05 Concepts and Definitions

CHAPTER 5

Concepts and Definitions

While we will be dealing largely with aspects of the subject matter generally included in economics that are different from those covered in the literature of the economic profession, the subject matter itself is the same. It will therefore be convenient to use the names and definitions that the economists apply to the various economic concepts, insofar as we will utilize these concepts without significant changes. The term “goods” has already been introduced. It is defined as follows:

Goods, are those things that satisfy economic wants, directly, or indirectly through participation in the production of other goods.

The economists’ definition of goods, which has been adopted for the purposes of this analysis, is considerably broader than the ordinary usage, which makes “goods” synonymous with “commodities.” Under this definition intangibles such as services are also goods, as is anything else, whatever its nature, that satisfies some kind of an economic want. The limiting adjective “economic” is a somewhat unconventional addition to the definition of “goods,” but this work will lay considerable stress on the point that items, which cannot be bought and sold, are outside the sphere of economics.

The word “goods” carries no implication of social desirability when used in its economic sense. It is rather unfortunate that the economic profession has adopted this particular term in preference to some one of the other words that would have been equally available, as the use of this terminology leaves the door open to confusion between the moral and sociological conception of good as socially desirable and the economic conception of a good as something that satisfies a want. It should be emphasized that from the economic standpoint all economic wants are alike. The opiates of the drug addict are goods to economics equally with the family bread and butter. The bombs and shells that destroy life and property are economic goods, even though their purpose is to do harm.

This does not mean that economic science approves of these things that are condemned by the ethicist. It neither approves or disapproves of anything, any more than physical science would contend that the diamond is too hard or that water boils at too low a temperature.

Utilities are those characteristics of goods which enable them to satisfy human wants, directly, or indirectly by participating in the production of other goods.

This concept of utility, or economic usefulness, as here defined, is an objective property; that is, one which has an actual existence independent of an individual’s mental processes. It exists whether he realizes it or not. Subjective concepts, those that exist only in the mind of the individual, are usually influenced by the objective—if they are independent of objective influence we usually suspect that there is something wrong with the mind—but they are not necessarily controlled by the objective.

Utility, as here defined, is not influenced by subjective opinion, except in certain special cases such as the administration of medicine, where the efficacy of the treatment depends to some extent on the patient’s mental attitude. The tomato had a utility as a food even in the days when it was considered poisonous. Anthracite coal had utility before anyone ever discovered that it would burn. Furthermore, goods often satisfy physical needs of which the individual is ignorant. It is only within comparatively recent years that the utility of certain foods in furnishing the vitamins necessary for health has been recognized. Citrus fruits and other natural sources of Vitamin C were performing their useful function of preventing scurvy and satisfying the want for health for thousands of years before their true utility was discovered.

The inherent utility of any good is, however, only a potential utility. In order to determine its actual utility we need to take into account not only the potential utility but also the relation of this potential utility to the wants of individuals. Bananas, ripening in Costa Rica, have potential utility to the inhabitants of Alaska, but no actual utility as long as they remain in Costa Rica. Ice has a potential utility for cooling purposes, but an inch thick coating on the river in midwinter has no actual utility of this kind. In general, the actual utility of an economic good depends not only on its inherent characteristics but also on the time and place at which it is available, and a very large part of man’s economic effort is expended in converting potential utility to actual utility by getting goods to the right place at the right time.

For convenience, it has become customary to speak of the inherent utility of goods at their original point of production as form utility, and to consider that additional time and place utilities are added as the goods are transported or stored. This is a useful concept, and the same practice will be followed in this work, but it should be realized that this is a purely artificial division for analytical purposes, and does not mean that a certain portion of the total utility is due to time, another to form, and so on. What we call the creation of place utility is in reality the transformation of already existing potential utility into actual utility by moving goods from one location to another where they are better able to satisfy wants. Many goods are produced at the time and place of use, and in such cases the actual utility cannot be broken down into form, time, and place components. But the same goods may be produced in an appropriate place and transported to the location where they are to be used, and then kept in storage until they are needed. In this case the actual utility is the same as in the first example, but for analytical purposes we say that time and place utility have been created in the processes of transportation and storage, and only the remainder of the utility can be characterized as the form utility produced in the original act of production. Time, place, and form utility are not different kinds of utility; they represent the same kind of final utility converted from the potential to the actual state by different processes.

Production is the creation of utilities.

This is another extremely broad definition. In ordinary usage the term “production” is restricted to primary processes such as manufacture or agriculture, but from the standpoint of economic life in general there is no difference between such activities and any other exertion of effort toward the satisfaction of wants. A gradual widening of the concept of production has been a notable feature of the history of economic thought. The first tendency was to consider only the activities directly connected with the creation of form utility as productive, and from the viewpoint of Karl Marx and other early economists a large part of the population was engaged on nonproductive work. Obviously, this put the theorists in a rather awkward dilemma. Most of these presumably non-productive operations were admittedly necessary, so the economist could neither advocate their abolition nor justify their existence. The development of the concepts of time and place utility was a big step toward resolving this difficulty, and it is now recognized that the railroad which transports the goods and the merchant who keeps them in stock until they are needed are producers in just as true a sense as the manufacturer who fabricates than originally.

The concept of services as goods has also been a gradual development. Many modern economists are still having difficulty with certain features of present-day economic life, particularly the activities connected with advertising and selling. Here, again, a broader understanding of the underlying situation is necessary in order to enable visualizing these activities in their true light.

The fact that income accrues to an individual from his activities does not necessarily indicate that there has been production. Theft, for example, involves effort, and it yields income to the thief, but this is not production. It does not create any utilities; it merely diverts them from one owner to another. Production, as herein defined, is measured in terms of the values created, not the amount of effort expended, or the individual income generated.

Consumption is the utilization of utilities for the satisfaction of wants, or for operations incidental thereto.

Consumption is the reciprocal of production. Production creates; consumption destroys. In production effort is expended. In consumption the results of effort are enjoyed. The definition, as given, excludes those uses of goods, which involve transformation rather than destruction of the utilities. This point will be elaborated later.

Utilities are often destroyed by agencies other than consumption during use. A warehouse may be destroyed by fire, or an earthquake may raze a whole city. Conversely, utilities may occasionally be created by purely fortuitous circumstances. So far as the operation of the economy is concerned, this unintentional creation and destruction of utilities has the same effect as if it were intentional, and since these incidental gains or losses are, at least to some degree, an unavoidable accompaniment of economic life, they will be treated for purposes of this analysis as an incidental part of the primary process. The definition of consumption has been phrased accordingly. If insects get into the flour in the consumer’s bin, so that it has to be discarded, the effect on the economic mechanism is exactly the same as if the flour had been consumed, and we will therefore treat this as consumption. If the insects made their inroads earlier, in the wheat before milling, or in the flour before it reached the consumer, the spoilage is simply another of the costs of production, and it will be so treated herein.

Labor is human effort devoted to production.

Here, again, it will be convenient to use the broad definition of the economist rather than the narrow popular usage which equates labor with manual work. Under this inclusive definition the efforts of managers, professional people, artists, entertainers, government officials, and all others who work in any productive activity constitute labor. From the standpoint of economic science one type of productive effort is the same as another. The familiar distinction between “blue collar” and “white collar” work is social and political, not economic.

Wages are the compensation received for labor.

In following the development of thought in the subsequent pages it will be essential to keep in mind that this definition of wages is coextensive with the definition of labor given in the preceding paragraph. All payments for productive effort are alike from the overall economic standpoint, and introducing distinctions based on social or technological criteria simply confuses the economic picture. There are significant differences in the basis of payment, to be sure, but in this work we will view the level of wages in terms of wage cost per unit of product, and on this basis it is immaterial whether the payments are made at hourly rates, as salaries, as fixed fees, as “fringe benefits,” or in any other manner.

Productivity, or productive efficiency, is the relation of the amount of values produced to the amount of labor, or its equivalent, that is expended.

To initiate an economic transaction the producer or owner of goods offers to sell them at what we may call a seller’s price, which he sets at or above the value to him as a seller. (This is the “asking price” of the organized exchanges.) An individual, or agent of a group of individuals, who is interested in the goods, either for consumption or for resale, then makes a counter offer, a buyer’s price, at or below the value to him as a buyer. (This is the “bid” price of the organized exchanges.) A process of bargaining then follows, terminating with an agreement on a sale price or, in the event of an impasse, without a sale. In some of the modern economies many of the seller’s prices, particularly in the retail stores, are fixed and not subject to bargaining, but in this case if the fixed price is above the buyer’s value the goods are not sold. The seller is then compelled to reduce his price to some lower level at which the consumers are willing to buy. This accomplishes the same result as bargaining, in a different manner. In the subsequent pages the term price, when used without qualification, will refer to sale price.

On the foregoing basis we have these definitions:

Price is a value placed on goods for purposes of economic transactions.

Seller’s value is the minimum price that the owner of goods is willing to accept for them at a specific time and place.

Buyer’s value .is the maximum price that an individual or agent is willing to pay for goods at a specific time and place.

The cost of goods is the price paid to obtain them, or if self-produced the values expended in production.

This brings us to the question, “What determines value?” On first consideration it might seem that utility is the primary criterion. Since the aim of all economic activity is satisfaction of wants, and utility (as herein defined) is that property of goods by which they are able to supply such satisfactions, it can hardly be denied that measurement of utility also measures the total results obtained from economic activity. But for present purposes we are not interested in the sum total of the material satisfactions that are realized; what we want to know is the size of that portion of the total that takes part in economic life, the portion of the utilities that, in the modern economies, can be bought and sold in the markets.

Although inherently subjective, value, as we have defined it, has a definite relation to utility, an objective property (as defined). In order that there may be value, the individual concerned must believe that there is utility to him, either directly or because of the possibility of exchange for other goods that he can utilize. It is not necessary that any actual utility exist, nor does the existence of utility automatically result in the existence of value. The essential requirement is a belief in the existence of utility. Many ineffective medicines have value because there are those who think that they are being helped by these concoctions, and are therefore willing to buy them. On the other hand, anthracite coal had no value until someone discovered that it would burn.

The perceived utility of economic goods is a factor in determining their value because it affects the individual’s willingness to make the expenditure that is necessary in order to obtain them. An equally important factor is his ability to pay the price. In Crusoe’s situation, the limiting factor is physical: his capacity for productive labor. If he finds it impossible to work more than an average of ten hours per day, then his average consumption of goods cannot exceed the equivalent of ten hours labor. When we examine some particular item such as the maintenance of comfortable temperatures in his house, we can see that both ability and willingness enter into the determination of the value of firewood. Part of Crusoe’s time must be spent in obtaining the necessities of life, and these items must be given precedence over the comforts. If half of his total labor is required for such purposes, the factor of ability limits him to five hours per day for obtaining firewood. But Crusoe is not willing to spend all of this time to obtain warmth, to the exclusion of all other non-essential objectives, and we will find that he sets a lower figure, perhaps something on the order of eight hours per week, as a maximum. If it requires more time than this to maintain a supply of firewood, he will accept the discomfort of a cold house, and apply his labor elsewhere.

We thus find that whereas cost may vary almost without bound, value has an upper limit. If the cost of production is above this limiting value, which we will call the potential value to emphasize the analogy with potential utility; these particular goods are not produced or bought. The difference between this concept of potential value and the value concept that the economists call “value in use” is in this limit imposed by a finite ability to pay. Like cost, “value in use” has no upper limit; it is this concept of value to which Joseph Schumpeter refers when he says that “total value will very often be infinitely large.”42 But this “value” has no economic significance, and bringing it into an economic discussion merely confuses the issues. Willingness to buy means nothing without ability to buy.

It should be noted that this limitation imposed by inability to pay any higher price is always effective, even in the case of the absolute necessities of life. The potential value of these necessities—food, for example—is relatively high, but it is still finite, not infinite as Schumpeter claims, because no matter how willing an individual may be to pay whatever price is necessary to sustain life, there is always a point at which he is no longer able to pay more. This is the potential value, and if the cost of food exceeds this level (by definition, a value to a particular individual and at a particular time) this individual and those dependent on him must starve, unless others come to their assistance, even though there is food somewhere which he could obtain if he were able to place a greater economic value upon it; that is, pay a higher price. We may deplore this situation, but it exists, and it is the function of economic science to analyze things as they are, not as we would like them to be, or as we think that they ought to be.

The potential value is the maximum amount, which an individual is willing and able to spend to obtain a particular economic product, if necessary. But ordinarily this great an expenditure is not required, and the actual value, the amount which he is willing to spend under the existing circumstances, is determined by those factors which make the maximum expenditure unnecessary. The first of these factors is the price at which similar goods are available. A certain article may have a potential value of ten dollars to the prospective purchaser, but if an equivalent article can be bought for one dollar elsewhere in the same general market, then the actual value of the article in question cannot exceed one dollar.

A second determinant of actual value is substitutability. On first consideration it may seem absurd to say that the value of oats is determined largely by the cost of wheat. One naturally expects value to be a characteristic of the commodity itself, on the order of density, viscosity, or some such physical property. Potential utility, as we have defined it, is such a property, an inherent characteristic of the goods, but value, potential or actual, is not. Except in the limiting situation where no acceptable substitute is available, value, in the sense in which the term is used in this work, is dependent to a very large degree on the cost of possible substitutes. Summarizing the foregoing, we find that potential value is determined by (a) utility, and (b) ability to buy (or produce). Actual value is determined by (a) seller’s offers (or minimum production costs), (b) availability and cost of substitutes, and (c) potential value (as a limiting factor). In an exchange economy the cost of production does not enter into the determination of values directly, but it does so indirectly through the seller’s offers; that is, sellers will not continue to offer products at less than the cost of production.

Whenever a deliberate economic choice is made, the decision as to what goods to buy or produce depends on the ratio of potential value to cost, how much value we get for our money, as the layman puts it. The most essential wants are satisfied first because the value-cost ratio is highest here; indeed nothing else has any value until after the necessities of life are provided for. This fact that less essential items may have little value, or perhaps no value at all, in spite of having considerable utility is one of the peculiarities of the value situation that is much easier to understand when we look at it in the context of the simple economy. Let us consider the case of an isolated person whose entire time is required for the production of the bare essentials of life, either because his environment is unfavorable, or because he is personally inefficient. To this individual, nothing outside of these essentials has any value, as herein defined, since, however willing he may be to produce it, he is not able to do so. Luxuries would still have utility, of course, and if there were any way of getting them without effort, he would be glad to have them, but he cannot devote any time to producing them, or to producing anything else that he can exchange for them, for if he does this he ceases to exist.

Now let us turn our attention to another individual whose productivity is fifty percent greater. In this case only two thirds of the total available labor time is required for producing the bare essentials, and the balance can be applied to improving the scale of living. Here comforts and conveniences begin to have a value. A third individual whose productivity is one hundred percent greater than the first would be able to assign a still greater value to these luxuries; that is, he would be not only willing, but also able to devote more of his labor to their production or acquisition. In general, we may say that the greater the productivity the higher the value that can be placed on non-necessities.

This is one of the places where scientific conclusions are distressing to some persons. Many economists and laymen wax highly indignant over the ability of persons with larger incomes to enjoy the good things of life that are denied to those not so fortunately situated, and they object to any kind of a terminology which might imply some justification for this state of affairs. They tell us that the wants of the poor are equally as strong as those of the rich, and that consequently, values are the same to all. But this is merely confusing value with utility. The utility of some goods may be the same to all, but in order to analyze economic processes we must have a concept that takes into account ability to pay the cost as well as desire to enjoy the goods. This does not imply either approval or disapproval of the existing situation, which requires the use of such a concept; it is simply a recognition of the facts. The value which most of us are able to place upon a yacht or an original Rembrandt has no economic significance, and nothing is gained by pretending that it does.

In this connection, it is interesting to note that the distinction between utility and value is recognized even by animals of presumably low intelligence, notwithstanding the fact that some of our savants manage to get them gloriously tangled up when they attempt to harmonize them with their own emotional judgments. The hungry cat will catch mice if there is no other source of food available, but he will not put forth the effort if a tenderhearted mistress is susceptible to some artful begging. The utility of mice as food is just as great in one case as in the other, but in feline economic life, as well as in human economic life, cost is compared with value, not with utility, and in accordance with the principles that have been set forth in the preceding discussion, the value of mice as food is decreased by the availability of acceptable substitutes at a lower cost.

As already noted, one of the principal determinants of buyer’s value. is the price at which the same goods can be obtained elsewhere in the same general market. Under some circumstances, sellers may offer limited quantities of particular items at abnormally low prices, especially if these goods are perishable. But they cannot continue to sell at a price below the cost of production. Under normal conditions the minimum price of any particular kind of goods is therefore the lowest cost at which any producer can produce them and transport them to the market area.

It follows that the amount of these goods available for sale at this price in this market, the supply, is limited to the optimum output of this one producer. If a somewhat higher price could be obtained, additional producers would be able to enter the market, and the original supplier might also be able to increase his output. It follows that the supply at this higher price would be greater. A still higher price would still further increase the supply. Thus the supply of a particular kind of goods in a market is not a specific quantity, but a series of quantities, a schedule, as it is usually called, corresponding to a similar series of prices.

The supply of an economic good in a specific market at a specific time is a schedule indicating the amount of that good which will be offered for sale at different prices.

As indicated in Chapter 4, the buyer’s value placed on goods by individuals must be above the seller’s price to enable a transaction to take place. At the minimum price (the seller’s value), the number of consumers whose value estimate is above this price is usually relatively large. The quantity that the consumers would buy at this price, the demand for these goods, is therefore also relatively large. At a higher price, some of the consumers find that the price now exceeds the value that they have placed on the goods as buyers. Consequently they do not buy them. A still higher price takes additional consumers out of the market. Thus the demand generally decreases as the price rises.

The demand for an economic good in a specific market at a specific time is a schedule indicating the amount of that good which will be bought at different prices.

In each case there is only one price at which supply and demand are equal. This is the only price that will “clear the market,” and it is therefore the price at which the transactions take place. Changes in either supply or demand result in corresponding changes in the market price.

The supply and demand relationships have been extensively investigated by the economists and are well covered in the economic literature. There is, however, a strong tendency to apply supply and demand reasoning to issues that are outside its range of applicability. “It is not too much to say,” contends one enthusiast, “that almost everything we know about the behavior of the economic system can be illuminated by way of reference to the fundamental cross of demand and supply.”43 But this is too much to say—far too much. The truth is that supply and demand theory does not illuminate all areas in economics. On the contrary, it has contributed greatly to the confusion that now exists in several important economic areas, particularly such subjects as the origin and magnitude of the total demand for goods, and the true significance of the money supply. The reasons for the inapplicability of the supply and demand principles to these issues will be discussed in connection with the examination of the individual issues in the subsequent pages.