them into the production process. However, until the final product is completed we can regard these producer goods as remaining in the factory, even though they have changed their form. Only at time ti when the finished product is completed and sold will these producer goods leave the factory. At that point, that portion of the stock of producer goods which leaves the factory must alone be replenished. Therefore, we can think of the unit price p(tx) of the producer goods needed to replenish stocks as the unit price of producer goods which leave the factory. That is, producer goods which were used up in producing final products which are sold at time tx are evaluated at current prices p{t^) prevailing at time tx. Even upon such a basis, there is no change in the fact that the average cost c(p(^)) calculated in terms of the current cost approach will not be the same as the average cost c(p(t0)) which was evaluated at prices p(t0) which were actually paid to acquire the producer goods used up in producing the final product. Ifpih) is larger than/?(f0), the current price approach overestimates costs, and in the converse case it underestimates them. However, these over-or-under estimations can to some extent be avoided, as we will explain below, if these producer goods are covered (hedge-sold) in the futures market at the time when they were acquired. Let us assume that a units of producer good 1 are required to produce

The period of production and hedging

75

one unit of the final product. According to the present or current price approach average costs will be

and according to the historical costs approach average costs will be

Here px(t) is the price of producer goods 1 at time t, and c(l) and c(0) are average costs evaluated according to the current price and historical cost approaches in relation to cost items other than the input of producer good 1. If, at the same time as injecting a into the production process at time t0, the firm false-sells an amount a of producer good 1 in the futures market with time tx as the term date, at price qi(t0), and buys back a at time tx, the enterprise will obtain precisely

as trading income from such hedging. Average costs determined by the historical approach are true costs when hedging of this sort does not take place; but where producer goods have been hedge-sold in the futures market, true costs are those where the trading income from hedging has been subtracted from average costs determined according to the historical approach. That is Pl(t0)a

+ c(0) - [qx(h)a - px{h)a\

(1)

Therefore, if we assume that /?i(f0) which is the price of good 1 at time t0 and qi(t0) which is the price of futures are equal, then true costs will be Pi(h) a + £(0). That is, with regard to producer good 1 where hedging took place it is the current price approach which gives the true cost. Therefore the average cost c(p(ti)) determined according to the current price approach is the true average cost where hedging has taken place for all producer goods. Hedging and risk avoidance The reason the firm hedge-sells in this way in the futures market at the same time as it purchases its producer goods, is in order to avoid the danger of fluctuations (falls) in futures prices. Let us now assume there are two firms A and B producing the same good, and that B hedge-sold the producer good 1 it acquired simultaneously with their purchase, while firm A did not. We assume that after the purchase of producer good 1 its price begins to fall, so that at the time where the product is completed, the price of good 1 is lower than it was at the time when the producer good 1 was bought in, i.e. P\{t\) (1 + m) \p\an + p*2a2l] p \ > (1 + m) [p\al2 + p\a22] This is the definition of the profitability of atfs at m. Were this p* = (p*, p2) to exist and were/?* and/?*> to be made proportionally large enough, the differences between the right-hand and the left-hand side of the inequalities would increase, and therefore for sufficiently large/?**, /?** the following inequalities would be established: Pr

> (1 + m) \pran

**(l

+

+ /?I*02i + Vx]

) \ * * +

**+V]

(4)

Here p \ * = kp\, p \ * = kp*2, and A: is a sufficiently large proportionality factor. If prices /?** are established, firms producing products 1 and 2 can all meet their costs and furthermore are able to receive a mark-up rate which is greater than m. Therefore firms will be 'profitable' at the rate m. Existence of equilibrium prices In Fig. 17, pi is taken on the horizontal axis and/? 2 on the vertical axis. (3) is established at point/?*, and (4) is established at point/?**. If we fix /?** i n the first equation of (4), and decrease /?**, a2i + Vl]

(5)

will be established at p[. p[ is the partial equilibrium price of product 1

Equilibrium production prices and their movement

81

r

0

b

px

Pi

Figure 17

when/?2 = p\*• This is greater than the partial equilibrium price/?" with p2 = 0,6 that is p'[ = (1 + m) [p'lciii + VJ

(6)

Let these points where partial equilibrium prices obtain be a = (p{, /?**) and b = (p'[, 0). As shown in Fig. 17, b must be located below and to the left of a. In the same way we may also obtain for product 2 the partial equilibrium points c = (p**, p2) when px =/?**, and d = (0, p2) when Px = 0. Since it can be shown that p2 >p2 > 0, d will be below and to the left of c. Since the partial equilibrium price curve of product 1 joins a and b, and that of product 2 joins c and d, both curves must intersect within the positive quadrant of the price plane, and their intersection will be at the point p° which is the point of general equilibrium of production prices. Thus if the coefficients at/s and m fulfil the conditions for profitability, positive equilibrium production prices will exist, and conversely whatever prices are taken, if (3) is not established then equilibrium prices will not exist. The production coefficients will be set by the state of technology but the mark-up rate is set by economic considerations. If firms demand very high rates they will be 'unprofitable' whatever prices 6

Since p*, p*2 > 0 , we may obtain from (3)

and therefore 1 > (1 + m)an. If we solve (5) and (6) with respect to p{, p'[, and consider the condition just obtained, we can immediately prove that p[>p'{>0.

82

Fixing product prices

are, and therefore, equilibrium production prices which are 'consistent' will never be established. This fact puts an upper limit on the value of m. The repercussions of changes in production prices By means of thoroughgoing application of the current value approach to the calculation of costs, firms repeatedly re-calculate their costs at the latest prices and revise their product prices. As a result of these 'iterative calculations' the prices firms fix for their products will approach equilibrium product prices. Of course, the convergence will not be complete and therefore actual prices will differ somewhat from their equilibrium values. But if we analyse how equilibrium prices vary we should be able to grasp the main trends in the variation of current prices. Now, if Vx changes, how might the equilibrium prices /??, p\ change? In Vx are included costs which are incurred in acquiring goods from Group II (producer goods whose prices are determined by competitive trading), goods from Group III (primary factors of production such as labour etc.), and fixed costs. For example, if the prices of Group HI goods which are necessary for the production of product 1 but are not used in the production of product 2 rise, or if only the wages of firms producing product 1 rise, V1 alone will increase whilst V2 will remain unchanged. Since such an increase in Vx will cause an increase in the solutionsp\ and/?'! to (5) and (6), points a and b in Fig. 18 will move to the right to a' and b'. Consequently the new partial equilibrium curve of product 1 will be given by the dotted line which passes through a', b'. The new equilibrium point will be at the intersection p1 of this dotted line and the partial equilibrium curve cd of product 2. If we express the difference px -p° between the new and old equilibrium points as Ap, we can immediately read off from Fig. 18 that Hicks' following three laws are established: (i) The price of good 1 whose cost Vx has increased will rise. Apx > 0. (ii) The price of good 2 whose costs do not increase directly will also rise. Ap2>0. (iii) The rate of price increase for good 1 will be larger than that for other goods. Ap1/p1 > Ap2/p2The above analysis is premised on the fact that the goods of Group I whose prices are set by the full-cost principle are of two kinds, but we can now carry out a similar analysis however many kinds of goods there are, and show that (ii) and (iii) above will be established in relation to all other goods, no matter how many kinds there are. Hicks explained that there are repercussions of price changes according to his three laws

The traditional theories

83

Pi

b'

Pi

Figure 18

amongst goods of Group II, but as the above (i), (ii), (iii) show, analogous laws of price changes are established amongst goods of Group I. 4 The traditional theories: the marginal productivity theory and the labour theory of value

The two orthodox theories In economics the theory that production prices are determined according to the full-cost principle does not yet form the main stream of contemporary thinking. The present situation is one where the marginalist theories of the neoclassical school are regarded as orthodox on one side of the world of economics, while on the other the theories of the classical economists (Ricardo, Marx or Sraffa) based on the labour theory of value are regarded as orthodox. How then is the full-cost principle different from these theories?

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Fixing product prices

As we shall make clear later, our theory is positioned between the two opposing orthodox theories. In one aspect it resembles neoclassical theory, and in another it resembles the classical school. Because of its position in relationship to the orthodox theories, our theory may perhaps suffer the fate of being abhorred by all those who call themselves orthodox as near relatives are sometimes hated. Yet the minute difference between us and our close relatives is very important. To ignore this would mean a return to our neoclassical or classical ancestors, and we would succeed to the errors they committed. Neoclassical marginalism Pealing firstly with the neoclassical economists, their basic conception is the same as the full cost principle, encompassing a 'U-shaped average cost curve' c{x) and an 'estimated demand curve' x{p). The latter describes how estimated demand for the firm's own product will change when its price changes. But in the neoclassical theory of the firm an inverse demand curve p(x) is usually employed which takes the volume of estimated demand as the independent variable, and price as the dependent variable, thus reversing the relationship. This price shows at what price we must sell, in order to sell-off a given output of x. Because the price has to be lower to sell a larger volume of output, the differential coefficient of p(x), p' = dp/dx, will be negative. Total sales R are p(x)x, total cost C is c(x)x, and profit II is R - C. (i) 77= R - C, (ii) R = p(x)x, (iii) C = c(x)x If we differentiate these with respect to JC, we obtain (i') IT = R'- C , (ii') Rf =p'x+p,

(iii') C = c'x + c

but so long as the marginal profit IT (that is, the increase in profit obtained for a unit increase in output x) is positive, profit is increasing; if it is 0, there will be for the time being no change; and if it is negative profit is decreasing. If profits which were hitherto increasing temporarily cease to change and decrease thereafter, profits at the point of temporary halt will be at a maximum. We therefore obtain II' = 0 as the condition for maximum profits, that is, /?'= C\ Namely, at the point of maximum profits marginal revenue (i.e., the increase in revenue obtained for a unit increase in output) will be equal to marginal costs (i.e., the increase in total costs required for a unit increase in output). Because p' < 0, the marginal revenue R' from the above equation (ii') will be less than the average revenue p. That is, the marginal revenue curve which shows how R'{x) changes with changes in x, will be beneath

85

The traditional theories

C

Figure 19

p{x), the average revenue curve (or the inverse estimated demand curve). Similarly, the marginal cost curve will be beneath the average cost curve where the average costs are falling (c' kA>m,we suppose A sells its own outputx° at the price PA

= {\ + kAy

(7)

In doing so the profits from x° will momentarily decline, but since B's customers will throng to A because it is selling cheaply, then if A expands its output from x° to 2x°, A will be able to get larger profits by dint of larger sales and a lower profit margin. However, the increasing output from x° to 2x° may cause a marked increase in the average costs of production. It will certainly not then be good policy to increase output to 2x°. It should confine its increase in output within the limits where there occurs no significant increase in average costs. That is, it should produce an output nx° such that c(x°) — c(nx°) does not have a significantly large negative value (where 1 < n ^ 2). Since in that case profits are

nn=pAnx°-c(nx°)nx0 provided that the product is sold at pricep A , they will be larger than the profit 77° = k°c°x° which is earned when only x° was produced and sold before the fall in price. For if we consider (7), the difference between the two levels of profit will be n»-n°=

[nkA - k°]c°x° + [c° - c(nx°)]nx°

(8)

Since the part within the second set of square brackets on the right-hand side of this equation will only attain a negative value such as can merely be ignored, whether or not Un is larger than 77° will be determined by whether the part within the first set of square brackets on the right-hand side is positive or not. If kA has a value sufficiently close to kQ this part will necessarily be positive so that we obtain TIn> 77°.9 That is, if firm A 9

Let pA be taken such that it is larger than the marginal cost at x() but smaller than p°. The TIn is an increasing function of n at n = 1. This can be shown in the following way. Differentiating IJn with respect to n, we obtain dnn/dn = {pA- {c'(nx°)nx° + c(nx°)}]x° On the right-hand side of this equation the part in the braces represents the marginal cost at x°. Since pA is taken to be larger than this, dTIn/dn is positive at n = 1; hence TIn > 77° for some n > 1 if pA is taken sufficiently near to p°.

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Fixing product prices

is content with a profit margin kA which is lower than k°, usurps customers from B and increases its sales to nx°, it can attain a much larger profit Un than the maximum profit W it would have attained had there been no price war. It is therefore worth A's while to declare war. Once challenged by A, B must also go to war. As long as B goes on selling at/?0 it will lose demand (n - l)x° to A and profits will decrease to &°c° (2 - n)x0.10 In order to maintain demand at its former level B must imitate A and lower the price pB of its own product to the level of pA. If it does so A will earn profits kAc°x°, because the clients usurped by A will be lost back to B. Therefore, in order once again to steal back the customers it has lost, A may well further lower its mark-up rate from kA to k'A. Only by so doing will A be able to raise its profits above kAc°x°. B will also fight back by making k'B — k'A. Thus once a price war breaks to try to achieve large sales through low profit margins, the mark-up rate will be continually lowered whilst kA and kB are greater than m. When finally they approach m, the price war will gradually come to an end because a greater reduction in the mark-up rate will make it impossible for the firms to survive. It goes without saying that for both firms the situation after the war will be clearly worse than the situation before commencement of hostilities when profits were maximized.11 However, such a price war will be unavoidable so long as both are independent, competitive firms, and there is no other way for them to avoid it but to form a cartel and jointly maintain prices.12 As long as industry is competitive, the mark-up rate of competing enterprises should just equal the rate m which makes their continuing existence possible. If we take k to be the firm's actual mark-up rate, it will be possible for k > m only where the firm is either a monopoly or forms an effective cartel with other firms in the same industry. We may be able to calculate the degree of monopoly exercised by a firm according to the ratio (k — m)/(k° — m). According to this index, when k = A:0, that is when the current mark-up rate is equal to the maximum profit mark-up rate, the degree of monopoly is 1; and when k = m, that is when the firm has to be content with a mark-up rate which just enables it to survive, the degree of monopoly is equal to zero. Most 10 11

12

Since 1 < n < 2, this profit will clearly be smaller than the maximum profit kc°x°. At each of the stages at which kA is lowered, A will always have done so because it anticipated an increase in profits due to larger sales at a lower profit margin. But because B responds in kind all of A's moves will be rendered negatory, and A's situation will ultimately be worse that it was at first. If A had been aware of this fact he would probably not have declared war. The same applies to B. If neither initiates the hostilities no price war takes place, and in this case A and B can be regarded as constituting a cartel tacitly. See Additional Note e.

The traditional theories

91

firms which have a monopoly or which actually participate in cartels, notwithstanding their position, have to be content with a mark-up rate much smaller than the k° of the neoclassical school due to the pressure from consumers, the mass-media and from legal restrictions. Ricardo Classical scholars such as Smith, Ricardo, and Marx believed prices were equal to 'production costs'; that is, production costs inflated by the addition of average profits, i.e. production prices. The full-cost principle may be considered as a version of resuscitation of the classical production cost theory. Let us consider an economy formed from agriculture, a consumption goods industry, and a capital goods industry. We shall call these industries 1, 2, 3. The capital goods industry (industry 3) produces all-purpose machines, which serve as tractors in agriculture, as spinning machines in the consumption goods industry, and as the robots which make all-purpose machines in the capital goods industry. Let alh a2h a3h lt be the production coefficients for the i-th industry; alh a2i represent the quantity of agricultural products and the quantity of consumption goods required to produce one unit of the i-th product; and a3h lt represent the number of machines and the number of workers also required to produce one unit of the i-th product. If 1000 units of the i-th product are produced by one machine the number of machines per unit product a3l will be 1 machine/1000 units. We can write cost of production equations (full-cost equations) for the three industries respectively as follows: Pi = (1 + m) \pxan + p2a2l + p3a3X + wl\] p2 = {l + m) \pxan + p2a22 + p3a32 + wl2]

(9)

p3 = (1 + m) \pxax3 + p2a23 + p3a33 + wl3]

For the classical economists, the task of their price theory is to explain by what the rates of exchange between products of different industries are determined (that is relative prices - for example, pjp2 etc.), and at what level these ratios settle. With the mark-up rate (or the classical economists' 'rate of profit') m and the wage rate w given, we can solve the above equations with respect to prices/?!, p2, p3 and divide them by each other to find the exchange rate pjp2. However, the classical economists were not satisfied with these mathematical solutions. Ricardo says The exchangeable value of the commodities produced would be in proportion to the labour bestowed on their production; not on their immediate production

92

Fixing product prices

only, but on all those implements or machines required to give effect to the particular labour to which they were applied.13 That is, if we let the amount of labour required to produce a unit of good i be A,-, the relative price pijp] will be equal to the relative amount of labour required A,/Ay, which is Ricardo's labour theory of value. How large then are the quantities of labour A1? A2, A3, required to produce a unit of each product? We shall start our explanation with A^ To produce a unit of agricultural net output not only will we need to produce consumption goods and machines, we shall need to produce more than one unit of agricultural output (due to the multiplier effect). The reason for this is that we need agricultural products, consumption goods, and machines to produce agricultural products, and must therefore also produce these consumption goods and machines. In order to do so additional agricultural products, consumption goods and machines will be required. Thus expansion of production by one unit in the agricultural sector will effect the consumption goods and machinery industries, and so these affects will further rebound on agriculture. Let the output of each industry required to produce a unit of agricultural net output be Xu X2 and X3. The volume of agricultural output needed to produce these outputs will be anXu auX2, and aX3X3, and so the output from agriculture Xx must cover these requirements and furthermore create one extra unit (the net product). In the case of consumption goods there is no need to create a net product, and it will suffice if X2 just covers the volume of consumption goods a2XXx, a22X2, a23X3, required to produce Xu X2, X3. The same will hold for machines. Therefore, Xx = anXx + aX2X2 + aX3X3 + 1 X2 = a2XXx + a22X2 + a23X3 + 0

(10)

X3 = a3XXx + a32X2 + « 3 A + 0 Furthermore, since the quantities 1XXX, 12X2, lyX3 of labour are needed to produce Xu X2, X3 respectively, the quantity of labour Xx required to produce a unit of agricultural net output will be given by (11) To obtain the quantity of labour necessary to produce a unit of the consumption good we replace 1 by 0 in the first equation of (10) and 0 by 1 in the second, keeping 0 in the third; we then solve the new set of 13

Ricardo, D . , On the Principle of Political Economy and Taxation, in The Works and Correspondence of David Ricardo, ed. P. Sraffa, vol. 1, Cambridge University Press, 1953, p. 24.

The traditional theories

93

equations with respect to A^-'s and substitute them into equation (11) to obtain A2. The labour value of the machine may be calculated in a similar way. It can be shown that the labour values A1? A2, A3 obtained in this way are equal to the solutions to the following equations: 14 A2 = A^n + A2#2i + ^3fl3i + h A2 = X\an + A2a22 + \3a32 + l2

(12)

A3 = \xal3 + A2fl23 + \3a33 + l3

If we write the equations for determining labour value in this form, what Ricardo is saying will become apparent. He contends that the ratios of prices which are obtained by solving (9) are equal to the corresponding values obtained by solving (12); but it is clear that in some cases this proposition is correct, and in other cases it is incorrect.15 Ricardo himself was fully conscious of this fact, but he considered, in the most part of his Principles, 'all the great variations which take place in the relative exchange value of commodities to be produced by the greater or less quantity of labour which may be required from time to time'.16 He confined himself to pointing out examples where his propositions would no longer be true. Marx It was Marx who elaborated the conditions under which Ricardo's labour theory of value would stand. Apart from the capitalist economies he considered societies which were still at the stage where workers and capitalists did not form separate groups, and he called such societies simple commodity production societies. Here profits and wages were 14

Solving (10) and substituting into (11), we obtain kx = L(l — A)~le{, where L is the row vector (/1? /2, /3), A the matrix {atj) and ex the column vector whose first component is 1, all others being 0. Similarly the labour values of the consumption goods and the machine may be calculated by the formulae, A2 = L{\ - A)~le2 and A3 = L(I — A)~le3, respectively. These three formulae can collectively be written in the form A = L(l-A)-1(el,e2,e3) where A is the row vector (A1? A2, A3). In view of the fact that (ex, e2, e3) is the 3 x 3 identity matrix, we obtain from the above equation A = AA+L

15

16

which is equation (12). The proposition holds true when all a^s are 0. However, where in agriculture an, a2l, a31 are all 0 and in the consumption goods and capital goods industries at least one of a \v a2n a3i *s positive, the labour theory of value will not be valid. That is, pjp^kj\ (i = 2,3). Ricardo, op. cit., pp. 36-7.

94

Fixing product prices

not differentiated, and the surplus was received in its entirety by the producers (that is, the workers). If in such a society there were to be differences in the rates of income earned per unit of labour in different industries, producers would probably move from industries with a low rate of income to those with a high one. Producers would cease to move, when the rate of income became the same throughout all industries. That is, the equations obtained by putting m = 0 in (9) would constitute the price equations for a static, simple commodity producing society. (Note that in these equations w would no longer represent the wage rate but the rate of income received per unit of the producers' labour.) By comparing these price equations with the value determination equations (12) we immediately realize that p / /w = A1, and therefore that PilPj ~ Kl^r That is to say, Ricardo's labour theory of value is completely correct for a static, simple commodity production society. This kind of society is, however, not a capitalist society. In a capitalist society m should be positive, and for the labour theory of value to be valid when m > 0, the production coefficients atj must satisfy a special condition. Marx called the proportion of indirect labour included in product i to its direct labour, that is ( A ^ + A2tf2/ + >M3/)A> the value composition of that product, and demonstrated that the labour theory of value was correct where the value compositions of all products were equal to each other, and also that the labour theory of value was correct in that case alone.17 Since the condition that the value composition of all products be equal is a very strict one, so the labour theory of value will only be valid in a capitalist society in very exceptional cases. As opposed to Ricardo who considered that the labour theory of value was valid except in exceptional cases, Marx considered that it would not normally be valid. Thus Marx abandoned Ricardo's theory of labour value but carefully preserved Ricardo's concept of value A,. He explained, by using the concept of value, how, in a capitalist society, workers were exploited by capitalists, and in so doing revealed how 'exploitation is the sole source of profit'. I have called this the fundamental Marxian theorem but do not go into its mathematical proof in this volume.18 Marx has thus used the concept of labour value to prove that profits are created when and only when there is exploitation. For Marx, the labour theory of value is no longer, as it was for Ricardo, a theory of prices. It is indispensable for the theory of exploitation, on the basis of which Marx rigorously establishes his own theory of profits; moreover, 17 18

For more detail see: Morishima, M., Marx's Economic, Cambridge University Press, 1973, pp. 82-3. See ibid., pp. 63-8.

How should we treat the traditional theories of the firm?

95

he obviously recognizes that relative prices generally deviate from relative values. In this sense it may be said that Marx is clearly superior to Ricardo, but in other aspects his theory has the same weaknesses as Ricardo's. They both assume that prices are determined by production costs - that is by the full-cost principle. Yet in the real economy the prices of one group of goods are set by competitive trading for which exchanges exist. The real economy is an eclectic mixed economy founded on both the full-cost principle and competitive trading. The theoretically pure Ricardo and Marx both ignored this fact, and constructed a 'unitary' model sticking consistently to a single principle.19

5 How should we treat the traditional theories of the firm?

Monopolists, price-takers and small proprietors I would like to outline my thoughts on how I regard the theories of the firm as they have stood in the past. I divide products into two groups; the first of which consists mainly of products from manufacturing industry which have no perfectly organized market (exchange), and the second of which consists of products which have exchanges (agricultural, forestry and fishery products, mineral products). With Group I products, where output is monopolized by a single firm the production activity of the firm may be explained by the classical monopoly theory. But when the mark-up rate decided by the monopoly firm (the difference between the monopoly price and average costs divided by average costs) is extremely large, the firm will not be able to accumulate profits without let or hindrance even though it has a monopoly. Due to the pressure of public opinion, moral pressure or political pressure from the government, the mark-up rate cannot exceed a given upper limit; subject to these constraints, the firm, with given demand and cost functions, will draft its production plan so as to maximize profits. The theory of the full-cost principle will pertain to all other firms producing Group I goods. In that even the number of competitors does not present any problem, but of course where there are few competitors it may well be easy for them to act in concert. Should they do so by forming an explicit or implicit cartel, they will behave in most respects 19

One might say that in the classical and Marxian economics prices are determined by competition and, hence, are not set by any particular individual or organization, while in the full-cost principle theory prices are set by the manufacturers independently of competition. This is a wrong interpretation of what I said in the text. What I said there is that for agricultural products competition is made mainly in exchanges, whereas for manufacturing products it is made, in terms of the mark-up rates, within the framework of the full-cost principle. Thus our prices are also competitive prices.

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Fixing product prices

as monopolists, but to the extent that they remain competitors the competition will be intense (even with two competitors). The price war which will take place between competitors may well more or less standardize their mark-up rates at the minimum value. The prices of goods in Group II will not be set by individual firms but in the exchanges. Such prices will then be declared as fair price for that time and will possess authority outside the exchange. Whether or not firms sell through exchanges, they will adjust the quantities they produce so as to maximize their profits with the official price determined on the exchange as a datum. In accordance with the equilibrium conditions of neoclassical 'perfect competition' whereby marginal costs equal product prices, firms will increase (decrease) their output when product prices rise (fall). Therefore, supply of Group II goods will be an increasing function of their price. In addition, small proprietors also exist in modern societies. Whilst themselves owning the land, tools and machines required for production, they are themselves workers. For such small proprietors income from their assets (capital) and income from labour are undifferentiated, and their income is what is left when each and every cost incurred in production has been subtracted from the price of their products. Their income equation will therefore be w/,- = Pi ~ Piau - p2a2i

(where w indicates the undifferentiated, combined rate of income received for one unit of labour by small proprietors), which, if rearranged, tallies with Marx's value equation (9) for a simple commodity production society. Where such small proprietors together produce between them the goods which they themselves consume in the production process and form a self-sufficient society of simple commodity production, the labour theory of value will hold within that society. However, in actual economies small proprietors all transact with capitalist firms (which produce goods in Group I or Group II), and therefore small proprietors do not make up a closed society. Thus the labour theory of value as a theory of price will not be valid for them. Price-adjustment and quantity-adjustment sectors If we treat small proprietors as separate, we can see at a glance the price-fixing mechanisms for goods of Group I and those of Group II are quite different. With goods of Group II product prices will be regulated by competitive trading in the market. If the demand which accumulates at the exchange is d and supply s, then p = F(d(p) — s(p)). Since firms will produce so that marginal costs are equal to the market

How should we treat the traditional theories of the firm?

97

price p° thus determined, we can add up the output of all firms and obtain the total output X(p°) for that good. Now if for the sake of simplicity we ignore the gestation period for production, all of the goods produced are likely to be supplied at the price p°. On the other hand, total demand in the society will be D(p°). If we assume that an unbiased sample of society's total demand and supply accumulates at the exchange, then d(p°) = nD(p°), s(p°) = nX(p°), where n is a stable fraction. When market equilibrium is established at the exchange, we must have d(p°) = s(p°), and therefore D(p°) = X(p°). In the case of goods of Group I, output is estimated when prices are fixed, but such an output is never anything more than an estimate. In actuality such estimates are often mistaken, and the effective demand which appears will sometimes exceed and sometimes be less than that estimate. Where production is inadequate it will rapidly increase, and where it is excessive it has to be sold off over a period. Yet even in this case the firm will not re-calculate its average costs of production in response to the amount it actually produces, in order to revise its price. Since it will continue to sell at the price it has already fixed, when it increases its output it will earn profits which are markedly greater than those anticipated, because the estimated fixed costs per unit of output overestimate the actual fixed costs per output. In the converse case where the actual volume of sales does not reach the size which was anticipated, profits fall rapidly below those anticipated and the firm often incurs great losses because it under-estimated the fixed costs per output. Firms which produce goods in Group I must absorb unsold goods into stocks when there is excess supply (D<X). They may well contract production in order to avoid swollen stocks. That is X< 0. Since stocks will decrease when there is an excess demand (D>X), firms will carry out an increase in production (X> 0). X here shows the total output of the good, and production will show a tendency to increase or decrease according to whether X is positive or negative. Therefore we can obtain the output adjustment function for goods in Group I:20 X=F(D-X) As long as there is nothing untoward in this adjustment process, prices will not be revised. Prices will be revised where costs have risen by 20

Put in more detail, producingfirmsdo not directly encounter thefinalbuyer. What they encounter is demand from wholesalers, supermarkets, consumers' associations and trading companies. If we let this demand be D', and the demand of the final buyer be D, then we may express the adjustment mechanism in the process of distributing Group II goods as X= F(D' -X),D' = G(D - D').

98

Fixing product prices

reason of an increase in wages or raw material costs, but they will not usually be revised by reason of an inadequate or an excess supply. In other cases too, where to lower prices may appear to improve the operating situation of the firm, firms will not alter prices unless they are driven into a corner. This is partly because the losses they continually incur are compensated for by large profits made when demand was buoyant; but it is also partly because to lower prices would be to announce publicly that they had been driven into a corner, which from the point of view of the management of the firm would be a bad thing. 21 Thus since the excess demand for Group I goods will be regulated not by altering prices but by changing the volume of output, we may say these industries constitute the fixprice or quantity adjustment sector. In contrast, those sectors which produce goods in Group II constitute the flexprice or price adjustment sector. As we have already stated, at the end of the nineteenth century industrial countries with the exception of Britain still had a large flexprice sector, but at present the size of the fixprice sector in most industrial countries is much larger than before, and the flexprice sector is gradually assuming the status of an appendage. 22 21

22

Even when they are monopolists, where firms which produce Group I goods find that the quantity of demand they actually attract differs from their estimated output, they may well leave prices unchanged and adjust quantities. Whilst this is true, since America, France and Italy still have a quite large flexprice sector, we may say that these countries' economies are mixed economies made up of flexprice and fixprice sectors. For a mathematical model of such mixed economies see: Morishima, M., Walras' Economics, Cambridge University Press, 1977, Chapter 7.

Determination of foreign exchange rates

1 The century of internationalism

Onset of protectionism It is no exaggeration to say that the period from the latter half of the nineteenth century and right through the twentieth century was 'the era of internationalism'. Britain was the pioneer in this. The period from 1840 to 1870 was one in which Britain strenuously advocated liberalism in economic ideas, and during this time the internationalization of the economy was pushed forward to the extent that the value of net imports and exports which had formed only 13% and 9% respectively of the Gross National Product in 1841 made up 24% and 20% in 1871.1 At the same time industrialization proceeded in Britain and she came to import food and raw materials from abroad and to sell industrial products to foreign countries. Britain thus became the 'workshop of the world' and other countries become 'Britain's granary'. Such an international division of labour only became possible in the context of Britain's huge colonial empire. Britain's industrial pre-eminence also made her militarily strong. Thus with the establishment of this international division of labour which enabled Britain to concentrate on her industries, the British Empire became stronger and larger. All the cogs in the machine fitted smoothly. Stimulated by Britain's success France and Germany both opened the doors of their economies, and then eventually even Japan began to march out into the markets of the world. We may infer that the period 1850-1880 in France corresponds to the period when Britain's economy was opened up (1840-1880), and in Japan it is probably 1880-1910. In France the ratios of imports and exports to GNP were on average 5% and 6% in the 10-year period 1845-1854, but reached an average of 16% and 13% in the ten-year period 1875-1884. In Japan they were just under 4% and 5% in 1880 but reached 17% and 18% respectively by 1

Some imports are re-exported abroad. Net imports is the figure we obtain by subtracting re-exports from imports. 99

100

Determination of foreign exchange rates

1910. Then, as did Britain, these countries built a large sphere of influence on the basis of the fruits of industrialization and with the regions under their influence as sources of supply of food and raw materials they attempted to reach an even more advanced stage of industrialization. Thus, directly connected with the earlier period of liberalism, the period of aggressive imperialist competition appeared. These countries, including Britain, sought sources of supply of food and raw materials and markets for their industrial products; competition to grab colonies was rife and their struggle eventually exploded in the form of the First World War. Attracted by the profits accruing to a monopolist, outsiders will attempt to break into an industry; monopoly therefore gives rise to competition. Competition ends when the victorious competitor becomes a monopolist. It is certainly not difficult to find historical examples of chains of causality where when X produces its opposite, the opposite will produce X. In the area of trade philosophy and policy, the philosophy of free trade gave birth to protectionism, and conversely the latter eventually provoked the reappearance of the former. In fact the British period of free trade was the successor to the period of parliamentary mercantilism. In that era, all the wealth of the colonies - both in gold and silver and in other resources - was exploited for the prosperity of the mother country. They were subordinated to the mother country. The relationship between the mother country and its colonies was that of head to limbs, aims to means. They together formed a self-sufficient commercial hierarchy. However, the opposition of the American colonists who wanted the abolition of the Maritime, Stamp, Sugar and Tea Acts, and subsequently, American Independence, rang the death-knell on this colonial system. Whilst free trade had its positive aspects in that it secured benefits for the mother country, it was also a policy designed to pacify the colonies and the product of compromise with them. Having been shown the success of the British Empire, other countries (Germany, France, America etc.) tried to emulate Britain. However, late in industrialization, they had to tread a quite different path from Britain. Unlike Britain, they did not put their faith in the philosophy of free trade and specialize in industries which, by international comparison, seemed advantageous to them. The industries in these countries which were relatively advantageous at that time in comparison with Britain were not in manufacturing, but were agriculture or mining. Therefore we should have to conclude that what they ought to have done according to the theory of comparative costs would have been to export the products of agriculture and mining to Britain and receive in return British industrial products. But to have done so would have

The century of internationalism

101

closed off to them the road to industrialization. If they were to become industrial countries in their own right and compete with Britain as such, they must needs abandon the theory of comparative costs upon which the philosophy of free trade was based and establish a new trade philosophy. It was the nationalist and protectionist trade theory of Friedrich List which met this need, and it suggested a variety of protectionist trade policies for the nurture and protection of her infant industries in order to overcome Germany's late entry onto the stage of world history. Putting up international fences When industry had been developed up to a certain point, colonies had to be maintained as the source of supply of raw materials and a potential sales outlet for manufactured goods. These colonies, like those of Britain in the mercantilist era, were subordinated to and had to serve their mother countries. Not only was there ferocious economic competition between the early and the late developing capitalist countries, such competition taking the form of improvements in the quality of products, the development of new production techniques, the lowering of production costs and of prices, the exclusion of the goods of other nations, by means of tariff barriers, and so on; wars often occurred to secure new colonies or to redistribute existing ones. Powerful countries would fight over a less-powerful one; or else it would be left to one of them to invade it. Thus the antagonism produced in the 'defence' of the British Empire against the imperial advance of late developing capitalist countries (chiefly Germany) eventually exploded in the form of the First World War. However, even when the result of the Great War was settled, the struggle for colonies did not end. Japan, which had fished in the troubled waters of the Great War, sent troops into the Shantung area of China in 1927 and caused the Manchurian Incident of 1931, the Shanghai Incident of 1932 and the Sino-Japanese War of 1937 (the China Incident). As well as making Manchuria independent in 1932 and enclosing the North-Eastern region of China in its own sphere of influence, Japan nibbled away at other regions of China during the Sino-Japanese War. With Hitler seizing power in Germany in 1933, Germany began to undermine the Versailles system. In October of the same year Germany left the League of Nations, and in 1935 declared it would expand its armaments. Japan, too, had left the League of Nations in 1933 before Germany, and had announced to America in 1934 its abandonment of the Treaty of Washington. Thus the League of Nations became little more than a name, and the era of international co-

102

Determination of foreign exchange rates

operation after the Great War, whose basic philosophy had been liberalism, became a thing of the past. In fact the London arms reduction conference of 1936 also broke down. The rising countries of Japan, Germany and Soviet Russia, particularly Japan and Germany, desired to build up their own systems of self-sufficiency by establishing spheres of influence which would enable them to rank with the British Empire. In 1935, Italy invaded Ethiopia. Within this historical context, the internal structure of the British Empire was compelled to change. The autonomous Dominions within the Empire (Canada, Australia, New Zealand, South Africa) were not inclined to sacrifice their own young industries for the sake of industrial development in the mother country, and problems of free trade versus protectionism not only existed between the British Empire and other capitalist countries, but were also a bone of contention between Britain and the Dominions within the Empire which possessed the potential to become industrial nations. In order to protect and develop their infant industries the Dominions were allowed to raise trade barriers. Moreover, in order that the Dominions should continue to provide export markets for Britain, the Empire had no other recourse but to raise high tariff barriers against foreign goods and grant preferential treatment in Britain's domestic market for goods from the Dominions in return for similar treatment from them with regard to British goods (Imperial Preference). That is, the British Empire intended to foster the infant industries of the Dominions at the cost of goods from other countries, but were it to carry out such a policy of exclusion it would incur the counter attack of other countries, and lose export markets in countries outside the Empire. Despite this, Britain went so far as to adopt a protectionist trade policy to make such a sacrifice because of the rapid advance of the late-developing capitalist countries and the necessity of defending the British Empire from within so as not to be ruined by these countries. A further reason was the need to protect British agriculture from the danger of collapse in the face of the world slump, even though that agriculture had already contracted to its minimum scale. Formation of economic blocs By 1932 the policy of Imperial Preference was adopted in its entirety, and Britain turned from a policy of free trade to one of protectionism. The period of free trade which had begun with the abolition of the Corn Laws in 1846 had run its course after 86 years. It will be clear from the following figures that the tariff policy was a great success. Canada, Australia, New Zealand, India and the West Indies were Britain's main trading partners within the Empire; if we compare the total of imports

The century of internationalism

103

from these countries to Britain and Britain's total exports to them with the total imports from Germany, France, Holland and Belgium and Britain's exports to those European countries, we find the following. In 1929 imports from the former were 1.1 times those from the latter, but had dramatically increased to 2.8 times in 1938. As for exports, those to the former were 1.2 times greater than those to the latter in 1929, and had increased to 1.6 times greater in 1938.2 Thus the result of the Imperial Preference policy was to shut out the countries of Europe from trade with Britain, and trading ties between Britain and the Dominions and Colonies within the Empire were markedly strengthened. The British Empire became a single, solid economic bloc, but because Germany and Japan also tried to establish their own spheres of influence, even by force of arms, the world economy entered an era of large economic regions encompassing many countries (Grossraum-Wirtschaft). These economic blocs were, at that time, each independent fighting units, and so the danger of war between them was always present. If we consider the problem in this way, we must conclude that the Second World War was the inevitable outcome of protectionist trade policies. With the various economic blocs as their bases, currency areas were formed, such as the Sterling, the Dollar area, and the Yen area. The countries which belonged to the Sterling area were not necessarily Dominions or Colonies of the British Empire (at first countries outside the British Empire such as Scandinavian countries, Iceland, Portugal, Argentina, Egypt, Sudan, Iraq, etc. also belonged to it; but when the Second World War broke out Scandinavia, Argentina, Portugal, etc. dropped out). Moreover not all Dominions and Dependent Territories of the British Empire belonged to the Sterling area: Canada and Hong Kong are outside the area. All currencies within the area were linked to the pound and their value in pounds kept fixed. Dollars earned in transactions by countries within the area with those outside it were gathered at the Bank of England which established an exchange equalization account (or an exchange stabilization fund) which it operated to keep the external price of the pound fixed. Multicentric economic blocs The Second World War struck a blow which shook the foundations of this system of arrangements. While it was natural that the economic blocs centring on Germany and Japan, who were the defeated countries, should have been dissolved, it was impossible even for the economic 2

Thesefiguresare calculated from Mitchell, B. R., and Dean, Phyllis, Abstract of British Historical Statistics, Cambridge University Press, 1962, pp. 320-6.

104

Determination of foreign exchange rates

bloc formed by the British Empire which was the victor to survive unaltered. The war taught nationalism to the populations of Colonies and Protected Territories in Asia and Africa with the result that after the war many became independent. It became impossible for Britain to maintain the imperial order. The Empire was broken up and in its place the British Commonwealth - an autonomous group of societies which had joined together freely and equally and whose components were Britain and the white Dominions - was expanded to include the non-white countries which had become independent after the war. Other than that there should continue to exist a union in the form of a Commonwealth of the many races contained in the old Empire, there was no real, substantive policy for the continuation of the Empire. After such major surgery the economic bloc formed by the Empire still had some life in it after the war, but the bloc itself no longer had its past power to lead or its solidarity, nor were its ties as economically attractive as formerly. However, such tendencies certainly did not mean that the end of the era of economic blocs was approaching. Leaving aside the economic and political bloc built by the communist countries of Eastern Europe which was a product of the Second World War, the great success of the EEC in which the major industrial countries of Europe have participated indicates that, in the domain of the international economy, still there is more than a little benefit to be got from collusion amongst several powerful countries. When Britain was forced to choose between the Commonwealth bloc or the EEC, it first countered by forming the European Free Trade Area (EFTA) together with Sweden, Norway, Denmark, Switzerland, Austria and Portugal - many of whom had at one time been members of the Sterling area - but to no avail. Britain aside, just as no industrial country which was strong enough to be compared with Germany, France and Italy, existed in the Commonwealth bloc, neither was there such a country in EFTA. In the latter half of the twentieth century when the diversification and subdivision of industrial products has become very marked, it is no longer possible for an economic bloc centring on a single industrial country of the scale such as Britain's, to produce a comprehensive range of industrial products efficiently. However closely the countries within such a bloc collude, the bloc's power to seal off and exclude others cannot be strong. Modern international trade relations which began with the hierarchical division of labour between the mother country and its colonies, had, after a long history, to develop towards monopolistic competition where the advantage lay with collusive alliances of powerful and diverse industrial nations (the so-called multi-centric economic blocs). That is, we have

The effects of fluctuations in foreign exchange rates

105

left an era of alliances between countries which were heterogeneous and complementary, and entered an era of collusion between countries which are essentially the same but in competition one with another. 2 The effects of fluctuations in foreign exchange rates Fixed exchange rate systems

Thus there was the period of free trade, the period of economic blocs where countries were heterogeneous with complementary economies, and the period of blocs of competitive countries, and yet it is very clear that the period for 100 years or more from the second half of the nineteenth century was remarkably internationalist. Of course, when heterogeneous and complementary countries formed blocs (for example, the British Commonwealth or the Greater East Asia CoProsperity Sphere) it was possible for the bloc as a whole to cut itself off and sever intercourse with areas outside the bloc. However, blocs formed from homogeneous and competitive countries will together become bankrupt if they trade only amongst themselves and do not seek raw materials and markets outside their bloc. Even though they are bloc economies they are, as a rule, open; and even in the extreme case of a closed bloc, the bloc economy itself is already highly internationalized when seen from the point of view of any given country within it. The main problem for the international economy is how to convert the various currencies of the countries from which it is made up. In the age of the gold standard when each currency was backed by gold, exchange rates were more or less equivalent to legally fixed parities. If the currency laws of Japan and Britain specified respectively that 1 yen comprised 11.57422 grains of pure gold, and that 1 pound would include 113.0016 grains of pure gold by volume, the amount of gold contained in 9.6632 yen and 1 pound would be equivalent, and the legally fixed parity would be 1 pound = 9.6632 yen. If the transport costs (including security costs and insurance) of sending 113.0016 grains of gold from Japan to Britain (or the reverse) are 1 yen, the actual exchange rate would neither go below 1 pound to 8.6632 yen, nor above to 10.6632 yen. That is, the value when transport costs are subtracted from the legally fixed parity will mark the lower limit of the exchange rate, and the value when transport costs are added to the legally fixed parity will mark the upper limit. (If for some reason the exchange rate falls below 8.6632 yen, a person wishing to exchange yen for pounds will first buy gold with sterling in Britain, and will spend 1 yen to send the gold to Japan where he will change his gold into yen. In doing so he will obtain 9.6632 yen and thus the net yen he acquires by this method will be

106

Determination of foreign exchange rates

8.6632 yen. Accordingly, should the exchange rate fall below the lower limit, a person changing pounds into yen will take steps to send gold and the exchange rate will not go below the lower limit. Similarly, should it rise above the upper limit a person changing yen into pounds will send gold and so the actual exchange rate will hit the upper limit and not exceed it.) Thus actual exchange rates will be kept within a fixed range around the legally fixed parity under the gold standard, and because transport costs, security costs and insurance fees will get smaller with progress in transport technology and the reduced fear of attack by pirates, the range will contract and the exchange rate will come to vary only slightly around the legally fixed parity. We may thus conclude that the gold standard is virtually a system of fixed exchange rates. From thefixrate to theflexrate regime The gold standard was temporarily shelved during the First World War, but after it the major countries returned to the gold standard. In the period of the great depression in the 1930s, however, these countries were compelled once more to prohibit the convertibility of gold as well as the export of gold.3 During the depression, all countries devalued their currencies in order to increase exports, but because they all tried to increase exports by the same method, devaluation followed by retaliation repeatedly occurred. At the time of the rebuilding of the international monetary system after the Second World War, there was established what may in broad terms be regarded as a kind offixedexchange rate system (the system centring on the International Monetary Fund), although it was not the same as the pre-war gold standard. The intention behind this move was to avoid a repeat of the chaos and confusion which attended fluctuating exchange rates before the war. To begin with, (1) the IMF fixed the exchange rate between the US dollar and pure gold at 1-ounce troy of pure gold = $35. Next (2) the countries belonging to the IMF fixed their own exchange rates either in terms of the US dollar or gold (e.g. £1 = $2.8, $1 = ¥360) and registered these rates. Then to preserve these rates, (3) America undertook with foreign Monetary Authorities to buy or sell gold without limit on the amount at a rate of $35 = 1 ounce troy. (4) Foreign Monetary Authorities took on the obligation through their exchange banks to trade in the exchange market in dollars with no limits imposed when the exchange rate of their 3

In September 1931 Britain abandoned the gold standard, and in December of the same year Japan once more forbade the export of gold and announced an Order to End Gold Convertibility. America left the gold standard in 1933, and France finally abandoned it in 1936.

The effects offluctuationsin foreign exchange rates

107

own currency fell 1% below or rose 1% above the rate registered with the IMF.4 This was based on the assumptions that America held enough gold to fulfil its obligations, and that each member country had an adequate exchange equalization account or exchange stabilization fund. Therefore, when America ceased to convert gold in August 1971 due to an insufficiency in its supply, the system - the IMF principle of fixed exchange rates - collapsed. Therefore, there is at present no upper or lower limit to fluctuations in exchange rates. For most of the period after the founding of the IMF £1 equalled ¥1008 and $1 equalled ¥360, but by January 1982 £1 equalled about ¥420 and $1 about ¥220. This indicates that the yen was cheap relative to sterling and the dollar throughout the 1950s and 1960s, which would seem to have contributed to the growth in Japanese exports. Moreover, this state of affairs lasted for a long time because of the IMF's fixed exchange rate system, and during this time Japan built up a powerful exporting industry sector. By the time of the change to a fluctuating exchange rate system Japan's balance of trade had already improved remarkably and, as a result of the change, the yen suddenly emerged as a strong currency. Exchange rates and product prices

Similarly, a weak pound should bring about an increase in British exports. But according to what logic will this result come about? In what follows we shall assume that Britain's exporting industries are manufacturing industries (therefore industries whose prices are determined by the full-cost principle), and explain first of all how changes in the exchange rate exert an influence on prices in these industries. Next we shall consider how such price changes affect export and imports. If we take a single manufacturing industry, some of its products will be sold on the domestic market and others will be sold as exports to foreign countries. The prices of the products will be expressed in pounds sterling in the home market and in dollars abroad. Similarly, when the industry uses imported raw materials, it must convert the dollar prices of 4

Looked at from the British point of view the exchange rate £1 = $2.8 is the rate in terms of foreign currency (the rate per unit of one's own currency in terms of an amount of foreign currency). However, the rate of $1 = ¥360 is, in Japanese eyes, the rate in terms of their domestic currency (the rate per unit of the foreign currency in terms of an amount of domestic currency). In Japan exchange rates are usually expressed in the domestic currency, but in Britain usually in the foreign currency. The monetary authorities in Britain which deal in foreign currency have an obligation to the IMF to buy dollars without limit at the rate of £1 = $2.8 x 1.01, and to sell dollars without limit at the rate £1 = $2.8 x 0.99. The monetary authorities in Japan who deal in the domestic currency must sell dollars without imposing any limit if the rate goes to $1 = ¥360 x 1.01, and buy dollars if it goes to $1 = ¥360 x 0.99.

108

Determination of foreign exchange rates

raw materials in their countries of origin into pounds when calculating costs. Exchange rates will be used when translating sterling prices into dollar prices, and as stated in footnote 4 two kinds of method exist for doing this. The first is to express the value of the unit of the domestic currency (pounds sterling) in terms of foreign currency, e.g. £1 equals $2; the second is to give the domestic currency equivalent of a unit of the foreign currency, e.g. $1 = £0.5. Let us show the former by q, and the latter by r, with their dimensions as $/£ and £/$ respectively. Then q = 1/V. When q changes from £1 = $2 to £1 = $1.8, the pound weakens, because the pound which hitherto had a value of $2 will now have a value of only $1.8. If we show the same situation for r, $1 = £0.5 will become $1 = £0.55, and so if the pound weakens q decreases and r increases. Now let product prices be p£ and imported raw material prices be 77$. The reason we go out of our way to add the subscripts £ or $ to these symbols is to make it clear that these prices are expressed respectively in sterling and dollars. In terms of the full-cost principle formula, p£ = (1 + m)Q, we have to deal with average costs C£ in terms of sterling in order to calculate/^, but to do this we must translate the raw material costs 77$ expressed in dollars into raw material costs 77£ expressed in pounds. For this purpose the exchange rate expressed in terms of the domestic currency r will be used which has the dimension £/$. That is % = r7r%- Furthermore, products will be sold on the domestic market at p£ but will be sold abroad with their prices expressed in dollars. In translating p£ into dollars the exchange rate expressed in terms of the foreign currency q will be used; it has the dimension $/£. That is, the prices in foreign markets p% will be equal to qp£. If the pound weakens, r will increase as explained earlier. Thus the sterling price of imported raw materials which forms a part of costs will rise, but the other elements in costs will not change, or they will only increase at a rate below that of the rate of increase of r. Consequently the rate of increase in total average cost Q will be less than that for r, and therefore the rate of increase of the product price p£ will also be less than that for r.5 Since we have qr= 1, q will fall at the same rate as r 5

This may be proved as follows. The mark-up ratio is given by m, and average costs may be divided into three parts. The first part of costs C{ are British industrial products which are used again as materials etc. The second part of costs is C2 which are imports from abroad used as raw materials or fuels. The third part of costs C3 are other costs, namely fixed costs, wages etc. C3 is unchanged when r rises, and C2 will only increase by the same or less than the rate at which r increases, the former where it is impossible to substitute domestic products for imported raw materials and the latter where domestic raw materials are substituted for imported ones which have become relatively more expensive. (contd.)

The effects of fluctuations in foreign exchange rates

109

increases. Therefore, the rate of fall of q will be greater than the rate of increase of /?£, and so the prices p$ = qp£ of those products on the foreign market will fall. That is to say, if the pound weakens the domestic price Pi of the products of British manufacturing industry will rise (so creating inflation), but these products may be sold more cheaply abroad. The effect on exports and imports of a devaluation of the pound Let the domestic demand for industrial products be DD, and foreign demand be DF. If we make DM the demand for similar products imported from abroad, of the total domestic demand DD, DM will be made up of foreign goods, and the remainder DD — DM will be made up of domestically produced goods. The sterling value of exports from these industries will be p£DF, and the value of imported manufactured goods will be rp'%DM and rir%k [(DD — DM) + DF] will be the value of imported producer goods. Here /?$ and TT$ are the foreign prices of imported manufactured products and imported producer goods, respectively, and k is the volume of imported producer goods needed to produce one unit of product.6 Where imported producer goods cannot be substituted for by other producer goods which can be domestically supplied, they are known as non-competitive imports, and in such cases k will not change. As against this, where the sterling price rrr% of imported goods has risen because of an increase in r, and, as a result, there has been a switch to domestically supplied producer goods away from imported goods, these imported producer goods are known as competitive imports. In the case of competitive imports k declines when r increases. The price of all British industrial products will be affected by an increase in r. However, let us consider those most strongly affected; that is, those industries where the rate of increase of product prices is highest. Let the rate of increase be h, and let us examine whether it is possible for h to be equal to or higher than the rate of increase r. In the equation the left-hand side will increase by the rate h, but on the right-hand side C2 will only increase by the same rate as r increases or at a lower rate. C3 will be fixed. Therefore in order that h be equal to or higher than the rate of increase of r, Cx must increase by a rate greater than h. But the rate of increase of Cx will depend on the rates of increase of British industrial product prices, and it will not be possible for Cx to rise by a rate higher than its maximum rate h. Were we to suppose a 'rate of increase where h^f a contradiction would arise, so the rate of increase will be hC\ + C\. Therefore if C\+C\&C\ + C\, we obtain C\+C\>C\ + C\, and the combination of imports and domestically produced producer goods before the increase in r will not have been the most efficient combination. Therefore, C\+C{2¥/£

1

PlJ

PlB

Similarly for other goods, if the purchasing power of the yen and pound are compared good by good and more of a good can be bought by converting pounds into yen and buying in Japan rather than by buying the goods directly in Britain, then the good will be imported from Japan. In the opposite case, Japan will import goods from Britain. Having said all this, let us divide goods into three groups. Group I are those goods which are in demand in both Britain and Japan (automobiles, tape recorders, etc.); Group II consists of goods which the Japanese demand a great deal of, but for which the British have hardly any demand (fish sausage, kimonos, tatami flooring, etc.); and Group III contains those goods which the British demand a great deal of, but for which the Japanese have hardly any demand (smoked herring, cheese, salami, Western-style furniture, etc.). For goods in Group II and III respectively, the following are likely to be valid

P*l±>±PU 19

(II)

PiB

The Purchasing Power Parity Theory is old and can be traced back at least to Ricardo and Mill, but it was Cassel who was its most powerful advocate and who gave it its name. See Cassel, G., Money and Foreign Exchange after 1914, 1923.

Changes in exchange rates PU

127 (III)

PiB

This will be because fish sausage made in Britain will be expensive, and the price of Japanese-made salami will also be comparatively high. Let us assume for the time being that for all goods in Group I the following holds: P

-^>±

PU

(I)

PiB

Looked at from the point of view of purchasing power, Britain will import goods of Groups I and II, and Japan will import goods of Group III. Therefore forces which tend to raise the exchange rate and forces tending to lower it will operate simultaneously. If both forces are strong, exporting and importing between Britain and Japan will be carried out under comparatively stable exchange rates. However, in the areas where lifestyles are very different as between Britain and Japan, British people will import almost no goods of Group II even if the terms of trade are favourable, and Japan will hardly import any goods of Group III. Only goods of Group I will be exported and imported, and in that area Britain alone will be the importer. The price of the pound is likely to fall quite markedly, but as long as the purchasing power relations of (I), (II) and (III) continue and the Japanese lifestyle does not change and thus generate a large demand for goods of Group III, JapaneseBritish trade will remain one-sided for a considerable period. However, a continued decline in price of the pound, p#/£, will eventually violate the conditions (I) and (II). Trade war For the above discussion we have generally ignored elements in the international balance of payments other than the balance of trade. However, the international balance of payments is made up of trade and non-trade balances of payments, the international balance of payments of capital account, and that of cash account. Thus what governs exchange rates is the entire international balance of payments excluding its cash accounts, and certainly not merely the balance of trade. Consequently, as in Britain for example, where the balance of trade is bad but the country is one whose non-trade balance of payments and capital account are comparatively good, the exchange rate for that country's currency (pound) will be fixed at a comparatively high rate (that is, at a value higher than the rate for the pound which would bring the balance of trade into equilibrium). As opposed to this, in countries

128

Determination of foreign exchange rates

like Japan and West Germany with poor non-trade balances of payments and weak capital accounts, the yen and Deutschmark exchange rates tend to be set rather low. Industry in countries where the exchange rate is comparatively high will tend to have poor export competitiveness, so effective demand from abroad will tend to be inadequate, the employment level will be low, and the unemployment rate will tend to rise. By contrast, countries whose exchange rate is comparatively low will be able to export competitively and will have low rates of unemployment. Considered in this way, we can see that the fact that a country's trade and employment are depressed may not necessarily be due entirely to those working in export industries (employers and workers). Where the country has, relative to its export sector, disproportionately strong shipping and insurance industries and holds a large volume of overseas capital, the pressure of a comparatively high exchange rate will come to bear on those in its export industries. Seen from this viewpoint, trade disputes are not collisions of interest between the trading sectors of the various countries involved, but discord between a particular country's trading sector and its shipping industry and insurance industry, as well as its overseas investment sector.

6 The futures market The inevitability of forward trading

As in other markets, the foreign exchange market has spot (actuals) and forward (futures) markets. Since with overseas trade in particular there is quite a gap between the despatching of a commodity and its arrival at its destination, it is normal for payments for imports and exports to be made through the futures market. For example, when a Japanese exporter a who has made an export contract designated in yen completes the shipment of his goods, he will at the same time draw or issue a foreign exchange collection bill, with Tokyo foreign exchange bank A as recipient, which specifies that 150 days after the time the shipment is made the London importer b will make payment. He will then take it along to bank A together with the shipping documents. A will then send it with the shipping documents to bank B in London, and 150 days after the shipment was completed B will hand over the foreign exchange collection bill, together with the shipping documents, to b in exchange for payment in sterling. B will then convert this sterling into yen in the foreign exchange market and remit it to bank A in Tokyo. Given this mechanism for making payments for foreign trade, if there

The futures market

129

were only a spot market in foreign exchange, payments for goods would have to be made by one or other of the following methods. (i) Bank A will calculate the pound equivalent, at the exchange rate of that day's spot market, of the amount of yen a is due to receive in payment from b. Bank A will then get a to draw (issue) a bill of exchange for the same amount of sterling, and will then purchase this bill with yen. One hundred and fifty days later bank A will get the amount of yen obtained by converting into yen on the spot market the pounds received in exchange for this bill. (ii) The second method is where bank A takes charge of the bill of exchange designated in yen which a has drawn (issued) for 150 days, and then when this period is up b will convert yen to the value of the bill of exchange into pounds on the spot market and pay them to a. Lastly, (iii) bank A will buy up the yen bill of exchange issued by a, using pounds to the value indicated by that day's spot price. At the same time bank A will demand payment in pounds from b. In this case, b will not receive the imported commodities until 150 days later but must make payment for them in advance. By the first of these methods, bank A will either gain or lose depending upon the spot rate when the bill was accepted and the spot rate 150 days later. That is, the bank accepts the exchange risk. By the second method, the bank will avoid the exchange risk but b will have bought his goods at an undetermined price for the pound, and therefore importer b has to accept the exchange risk. By the third method neither trader a or b nor bank A will sustain an exchange risk; but since b receives his goods 150 days after the deal is made we should regard the third method of payment as a kind of variant of futures dealing. That is, unless the third method is adopted, either the trader b or the bank must accept an exchange risk by having the bill of exchange settled in the spot market. What happens then if the bill is settled in the futures market? Since the export contract was concluded in yen, exporter a has the right to receive a fixed payment in yen after 150 days. But if a were instead to obtain b's agreement that when the 150 days were up, b would pay to a a sum in pounds, at some mutually agreed rate of yen to the pound, which is the sterling equivalent of the sum in payment owed to a by b, then b will avoid the danger which stems from the fact that the future market rate of exchange between the yen and the pound is as yet undetermined, and hence uncertain. Moreover, the bank acting as intermediary merely has to ensure that the agreement concluded is carried out, and therefore

130

Determination of foreign exchange rates

it sustains no risk. Trading in futures consists of this kind of forward trading and the settlement of export (or import) deals where time elapses between the despatch and the receipt of goods normally takes place through the foreign exchange futures market. Premium and discount Let the spot exchange rate for pounds per yen be p £ / ¥ , and the exchange rate for 150-day futures be p£/ ¥ . These prices usually have a systematic discrepancy between them and this systematic difference between them depends on the level of interest rates in the two countries at the time. If we let the interest rate in Britain for a 150-day period be r£, and that for Japan in the same period be r ¥ , a person with m yen who changes his cash into pounds on the spot market and deposits these pounds is able to obtain h = (1 4- r£)/?£/¥ra pounds 150 days later. If, on the other hand, he deposits m yen in the form of yen and immediately sells the principal and 150 days' accumulated interest (1 + r ¥ )m for pounds on the futures market, he obtains 150 days later k = pf£/^ x (1 + r ¥ )m pounds, h and k must be equal, because if h > k, people will change the yen they have into pounds on the spot markets, and since it is more profitable to make deposits in pounds than yen, the supply of yen on the spot market will increase and the spot price of the yen against the pound will fall. Consequently p £ / ¥ will decline. By contrast, if h < k, then since it will be more profitable to make deposits in yen and to convert the principal and interest into pounds on the futures market, the supply of yen futures will increase, and the price of yen futures p£ / ¥ will fall. Thus eventually h = k, that is the following will become valid: = p $ / ¥ ( l + r¥)

(20)

If the value by which the futures price /?£ /¥ deviates from the spot price p £ / ¥ is positive, it is known as the premium, and if it is negative, it is known as the discount. If we consider the above equation, then ty¥ " P£/¥ -

1 ~r r^

and therefore the premium will be proportional to the difference between the British and Japanese rates of interest. However, this kind of equation will be valid only in the case of certain special expectations regarding prices. A person who has m yen can, rather than changing them into pounds on the futures market and depositing the pounds for 150 days, instead deposit the yen as they are, and 150 days later can change the principal and interest into pounds on the spot market. The spot pound price per yen 150 days later can only be

The futures market

131

anticipated at present. If we let the anticipated or expected spot price be /?!/ ¥ , the person who has changed yen into pounds by such a method may 150 days later be able to have; = p\j ¥ (1 + r ¥ )m pounds. If such ay is larger than k, that is if / = p | / ¥ ( l + r ¥ )m > k = /?£/ ¥ (l + r ¥ )m, people with yen will judge it more profitable to change these yen into pounds later on in the spot market, rather than change them into pounds now on the futures market. Therefore, converting in sterling futures will disappear (the demand for pounds futures will decrease) and the price of pounds expressed in yen (that is, p^/£) will fall, and therefore /?£/¥ will rise. By contrast, if/ is smaller than k> /?£/¥ is likely to fall. Price expectations depend on the individual and whatever information mechanism develops not everyone will view the future in the same way. For one group of people j> k, and they will behave so as to raise Pfi/y above the value set by (20). Another group of people for whom j (i + ;,) 2 (i + ;,) 3 Putting k = 1/(1 + ib) we get v = £1 x (k + k2 + A:3 + . . . ) = £1 x =— \-k ib Bearing in mind our definition of yield ib(ib = £l/pb) it is clear that pb = v.

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The modern industrial society

annual yield on bonds held in perpetuity. This will in our model below be termed the long term interest rate. Since bonds can be transferred at any time there is the yield appropriate to holding for a limited time, i.e. the short term or medium term (or more generally n period) interest rates. Let us now suppose that bonds are held for one period only and are sold on the bond market in the next period. Since the sales value of bonds has not yet been decided in the current period any estimated price can be no more than a prediction. Assuming now that the expected sales value is p'b, when the bonds are sold in the next period interest (of £1) will have by then been acquired; therefore when a bond of the current value pb has been held for one period and disposed of at the start of the next period, its short term rate of return ix will be given by the formula Pb

Where the same bond is held for two periods and is disposed of in the period after next (with an expected sales value of p"b), it will get interest of £1 at the beginning of the second period and at the beginning of the period after that. If bonds are bought by the first interest of £1 which is obtained at the beginning period, one can buy \/p'b units of bonds, and if they are kept for a further period and then sold they will be sold at P'blp'bi w ith additional interest of l/pb. Moreover, one unit of the bond originally held will be sold at p"b in the period after next, producing interest of £1. For that reason if bondholders dispose of their bonds in the period after next they will get a total sum of i.e. ( Thus where a bond is held for two periods the yield per period i2 is supplied by the formula

Here the first item on the right-hand side is 1 + iu the second is 1 + /,' (i[ is the expected yield where a bond is held for one period from the second to the third periods). This means that Similarly, when a bond is held for period n the yield in is given by (1 + !„)» = (1 + I,) (1 + i{) (1 + *',') . . . (1 + ,V» " »)

Equilibrium on financial markets

173

This means that the yield over period n is given by the yield in the short term and its expected values. Thus the various long and short term yields are tied to each other. In particular, when the short term yields are expected to be constant to each other (i.e. when il = i[ = i'[= . . .), the yields on bonds will be equal to each other regardless of how long they are held (i.e. ix = i2 = . . . = /„ = . . .)> a n d will in turn be equal to The interest rate on time deposits id will normally be lower than the yield on bonds it held during the same period, but the difference between the two must be neither too great nor too small. If it is too great (i.e. if the interest rate on time deposits is too low) rentiers will try to hold their surplus not in the form of deposits but in the form of bonds. The price of bonds pb will rise (therefore their yield it will fall), and deposits will decrease; so the city banks will try to borrow from the central bank (hence the official rate of interest will rise, resulting in a rise in the interest rate on time deposits). If, by contrast, the difference between it and id is too small, banks will get no profit from lending the funds they have amassed to enterprises by purchasing company bonds (and, in fact, with such a difference they cannot pay their administrative expenses). Consequently banks cease to engage in the purchase of bonds and as a result pb falls and yield it increases. If, furthermore, the banks' purchase of bonds decreases, their demand for advances from the central bank also falls and the official interest rate falls as well. This then results in a fall in the interest on deposits. In this way the difference between /, and id must be of an appropriate magnitude, but what is an appropriate magnitude of difference depends on (a) the city banks' administrative expenses required for being entrusted with one unit of time deposits and using it for the purchase of bonds (the difference between it and id must at the very least cover these expenses) and (b) the elasticity of time deposits with respect to the interest rate (i.e. if id should fall what proportion of their deposits will rentiers try and convert into bond holdings) as well as other factors. The smaller the amount of bonds bought, the greater the cost attendant on the purchase becomes per each unit. By contrast in the case of time deposits the cost of entrusting the banks with an amount of money does not get higher even where very small sums are involved. Thus where a balance is small it becomes time deposits, and where it is large it tends to be held in the form of bonds, but if the differences in interest rates between the two gets larger, it covers the difference in the two costs, so that small denominations of time deposits will more and more be changed into the form of bond holdings. It is thus the difference between the cost attendant on dealings in bonds and that required for

174

The modern industrial society

time deposits which decides the interest-rate elasticity of rentiers' time deposits. The yields on various financial assets must in this way fulfil mutually appropriate relative conditions, and not only that, their absolute level must retain an appropriate level in terms of its relationship with money.31 Money (whether cash currency or deposits currency) is not interest bearing, or even if it is the rate is very small; but it has instead the advantage that it can be used at any time. Thus if the yield on bonds and other items is too low, people will think that it is not worth losing the convenience of money for this kind of low yield; they will stop holding their balances in the form of bonds and convert them into money. Conversely, if yields are too high money will be changed into bonds. Not only that, interest rates must keep to an appropriate relationship with the foreign exchange rate, just as we have seen in section 6 of Chapter 4. For the yield on eachfinancialasset to fulfil these kind of relative and absolute conditions, it is necessary for the central bank and the exchange stabilization fund to conduct delicate market operations in the bond market and the foreign exchange market respectively, so as to hold the official interest rate and the exchange rate at appropriate levels. Each of these various kinds of financial assets can to a high degree be substituted by another, and demand and supply react sensitively to small differences in yield. The smooth operation of the financial market is like manipulating a fighter with acute rotational performance, and the slightest failure to control the joystick can result in disaster. Determination of prices Finally, we will look at the way in which prices pu p2 of consumer and 31

However, this 'appropriate level' is likely to be different depending on whether or not there is inflation. The rate obtained by subtracting the anticipated rate of price increases from the rate of interest on time deposits (or the yield on bonds) is termed the real rate of interest on time deposits or the real yield on bonds, but when the expected rate of increase in prices is very high such real rates or yields will either have a low value, or, in extreme cases, a negative one. Hence those holding time deposits or in possession of bonds become virtually non-existent; such people are likely instead to invest in land or property, for example, or in stockpiling. Thus a rate of interest on time deposits or a yield on bonds which may have been at the 'appropriate' level at a time when there was no inflation, ceases to be appropriate the moment inflation appears. The choice of whether to hold savings in the form of cash, bonds or time deposits, will depend on the yield on bonds and the rate of interest on money, but the choice of whether to hold savings in the form of financial commodities, such as cash, bonds, or time deposits, or in the form of land, property, stocks or other physical commodities, is likely to depend also on the rate of price increases or else the expected rate of such increases. Therefore the demand for cash balances on the part of individual and enterprises U (;' = w, e, r, i) is a function not only of the rate of interest and the yield but also of the rate of price increases (or the expected rate of such increases).

Equilibrium on financial markets

175

capital goods are determined. As has already been mentioned on several occasions, prices are calculated according to the formula of the full-cost principle; the mark-up rate ra, which we have up to now regarded as given in the calculation process, in fact differs in size according to the level of interest rates. It may, at first sight, seem that m is decided by each enterprise individually. However, an enterprise which calculates its prices using a mark-up rate which is too high is forced to sell its own products at a high price; so it will either be outdone in competition or will have no choice but to use a smaller m. Thus competition pushes down m to a limiting value which is fixed in accordance with the level of interest rates. That is to say when m drops below its limit an enterprise will choose to go out of business, investing its operating capital in the purchase of bonds or in time deposits, rather than continuing to operate and receiving profits with m at a low level. This, therefore, results in either excess demand for bonds (whenp^ rises and ib falls) or in an increase in city bank deposits (in which case advances from the central bank decline and the official interest rate and rate of interest on time deposits id both fall). Whatever the case, a smaller m is only compatible with lower interest rates. We can below write the relationship between the interest rates and the mark-up rate as m = m(ib, id)

(15)

If we look next at the depreciation reserve, let us assume that each unit of capital goods uses up its 6 x 100% each time one unit of product is produced. To produce one unit of consumer goods (or capital goods) a4i (or a42) of capital goods are used. Since each of these consumes 6 x 100% of a41 (or a42), each time a unit of consumer goods or capital goods is produced,32 then the price p4 of the capital goods consumed in terms of wear and tear must fulfil the relationship P4=0p2

(16)

If we substitute (15) and (16) in the equations for determining prices we get 32

The rate of wear and tear of capital goods used in the production of consumer goods is not necessarily the same as that of capital goods used in the production of other capital goods, but for the sake of simplicity it will be assumed below that both are equal. For administrative reasons of taxation the statutory rate of depreciation allowance is determined for capital goods over a single period, but it does not necessarily reflect actual technical capital wear. However in order to calculate the average cost which constitutes the basis for calculating the price of its products, and in order to calculate the amount of depreciation for which money must be set aside for the renewal of capital goods in the future, an enterprise has to make up cost accounts which are based on actual technical wear and tear.

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The modern industrial society

px = (1 4- tx) (1 + m(ib9 id)) (wa3l + p20a4l + rpla5l)

(17)

P2 = (1 + '2) (1 + rn{ih, id)) (wa32 + p26aA2 + rp5*052)

(18)

In these formulae the rates of indirect tax, tu t2 are policy variables determined unilaterally by the government, p* is determined by foreign markets, r by the foreign exchange market, while m is obtained when the interest rates are determined in the financial markets. Furthermore 0 and atj are fixed numbers determined according to the technology of production. Thus if the wage rate w can be given as well the capital goods industry will determine product prices p2 so as to fulfil equation (18), and the consumer goods industry will calculate its cost of production on the basis of that p2, and determines its own prices px after adding to it profits and taxes (equation 17). When the price of each good has been decided in this way, the demand for consumer goods on the pa'rt of workers, entrepreneurs and rentiers is determined. Exports, on the other hand, are determined by foreign demand, while government demand Gx is determined as a matter of policy by the government. Output is regulated so as to be equal to the sum total of these demands. Similarly the output of capital goods is determined to make it equal to l2 + E2 + G2, where investment demand I2 as well as foreign demand E2 and government demand G2 may be regarded as given. The interest rates and the foreign exchange rate are determined on the financial markets and the foreign exchange market respectively, but the level of the interest rates and the exchange rate are largely dependent on the volume of bond purchases 8BC and amount of lending 8QC by the central bank, and on the exchange stabilization fund's purchases of foreign currency Df, both of which are determined as matters of policy. As has thus been seen, our system includes many policy variables. Tax rates tu t2, tw, te, tr are, first of all, determined by taxation policy, while government expenditure G1? G2 is determined by fiscal policy. 8BC is determined by the bond purchasing operations of the central bank, 8QC by lending policy, while Df is determined by the exchange stabilization fund. Given that these policies have been decided, once enterprises' investment plans have been decided, as long as the wage rate w is given, all other economic variables are determined according to our model. That is to say prices are determined by the mark up principle, output by the principle of effective demand, and the interest rates and the exchange rate by the law of demand and supply in competitive markets.33 33

This system is an extension of the conventional IS-LM model described in Additional Note g.

Is full employment possible?

1 The labour market

The ethos of the people and the labour market The labour market is where dealings in labour service are carried on. Labour service, unlike a normal commodity, cannot be stored. That labour which for any length of time whatsoever has been unemployed or squandered on enjoyment has been lost in perpetuity. Moreover labour service has to be furnished by people; there is no such thing as labour without people. Consequently a labour contract for the supply of 'prescribed labour over a fixed period of time' is essentially something restricting that worker during that period, and a bad labour contract is bound seriously to harm the freedom of the individual. For example a labour contract which engages 'to work for one's whole life for a certain individual (or for a certain company)' must essentially be regarded as something very close to a contract for the purchase and sale of slaves, and not merely as a contract governing the purchase and sale of labour service. In the case of the selling and buying of slaves not only does the payment for the sale of the slave's body not go into the hands of the slave himself, but a slave has no freedom even outside his working hours. If instead that payment was to come into the slave's own hands and with it he became a free slave, free to spend his private life as he wished outside his working hours, there would be no difference between such a free slave and a person who, while selling his own current labour service on the spot labour market, at the same time sells on the futures labour market any labour service he may offer in the future. The difference between a free slave of this kind and some kinds of worker e.g. workers in the lifetime employment system and professional athletes - is minimal. Since modern capitalism must not embrace elements of slavery even in the smallest degree, great care must be taken in organizing the labour market so as to prevent such elements from emerging. First of all, because workers must be completely free individuals, all labour contracts which restrict the freedom of the worker are illegal. 177

178

Is full employment possible?

Therefore even where there is a lifetime employment system there must be nothing akin to a legal enforcement of lifetime service for the worker. Even where an employment contract has been agreed on the understanding that an employee will continue to work over a long period, the worker must be free to resign if he should submit his resignation. If this were not the case the worker's right to freedom of occupation would be violated. Therefore while there may be a lifetime employment system the system is not enshrined in law, and anyone who deviates from or goes against this system is only going against a social custom whose contravention leads to no worse than moral censure and economic disadvantage. For that reason this kind of labour custom is not prevalent in societies which put their trust only in legally guaranteed contracts; moreover in societies where individuals in contravention of such customs (i.e. individuals who have left a company midway) are not subjected to social censure on the grounds that they have shown insufficient loyalty towards their company, lifetime employment systems are not common, even as a custom. Similarly, as far as the employer (entrepreneur) is concerned, as long as the economy within which he operates is a free enterprise system, his freedom of management must be preserved. Consequently labour contracts whose provisions would contradict his freedom to manage are acceded to only as matters of mutual understanding, and such contracts are, strictly speaking, entirely unlawful. One labour market of a certain specified type may be approved according to the historical environment, national ethos and perception of values of the people, but under a different historical environment it would completely lose all its support, and would not be able to function. For English workers believing their occupation to be their God-given destinies, loyalty towards their occupation takes precedence over all other things (for example over loyalty to the employer).1 In a society such as this electricity workers regard it as their calling to sell their labour on the labour market for electricity workers, so feel no guilt at changing to one employer after another, and they continue to supply labour service as electricity workers on their own specific labour market. They closely resemble workers in Japan before modern capitalism was firmly established. If, by contrast, one takes a modern Japanese worker (for example an electricity worker) who regards his company as the master he must serve, and who believes that he must love his company in the same way as he would love his country, his prime object of concern is whether or not he will be able to continue to give his labour to 1

As has been pointed out by Max Weber, this kind of religious sentiment is well expressed in the word 'calling' used in English to refer to an occupation.

The labour market

179

the enterprise to which he belongs, and as long as he continues to work for that company he will not mind in the least if the kind of work he does there changes a bit. For that reason a labour market for electricity workers in the sense of electricity workers appearing as suppliers of labour on the one hand and various companies seeking to employ electricity workers on the other, i.e. a labour market where supply and demand confront each other, is not really very developed in Japan. Japan has instead developed what might be called an intra-enterprise market, which means that on the one hand all the employees of an enterprise present themselves as suppliers of labour, and on the other the enterprise demands from them various types of labour. Each enterprise has its own synthesized labour market. Where such a labour market as this operates labour unions are likely to take the form of enterprise unions, as is in fact the case in Japan, while where the labour market is of the English type there is a tendency for labour unions to become trade or industrial unions. As has been made clear by Max Weber and others, the fact that British people have a strong loyalty to their occupation rather than the enterprise for which they work, while the reverse is true of Japan, has something to do with the religions of the two peoples. Therefore the structure of the labour market becomes in the final analysis dependent on the religious perceptions of the people. Whatever the case the labour market is conspicuously a product of history and is without doubt a very 'human' market. 2 The basic structure of the labour market in modern industrial society The structure, constitution and function of the labour market thus differ tremendously from country to country, but despite this it is an undeniable fact that the labour markets of all modern industrial countries possess a common fundamental structure. That is to say labour can be divided into regular labour which is in demand not just once but repeatedly, day after day, and temporary labour which is in demand on only one occasion, or seasonal labour which is required only at certain periods during the year; the labour which constitutes the main force in industrial society is regular labour in need of systematic work. Therefore a worker who is today working in a certain factory can expect to be employed there tomorrow as well, as long as he does not possess any serious shortcomings. Consequently we have a situation where there is within each factory (or each company) a labour market where the 2

Weber, M. The Protestant Ethic and the Spirit of Capitalism, London, George Allen and Unwin, 1978; Morishima, M. Why has Japan 'Succeeded'?, Cambridge University Press, 1982.

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Is full employment possible?

workers employed by that factory (or company) constitute the suppliers of labour and the respective factories (companies) are providing the demand for labour (i.e. an internal labour market); in these markets labour contracts are not operative on a daily basis, but are valid for longer periods of time - weeks, months, years or even several years. Since in this sort of labour market contracts are valid until a specific point of time in the future, it becomes a kind of futures market and the wage rate decided upon there is fixed throughout the term of the contract. In this way the dominance of the internal labour market in the labour market as a whole contributes to a lack of flexibility in wage rates over a certain period, but in the supplementary labour market outside there is a certain degree of flexibility in wages. Factories and companies cannot secure all the labour they require from the internal market. Enterprises do not necessarily always operate on a fixed scale, and there will always be some enterprises which are expanding while others are contracting. Expanding enterprises will have to recruit labour from outside the internal market, while those reducing their scale of operations will be forced to release workers whom they have hitherto been employing outside the internal market as unemployed. Apart from this enterprises will also have to employ new workers to replace those workers who have left because they have reached the age of retirement, or for other reasons. There is in addition, the demand for labour from newly established enterprises. Demand for labour from such quarters appears on the labour market which must be used in search of labour outside the internal market, what we will now call the general market. Suppliers of labour in this market comprise such people as individuals who have just left school or college, the unemployed and those who are currently employed with one enterprise but who wish to move to another. In some cases these suppliers of labour compete on equal terms to find employers on the general market, while it is also frequently true that they are differentiated from each other and the general market is subdivided into more segmented markets. In the case of England, for example, where an enterprise is seeking to purchase on the general market a labour skill of a specified quality those possessing that skill must compete on an equal basis regardless of whether they have just left school, whether they are unemployed, or any other such conditions. In the case of Japan, where an enterprise is purchasing not only the skills of a worker, but also his loyalty to the enterprise,3 an individual who 3

Morishima, M. op. cit. pp. 117-28.

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181

claims that he wishes to move to another enterprise because he is not satisfied with the one at present employing him is at a very great disadvantage compared to a recent school or college leaver who remains as yet 'untainted'. The market for school or college leavers is quite distinct from that for the unemployed and movers from one firm to another, which is in turn distinct from the market for temporary workers. In the market for temporary workers, the demand for very short term, irregular labour is met by those who require seasonal work, students and the long term unemployed. The demand for the labour of school and college leavers is communicated to those intending to graduate or leave school through their respective educational institutions, and supply is adjusted to demand through the medium of the company entrance examination. (Alternatively, when the supply is small the demand is left unmet.) In contrast to this the demand for the labour of the unemployed and those transferring from one employment to another and the willingness of these people to make their labour available are communicated to each other through the mediums of employment agencies and individual personal connections. In Japan the unemployed and those moving from one job to another are normally employed to a greater or lesser extent merely on a supplementary basis. For that reason their position within the enterprise labour union after their unemployment is low, therefore the assistance they receive from the union will also be small. In the market for school and college leavers where it is not a worker's skill but his loyalty which is being purchased, the question of what level and what kind of skill the suppliers of labour possess hardly comes into consideration; the main criteria by which the employer determines success or failure in the company entrance examination are the applicant's desire to acquire skills and the latent ability he or she might possess. In the market for the unemployed and transferring workers, by contrast, an employer will be looking not for loyalty, but rather for skills, so this market will be subdivided on the basis of each specialized skill on offer. Also, in a society such as Britain, where the skills possessed by a worker become the main criterion for a decision whether or not to employ that worker, it is natural that the general labour market, as manifested in such places as Jobcentres, should be subdivided into various sectors on the basis of skill, but in an economy such as this the dividing line between the internal labour market and the general labour market is not a very considerable one. Individuals supplying labour on the internal market always have an eye to the situation on the general market outside as well, and if they see a good opportunity will

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Is full employment possible?

present themselves on the general market as individuals wishing to change employment. Flexibility of wages

As was said before, in the labour market in a modern industrial society any treatment of workers in the manner of slaves is as far as possible avoided, so there is a ban on all acts reminiscent of the auctioning of slaves, horses or cattle. Consequently the sale and purchase of labour by auction is never undertaken, and even where employment agencies act as intermediaries in putting those seeking employment in touch with available work considerable attention is paid to keeping in mind the characteristics and desires of the individual. Public employment agencies try to introduce the right person to the right job, trying to preserve both the worker's freedom of choice of work and the employer's freedom to employ, and standing midway between worker and employer, siding with neither and acting in a neutral manner. However, agencies are not the only intermediary organizations. In each enterprise the personnel section is also likely to engage in its own labour-seeking activity, and in such cases will undertake positive recruitment measures through newspaper advertisements or personal connections. Out of those who apply the employer select those he regards as most qualified. This method of selection is in essence a cross-trade; the supply of and demand for labour are brought together not by changing wages but by regulating its volume. The demand side for labour is not likely to revise fundamentally the wages which were announced in the first place during the process of seeking employees. It may on occasions modify the wage rate to a greater or lesser degree in response to the wishes of applicants, but a drastic change is out of the question. Even where the number of applicants exceeds the number of vacancies, neither the enterprise nor the applicants will try to bid down wages, and even in the reverse case any bidding up of wages - at least after the selection has already started - is as a rule avoided. It is essentially a regulation of volume, where applicants in excess of the number of vacancies are thrown out, and, where vacancies exceed applicants, the attempt to fill the vacancies which remain is abandoned. Where labour is in short supply and enterprises have been unable to secure all the labour they need they are likely even after that to continue to make efforts to fill their remaining vacancies. Since they will once again be unable to find suppliers of labour if they have only offered the same wages as before, enterprises will almost certainly offer wages higher than the previous ones. However, though an enterprise may be able to fill its vacancies by doing this, if it should become clear that there

Labour unions

183

is a disparity in wages between the workers who were recruited initially and those who entered the company subsequently, those new members of the company who entered it first are likely to call for equal treatment and to demand a rise in wages to remove the disparity. Furthermore all those workers who entered the company in the past will start to agitate for an increase in wages. If the enterprise should accede to such an across the board rise in wages it will have no choice but to increase the price of its products. Should it do this, demand for its products will then decrease, which will provide a severe blow to the enterprise, so rather than all this happening the enterprise is more likely to choose the alternative of leaving its vacancies unfilled. Therefore even where the demand for labour exceeds its supply wages will not rise and the excess demand will remain unmet. Thus regardless of the existence of an excess demand for or supply of labour there is no outward change in the money-wage rate. In that sense wages are inflexible upwards and downwards. Nevertheless in real terms (i.e. if we bear in mind the quality of the labour which is being secured) wages are flexible. By this we mean that when labour is in excess supply and unemployment is high the recruitment side is able to take its choice of the available labour, so that only good quality workers will be employed. Conversely when the demand for labour is increasing and the supply is tight enterprises will be forced to employ even the lower quality workers. Therefore, the wages which are to be paid per unit level of quality of work are low at a time of high unemployment and high at a time when unemployment is low. 2 Labour unions Trade unions and relative wages

We have already said that the structure of the labour market differs greatly according to whether the object of loyalty which the worker must serve is his occupation or his enterprise. Let us now call a society where the mainstay of a worker's morality is his loyalty to his occupation, a British type of society, and one where loyalty to the enterprise is the worker's supreme ethical virtue, a Japanese type of society. These societies possess labour markets whose structures are respectively as follows. First of all in a British type society there is hardly any barrier between the internal market within each enterprise (the market where contracts for the labour of those already employed by the enterprise are renewed) and the general market (that for school and college leavers, those who wish to change their employment and those who are unemployed).

184

Is full employment possible?

Moreover both the internal market and the general markets are subdivided according to trade. The internal labour markets in all enterprises for electrical workers for example, are tied up with the general labour market for all electrical workers, therefore for each individual electrical worker the question of what enterprise he should work for is hardly a problem. If he is dissatisfied with the enterprise which is currently employing him all a worker has to do is to move to another enterprise. It is, however, extremely rare for an electrical worker to change his occupation and to work in another kind of employment (for example as a miner). Where the structure of the labour market is of this kind electrical workers have to form a labour union consisting only of electrical workers, on either a national or regional basis; it would be senseless to form an electrical workers' union for each enterprise. Trade unions covering the whole nation do not serve the interests of workers of any specific enterprise in particular, so as long as they belong to that specific occupation those who are unemployed as well are qualified to be union members. Since labour unions are organized on the basis of their respective trades it goes without saying that in a society such as this each enterprise will have to negotiate with a very large number of labour unions. Wages are decided as a result of negotiation between each enterprise and the labour union, and the existence of labour unions with the characteristics described above contributes to the establishment of uniform wages over the nation as a whole. Labour unions are not so irrational as to ignore completely the management situation in each individual enterprise, so that there may be some differences in wages for the same trade in different enterprises; however, such inter-enterprise wage differentials are very small by comparison with those which can be found where there are enterprise labour unions, as described in the next subsection. Since, however, there is a difference in the bargaining power of the various trade unions, an occupation which has a powerful union will invariably negotiate successfully with the enterprise, and for that reason the members of such a union will always obtain more advantageous wages than those in other occupations. Consequently one matter frequently under discussion in societies such as this is whether the relative wages for different occupations are, in fact, fair or not. However, if the wages for a certain trade continue at a comparatively high level over a long period, then there will be a tendency to regard this situation as fair per se, so a movement for just wages is no more than a movement which supports the wage relativities which currently exist, and there is a tendency for relative wages, which reflect the real power of labour unions, to be upheld in the name of 'fairness'.

Labour unions

185

In such a society as this, therefore, if one labour union should be successful in raising its wages, then this will set in motion other labour unions as well, and they too will demand wage increases. This means that the movement for a rise in wages is easily spread from one occupation to another and brings about across the board wage rises in all occupations, though such rises cannot be said to be strictly commensurate with each other. Nor will the relative wages in various occupations be in proportion to the marginal productivity of the respective workers. Nor will they be in proportion to the degrees of scarcity of each kind of work. A significant influence in the determination of relative wages is also exercised by factors usually regarded as outside the field of economics, such as what sort of scale of strike can be backed up by the funds of the respective unions, the degree of leadership possessed by the leading members of a labour union, as well as how skilfully they are able to enlist the support of public opinion. And wages determined in this fashion become the norm for recruitment on the general market. Enterprise labour unions and wage differentials between enterprises Where each worker feels strong sentiments of loyalty towards the enterprise to which he belongs, once a worker has become employed he will very rarely move to another enterprise, so the labour market is subdivided on the basis of each individual enterprise. For such a society as this, enterprise labour unions are more appropriate than trade-based labour unions. Within each individual enterprise a union is formed which has as its members all the workers employed in that enterprise (or all those among them who are interested); wages for all the different occupations embraced by that enterprise are then determined as the result of negotiations between the enterprise and its union. Some enterprises possess in addition to their labour unions staff unions whose membership is the white collar workers employed by the respective enterprises, while other enterprises make no distinction between workers and staff members and have only a single employees' union where both groups can become members on an equal footing. In cases such as this the union participates in the determination of the salaries of white collar employees as well, negotiating on their behalf. An enterprise labour union (or staff union or employees' union) of this kind is not involved merely in the determination of wages and salaries, it also has a significant interest in promotion within the enterprise, and there is a tendency for the relative wages of a worker to depend on his position within the enterprise rather than on the occupation of that worker. Temporary workers, retired workers or those made redundant as a

186

Is full employment possible?

result of personnel retrenchment are in principle lacking the qualifications to become members of an enterprise union. Such enterprise labour unions frequently come together on the basis of industry to form national union councils and pursue a joint campaign, but during such a struggle the individuality of each individual union remains dominant, which means that it is not difficult for considerable wage disparities between enterprises to appear.4 As has been said, we cannot decide what sort of relative wages are fair between different occupations (e.g. miner, train driver and automobile worker), and there is ultimately a tendency to regard as fair wages those relative wages which have historically prevailed over a long period. With regard to relative wages between enterprises, however, there, is one universally acceptable perception for deciding what sort of relative wages are fair. That is to say, what could be termed fair is for the relative wages for the same work offered by enterprise A and enterprise B to be 1:1. Despite this, where each enterprise decides wages as the result of negotiation with its own labour union, relative wages for the same work in different enterprises often deviate considerably from the 1:1 standard.5 Thus under the enterprise union system notable wage disparities tend to exist between outstanding enterprises (large enterprises) on the one hand, and enterprises where business is poor (medium and small enterprises). Since those enterprises which can pay only low wages are unable to ask loyalty of their employees, the internal labour market of these enterprises is unable to construct an effective barrier against the outside, and workers in these enterprises will easily change their jobs when it is advantageous for them to do so. They present themselves on the general market used by the unemployed and other workers changing from one job to another, and mutually compete for wages which are, even just a little, higher. However, the workers who appear on this sort of market are those who are excluded from any enterprise union, so they receive no union protection whatsoever. For that reason this market is completely a buyer's market. Employers offer extremely low wages calculated on the basis of wages offered by not very prosperous enterprises, and those suppliers of labour who have not been able to get 4

5

Professor Peter Wiles' comparison of Japan and Yugoslavia has revealed that there is a tendency in countries where enterprise unions exist for there to be very large wage differentials between enterprises regardless of the nature of the system; it makes no difference whether a country has a free enterprise system or whether it is a socialist country. Concerning this point see Morishima op. cit., p. 174. This demonstrates that relative wages depend very greatly on the enterprise's management situation and the power of the labour union. Similarly where craft unions exist relative wages depend largely on the strength of each individual craft union. As a result they are far removed from any ratio of the pure marginal productivities of each occupation.

Labour unions

187

themselves selected are thrown out. On the general market for school and college leavers enterprises offer wages in line with those agreed to by the labour union in their respective internal markets. For that reason the wages of those who have been able to gain employment with the best companies are high, while those who have only been able to gain employment with the less prosperous enterprises will receive very low wages. Those who have been unable to obtain employment with any enterprise will become unemployed and enter the general market for the unemployed and those who wish to change their employment. Here they will be forced to compete with others for work which is, to say the least, unattractive. The latent tendency towards slavery in modern society Whether in a society like Japan or in one like England, the role played by the labour union in wage determination is a considerable one. A union which is low in funds cannot commence a strong strike, and ultimately will be forced to give way to pressure from capitalists and management. Even a union which possesses ample funds to make it strong enough to continue a strike over a long period will not only lose the support of public opinion but may even tend to find that its own membership is split into factions at odds with each other if the union leadership is excessively aggressive. An enterprise depends for its success not just on its strength in terms of capital; it also depends greatly on such characteristics as the resolution of the entrepreneur, on his leadership and on his administrative and managerial ability. In exactly the same way a labour union's success or failure in winning good wages could without exaggeration be said to be tied up with whether or not those at its head offer outstanding leadership. Moreover a first class union president will make his name as an entrepreneur as well. Consequently any enterprise which possesses its own union is likely to regard intra-company conflict between the union leadership and management divided into two camps - labour and capital - as a waste of the valuable commodity of leadership capacity. Seen from this point of view, the fact that in many Japanese enterprises the president and directors look for their future president among the union leadership ceases altogether to be a strange 'Japanese custom'. The participation of the union leadership in the enterprise's management meetings which takes place in West Germany must also be seen not just as a sop to workers but as an effective means of making the most of their leadership ability. It is a fact that the lives of workers have been conspicuously improved through the power of labour unions, but despite this under the surface

188

Is full employment possible?

workers remain in just as much of a weak position as they were before. Because workers have no means of living other than by working for wages, they are in a very disadvantageous position, and may be forced to put up with unfair, low wages. Although in modern industrial societies great efforts have been made to try and sweep away the residue of the 'slave market' from the labour market, there is no change in the fundamental characteristic of capitalist society whereby the capitalist side is in a favourable position to impose low wages on the worker. In a society like England a low level of unemployment means that the capitalist is in a less advantageous position, and even inferior workers have a considerable chance of being employed at the wage demanded by the labour union; when the unemployment rate is high, however, only the best workers have a considerable chance of employment, so unions are likely to be unable to demand high wages. In a society like Japan, however, there is no assistance from labour unions in the general labour market for the unemployed and those wishing to change their employment, so only very low wages are on offer. Even though it may be something of an exaggeration to do as Marxists do and designate modern factory workers as semi-slaves, it is a fact that, in modern society, just as Marx pointed out, while workers may be legally free they remain no more than individuals who are compelled to work, in the final analysis by the iron law that 'he who does not work must not eat'. That this kind of latent tendency towards slavery does not apparently become an observable tendency in present-day society is due to the provision of unemployment benefit based on a system of social security. 3 Unemployment (I): Marx

Kinds of unemployment Unemployment is usually categorized as one of three kinds on the basis of the reasons behind it. These are frictional, cyclical and structural unemployment. As we have already seen, the unemployed gain information on job vacancies through such media as employment bureaux, newspaper advertisements or talking with acquaintances. Consequently information concerning the situation vis-a-vis vacancies in a different region is hard to come by quickly, and even if such information is obtained employment opportunities are frequently let slip on the grounds of factors such as inability to prepare for moving or family circumstances. However, unemployment resulting from this sort of reason would, given time, probably gradually disappear. Information regarding vacancies would eventually be passed on to a large number of people, and some of the unemployed would become sufficiently pre-

Unemployment (I): Marx

189

pared to move. For this reason this sort of unemployment is called transitory, or frictional unemployment, and with an economic theory which supposes an ideal situation without any friction, such unemployment can be either completely ignored or left undiscussed. Cyclical unemployment is that which is produced when business is bad, and is largely removed when the upturn comes. Structural unemployment is that resulting from a change in the structure of the economy. It includes unemployment based on such changes as, for example, a reduction or total disappearance in the demand for a certain kind of labour due to the appearance of a labour saving machine (e.g. robots), workers becoming redundant due to the exhaustion of natural resources (e.g. miners and coal), or the decline in the demand for agricultural workers as a result of the progress of industrialization. Unemployment resulting from the loss of overseas markets and the extension of monopoly are also categorized as structural. Furthermore where there exist large disparities in wages between enterprises or between industries, there will exist in one part of the economy individuals who work for very low wages; such individuals are working because they have to do so to stay alive, but must really be regarded as unemployed rather than employed. This kind of half-employment half-unemployment is called disguised unemployment.6 Three views of unemployment: Marx, Keynes and the classical school We shall below disregard frictional unemployment, and for the purposes of our analysis of unemployment divide it into the three following kinds. First of all we have unemployment originating in insufficient machinery and capital equipment. Since people originally had no machines and began to produce things with their bare hands, it is possible even today to produce goods using only labour which almost exclusively uses primitive methods of production. In a modern industrial society, however, if an entrepreneur no longer has machinery he no longer needs labour.7 As long as there is capital (taken below to include both 6

For disguised unemployment see, e.g. Robinson, Joan, Essays in the Theory of Employment, Oxford: Basil Blackwell, 1947 (2nd edn); Nurkse, Ragnar, Problems of Capital Formation in Underdeveloped

7

Countries, Oxford: Basil Blackwell, 1953;

Morishima, M., The Economic Theory of Modern Society, Cambridge University Press, 1976. Also see Additional Note h for Keynes' voluntary unemployment. The relationship between machinery and workers in a modern industrial society resembles that between warships and sailors in a modern navy. If the warship should sink the soldiers are either saved and assigned to another ship, or are defeated; similarly a modern worker without machinery is either re-employed in a new factory possessing machinery or made unemployed. Workers can no more initiate the production of goods with their bare hands than sailors can swim to the attack on an enemy vessel.

190

Is full employment possible?

machinery and capital equipment), labour will be in demand, and the volume of capital in existence will determine the maximum limits of the demand for labour. For that reason, looked at from this point of view, unemployment comes into being because the amount of capital which exists is insufficient to provide work for all workers, and the accumulation of capital may be regarded as likely to remove unemployment if such accumulation should progress sufficiently. However, machinery is designed so as to require fewer workers to operate it the newer it is. That is to say the more advanced a machine is, the less its capacity to absorb labour, which means that the amount of capital sufficient to absorb all labour will be enormous and, therefore, will never be able to be accumulated. Unemployment resulting in this way from a shortage of capital, in the light of capital and labour being complementary, is known as Marxian unemployment (i.e. the reserve army of labour). However, an analysis of unemployment along these lines tacitly assumes that 'there exists sufficient effective demand to put to work all the capital which exists'. Yet it would be foolish to put to work all the capital which exists and produce up to a level where sales are impossible at a time when this sort of demand does not exist, so in such a case part of the capital is bound to lie idle. Simultaneously the number of workers employed will be reduced, and the rest become unemployed. That is to say unemployment will arise even where capital still remains to be used, as long as there is insufficient demand for goods. This kind of unemployment is Keynesian unemployment. On this occasion whether or not the demand for products is inadequate is determined by its magnitude relative to the size of the capital actually in existence.8 Where the given demand is such that even the full operation of all available capital will not fulfil it there will be excessive use of capital, production costs will mount and product prices will rise. Since immoderate use of capital means at the same time workers having to work outside their normal hours (either by overtime or by the introduction of night shifts), wages too will rise. The inflated demand will be absorbed by a rise in prices and the real volume of demand for products will be equated with the amount of output produced by the over-used capital, establishing an equilibrium in the product market. In contrast to this the classical school of economists regard unemployment as resulting from wages not being at their equilibrium value. Unemployment appears because the demand for labour is less than the 8

We will suppose, however, that there exists the right number of workers to operate all the capital in actual existence. Without this number of workers wages would begin to rise at the point of full employment, producing inflation, and the excess demand for products would be absorbed through price increases.

Unemployment (I): Marx

191

available supply and for unemployment to be zero the demand for labour must be equal to the supply. Since both supply and demand for labour are regarded as being functions of the price of labour (i.e. wages), wages must be regulated in order to balance supply and demand. Where wages are higher than the equilibrium value, demand will be below supply and unemployment will result. Unemployment is therefore a transitional phenomenon prior to a rationalization of wages, and is likely to disappear before long. Despite this the permanent and chronic existence of unemployment in the actual economy is attributed by the classical school to the fact that as a result of external stimuli affecting the economy from one moment to the next, the equilibrium value of wages is forever changing, and even if wages are adapted in accordance with this the speed at which adaptation takes place will be less than the rate at which the equilibrium value itself fluctuates.9 Preparations for analysis In this section and the following one we will attempt to analyse the three kinds of unemployment - Marxian, Keynesian, and that of the classical school - within the framework of our model of modern industrial society. To take Marxian unemployment first, we may write the equations for equality of demand and supply for consumer goods and for capital goods as Xx = D\ + D\ + D[ + Ex + Gj

(1)

X2 = I2 + E2 + G2

(2)

respectively. If we assume that the consumption expenditures of workers and entrepreneurs, pxDwu pxD\, are linear functions of their respective disposable incomes (1 - tw)W and (1 - te)allv/e obtain PiZ)ir = c w (l-r M ,)W + p1yM,, PiDi = ce(l-te)an

+ Plye

(3)

where cW9 ce are workers' and entrepreneurs' marginal propensities to consume, and yw, ye are the quantities of consumer goods which workers and entrepreneurs would demand if their incomes were zero. 9

The neoclassical school, which currently occupies the position of orthodoxy in the world of academic economics, has assumed the mantle of the classical school with regard to many fundamental points, including the question of unemployment; at the same time it has refined and modernized the theory of the classical school. For a classic exposition of neoclassical theory see, for example, Hicks, J. R., The Theory of Wages, London: Macmillan, 1963 (2nd edn).

192

Is full employment possible?

Throughout the following all these coefficients are assumed to be constant. In addition we have W = w(a3lXx + a32X2) + w(M + Nb)

(4)

all= am{cxXx + X )

where a, which is also assumed to be constant, represents the rate of distribution of profits to entrepreneurs. If we substitute (4) into (3) and then (3) into (1), we can write (1) as Xx = bxXx + b2X2 + ux

where bx = cw(l - tw) — a3X + ce(l - te)a ^

Pi

(5)

Pi

b2 = cw(l - tw) — a32 + ce(l - te)a — Pi Pi

(6)

ul = yw+ye + D\ + El + G1 + cw(l-tw)-(^

+ Nb)

(7)

Pi

In among these the demand for consumer goods of rentiers D[ depends on their disposable income, i.e. their after-tax interest income from the bonds and time deposits which they held at the beginning of the period, (1 — tr)(Ar + rBQ, so that it is independent of the output of consumer and capital goods during the period, Xx and X2. In the following it is also assumed that the government's and city banks' employment, N8, Nb, are zero. Therefore, ux is independent of Xl9 X2; similarly we may also regard u2 = I2 + E2 + G2

(8)

as independent of Xu X2. We shall below call uu u2 exogenous demand and the total demand including that part of consumption which depends on income, i.e. bxXx + b2X2 + ux and u2, the effective demand. The maximum level of employment which can be associated with a given capacity of capital equipment Marxian unemployment may be elucidated by solving the problem of what is the maximum amount of employment which can be created with a given stock of capital goods (machines and capital equipment) K, if there is no constraint on exogenous demands, uu u2. Any excess of labour supply over this maximum employment must inevitably remain

Unemployment (I): Marx

193

unemployed, as long as there is no change in the capital stock K. Marxian unemployment therefore results. This maximum level of employment can be determined by solving the following problem: maximize the amount of employment, a3XXx 4- a32X2, subject to the conditions a4XXx 4- aA2X2 ^ K

X2 = u2

(**)

where Xx ^ 0, X2 ^ 0, ux ^ 0, u2 ^ 0. Since there is no other constraint on ux and u2 than that they should not take on a negative value, the conditions (*) and (**) are equivalent to

respectively. Therefore, the above problem of determining the maximum level of employment is reduced to a problem of linear programming: maximize C13XXX + C132X2

(9)

subject to /C ^ dAXJCx ~\~ uA2/v2

\10)

Xx 2* &,AT, + b2X2

(11)

X2^0

(12)

(Note that the coefficients a's and b's are all positive.) In order to solve this problem it is important to see that the coefficient bx is a positive number less than 1. This can be shown in the following way. In the definitional expression (5) cw and ce must not exceed 1 because they are workers' and entrepreneurs' marginal propensities to consume. l — tw and \ — te take on their maximum value 1 when the tax rates tw, te are zero. The rate of distribution is greatest at a= 1 where profits are distributed in their entirety among entrepreneurs. Therefore bx cannot exceed (wa3X 4- mcx)/px, and this upper limit of bx is less than 1 because the numerator wa3X + mcx is only a part of (1 4- m)cx and the denominator pj is obtained by expanding the latter at the rate 1 4- tu so that the ratio is less than 1. Hence the constraint (11) concerning Xx may be rewritten in the following form ^ i ^ ~ — T x2

(ir)

194

Is full employment possible?

Since 1 > bx > 0 andfe2> 0? the right-hand side of the above expression gives a straight line rising to the right (i.e. 06 of Fig. 23). The constraint (11') requires that Xx should be either on this line or on its right. We can next give the constraint (10) on Xu X2 due to the shortage of capital stock the following geometrical interpretation. Letting K/aAX = a and K/a42 = fl',we will make a triangle by joining a and a' (see triangle 0aar in Fig. 23). It can then easily be shown that any point within this triangle satisfies the constraint (10) imposed by K.10 It is therefore clear that in Fig. 23 the edges and the inside of the shaded triangle give the set of all points which fulfil both these two constraints and (12). Which point within this set, therefore, is the one which maximizes the total amount of employment (9)? Let N be an arbitrary number which is positive. Dividing it by a3l and fl32, we obtain l = N/a31 and l' = N/a32, respectively. Joining / and /' which are positioned on the two axes we get a triangle 0//' (see Fig. 24). In just the same way as was demonstrated in the case of triangle Oaa' in 10

That at any point on the line aa' (e.g. point x) aAlXx + aA2X2 = K can be proved as follows. As is apparent from the figure, X2/(0a - X{) is equal to the slope of aa', i.e. to a4l/a42. Therefore given that 0a = K/a4l we get (K/a4l) - Xx

a42

therefore a4xXx + a42X2 = K. Since Xx = X[, X2>X2, at any point within the triangle Oaa', e.g. x' = (X[, X'2) the following inequality will obtain a4XX[ + a42X'2> 0, that is, o> increases towards OJ*, and if of < o), then which gives the ratio of the amount of increase in the value of output of the consumer goods industry (pxAXx) to that of the capital goods industry (p2AX2), is called the propagation coefficient of output expansion. Effect on GNP How much will the expansion of production in the capital goods industry, brought about by an increase in investment, stimulate production activities in the national economy as a whole? This may be well investigated in terms of the multiplier effect, by which each increase in investment is multiplied in order to give the resulting expansion of Gross National Product (GNP).1 The gross domestic product of the economy at market prices may be defined as the amount which remains after subtracting the value of imports needed for production from total gross output; that is, pxXx + p2X2 - rpt (a5xXx + a52X2)

where the part in parentheses, i.e. F in Table 6, represents the total amount of raw materials and others imported from abroad to produce Xx and X2 (see Table 6, row 5). In addition, the rentiers of the country have assets overseas of the amount rplB£, and, by making use of these assets for production, obtain interest income rB£. On the other hand the country pays interest income fl^to the foreign rentiers. Therefore the Gross National Product (GNP) of the country - that is, the total value created by the production activities carried out domestically and abroad by the people of that country - is given by2 Y = PxXx+p2X2 - r^a5X P\ 1 2

PxXx

- r^a52p2X2 Pi

For a definition of GNP see Additional Note g. See the first equation on p. 287 below.

+ rB^ - & (10)

224

Fiscal policy

If we write rPt

Pi

51

1,

Pi

these represent the proportion of the product prices px and p2 respectively accounted for by the cost of imported raw materials and fuel. In view of (1) and (9), we obtain from (10) (11) This equation shows how much of an increase in GNP will result from the increase in investment, AI2. By writing AI = p2AI2 which gives the increase in investment in terms of money value, we at once obtain the ratio of A Y to AI from (11) - that is from the part in the brackets on the right-hand side of (11) - which is called the investment multiplier. The formula of the investment multiplier can alternatively be written in the following form shown in (11'). First, let j8w be the share of AW in AY; then

_AW_w(a3lAXl AY AY Similarly, the share of a ATI in AY will be <xAII_ am(cxAXx + c2AX2) ~AY~ AY Therefore, the shares of workers' and entrepreneurs' after-tax income (disposable income) are (1 - tw)f$w and (1 - te)fie, respectively. Let mc be the average of workers' and entrepreneurs' marginal propensities to consume, cw and ce, weighted by these shares; then mc = cw{\ - tw)(3w + ce(l ~ te)pe If we also define the marginal propensity to import as mF (with respect to GNP), then rp*AF /XiPiAXi + fi2p2AX2 ttiF =

=

AY AY We then easily find that formula (11) can be rewritten in the form as is given in Additional Note i: AI

1 — mc +

The investment multiplier

225

Most textbooks of macroeconomics use formula (11') rather than formula (11). However, it should be noticed that (11') cannot be used as long as the shares, ($w, /3e, and the propagation coefficient b2'/(l — &i), remain unknown. To obtain them, all the procedures which we have gone through above have to be followed. The approximate numerical value of the investment multiplier Coefficients bx and b2 take on the following approximate numerical values. Let the workers' marginal propensity to consume cw be 0.9 and that of the entrepreneurs ce, 0.4. The tax rates on wage income and on entrepreneurs' income, tw and te, are assumed to be 10% and 30%, respectively. The indirect-tax rate on consumer goods and that on capital goods are both 5% (that is, ^ = ^ = 0.05), while the rate of mark-up m is 30%. Supposing that the capital goods industry is more labour-intensive than the consumer goods industry, let us be concerned with a case where the wages per unit of output in the capital goods industry amounts to 50% of the price of the product, while the same figure is only 40% in the consumer goods industry, that is, w w — 0 31 = O.4, — a 32 = 0.5 3

Pi

Pi

Given these numerical values we can calculate both cjpi and c2/p2 a t 0.73.4 We know that the percentage of profits to be distributed to entrepreneurs is somewhat unstable, depending on the economic situation at the time; where only 10% is distributed to entrepreneurs (a = 0.1), we obtain &! = 0.330, &£ = 0.411 Provided that the marginal propensity to import of each industry with respect to its output is 10% (i.e. /^ = /x2 = 0.1), then the value of the investment multiplier can be calculated at 1.45. In the extreme reverse case where the total amount of profits is distributed to the entrepreneurs (i.e. a = 1), we still obtain only bx = 0.385 and b2 = 0.466 and the value of the multiplier remains at 1.58. Thus we find that the value of the 3

4

These figures are not 'realistic'figureswhich have been econometrically confirmed, but are used throughout this chapter as a guide in the derivation of various economic propositions. There is, however, no question of producing any specific proposition such as is crucially dependent on these particular figures. The adoption of the form of numerical examples in the analysis which follows is to spare the reader complex algebraic formulas and the object of concern in this chapter, as in the others, is to elicit general propositions. If we substitute f, = 0.05, and m = 0.3 in the price formula /?, = (1 + /,-) (1 + ra)c, we get 0.73 as the value of cjp^i = 1, 2).

226

Fiscal policy

multiplier does not react particularly sensitively to a change in the distribution coefficient a. It will normally be the case, as has been assumed above, that workers' marginal propensity to consume will be much higher than that of entrepreneurs, and that the tax rate on wage income is lower than that on profit income. For the sake of simplicity, however, it is assumed in most textbooks that cw = ce and tw = te, and these are represented by c and t, respectively. It is also tacitly assumed in textbooks that the percentage of respective product prices accounted for by wages is the same throughout both industries (that is, w w — 031 = — 0 (However for the sake of simplicity let us suppose that prior to money creation Lb = Mb.) Now if the demand created for bonds on the part of the city banks is of the amount of (7), pb8Bb must be increased by that amount, hence Lb - Mb must be reduced by the same amount. (We assume that 8Qb and wNb remain unchanged.) Since it is assumed that prior to any creation of money Lb — Mb = 0, this means that after the currency has been created Lb-Mb=

1

~ ° " e8Mc 1 — e + sa

(9)

Since the excess supply of bonds on the market has been wiped out by the central bank's manipulative purchase of bonds, enterprises and government are now able to sell the amount of bonds they wished to do, and therefore carry out the investment and government expenditure regarded as desirable. As a result production will take place exactly according to plan, while the supply and demand of both workers and entrepreneurs will be realized without a hitch. Their cash balance plans will be exactly as they were before the currency was created. As the bond market is in equilibrium as a result of the central bank's manipulative purchasing, and all other markets are also in a state of equilibrium, so the money market too must balance. For this reason (Lw - Mw) + (Z/ - Me) + (Z/ - Mr) + {V - M') =

8MC

(10)

1 — s + ecr

That is to say if the central bank manipulates the purchase of bonds and is able to create money, this will produce in the private-non-bank sector an increase in cash balances which is equal to the amount of money created, 8MC, expanded by the credit creation multiplier. 13 14

Because of this Ds% = 0, therefore 8MS = 0. Assuming that the supply and demand for consumer goods, capital goods and time deposits are all in balance.

266

Monetary policy

This fact may also be explained as follows. Of the amount 8MC dispersed to the private sector, e8Mc is deposited with the banking sector, while the remainder (1 — e)8Mc stays in the various non-bank sectors in the form of cash. The city banks try to maintain cash reserves at the level of (6); since the city banks already received e8Mc of cash when the current account was first opened, the amount of net cash reserves which the banks have to create afresh is -e8Mc-e8Mc 1 - s + ea This amount of cash must be absorbed by the banking sector from the non-banking sector, hence the net increase in cash held in the nonbanking sector will be c

(1 - e)8Mlc -\ - I

\\-e+ea

c

c

e8M e8Mc --e8M e8Mc] I-•= — - — — 8MC

J

Since current account deposits increase according to (5) the increase in currency Mu including not just cash but also current deposits, must be 1 8MC (11) 1 — e + ea That is to say the cash balances held by the private-non-banking sectors increase according to (10). This kind of accumulation of cash balances on the part of the private sector will later on stimulate inflation, as will be explained below. For the time being, however, the inflationary pressure resulting from over-investment has been successfully removed by the central bank's manipulative purchase of the surplus government and enterprise bonds on the open market. The existence of excess supply on the bond market (i.e. of excessive demand for capital) would cause the yield on bonds to rise and stimulate price inflation by raising the mark-up rate of each enterprise, but the provision of this capital by the central bank avoids inflation through this sort of channel. However, this kind of policy does in the long term have a considerable influence, as will be analysed in section 4.

Lending policy There are two kinds of lending policy. In the first of these, the central bank alters the official interest rate and then lends to city banks the sums they require in accordance with this new rate. In the second, the official rate is left as it is, and the central bank then lends the city banks the

Roles of the central bank and exchange stabilization fund

267

amount of high-powered money which it could not obtain from the non-banking sector. Under the former it is the change in the official interest rate which is important; under the second the fact that the city banks are supplied with the amount of money which they require, with no change in the official rate. The latter case may be further subdivided into (1) where the whole of this required sum is lent out, and (2) where a limit is set to the amount to be advanced and where advances are made only up to, and not beyond, this limit. We shall below analyse the case of (1), i.e. where the central bank maintains the official interest rate at the current level, and sets no limit on advances to the city banks. Suppose the time deposits of rentiers are 8Qr(> 0) and the amount of time deposits desired by the city banks is 8Qb( Ac). The result of this will be the creation of high powered money of the amount 8MC = 8QC — Ac. This volume of currency will be used by the city banks to back up further creation of credit,18 8Bb will be increased to supplement the hitherto inadequate demand for bonds, and the bond market will be turned into equilibrium. This means that the excess demand for credit is removed by credit created on the basis of advances from the central bank. This kind of process is inflationary. First of all, should part of the excess supply of bonds be absorbed by a fall in pb the rate of return on bonds will get higher, bringing about a rise in the mark-up rate m = m(ib, id) in each industry, producing in turn a rise in their prices pu p2. Secondary a rise in/?! causes the real wage rate w/px to fall, leading trade unions to demand an increase in money wages to compensate for this fall. Needless to say such wage increases stimulate price increases. Thirdly, the furnishing of credit bestows purchasing power on those who would not otherwise have it. The new enterprises and new projects from existing enterprises which are thus given a say in the market now appear in the producer goods market and compete in the scramble for producer goods. Where vast amounts of unused producer goods exist the competition is not that fierce, but even in this case some scramble is unavoidable. The setting up of new enterprises or the formation of new project teams employing only hitherto unemployed workers is likely to result in failure for such new enterprises or projects, so at least for their core members they are likely to try to obtain able workers from some other enterprise. Whatever the case, a scramble will, to a greater or lesser degree, be inevitable, and if we suppose, as Wicksell does, that there is from the first full employment,19 then the competition will be fierce indeed. The wage rate w rises, producing cost push price rises.20 Inflation from the creation of money The amount of money created anew, 8MC, will accumulate in the non-banking sector. In order to analyse the unadulterated effects of this accumulation of money on the volume of production Xu X2, on the lending by the central bank (and hence on the creation of money) and on the demand and supply of bonds (hence on the demand and supply of 18 19

20

For the process of credit creation see the earlier section on lending policy. Wicksell, K., Interest & Prices, 1936 (reprinted, 1962, by Augustus M. Kelley, New York), p. 132, p. 143 etc. For Wicksell's own explanation of the cumulative process see pp. 102-56 of the same book. Wicksell does not assume the full-cost principle as we do, so the mode of price fluctuations which follow from his model differs from the above.

The Wicksellian cumulative process

273

investment fund) during the next period (second period) of money creation, let us suppose that the price inflation described above did not occur.21 As we shall see later price and wage inflation create positive or negative forced saving. We will first of all analyse the simple case where forced saving is zero, and subsequently observe how this simple case is made more complex by the subsequent introduction of positive or negative forced saving. First of all, in view of workers', entrepreneurs', and rentiers' consumption functions we obtain from their budget equations:

(1 - te)all+ Me = ce{\ - te)an+pxye + Z/, (1 - tr)Ur + Mr = cr{\ - tr)Ur + Plyr + pb8Br+8Qr where Ur = Ar + rBr. At the beginning of this second period the amount of currency held by workers Mw increases, so the left-hand side of the above equation will increase, and as a result the right-hand side must increase as well. Thereupon each item on the right-hand side is likely to increase too. That is to say, it can be assumed that the propensity to consume cW9 the amount of consumption at zero income yw and also desired balance Lw will all increase in line with the increase in Mw. Similarly during the second period both Me and Mr increase above their level in this first period, so the entrepreneurs' and rentiers' propensity to consume and their amount of consumption at zero income ye, yr will also increase over their present level. Their demands for money balances Le, Lr and the amount of savings held by rentiers in other forms Pb^Br, 8Qr, rp%bBr^ are all likely to increase. This kind of increase in the propensity to consume and in the basic amount of consumption brings about an increase in the effective demand for consumer goods. (Note that prices are assumed to remain unchanged, so there is no forced saving effect.) On the other hand the official interest rate and the price of bonds (hence their rate of return as well) remain unchanged, so there is no reason to suppose that invest21

We now suppose that the excess supply of bonds in the current period is removed merely by the creation of money 8MC, and that no price mechanism works in the bond market. In such a case pb (and therefore the yield on bonds) is constant, so m is also constant. It is furthermore assumed that considerable unemployment exists among all kinds of labour, and that no scramble for labour has emerged despite the appearance of new enterprises and new projects. Given this w too will be constant, so price inflation of the kind explained above will not occur in the current period. Below, we shall in the first instance carry out analysis of this kind of simplified case.

274

Monetary policy

ment I2 alters.22 There is, therefore, no change in the effective demand for capital goods. The volume of production of consumer goods Xx increases, while the volume of production of capital goods X2 is held at the same level. As a result wages W, the depreciation reserve H, the amount of imported raw materials and fuel rp*F, profit 77 and government tax revenues T will all increase. This is the result of Xx and X2 adjusting to their respective effective demands, and this also means that excess demand for both consumer and capital goods is zero. Hence according to Walras' Law we get pb[8Br + 8Bl + 8Bf + 8B8 + 8Bb] + [8Qr + 8Qb + 8QC]

+ [(Lw - Mw) + (Z/ - Me) + (U - Mr) + (V - M) + (Lb - Mb)] = 0 (16) Here 8QC is the lending of the central bank in the second period which is made when no money has been created (i.e. 8QC = AC in the second period), and assuming that the amount of time deposits, -8Qb, which the city banks desire to raise is exactly equal to their time deposits received from the private sector 8Qr and their advances from the central bank 8QC, then 8Qr + 8Q0 = -8Qb, and for that reason the sum of the contents of the second square brackets in the above formula will equal zero. If we suppose an adjustment in the foreign exchange rate so as to remove the excess demand for foreign currency, the total for the third square brackets in the above formula will also be zero. For that reason if the sum of the terms in the first square brackets (excess demand for bonds) is negative the sum of those in the fourth square brackets (excess demand for currency) will be positive, and vice versa. Now the first two items within the fourth square brackets represent the savings in the form of money made by workers and entrepreneurs respectively. By virtue of the budget equations mentioned earlier these usually have a positive value except where the respective incomes are extremely small; likewise the third item (money savings of rentiers) is also positive. The fifth item too will be positive. If we rewrite the budget equation of the city banks (the sum of the elements of column 9 in Table 6 = 0), we get Ab - 8Qb = wNb + pb8Bb + (Lb - Mb) 22

Where prices fluctuate, investment (in housing and other construction, equipment and stocks) will depend upon the real interest rate (the difference between the money interest rate and the anticipated rate of inflation) and not the money interest rate. (Should the real rate of interest increase, then investment will decline.) In this particular case, however, the predicted rate of inflation is 0, and the money rate of interest is constant, so the real and money rates of interest will be equal and constant.

The Wicksellian cumulative process

275

where Ab must increase in the subsequent (second) period, since during the first period the central bank has implemented a positive lending policy, the city banks have accordingly created credit and advanced money to enterprises, and hence the income from interest accruing to the city banks during this subsequent period is going to increase. As has already been stated -8Qb= 8Qr + 8QC. The 8Qr of the subsequent period will be higher than that of the first period, and the same is likely to be true of 8QC (= Ac) where the positive advances made by the central bank will be reflected in Ac showing an increase over its value in the first period. With -8Qb therefore increasing, the left-hand side of the above formula will increase. This is likely to mean that each item on the right-hand side is positive, and that each increases to a greater or lesser degree. On the other hand the budget equation of the enterprise investment sector (the sum of the elements in column 6 of Table 6 = 0) can be written as [p2l2 -H-(l-a)II\-

& = -pb8Bl - (V - M 0; (ii) that if the labour-intensive condition is reversed, it amounts to Gx > 0 and G2 = 0, and (iii) that if the two industries are equal in labour intensity, Gx and G2 are indeterminate. 16. Total savings which can be written as (t) on p. 281 are also equal to the sum of all the elements of rows 9-12 in Table 6, plus/?2/2 (savings in kind). Using this relationship compare Keynes' definition of Say's law (total savings are identically equal to investment p2l2) and the Lange-Patinkin definition of it (excess demand for domestic currency is identically equal to 0). (O. Lange, 'Say's Law: A Restatement and Criticism', in his Papers in Economics and Sociology 1930-1960, Oxford, Pergamon Press, 1970; D. Patinkin, Money Interest and Prices, 2nd edn, New York, Harper and Row, 1965). Show that Say's law in the Keynes sense is incompatible with the existence of an investment function (so that the economy in Chapters 5-8 is freed from the law). Where Say's law prevails in the Lange-Patinkin sense is general overproduction impossible? 17. Examine the effects of a change in the pound sterling exchange rate upon production and employment. Discuss the following statement by Keynes: It is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier.

Chapter 7 18. If you were the Chancellor of the Exchequer what kind of fiscal policy would you propose in order to decrease unemployment? Explain, and advance the reasoning to support your recommendation. Also, based on those numerical values of the coefficients of the model which are used in the text, estimate the effects of your policy on employment and GNP. 19. Give an analytical verification of the fact that progressive taxation plays the role of an automatic stabilizer (or built-in stabilizer) which reduces the amplitude of GNP by bringing about a fall in the value of the investment multiplier in times of boom and increasing its value in time of slump. Furthermore, given that the value of the multiplier is a low one of around 1.58 (see p. 225 above), is not the above assertion likely to exaggerate the automatic regulatory function of the economy? Discuss.

298

Exercises

20. The various effects of a change in the rates of indirect tax tu t2 have been discussed in the present volume only in a heuristic fashion. Using mathematical formulae, give a rigorous analysis of the effects exerted by such changes on px, p2, GNP etc., (i) disregarding any repercussions on ib, id, r, and (ii) taking into account such repercussions.

Chapter 8 21. 'Say's law implies a peculiar nature of the demand for money, namely, that the individuals in our system, taken together, are always satisfied with the existing amount of money and never wish to hold either more or less. Under these circumstances the money prices of commodities are indeterminate.' (O. Lange). Thus Say's law is inconsistent with the existence of a money economy.' (D. Patinkin). Discuss. Also discuss whether this kind of proposition remains correct where each firm determines its prices according to the full-cost principle, with particular reference to the case where the central banks adopt the policy of adjusting the supply of money so as to cancel any excess demand for (or supply of) money from the public. 22. Discuss the view that Keynesian policy is a policy for creating inflation, rather than a remedy for unemployment. 23. Discuss the effects of the creation of money upon prices, output, etc. in each of the two following cases: (i) where the exchange stabilization fund creates money to stabilize the foreign value of the country's own currency (the pound), (ii) where the central bank creates money by buying government bonds issued to finance an expansion in government personnel.

Index

Arbitrage dealing, 53 Arrow, K. J.,40n

Credit creation, 252, 291 multiplier, 254 multiplier process of, 255

Balanced budgeting multiplier effect of, 243 Bank central, 150, 262 central bank lending, 160 commercial, 150 Bertrand,J.,284 Bohm-Bawerk, E. von, 156n Bond annual yield of, 171,172 market, 167 Budget equation for banks, 150 city banks, 256 entrepreneurs, 144 exchange stabilization fund, 151 firm's investment sector, 147 foreign trade, 148 government, 149 investment sector, 256 rentiers, 145 workers, 143

Dealer foreign exchange, 114 Deane,P., 103n Debreu, G.,284 Deficit financing, 235 Deflation, 257 Demand curve, 21 estimated, 70 Devaluation of the pound, 109 Discount, 130 Disorderly bidding, 20

Cassel,G.,15 Chamberlin, E. H.,284 Clark, C.G.,219n Classical (neo-classical) school, 83, 84,189 Cob-web theorem, 159 Comparative-advantage theory of international division of labour, 282 of production cost, 36 Complementary goods, 41, 56, 58 Cost assessment current price approach, 74 historical cost approach, 75 Cost curve average, 68 Cournot, A.,54n,88n

Economic blocs, 102 Economic linkage table, 140, 255, 256 Edgeworth,F. Y.,284 Effective demand principle of, 6,152 Employment multiplier, 227 Equilibrium existence and stability of general, 47 existence of, 23 multiple, 24 partial equilibrium curve, 44 Excess demand function, 283 quantity of, 42 Exchange, 17, 39 commodity, 17 composite, 56, 56n general equilibrium within, 43 stock,161 Exchange rate and product prices, 107 automatic balance-of-payments adjusting function of, 122 basic rate, 120 cross rate, 120 export and, 211 fixed rate system, 105,106

299

300

Index

Exchange rate (contd) fluctuating rate system, 106 inter-bank market of, 112 under gold standard, 105 Exchange Stabilization Fund, 139, 151, 262 Fixprice economy, 32, 39, 39n historical background to making of, 34 Fiscal expenditure policy, 231 Foreign currency demand for (due to non-trade causes), 384 Flexprice economy, 32 Free trade theory, 35, 99,100 Friedman, M., 204n, 205, 205n, 206, 206n Full-cost principle, 27, 68, 91, 205, 205n price competition under, 29 Futures market of commodities, 61, 64, 74 of foreign exchange, 128 Government, 149 Gross National Product (GNP), 223, 285 Haavelmo,T.,249n Hahn,F. H.,40n Hall,R. L.,27n Hedging, 63, 65, 72, 75,131 Hicks, J.R.,156n,191n, 296 chain rules, 61n Law of prices, 48, 56, 82 Hitch, C.J.,27n Industrial country lacking natural resources, 4,135 large, medium-sized and small, 3 Industrialization de-industrialization, 218 tertiary, 219, 220 Inflation, 257, 272, 292 cost-push, 292 demand-push, 292 from the creation of money, 272 Interest money rate of, 271 natural rate of, 271 real rate of, 174n, 274n system, 171 Investment multiplier, 221, 224, 289 approximate numerical value of, 225 IS curve, 287 Jaffe,W.,137 Japan Inc., 252 Kalecki,M.,32n

Kantorovich, L. V., 2n Keynes, J. M., 7, 7n, 32-4,112n, 189, 197n,208,249,249n,250,292 Kuznets, S. S.,219n Labour market structure of, 179 Labour union enterprise, 185 trade union, 183 Labour theory of value, 92, 93 Lending policy, 266 LM curve, 287 Luddism, 212 Machinery, 212 Marginal productivity theory, 84 Marginal propensity to consume, 224, 226 to import, 224, 225 Mark-up rate, 27, 27n, 30 Marx, K., 13,13n, 93,188,192-7 Mitchel,B.R.,103n Money deposit, 164 high-powered, 165, 254 Mly 164,166 M2,165 multiplier, 167, 254 quantity theory of, 201 Monopolist, 95 Morishima, M., 7n, 61n, 94n, 137n, 179n Mosak,J.L.,41n National income, 285 Nurkse, R.,189n Oil shock, 261 Open market operation, 263 Overloan, 268 Phillips curve, 204, 208, 208n Premium, 130 Price-adjustment, 96 function, 22 Price-taker, 95 Price war, 88, 284 Production period, 72,156 price: existence of equilibrium, 78-81; repercussions of changes in, 82 structure of: single-track progression, 156n; multi-track progression, 156n Profitable at the mark-up rate m, 80, 294 Protectionism, 99

301

Index Purchasing power parity theory, 124 Quantity-adjustment, 96,158 Reselling, 284 Ricardo, D., 7, 91, 92n, 212, 218 Robbins, L.,2n Robinson, J., 189n Robot, 216, 220 Samuelson,P. A.,23 Saving aggregate saving function, 281, 297 forced, 277 Say's Law, 6, 7, 7n, 293, 297, 298 Schumpeter, J. A., 257n, 259n, 294 Sham buying, 61 buying back, 284 trading, 283 Small proprietor, 95 Speculation, 63,131 Stagflation, 259 Stock market, 161 Substitutive goods, 41, 43, 55 Supply curve, 21 Suzuki, Y.,161n Tax increase catalytic effect of, 243

Tax reduction, 237 income tax on wages, 237 income tax paid by entrepreneurs, 239 in indirect taxation, 240 Time deposits sector, 170 Trade war, 127 Trading by tender, 15 competitive, 39 cross-trading, 15 Unemployment classical (neo-classical) view of, 200, 201 disguised, 189,189n, 219 Keynesian, 190,197,198 Marxian, 190,192-7, 296 natural rate of, 206 voluntary, 288 Wage differentials between enterprises, 185 effect of a cut in, 208 flexibility of, 182 Walras,L.,7,7n, 13,14 Walras' Law, 152 Weber, M., 179,179n Wicksell,K.,156n,272n Wicksellian cumulative process, 271 Wiles,P.,186n Zimmerman, M., 30n