Chapter VI: Markets and Prices

“The member of Parliament who supports every proposal for strengthening this monopoly is sure to acquire not only the reputation of understanding trade, but great popularity and influence with an order of men whose numbers and wealth render them of great importance. If he opposes them, neither the most acknowledged probity nor the highest rank, nor the greatest public services, can protect him from the most infamous abuse and detraction, from personal insults, nor sometimes from real danger, arising from the insolent outrage of furious and disappointed monopolists.”

ADAM SMITH

1. Free Prices Clear the Market

In the preceding chapters we have carried our analysis of the mechanism of our nonsocialist economic system to the point where we can now understand why the formation of prices on the different commodity markets is the process which directs and regulates the whole, a process to which every economic problem must be inevitably referred. It is now our task, proceeding from the simple to the complex, to concentrate our inquiry into this process.

The best procedure will be to take as our starting point the popular axiom which states that market price at a given moment is determined by supply and demand. In so doing we shall be making our first near approach to the problem. The axiom states that increasing supply and decreasing demand cause prices to fall, and that decreasing supply and increasing demand cause them to rise. We may express this simple and familiar relationship by saying that prices vary directly with demand and inversely with supply. Therewith we have by no means exhausted all the interconnections of supply, demand and price, however. It is important to note that not only does price depend upon supply and demand but that, conversely, supply and demand depend upon price. This dependence, too, is one with which we are all familiar. We may express it, axiomatically, by saying that supply varies directly and demand inversely with price.

These two observations lead us to a third, namely that demand, supply and price are mutually interdependent. The mechanism of price formation based on these interrelationships functions in its simplest form as follows: when there is a disparity between supply and demand, the price rises or falls until, under the counterinfluence of price, supply and demand are brought into equilibrium. The price which results is the equilibrium price which will not vary so long as the market situation does not change. This price is characterized by the fact that no seller or buyer prepared to accept it will leave the market unsatisfied. Until the price has found this level, it will continue to fluctuate. The equilibrium price is that price which clears the market. This is one of the most important and elementary of the whole body of economic principles; it should be fixed firmly and indelibly in our minds.¹

A natural consequence of this elementary axiom is that the expressions “supply” and “demand” must always be used in a relative sense. A good is not simply offered or demanded, but offered or demanded in relationship to a certain price. If the price changes, supply and demand change with it. This does not mean, however, that supply and demand depend only upon price. It goes without saying that even if the price remains the same, more of a given commodity will be supplied if a technical improvement (for example) results in a lowering of its costs of production; likewise, the demand for a commodity will increase (its price remaining constant) as it grows in favor with the buying public. It remains true that supply increases with rising prices and that demand increases with falling prices, but the level at which this occurs will meanwhile have changed. It is customary to describe such movements as shifts of the supply and demand schedules (or of the curves of supply and demand). Consequently, an increase in supply may result equally from a rise in prices (the supply curve remaining unchanged), or from a shift in the supply curve (prices remaining unchanged), or from both at once; inversely, a fall in prices, or a shift in the supply curve, or a combination of both can bring about a decrease in supply. The same holds true for an increase or decrease of demand. Hence, all these expressions have a double meaning which should not be lost sight of. Our first elementary axiom applies only in the case where the curves of supply and demand are given. Should these change, a displacement of the equilibrium price takes place. If we were to seek the causes of this displacement we would be led to analyze on the one hand, every circumstance which figures in the buying public’s valuation of a good, and on the other, the manifold conditions governing supply. This would lead us into complications which, at this juncture, can only be hinted at.

The elementary relationships thus far exposed are exemplified in striking fashion in every attempt of government to establish, by decree, a price other than the equilibrium price. An example of this with which we are by now familiar is the “ceiling price” policy which, during both World Wars, attempted to prescribe a price lower than the equilibrium price. The prices of the basic subsistence goods rose in wartime as a result of inflation but also and quite naturally because supply diminished while demand increased. In this situation, the understandable but nevertheless superficial view prevailed that consumers were being arbitrarily exploited and that to put an end to this abuse it was required simply that a system of maximum prices be imposed by government fiat. The result was that the regulatory function of the free formation of prices was arrested, provoking the now familiar chain reaction in which the unsatisfied segments of demand produced first the queue and finally rationing. Simultaneously, disturbances developed on the supply side, remedies for which were sought in forcible interventions in production (compulsory deliveries of goods, compulsory crop-planting, etc.). The lesson for the future yielded by these experiments is that the mechanism of price formation is such a vital cog in the greater mechanism of our economic system that it cannot be tampered with without forcing us to enter upon a path which ends in socialism pure and simple.

The experiences with the system of maximum prices had their parallel in the results observed with the opposite system of minimum prices which was in effect following World War I. Just as the scarcity of goods during the war led to efforts to protect consumers by setting maximum prices, so too the surpluses existing in many categories of goods during the Great Depression resulted in efforts to insure producers against further sharp price declines by establishing and enforcing minimum prices. The artificially high prices which ensued prevented the clearing of the market through the lowering of supply and the augmenting of demand. The surpluses which resulted from the imposition of these artificial prices could not be disposed of other than by having the state purchase them and store them at great expense (valorization, parity price policy). And thereby hangs a tale—of woe. As was demonstrated in every instance, e.g., the valorization of Brazilian coffee, the maintenance of high prices not only prevented the adaptation of production to the market situation but, under the incentive of the prices offered by the state, actually caused an extension of production. The more the warehouses bulged, the higher rose the costs and the more the market groaned under the pressure of this latent supply. Thus it was that the valorization of Brazilian coffee, to take this one example, ended in a lamentable debacle, leaving to the state huge debts and mountains of unsold coffee, a part of which was ultimately dumped into the sea. It would be well if those who continually reproach “capitalism” for its destruction of coffee would keep in mind that it was precisely a planned-economy correction of “capitalism” which provoked this chain reaction whose end result appears, and rightly so, as so senseless.

It could perhaps be objected that an economy of minimum prices might succeed if the spade were pushed deeper and the control over supply extended to the entire apparatus of production. The objection is doubtless valid but serves only to illustrate once again the principle that interferences with the price mechanism lead to ever more drastic and extensive interferences culminating in the completely planned economy of socialism. We have also to notice that the application of the planned economy to production as, for instance, in the various species of crop control, in the rationing of output and similar measures, leads in turn to still other and greater problems. If, for example, one country restricts the production of a given commodity in order to keep its export price high, the result will be that other countries will simply increase their production of that commodity. This explains why restrictions placed on rubber cultivation in the English colonies after World War I ended in a fiasco and why, at a later date, similar consequences were observed to flow from the cotton policy of the United States.

Still other problems are generated by market interventions. Thus in agricultural production, where the above difficulties have been most in evidence, truly effective control of production is very difficult to realize so long as the whole of agriculture has not been collectivized according to the somewhat unattractive Russian model. But it is to just such a result that this whole policy can lead if the state is compelled to apply its planned-economy interferences on an ever wider scale. One circumstance, in particular, tends to accelerate this tendency, namely, that when a restriction is placed upon the production of one agricultural commodity, farmers will tend to increase the production of another by as much. In fine, disorder breeds disorder, requiring in the end an ever more comprehensive control of production according to planned-economy methods. In this situation, it would be strange if the state should not try to solve the dilemma by forcibly increasing demand just as it had forcibly restrained supply. We have, in fact, witnessed in recent decades the development of a special technique for this purpose, a notable example of which is the compulsory use of alcohol as an ingredient in motor-fuel mixtures.^* If we add that the agricultural policies of many countries during recent decades have evolved along similar lines, it becomes sufficiently plain that the formation of prices is the regulator of our economic system and that it cannot be tampered with without requiring, in the end, a reconstruction of the entire economic system. It is doubtful whether all those who recommend interferences with the formation of prices appreciate the fact that the magnetic pole of such a policy lies in Moscow (and, we should have added a while back, in National Socialist Berlin). “With the first step we are free, with the second we are serfs.”

2. Elasticity of Supply and Demand

We take now a further important step in our investigation with the establishment of the fact that the degree to which supply and demand react to price changes differs on different markets. On one market a twofold increase in price results in a somewhat less than twofold increase in supply, and reduces demand somewhat less than half; on another market changes in supply and demand will exceed markedly (in quantitative terms) the price changes that have given rise to them. The elasticity of supply and the elasticity of demand are in the first case low and in the second, high. The degree of elasticity of supply and demand (coefficient of elasticity) has, in turn, a significant bearing on the character of price formation on the several markets. A simple example will make this clear.

The Christmas season is hardly a period in which we could expect that people, preoccupied as they generally are with other thoughts, would take the time to reflect on an interesting Christmas problem in economics, namely, the peculiar situation of the Christmas tree market on the day before the holiday. The first thing we find is that the elasticity of demand for Christmas trees is indubitably low. This is so because it would require a very marked rise in price to make the average family give up the idea of having a Christmas tree and, on the other hand, because it would require a very marked decrease in price to induce the average family to buy more than one. The day before Christmas, the supply of Christmas trees is inelastic too, seeing that it cannot be increased by additional cutting of trees nor diminished by putting them in storage. Twenty-four hours later the trees are no more than ordinary cut pines which can be used, at best, only as a covering for rose bushes or as firewood. The effect of this two-sided inelasticity on the Christmas tree market is clear: if there are too few trees on the market, a very marked rise in price is required to equate supply and demand; if there are too many trees a very pronounced fall in price is needed, a fall which may even reach the “firewood” point. Everyone, in fact, has had the experience of discovering that just before the holiday, Christmas trees are ordinarily either very cheap or very expensive. Supply and demand, given their inelasticity, cannot yield. Hence it is the price which must yield all the more in order to reestablish market equilibrium. The smaller is the elasticity of supply and demand, the greater is the flexibility of prices. This principle allows us to understand more precisely the characteristics of the several different kinds of market.²

Of special interest to us is the agricultural products market. Corresponding to the low elasticity of demand for food (of which we have already spoken in Chapter I), the elasticity of demand for agricultural products is generally not very high. Although we should not underestimate the elasticity of demand for the more expensive quality products of agriculture (butter, eggs, vegetables, meat, etc.), this elasticity is certainly low for the various bread grains. Since in the short run the supply of grains is also very inelastic, we can understand why as early as the 17th century an English statistician, Gregory King, could formulate the rule that the price of grains is usually subject to fluctuations greater than the corresponding harvest fluctuations (King’s rule). If the supply is too great, a sharp fall in price is needed to stimulate demand sufficiently to clear the market, and if the supply is too small an equally sharp rise in price is necessary to restrain demand sufficiently. From which it follows that the farmers, under certain circumstances, may stand to gain more from a poor harvest than from an abundant one. Proof (among others) of this fact is supplied by the American cotton farmers in the state of Alabama who in 1919 raised a monument in honor of a harmful insect, the boll weevil, in gratitude for its partial destruction of the huge price-depressing cotton crop of that year. If we add that the agricultural markets are characterized by still other anomalies, we can readily see that they represent a case apart in the formation of prices, a circumstance which confronts the agricultural policymakers with a number of crucial and important tasks.³

The labor market must also, as a rule, be considered as presenting a special and difficult type of price formation, though the laws of price can be applied to it in the same way as to the commodities market. While the elasticity of demand for labor differs in the different phases of a cyclical movement, declining to a very low point in the depression phase, the elasticity of supply, at least for the skilled trades, may be said to be decidedly low. This is so because human labor, lacking financial reserves for the most part, cannot be put in “storage” for very long. Then again, due to the time required for its training and to its great immobility, the labor force can be expanded over the short run only within narrow limits. This low elasticity of the labor supply can be increased by all sorts of politico-social measures such as aid to the unemployed which augments their “storageableness,” by retraining programs, establishment of more effective communication between the supply and demand sides of the labor market via improvements in employment agencies’ techniques, etc. The longer the period of training required for a given kind of labor, the more delayed will be the adaptation of supply to the market situation and, by the same token, the more difficult it will be. A good example of this is the academic labor market, in the several branches of which conditions of oversupply are easily changed to situations of shortage and vice versa; and we can appreciate that the advice of a wise uncle to his nephew, to study for the profession most in vogue at the moment, will remain wise advice only so long as there are not too many such uncles and nephews.

There are some special considerations respecting the elasticity of supply which merit our attention here. The most important of these is that elasticity is ordinarily smaller in the short run than in the long run. This is all the more likely to be the case the longer the time required to produce or to transport the goods to market, and the bigger the losses that would be sustained by withholding them from the market. This is why supply on the fish markets is, at any given moment, extraordinarily inelastic and subject to the caprice of demand, while from one fishing day to another, it can recover all its elasticity. The same is true for practically all the food markets—the result of which may be the appearance of vexatious disturbances and bottlenecks in such markets. Their elimination is an important task of economic policy. The stock exchanges, also, offer us examples of markets on which supply, during trading hours, is usually very inelastic, a circumstance which can occasionally lead to unexpected and possibly dangerous fluctuations in stock-market quotations. Such fluctuations are especially likely to occur when brokers are receiving from their clients a large number of orders to sell without any specification as to minimum price. In all such cases of “unlimited” supply, elasticity is reduced to zero, a phenomenon which may be observed with particular clarity at an auction (abstracting from those cases in which the owner sets the minimum bid).

The cases of totally inelastic supply, as well as of totally inelastic demand, border upon the domain of price curiosities. Also to be included in this latter category are the cases of inverse inelasticity in which supply and demand respond to price changes in a direction opposite to the usual one. It is quite possible, for example, that a fall in agricultural prices may provoke an increase rather than a reduction in cultivation as a consequence of each farmer seeking to compensate for price declines by raising his output. Official exhortations to restrict crop acreage can, in this situation, produce the opposite effect since many farmers would probably expand production in the expectation that all the other farmers would obey the official entreaties. Cases of this kind have actually occurred in the United States. A similar process may be observed on the labor market where price (wage) declines may result in increased labor productivity as each worker strives to maintain his existing income. An example of the inverse elasticity of demand is the familiar case in which an increase in prices causes an increase in demand because of speculation that prices will increase still further in the future.

Let us take note, finally, of the fact that the elasticity of demand can be used in quite another sense than that in which we have thus far used it. Having defined elasticity as the degree to which demand reacts to price changes, we may also speak of an elasticity of demand in terms of the degree to which the demand of individuals reacts to changes in their incomes. We distinguish in this case the price elasticity of demand from income elasticity of demand. This latter case involves considerations with which have already dealt (Chapter I, Section 2).

3. Prices and Costs

Since the majority of economic goods can be increased by the act of production it is clear that the scale on which such goods are supplied reflects their costs of production. If prices were insufficient to cover costs, producers would incur losses which would no longer permit them to maintain production to the previous extent; supply, in such case, diminishes, causing prices to climb until they have once again attained the level of costs.

One might suppose that with prices remaining below the level of costs, a given industry would cease operations altogether. This, however, need not be the case, to the extent that the costs of production differ for different levels of output and for the different firms within an industry. When prices decline, only that segment of the total output of the industry is immediately affected whose production costs are highest (marginal output). The remaining segments continue to manage on the lower prices. If, however, these remaining segments of output are unable to meet demand, prices will be forced up until marginal production again becomes profitable. Thus, if the costs for each segment of the total supply differ (which is usually the case), it is the highest costs at the time (marginal costs) which determine the over-all height of prices (for a given industry). But as the prices offered for all the segments of supply (of the same type of good) are ordinarily the same, the favored producers realize an extra profit which results from the gap between the market price and their low costs of production (producers’ rent).

It would seem that in making this observation we have once again tapped on that hollow place in our economic system for which we moderns have developed such a sensitive ear. Is it not a provocative notion that at the existing level of prices we are paying fat profits to these privileged producers? The first and most important reply to such a complaint is that insofar as our economic system is not completely permeated with and ruled by rigid monopolies, there will always be powerful forces at work to lower marginal costs. On the one hand, the favored producers will seek to increase their cheaper output in order to drive the marginal producers from the market; on the other hand, the marginal producer will seek to attain the lower cost levels of his more favored competitors. In this way, unrelenting competition gnaws away night and day at producers’ rents to the exceeding displeasure of the producers who strive by every available means to curb competition, including the (unfortunately) easy matter of getting the state to lend them a sympathetic ear. But as we shall see later, in detail, this is a circumstance which cannot be charged to the market economy as such. In any case, producers’ rents are sources of gains which are sooner or later dried up, even in agriculture, as the experience of the last decades has forcefully made clear. But should these observations fail to remove concern, it need only be pointed out that tax powers are always available to satisfy our desire for social justice without a total overthrow of the economic system.

We can see, then, that the concept of “costs of production” is by no means a simple one. A further complication is that not all of the factors entering into the costs of production have the same bearing on the determination of prices. The influence of these costs on the determination of prices is obviously not due to the fact that a well-meaning authority, out of its love of justice, reimburses producers for their expenses in the same way as the government indemnifies a functionary for expenses incurred on an official journey. If this were true, then it would be only right that the producer agree to a minute examination of his costs by a kind of supreme economic “accounting department” and that for every productive undertaking he secure an official authorization of the kind required by governments for official missions of their functionaries. This is something which the producer, who would like to have a government guarantee for the complete indemnification of his costs, would do well to reflect upon. Only a little thought is required to realize afresh that such a road, once embarked upon, leads straight to Moscow (or, in the National Socialist era, to Berlin). If that is not what the producers want, then they ought, with good grace, to accommodate themselves to the laws of our economic system.

These laws are so constituted that the costs of production exercise an influence on price only insofar as their indemnification is necessary for future production. If this indemnification is not assured, the means of production can go on strike in order to find more remunerative employment. This they can do, however, only where there exist alternative opportunities for employment. If the price of coal falls to the point where the owners are unable to retain their workers or to meet current costs, then the mines will close down. The workers, the lubricating oil, and the fuel can be used elsewhere. But for the mine pits themselves there exists no alternative use. The capital invested in them cannot be “retrieved.” Normally, the price should be sufficient to cover the payment of interest and amortization on this fixed capital. But if the price falls to the point where the payment of interest and amortization on the fixed capital is no longer assured, the owner of the mine would still do well, as a rule, to continue operations rather than bring them to an abrupt stop, even though the price no longer covers the full costs of production. The fixed capital in such cases may be “written off” either through the depreciation and consolidation of the extant shares of stock or, in the last resort, through bankruptcy proceedings. The certain result of this is that there will be no inflow of new capital to allow for the replacement or the expansion of physical facilities. These consequences, however, will only manifest themselves over an extended period of time. We can, at this point, sympathize with the melancholy utterance of a pessimistic banker that a new hotel is generally profitable only as a “second hand” operation.

The preceding reflections on the nature of the costs of production should serve to stiffen our resistance to laments that this or that branch of production is in imminent danger of collapse because prices are too low, and to harden us a little against the demand that this or that industry be assured a satisfactory level of prices by means of tariff protection or similar measures on the grounds that otherwise it faces “certain ruin.” We are now aware of the exaggeration concealed in this extremely popular tactic. In the first place, a fall in prices seldom renders a given industry altogether unprofitable and this because production costs for individual producers are not uniform but different. We find that in almost every instance a given industry comprises firms which are graduated in terms of their efficiency: at the top of the scale, the most efficient, capable of weathering severe price declines, and at the bottom, the firms on the margin of existence—those that just get by. Hence, if prices fall, e.g., as the result of foreign competition, the immediate casualties will be confined to the group of marginal firms. What we may expect, then, is not the disappearance of the whole of a particular industry but principally a change in the relative size of operations of the several firms in the industry. Were foreign competition to be eliminated by protective tariffs or import quotas, the state would be guaranteeing, in effect, the profits of the most efficient producers, the very ones who least require protection. In the second place, to justify such somber prognostications as the above, the drop in prices would have to be severe enough to affect not only fixed capital costs but variable costs as well.

4. Monopoly

Now that we have established that the costs of production (in the sense already used and for the reasons we have indicated) constitutes in the long run the lower limit to which prices can fall, the question suggests itself whether and to what degree they can rise above this lower limit. That they can so rise is undeniable. It is, however, also clear that there is a powerful force which again pushes prices down to the level of costs, namely, the increased supply which results from the competition among the producers to sell at the higher price. The more ineffective this force becomes, the closer we approach monopoly. The resulting peculiarities we must now describe.

The characteristic feature of a monopoly, be it a single enterprise or a monopolistic combination of enterprises (cartel, syndicate, trust) is that it (or they) can freely determine the amount of supply; and where supply is sufficiently curtailed, prices can be held above the level of costs. If we proceed on what is probably the not unreal assumption that the monopolist seeks to maximize his profits, the question then is what price should he select to attain his goal? Should he choose a high price, his profit per unit will be high but his total sales small (“small turnover, large per unit profit”). Should he choose a low price, the profit per unit declines, while total sales increase (“large turnover, small profit per unit”). Confronted with these alternatives, the monopolist will select that price which, multiplied by the number of units sold, will yield the maximum net profit. He will seek by a series of experiments to establish the location of this maximum point. This will vary, of course, from firm to firm, and from plant to plant. The decisive factor here is the elasticity of demand; upon it will depend whether an increase in price will induce a sharp decrease in sales or whether a decrease in price will stimulate a sizable increase in sales. If the telephone company can count on a high elasticity of demand for telephone service, it will find that a reduction in its rates will result in an addition to its revenues which exceeds the total of the amounts lost on the bills of the individual subscribers. Thus, the greater is the elasticity of demand the lower is the monopoly price, and vice versa. From this it follows that a monopoly of foodstuffs may have extremely dangerous consequences for the community, especially a monopoly of grains.

Because of the importance of the elasticity of demand in the determination of monopoly price, the managements of monopolistic enterprises—railroads, electric power companies, the post office, state tobacco monopolies—must base their price policies primarily on this factor and have a fairly clear notion of what the coefficient of the elasticity of demand is in the given case. The monopolist must also take into account the fact that the elasticity of demand is decisively affected by possibilities available to consumers to turn to a substitute product (from the railroad to the automobile, from the gas stove to a coal or electric stove, etc.). On the other hand, there are cases where the elasticity of demand is low, e.g., matches or sewing thread, objects which though they possess slight value in themselves nevertheless have great practical importance. Expenditures for such items are imperceptible in contrast to expenditures with which they are associated (for heating and smoking, and for suiting material and tailoring, respectively), while their mass consumption assures to the manufacturers a large profit.

The position of the monopoly price point is further influenced by the structure of costs at different levels of supply. If costs are of the increasing type (i.e., if they increase as output increases), then a higher price is more advantageous for the monopolist; if costs are of the decreasing type, it would be wise to establish a lower price. Mining monopolies (where increasing costs are encountered) may incline to a policy of restricting supply and keeping prices high, while the publisher of a copyrighted book such as this one will find it to his advantage to fix its price as low as possible; the resultant broadening of the market enables him to benefit from the dominant tendency in book production, which is one of decreasing costs.

This last example suggests a further complication in the formation of monopoly price. If, for instance, the present book were a novel or a play, the publisher would have at his disposal still other means of increasing his profit. To begin with, he could publish a deluxe edition of several hundred copies, on imperial Japan paper and bound in vellum, “numbered and signed by the author.” These he could sell to collectors at a high price. Next, he could bring out an ordinary edition at a medium price, and finally, a “popular” edition for the masses at a sensationally low price. For our publisher to have brought out the popular edition first would not only have entailed extra risks but a further obvious disadvantage in that those who might have been willing to pay a higher price for the ordinary edition, and even for the deluxe edition, would have profited from the lower price of the popular edition. By beginning with the more expensive type, our publisher puts to use his knowledge of the fact that a uniform price for the entire market establishes itself in accordance with the willingness to buy of the marginal buyers, i.e., those whose desire to buy is the weakest. Thus, the establishment of a single uniform price for a given commodity yields to all the buyers who otherwise would have paid a higher price for it a saving which they owe to the greater reluctance to buy of the marginal buyers. This saving, the counterpart of producers’ profits, is designated as consumers’ surplus, an expression to which, naturally, many will object since it refers not to a positive gain but only to a saving. It is understandable that the producers would cast a covetous eye on consumers’ surplus; they are compelled, nonetheless, to cede this much to the buyers so long as a uniform price obtains for all the quantities of a good sold within a given time period. A prime function of competition, we may note, is to ensure, through an easily understood process, such price uniformity.

But the monopolist has the possibility, thanks to price differentiation, of increasing his profit at the cost of the consumers. This is accomplished in such a way that the whole of demand is ranged in different classes, according to the different degrees of surcharge possible. Next, prices are adapted to the several classes on the basis of what the traffic will bear in each case, as shown in our example of the different editions of the same book. In this example, price differentiation was rendered possible by artificially dividing the good in question into different qualities, the markets for each of these quality classifications being then successively exploited. The practice of selling a good first at a high price and then, following a progressive saturation of the higher strata of demand, at a low price, is usual even in the case of patented manufactured articles. Consider the example of the so-called zip fastener. When it first appeared on the market, it was regarded as an amazing innovation and commanded a high price. Today, the zipper is so cheap that it has been adapted to thousands of different uses. Similarly, most of the price phenomena connected with the production and sale of articles of fashion are explainable in terms of this principle.

There is an abundant assortment of examples that could be cited to illustrate the process by which a good is divided, artificially, into different subclasses. The transport industries afford a prime instance of such class divisions. The establishment, by the railroads, of a hierarchy of rates for passenger traffic enables the managements of such enterprises to leave to the passengers themselves the business of finding their appropriate classification according to the rates they can afford to pay. Customers in the upper classifications are drawn thereto by the greater comfort, but more especially by concern for their social position and by the less crowded condition of the compartments, things which are precisely the result of higher rates. In this and in analogous cases, (e.g., at the theatre), price classification becomes the equivalent of quality classification; this is true in every instance where the payment of a higher price carries with it a visible social distinction and procures the advantages which result from less crowding in the higher price classes. We shall find this tendency to be the more marked the more crowded are the lower priced accommodations. Otherwise, it would be necessary to install more amenities in the higher price classes. Hence, in the case of a railroad whose coaches are normally filled to capacity, there will be no need for the management to spend much on better equipment for the higher priced accommodations. Quite other considerations, again, must be taken into account to explain the differences in postal rates for letters and for printed matter and, similarly, in electricity rates for the home and for the factory.⁴

The formation of prices on a purely competitive market or on a purely monopolistic one are, in reality, rare occurrences, for these “marginal cases” suppose the existence of conditions which are practically never completely fulfilled. Pure competition occurs only where the number of independent sellers is very great and where there is a perfect market, that is, a market where all the sellers and buyers are simultaneously and always aware of each other’s offers and among whom, accordingly, a process of continual adjustment is going on. These conditions are most nearly realized, however, only on organized markets, in particular, on the most advanced type of an organized market, the stock market. If free or perfect competition exists anywhere, there is where it must be sought. Rather different is the situation on the unorganized markets of which we select retail trade as the best known example. When I enter a store to buy myself a hat, I enter, indeed, the “hat market” in the broad sense that I assert my demand for a hat, simultaneously with the rest of the hat demanders, against the total supply of hats available. But since total supply and total demand in this case coincide neither in time nor in place, a quick over-all view of the market situation is lacking. I must have sought out many shops before being in a position to fairly judge hat prices; many customers must have left hat shops shrugging their shoulders before shop owners bring their prices down and in turn influence the hat manufacturers to do the same. It is to be noticed, then, that the entire mechanism of price formation functions in this instance slowly and hesitantly, a characteristic which explains the many monopoly-like peculiarities of price formation in retail trade.⁵

But the fact that free competition does not really exist in the chemically pure state, and that many prices contain a certain monopolistic element, must not lead us to conclude that our economic system rests, at bottom, no longer on competition but on monopoly. Such a conclusion would be quite wrong. It is to be observed, first, that pure monopoly is an even rarer phenomenon than pure competition. The most important instances in which the monopoly element prevails over the competitive element are: (1) natural monopoly where the few existing deposits of certain resources are owned by a single individual or group (e.g., the South African diamond syndicate); (2) juridical monopoly based on a grant by the state of an exclusive right to produce or sell a particular commodity (patents, copyrights, etc.), though such a right is usually valid only for a specified period; (2) transportation monopoly where the monopolist is protected within his production area against outside competition by the high costs of transport, a situation which may therefore also be termed area monopoly (for example, Pittsburgh steel manufacturers); (4) lastly, trade name monopoly arising from the susceptibility of consumers to advertisers’ suggestions that a given product is unique of its kind (use of brand names). But even in these cases the monopolies, as a rule, must reckon with a number of contrarieties: the possibility that consumers will shift to a substitute product, the tendency for outsiders to move in as the monopoly operations become increasingly profitable, and finally and above all, foreign competition (insofar as the monopolist does not succeed in warding off the latter either by inducing the state to establish protective tariffs or import quotas, or by organizing an international cartel). Finally, the monopolists have to beware of employing their power in such ruthless fashion as to incite public opinion and the state to retaliate; this, however, is an obstacle which may be effectively overcome by the monopolists’ skillful influencing of public opinion and of official bodies.

One of the particular accomplishments of modern economic science has been its investigation and definition of the several possible intermediary stages (“market forms”) which may lie between pure monopoly and pure competition. But however useful such a procedure, it has had the unfortunate consequence of leading many to conclude that the concepts “monopoly” and “competition” are, for practical purposes, unusable since, in fact, only the intermediate forms exist. Such blurred distinctions serve not only the monopoly interests but also the collectivists who would view only with uneasiness the restoration of a genuinely competitive economy, inasmuch as they need monopoly as a sort of Exhibit A in their arguments for the establishment of a state monopoly as the only remaining solution to the problem. It is certainly possible to define competition and monopoly in such a way that competition can be shown to be unrealizable; consequently, every attempt to take active measures to restore this narrowly defined “competition” to life will be doomed to failure from the start. Such a definition is, however, meaningless. To supply a definition which makes sense, we must begin with what is a decisive question for the ordering of economic life, i.e., how the actual productive forces of the national economy should be allocated as among the several alternative uses. Then monopoly appears as that market form which frees the producer (to the extent to which he controls supply) from the influence of the consumer over the uses of the productive forces. This arbitrary power of the producer attains its maximum extension when production, in accordance with the collectivist program, is concentrated in the hands of the state which then becomes the most dangerous and most powerful of all monopolists. Not the least reason for fearing a state monopoly is the fact that this most powerful of monopolies is simultaneously the one easiest to disguise with slogans.

A criticism which, at the present writing especially, is very widespread is that our economic system is now and will continue to be dominated by monopolies. To this our emphatic reply must be that there is no necessity for such a development. Indeed, it is astonishing how, in every case, competition sooner or later triumphs over monopoly, if only it is given the chance. To say that “competitive capitalism” is necessarily “monopoly capitalism” is simply untrue. The truth is that there is hardly a monopoly worth the name at whose birth, in one way or another, the state has not acted as midwife. Indeed, the history of heavy industry monopolies in Germany has shown that even where the state directly intervened to establish a monopoly, vigorous coercive measures were necessary to force the several producers under one roof. There would probably be few monopolies in the world today if the state, for numerous reasons, had not intervened with all the weight of its authority, its juridical prestige, and its more or less monopoly-favoring economic policy (including the policy of restricting imports) against the natural tendency towards competition. Constant and vigorous assertion of this truth is necessary since an exactly opposite view is generally affirmed, and in a manner such as to suggest the inanity of further discussion of the point. Decades of Marxist propaganda have greatly contributed to the diffusion of this bias. The reigning ideology which enthuses over the “monumental” and the “grandiose,” and which grows positively lyrical on the subject of “organizing” and “commanding” (at the expense of the natural and the spontaneous), is obviously an ideology favorable to monopoly. Neither do the monopolists fail to make the most of the state of mind of those who go about moaning that “capitalism” is dead or dying, that the competitive system is a contemptible and vulgar business which ought at the earliest opportunity to be replaced by a tightly organized economic system, and more of the same. Nothing, however, prevents governments from shaping their economic policies to the end that the natural tendency towards competition will once again be permitted to play its proper role in the economic system. Such action appears, at the moment, to be rather unlikely. This is certainly not the fault of “capitalism,” but a consequence of the dominance of certain ideologies. We have as little reason to suspend the fight against these ideologies as we have to doubt the economic noxiousness of monopolies (in most cases) in their ultimate effects.

The principal charge that can be formulated against monopolies is that they do violence, in the fashion already described in Chapter II, to the “business principle” and thus to one of the most essential principles of our economic system. Simultaneously, they introduce into economic life an element of arbitrary power which, in the extreme case of the complete and all-embracing state monopoly (collectivism), becomes absolute. Not only are monopolies in a position to reap super-profits (since competition alone can compel the rendering of a good or service equal in value to payment received) but they cause still further damage by gravely lessening the suppleness and adaptive power of our economic system.⁶

The full perniciousness of monopoly price formation becomes apparent when we remember that prices are the better able to fulfill their regulatory function in the economy the more flexible they are and the more faithfully they reflect the costs of production. Every price is a double appeal addressed to buyers and sellers: to the sellers an appeal to increase or restrict their supply; to the buyers an appeal to restrict or to increase their demand. Thus prices regulate simultaneously the use of the productive factors of the economy whose prices constitute, jointly, the production costs of a good. To sum up, prices are nothing other than continuous appeals to the consumers to decide which of the economy’s scarce production goods should or should not be, at any given moment, allocated to the various economic uses which can be made of them. It stands to reason that prices will the better acquit themselves of the function the less they are manipulated by monopoly power or by interventions of the state.

Only in one case is that situation characterized by the word “monopoly” (which in the strict meaning of its Greek root means “single seller”), viz., the exclusive concentration of the supply of a commodity in a single hand, a consciously pursued objective of economic policy. This is the case of the government’s fiscal monopoly by means of which a government (as in the well-known example of the tobacco monopolies of some countries [Austria and Italy]), having forcibly eliminated all competition, openly employs its resulting power to raise prices for the purpose of securing income for which it otherwise would be dependent on excise taxes on the commodity in question.

Precisely this special case makes clear that howevermuch a monopoly position may be desirable from a purely egoistic point of view, it is something which from the standpoint of the general welfare is undesirable, or at least must be regarded with serious misgivings. A consensus may be said to exist on the point that monopoly is basically undesirable because it involves the exercise of a degree of power in the economic and social life of the community which, even where the power is not consciously abused, appears incompatible with the ideals of freedom and justice and in addition creates the danger of disturbances of economic equilibrium and a lessening of productivity. Most people quite correctly associate with the concept of “monopoly” notions of exclusiveness, privilege, arbitrariness, excessive power, and exploitation. These characteristic attributes of monopoly are simultaneously the grounds for one of the most weighty and irrefutable objections to collectivism. As mentioned above, such an economic order, by its extreme concentration of production and distribution in the hands of the state, establishes a complete and all-embracing monopoly against which, in virtue of the apparatus of state coercion on which it rests, there is no appeal. The basic nature of such a system, moreover, is unaffected by possible decentralization of the governmental administration machinery or by the practice of inciting the state-run plants to compete with each other. The idea that in this case the state’s exercise of monopoly power provides a guarantee that such power will be employed in the interest of the general welfare is revealed as a fiction.

In a few important instances, monopoly is to be recognized on technical or organizational grounds as superior or even as essential; such instances are the so-called “public utilities” (gas, electricity, water, telephone) in which it is all but impossible to permit the existence of competing firms. All the more unendurable in such cases would be monopoly left to its own devices, particularly since what is at stake here are services which are indispensable to the public. All the more necessary is it, in cases such as these where monopoly is practically unavoidable, to establish a system of control and supervision of the monopolistic enterprises (see Note 6 following this chapter).

Recently, the attempt has been made (in particular, by Joseph A. Schumpeter in Capitalism, Socialism, and Democracy) to prove the advantages of monopoly by reference to the special case of public utilities. It is precisely the economic power and capital reserves of the large organization, so runs this argument, which favor technological innovation and progress. What is valid in this argument is that it cannot be known beforehand what use a monopolist will make of the power over which he disposes, whether he will merely extract profits from his enterprise, allowing it otherwise to stagnate behind the sheltering wall of market power, or whether he will seek to enter upon new paths of discovery and invention. What is true in any case is that the promotion of technological progress by means of monopoly can be expected only under specific, and for the most part only infrequently encountered conditions. The decisive fact remains that monopolists dispose of a degree of power over their markets and over the economy which a well-ordered, purposeful economic system based on a just relationship between performance and reward cannot tolerate. To the extent that technological progress is rooted in monopoly privilege, it is at least questionable whether the economic resources of the nation are being employed in accordance with the wishes of the consumer, such as these wishes would have manifested themselves in a context of effective competition.

At the same time, there is one consideration in this connection to which we must pay due regard if we are to arrive at usable definitions of monopoly and competition. Concepts of “pure” or “perfect” competition based on abstract mathematical models, whose assumptions must necessarily remain unrealized in the dynamic reality of economic life, should be replaced by the concept of “active” or “workable” competition in which the continuous striving of the producers for the favor of the consumers is emphasized as the essential note of competition. Where competition of this kind is maintained, it is probable that now one, now the other producer will advance ahead of others and thus acquire a special position. Such a situation is not to be described as “monopolistic” however, so long as other producers have “free entry” into the market in question and thereby the opportunity of themselves acquiring, in turn, such special positions. In this continuous testing and contesting of the protagonists in a given market, and in the incentives provided by the temporary advantages of market dominance, we see precisely that characteristic feature of competition which makes it such an extremely valuable institution. A position of dominance in the market need not be qualified as “monopoly” providing it is temporary and the leader is closely followed by competitors who are free to overtake him in turn. Hence, it does not follow that such progress as is promoted by the expectation and hope of taking the lead in a given industry should be attributed to monopoly. It is legitimate to speak of monopoly only where this competition for the “lead” is eliminated and the “lead” becomes a permanent position of privilege and power—a situation which is calculated more to hinder than to promote progress. On this reasoning, the state’s legal sanction by a patent of the “lead,” provided by an invention or innovation, constitutes not only just security for intellectual property rights, but also an indispensable economic incentive. Patent rights begin to be problematical, however, to the extent that competition is thereby hindered, and monopoly rights ending in abuses of market power are created.

Where competition is defined as a situation of continuous striving for the favor of the consumers, the concept of monopoly is correspondingly narrowed and limited to those cases in which this striving with its temporary positions of power is eliminated and replaced by a situation of permanently protected positions of power in the market. This makes it possible to set forth all the more unreservedly the evils brought upon the whole community by monopoly. They are found: 1. in the position of dominance of the producer over the consumer achieved in virtue of the elimination of the striving for the favor of consumers who, in turn, lose their appropriate economic role as the “sovereigns” of production; 2. in the resulting possibility of exploitation of consumers and the disruption of the just relationship between performance and reward (business principle), so that the monopoly price lacks the note of the “just price” peculiar to a competitive price; 3. in the weakening of the incentives inherent in competition to provide optimum supply in terms of both price and quality; 4. in the disturbance to the total economic order based on competition and free prices and in the resulting misallocation of resources; 5. in the creation of positions of power which seal off markets from new entrants, thereby depriving them of a fair chance at the economic and social opportunities which otherwise would have been available. Monopoly conditions may exist not only on commodities markets but also on the various individual labor markets in virtue of the power of strong labor unions to establish—by means of techniques such as the closed shop—exclusive control of the supply of labor. The resulting economic evils are analogous to those we have already described.

Applying what we have said thus far to the economic system which predominates in the free world, viz., the market economy, it is clear that such an economy, precisely on account of the central role played in it by competition, suffers a diminution both of its efficiency and its justice (in social terms) where it is plagued by monopoly. If it is desired to reap all those advantages of a market economy lacking in a collectivist economy, if what we wish is a “social market economy” of the type so successfully maintained by the German government since 1948, then the fight against monopoly and the maintenance of effective competition must be recognized as one of the prime conditions thereof.

To properly evaluate the possibilities of a successful fight against monopolies, we must note first that the emergence and even more the duration of monopolies (in the realistic sense used here) are confined within much narrower limits than is popularly supposed and is maintained by social theories which aim at putting the nature of the free economy and its prospects in the most unfavorable light possible. Equally erroneous, we may add, is the view that the development of modern economic life and technological progress tend in ever increasing degree to favor monopolism. If there is an immanent tendency in the free economy it is, today as yesterday, a tendency in the direction of competition, not monopoly. This tendency has been in our time strengthened rather than weakened due precisely to the continuous revolutions in technology and improvements in transportation—with their market-enlarging effects—and the economic development of new areas. Everything is in movement as never before and he who is on top today, whether he be the greatest and most powerful, can maintain his place against his closely following rivals only with the most strenuous effort. If, notwithstanding, monopoly remains one of the greatest problems of our age, this is due not alone to the fact that the conditions favorable to competition are realized only with delay and in any event incompletely, but also to the manifold, often unconscious governmental interventions which frustrate competition. Perhaps the most serious of such interventions are those governmental measures aimed at eliminating foreign competition by means of restrictions on imports.

There is no question but that the outmoded old-liberal view that the desirable situation of free competition is self-perpetuating so long as the state refrains from economic interventions of any kind has been shown to be a fateful error. At the same time, there is a kernel of truth in the notion. Maximum international trade has been shown to be a highly effective corrective for monopolistic tendencies. But it would be unrealistic to count on the realization of this ideal, and even in such case it would be an unjustified simplification to regard the problem of modern monopolism as solved. Consequently, the governments of the free nations of the world cannot avoid the obligation of making the restraint and reduction of monopoly the object of a specific antimonopoly policy. The obligation is indeed one of the most urgent confronting those anxious to defend the free economy successfully against a collectivism whose appeal and propaganda are based largely on the alleged monopoly elements in “capitalism.”

Since it happens only rarely that an individual producer can attain and maintain a more than temporary monopoly position (exception being made for the case of natural resources), the existence of monopoly generally supposes that a number of producers have joined together for the express purpose of eliminating competition among themselves (the principal form of such combination is the cartel, though it is to be observed that not all cartels are formed for the purpose of eliminating competition, in particular not such cartels whose interest is the promotion of more rational specialization, scientific research, and the exchange of technological information). In this case, freedom of contract is uniquely and illegitimately misused to restrict contractual freedom and hence economic freedom in general.

At the same time, the inherent difficulties and weaknesses of the cartel ought not be underestimated. As noted above, it is not easy to bring together the firms of a given industry and to keep them together in spite of their persistently divergent interests, and it is still less easy to deal effectively with the omnipresent threat of competition by outsiders who can destroy the cartel by selling below the cartel price. With the intent of overcoming such difficulties the cartels customarily resort to the technique of “compulsory membership,” a procedure which must arouse the deepest misgivings. A further disturbing fact is that the difficulties attendant on the formation of cartels vary in severity in different industries (they are least important in those heavy industries which consist of a few large firms, whose fixed capital investments are large, and which are engaged in the production of homogeneous mass-produced commodities), with the result that the less “cartelizable” industries (finished goods industries such as the textile industry) are at a serious disadvantage.

Antimonopoly policy is consequently essentially identical with the legal control of the cartel form of organization. Such control may take three forms. The mildest—and therefore also the least effective—form is the one under which cartels are admitted in principle and only their “abuse” prohibited (principle of prevention of abuse). The second possibility is the prohibition of cartels as such, enforced by the police power of the state (principle of prohibition on the model of the American antitrust legislation of 1890). The third and most desirable form of control is to make cartels subject not to criminal but civil prosecution and thereby to deprive a cartel agreement as an abuse of freedom of contract of the protection of the law (principle of denial of legal protection), without prejudice to the legal exceptions that might made to such a general rule. There is ground for the expectation that the adoption of this form of control would solve the problem of monopolism satisfactorily and silently.

5. Price Interrelationships

Up to now we have considered the formation of prices only on a limited market, as if each time we had to do only with a particular market and a particular good. In truth, however, the several markets are more or less closely interconnected and to this fact we must now give a moment’s attention.

Markets are related to one another first in the general sense that supply and demand on one market are somehow affected by total demand and total supply on all other markets. If more of one good is suddenly demanded, less of some other good will be demanded. If small plane flying should become a popular sport, it is probable that the demand for baby carriages and baby clothes would decline since the incomes of most people would be insufficient for the upkeep both of an aeroplane and a numerous family. If bread and butter are expensive, the demand for books or furniture will suffer—one could give endless examples of this.

But besides this general interdependence of all markets, we find also a special and narrower interdependence of those markets which, in one way or another are directly “joined.”

The first example of such a joint relationship is the case of commodities which are substitutes for one another: margarine for butter, artificial for real silk, tea for coffee. It is clear that movements in the prices of such substitute goods will show a marked parallelism. These market relationships have an additional importance in that the possibility of substituting one commodity for another provides consumers with alternatives that tend to limit excessive price fluctuations.

Consider now a second and still closer interrelationship resulting from the so-called joint production of goods. This concept is taken to mean goods which are produced simultaneously by the same productive act, such as gas, coke, and tar in gas (or coke) production, or as iron and slag in foundry operations, or as wool and meat in sheep-raising. All these cases—and they are surprisingly numerous—of joint production present a most interesting variation from the usual type of price formation. Goods of this type are the Siamese twins of the economy, each of whom has its own life and would like to follow its own way but is nevertheless linked inseparably to the other. The salient point is that one of the linked goods cannot be produced without the other; their costs of production are joint and indivisible. It is of course true in this case as elsewhere that total receipts must cover the combined costs of production if production is to be maintained in the long run. The proportion in which the costs of production are shared by the jointly produced commodities (as reflected in their prices) is determined by the intensity of demand for the one and for the other commodity. If there is a greater demand for one of the products than for the other, the one for which there is the lesser demand must be sold at a price low enough to assure the disposal of what amounts to a “waste product.” Thus, if the demand for the principal commodity increases without a corresponding increase in demand for the by-product, there may result, by reason of the unavoidable joint production relationship, a marked fall in the price of the by-product. Consequently, those producers who are concerned solely with the by-product, may find themselves in a most vexing situation. A good example of this is silver which, in recent times, has been supplied largely as a by-product of copper and zinc production. Since the demand for copper and zinc has increased much more than for silver, a fall in the price of silver has ensued which—until the rise in silver prices in 1961-62—severely affected operations of mines engaged in the production of silver only.⁷

Consider next, as a final example of market interrelationships, commodities which are complementary to each other and which arc consequently jointly demanded. There are many such goods: ink, pens and paper; trout and white wine; collars and ties, etc. The understanding of this market relationship can be of real importance for those responsible for economic policy. If, for instance, it is desired to better the position of a given industry, an efficacious course of action might be to lower the price of a complementary good. One could, for example, bring about a preceptible improvement in the position of the dairy industry in many countries by lowering the tariff on coffee imports.

6. Foreign Trade and International Price Formation

For a highly developed country, self-sufficiency remains a dream and, to vary a well-known expression of Moltke’s, not even a pleasant dream—all the less pleasant the larger, the richer, and the more powerful a country is and wishes to remain. It is fitting, then, that we include in our survey a brief description of the special characteristics of international market and price relationships.⁸

Technical advances in the transportation and preservation of goods have gradually eliminated the chief obstacle to commerce between widely separated regions, viz., the expenses and the losses connected with the conquest of distance. Indeed, international trade has truly become world trade, linking together not only neighboring countries but also those most remote from one another. To be sure, not all goods are equally suited to international trade, since the resistance of each good to the conquest of distance varies. There are goods which are real globe-trotters, whose motto might be said to be “where I prosper (i.e., where I get the highest price), there is my country.” They are of such robust constitution that neither the longest overland trips nor the most fatiguing sea voyages seem to affect them. They do not spoil; moreover, their specific value (i.e., their value per unit of weight or volume) is high enough to remain relatively unaffected by transport costs. These are the goods which are designated as international goods. To this group belong the bulk goods of world trade: wheat, metals, rubber, coffee, textiles, etc., and the majority of manufactured goods.

Other goods are not so cosmopolitan. Their “patriotism” is so marked that only in exceptional cases do they undertake a trip abroad. To this group belong goods which spoil quickly: strawberries, fresh fish, livestock, and finally—the proletarians among goods—paving stones and bricks. The latter could no doubt survive the longest voyage, but their specific value is so slight that they would be unable to afford the travel expenses involved. Lastly, there is a group of goods whose patriotism is truly staunch; there is nothing to be gained in their being shipped abroad. Such are goods which, as in the case of certain household goods, serve solely for the satisfaction of a want peculiar to one country.

In addition to material goods, services have acquired increasing importance in world trade, a proof of which is the ever-growing extension of tourist traffic (the so-called “invisible” imports and exports). The majority of services must, in fact, be procured in a given locality and it is upon this peculiarity that the tourist trade rests. The movement of tourists to Switzerland thus represents a virtual (invisible) exportation, though it is certain that not every Zurich barber realizes that in cutting an English traveler’s hair, he is engaging in the export business.

It is, however, not without interest to note the fact that technical progress has made possible the transportation of services which heretofore were available only locally. The motion picture industry, for example, makes it possible for a theatrical performance to be packed in a tin and shipped, ready to be enjoyed, throughout the whole world, a development which has had no small significance for the world economy. Radio and now television-by-satellite render even the film-container superfluous. Whether application of the canned goods principle to art will preserve its quality while increasing its quantity remains an open question.

But international trade is not confined to goods and services alone. It also includes, exactly as trade within a country, every conceivable type of credit transaction and capital transfer. In the course of the development of international trade, the latter activities have acquired ever increasing importance, but they pose problems too complicated to be discussed here.

The importance of international trade can hardly be over-emphasized. The fact is that the nations of the world have, in recent generations, attained a degree of economic interdependence of which few persons have any accurate idea. All countries, all regions are today so closely linked together by economic interrelationships of every kind that a whole has been created in whose successful functioning, as well as in whose decline and destruction, all share. If we do not succeed in rebuilding the structure of the world economy, so heavily damaged by the storms of recent decades, every country will be condemned, in greater or lesser degree, to the ravages of a lingering aenemia. No country can remain indifferent to the success or failure of the reconstruction of the world economy. No country which has its own interest at heart can afford not to contribute its share to such a reconstruction.

A fact which merits the attention of psychologists and sociologists is the astonishing inability of most people to comprehend any matters relating to international trade—a purblindness such as they manifest towards no other aspect of economic life. Surrounded by this incomprehension, the economist’s task is a truly ungrateful one. Having in view the welfare of his country, his concern is to explain dispassionately the nature and functions of foreign trade, disassociating these from the extra-economic difficulties arising from such trade. However, the effort to reveal the inanity of the arguments which are invoked in favor of sealing up the country economically, and to expose the superstition behind the fear of an unfavorable balance of trade is one which generally meets with a peculiarly disappointing response. It is not without reason that the great English economist Alfred Marshall could say that for a true economist it was almost impossible to be a good patriot and to have at the same time the reputation of being one.

It is, of course, true that it is precisely in the realm of international trade that we encounter concepts which are especially difficult to comprehend. These concepts can be mastered only when we begin by considering the nature of international trade in its simplest form, starting with the idea that, exactly as internal trade, it rests on the division of labor and on the exchange of goods resulting from this division of labor. No matter how widely extended in space is trade arising from the division of labor, nor how bewildering the tangle of enterprises that compose it, the whole resolves into one process, the nature of which was previously made clear in our discussion of the structure of the division of labor. The fact that in the case of international trade the participants in the process belong to different payment communities does not any more change its underlying character than the fact that they possess different passports and different residences. Nonetheless, international trade encompasses a number of peculiarities which, in a given instance, may give rise to difficult theoretical and practical problems.

Once we have grasped the idea that foreign trade is founded on the principle of the division of labor, the real functions of imports and exports become immediately clear, and a number of misunderstandings are dissipated. Above all, we are in a position to rectify the widespread notion that an export is something good and an import something bad, so that what matters most is to export as much as possible and to import as little as possible. Clearly, exports and imports stand in the relationship of means to end: to be supplied as abundantly as possible with goods is the end, but since the foreigner, alas, generally does not make us a gift of his goods, we must give something for them, and what we give are exports. There are, to be sure, many commodities which we get gratis from abroad, e.g., birds of passage, flotsam, fish, and so forth, and if the concept “abroad” is taken in a vertical sense, we can also include in our reckoning sunlight, meteors, and other presents from Heaven. No one will complain over these cases of “pure” imports, no one will anxiously inquire whether there has been a corresponding export. But the cheaper is a foreign good, the closer it approaches to being a free gift. The less must a country export to pay for its imports, i.e., the higher are export prices in comparison to import prices, the greater is that country’s gain from the international division of labor.⁹

This conclusion, however, is so opposed by current opinion on the subject, that we must attempt still a second demonstration of its truth. When a country does not produce everything itself but procures some things through exchange with another country, it adopts a method which—as we learned in a foregoing section of this book (pp. 66-67, 129)—permits it to produce certain products cheaper than before. Let us suppose that foreign trade between Turkey and Switzerland consists in the exchange of Turkish tobacco against Swiss paper. We may then conceive of the paper factories in Switzerland as nothing other than huge machines producing cheap tobacco. Conversely, the eye of the economist discovers that the tobacco fields of Anatolia are, in the last analysis, plantations on which paper is grown more cheaply than if it were produced directly. Foreign trade is similar, then, to a labor-saving machine or to any other method of lowering production costs. The usefulness of this machine is the greater, the more favorable is the ratio of cost to yield, i.e., the less we are required to export in order to obtain a given quantity of imports. The dearer is tobacco and the cheaper is paper, the better it is for Turkey, and vice versa for Switzerland. Were the Swiss to put an end to this exchange by prohibiting tobacco imports and growing tobacco themselves, they would be behaving exactly as if they had smashed a labor-saving machine. In addition, the question would arise as to who would now buy Swiss paper, for the Swiss who had up to this point purchased Turkish tobacco had also thereby indirectly purchased their own paper. Conversely, by prohibiting the import of paper, Turkey would not only deprive herself of good and inexpensive paper but would cause a part of the harvest of tobacco to remain unsold inasmuch as every Turk who had purchased paper had also indirectly purchased Anatolian tobacco.

But perhaps all that we have said thus far is not fully convincing, since it appears to suggest that there is really no foreign trade problem at all. Should all countries then proceed to pension off their customs officials? Although worse things could befall mankind, our preceding reflections have had no such radical objective in view. Foreign trade, in fact, encompasses a number of problems which are extremely difficult to solve and which may justify some degree of state regulation. But these problems are quite other than what they are usually thought to be. It is impossible, in a few words, to give any adequate description of them. It must suffice to refer to what has already been brought out in another part of our inquiry: that for the increase in productivity which we owe to the division of labor we must pay a price in the form of possible economic, social, and cultural disadvantages. The further the division of labor is pushed, the more proper it becomes to ask the question whether this price is not too high. This applies especially to the international division of labor which, for obvious reasons, is possessed of a particularly unstable and uncertain character. It is for this very reason that the ideal of obtaining provisions as cheaply as possible is, at present, frequently thrust in the background in favor of other ideals. We should beware, nonetheless, of allowing ourselves to be led astray by those who cite these ideals merely to cloak their own economic interests. To this we may add that the importation of cheap goods, though generally advantageous at present, can have a paralyzing influence on the future development of domestic production or can lead to costly dislocations to which it would be undesirable to see the domestic economy exposed. These few remarks must suffice to show that one need not do violence to logic to justify the purposefulness of governmental interventions in foreign trade. Economics does not teach that every intervention of the state is an evil; it teaches only that it is necessary to weigh carefully the facts in the given case, and thereby proves itself to be the indispensable instrument of a far-sighted and genuinely national policy.

In spite of all we said thus far, we have not yet fully clarified the principle of the international division of labor. Carrying our inquiry further, we discover a difficulty which has already given rise to many wrong opinions. When I write books and leave to the carpenter the job of making bookshelves, I provide one more instance of that division of labor in which every individual is superior in his own field to the nonprofessional and indubitably the better off, economically, for such specialization. But what if it is a question of cataloguing my library? Would it be advantageous for me to engage someone for this task, even though I can do it better myself? Should I engage a gardener to spade my garden although I could do the work just as well myself? There can be no question that it would be to my advantage to employ a librarian and a gardener if my skill in writing books is greater than in cataloguing or spading. It is easy to transpose these simple cases to the level of the world economy. In the exchange of goods between tropical countries and northern industrial countries we have an obvious case of reciprocal superiority in production. We can now also understand how two countries can enjoy a profitable commercial exchange even though one of them is inferior to the other in all branches of production, the proviso being that its inferiority is not the same in all branches of production. Israel for example, is a country which has received a niggardly endowment from Nature. Many infer from this that the Israeli economy should be protected against competition from more favored countries. But there is no reason why Israel should not also enter into advantageous trade relations with countries which are superior to it, if it limits itself to those branches of production in which its inferiority is the least. On the contrary, since Israel can change nothing with respect to its generally rather unfavorable production conditions, the resort to tariff protection to render profitable branches of production in which its inferiority is relatively great can only worsen its situation, to say nothing of the fact that thereby the burden of its productive inferiority would probably be shifted to weaker shoulders. Naturally, such a country must resign itself to having low money costs (meaning, chiefly, low wages), but it would be a still poorer country were it to refuse to share in the division of labor of the world economy. Poor countries can afford even less than rich ones to shut themselves off from the world economy.

In a world where people could move freely from one country to another, equilibrium would result from the fact that people inhabiting the poor countries would flow into the rich countries until average incomes had attained the same level everywhere. There would be, then, no rich countries or poor countries, but only countries with dense or sparse populations. But since there are in fact a thousand and one obstacles to international migration, people must accommodate themselves to unfavorable production conditions by being content with low average incomes. Moreover, their situation could not fail to be considerably improved by the fact that the world economy would allow them to confine their production to the industries in which they can best meet competition. In this way, the international movement of goods acts as a substitute for the now shackled international movement of persons.¹⁰

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* This type of compulsion is found in some European countries. A parallel American example would be the law which requires margarine to be sold uncolored, thus indirectly increasing demand for butter.—Translator’s note.

NOTES

1 (p. 143) The Interplay of Supply, Demand and Price

Price, on a free market, is stabilized only when it has reached a point at which supply and demand are equal. It follows at once that every variation from this equilibrium point acts on supply or on demand in such a way that the price oscillates around the equilibrium point. A diagrammatic representation of this mechanism (in its simplest form) will help us to grasp the relationships involved:

In this diagram, the unit quantities of a good are inscribed on the X axis while the monetary units are inscribed on the Y axis. The curve NN—called the demand curve—indicates which amounts of a given commodity would be demanded at different possible prices. This curve is, of course, arbitrarily drawn, but it shows us that the amount demanded tends to fall when the price rises and decreases when the price falls. Correspondingly, the curve AA’—called the supply curve—indicates that supply increases with rising and decreases with falling prices. If we let P denote the point at which the two curves intersect, then the equilibrium price, according to our elementary axiom, is PM. We may establish the truth of this proposition by employing a sort of indirect geometrical proof in which we suppose that a higher price obtains (for example, we may suppose that price lies at the point P₁M₁). From our diagram it is clear at once that this price is untenable, since there will now be an excess of supply over demand (P₁P₁) which will depress the price until it has fallen back to the point P. The same principle applies if we suppose a case in which the price is at a point below P (e.g., at P₂). Hence, it follows that in the long run no other price than the price PM is tenable.

The above diagram ought to be engraved on the memory since it provides an easy and exact demonstration of the simultaneous interplay of supply, demand and price. It shows, moreover, with especial clarity, that supply and demand should never be regarded independently of price; that, on the contrary, every price is, other things being equal, related to specific aggregate amounts of supply and demand. This is what we have referred to in the text as the supply schedule and the demand schedule. Changing conditions (e.g., fashion changes on the demand side, technological progress on the supply side) can, of course, cause supply and demand schedules to change. In this case we must bring about a shift of either the supply curve or of the demand curve. Assume that the market of interest is the market for electric light bulbs and assume further that a new process of manufacture has brought about a reduction in the costs of these bulbs. We shall find that we should have to substitute a new supply curve for the old (e.g., A₁A'₁). The new equilibrium price will be found to lie at some point lower than the previous one.

The form of demonstration selected here goes back to Alfred Marshall whose Principles of Economics (8th ed.; London, 1922) is indispensable for a thorough study of the interrelationships which we have sketched in outline only. See also: H. D. Henderson, Supply and Demand (New York, 1922); E. Barone, Principi di economia politica (ist ed.; Rome, 1908); George J. Stigler, The Theory of Price (2nd ed.; New York, 1953); H. von Stackleberg, Grundlagen der theoretischen Volkswirtschaftslehre (Berne, 1948); W. Krelle, Preistheorie (1961). The Marshall study gives us a glimpse of the theoretical difficulties encountered in any careful analysis of the theory of market equilibrium. One of these difficulties, perhaps the greatest, caused Marshall himself no little trouble and has even in recent times continued to be a point of intense interest to economists. The difficulty emerges when account is taken of “time”—a factor which in economic analysis is all too easily neglected. Where the time factor is included, it will be found that while one set of consequences may be yielded in the short run, another, perhaps very different set will be yielded in the long run. As the example of the automobile shows, an increase in demand over a long period can cause a fall in prices due to the fact that, in accordance with the law of mass production, it results in a shifting of the supply curve towards the right.

2 (p. 147) The Elasticity of Supply and Demand

The slopes of the supply and demand curves also reflect the degree of elasticity of supply and demand. The less is the amount of slope of the curve, the greater, in both cases, is the elasticity. The particular problems connected with these concepts, which are as important as they are interesting, have received increasing attention in the literature. Cf. Henry Schultz, Statistical Laws of Demand and Supply (Chicago, 1928); G. F. Warren and F. A. Pearson, Interrelationships of Supply and Price (Ithaca, N.Y., 1928); J. Marschak, Elastizität der Nachfrage (1931). The concept of elasticity obviously opens up a fertile field for statistical mathematics, and there is every reason for continuing to follow progress in this field with the closest attention (e.g., the calculation of exact coefficients of elasticity for individual commodities). If it is planned to increase the amount of a consumption tax or of a tariff, to reduce railroad rates or to enact some similar measure, it is generally desirable to have a precise idea of the elasticity of demand in the given case in order to evaluate the possible consequences. To be sure, it should not be forgotten that in the matter of elasticity coefficients we are dealing with historical, and hence changing data, and not with constant magnitudes. On these matters, see L. von Mises, Human Action (New Haven, 1949), pp. 347-354, a book which takes a decided and, we may add, justified stand on the issues in question and simultaneously warns of the misuses of mathematical methods in economics.

3(p. 148) Kings Rule

It may prove helpful, in trying to grasp the meaning of King’s rule, to dwell for a moment on a highly simplified economic situation. Let us suppose that in a given year wheat is harvested to a total of 100,000 bushels and that at the price of $1.00 per bushel it yields a total income of $100,000. Suppose further that in the following year the harvest reaches 125,000 bushels. Will total income be the same, higher, or lower? It is clear that this depends solely upon the elasticity of demand for wheat. If elasticity is such that demand increases in exactly the same proportion in which the price falls (unitary elasticity) total income, where price is $.80 per bushel, will again be $100,000. But let us now suppose that the coefficient of elasticity for wheat is less than 1. Then the total income yielded by the new harvest will be less than the amount received for the previous year’s harvest. At a price of $.70 per bushel total receipts would amount to only $87,500. This does not necessarily mean that the farmers will be worse off for it is still required to know what the costs per unit would be for a more abundant harvest. It can be supposed in any event that in not a few instances farmers stand to gain less from an abundant harvest than from a poor one. Cf. W. Röpke, “Das Agrar-problem der Vereinigten Staaten II, “Archiv für Sozialwissenschaft, Vol. 59, 1928, pp. 96 ff.

We must proceed, cautiously, however, in attempting to make practical use of King’s rule in the field of agricultural policy. In the first place, we should keep in mind that this rule applies only to grains. In the case of refined as distinct from raw agricultural products, the coefficient of elasticity of demand is higher (unity and above). This means that, for example, in a period of declining prices (or rising consumer incomes) the prospects for increased sale of butter and similar products may be considered good. There is little cause to fear over-production if the farmer is given the opportunity of obtaining inexpensive cattle feed and, in consequence, finds himself able to get by with a lower price for his butter. The results of over-production may be additionally offset by economic policy aimed at raising the income of the consumers (and thus incidentally favoring the production of the refined agricultural products). In the middle European countries where the production of refined agricultural goods, due to the proximity of markets, enjoys a natural advantage over the production of staple foods (grains), a rational agricultural policy will consist above all in a policy of lowering tariffs on grains. From such a policy, the following will result: (1) cheapening of the costs of production for the refined agricultural products; (2) increase in the amount of consumer income available for such products; (3) fall in the price of the refined commodities and to this extent a sensible improvement in the urban food supply; (4) contracting of advantageous trade agreements, improvement of the situation of the export industries, and increase of consumer incomes; (5) specific improvement of the small agricultural unit (peasant holding)^* and, since the production of refined agricultural products requires an especially intensive application of labor, an increase of employment opportunities in agriculture. On these questions see: W. Röpke, German Commercial Policy (London, 1934); W. Röpke, International Economic Disintegration, op. cit.; W. Röpke, The Social Crisis of Our Time (Chicago, 1950); W. Röpke, Civitas Humana (London, 1948); W. Röpke, International Order and Economic Integration (Dordrecht, Holland, 1959).

4(p. 156) The Formation of Monopoly Price

Here again the decisive relationships are best demonstrated with the aid of a diagram. As previously, we inscribe on the X axis the units of quantity, and on the Y axis units of money, and we suppose NN’ to be the curve of demand for a given monopolized commodity.

Moreover, we assume that the monopolist’s costs of production per unit remain the same, regardless of the amount of production (constant costs). We designate this cost behavior by the straight line KL. The monopolist will naturally choose a price situated somewhere above OK. But where? Which of the many possible prices will he choose? Should he choose too high a price, he will, as we can see from our diagram, be able to sell only the quantity OA. The whole of his gain will be inscribed in the rectangle PKK₁Q. If, on the other hand, he wishes to sell a large quantity, e.g., the amount OC, it is evident that he will have to lower his price to OP₁ In this case his gain is PKK₃Q₁. Clearly, the monopolist has chosen in this case too low a price. He will now proceed to experiment until he has arrived at the price OP₂, at which the product of the quantity sold times profit per unit attains its maximum. This is shown in the rectangle P₂KK₂Q₂. The reader is free to vary the diagram to take account of rising or falling unit costs or different degrees of elasticity. In this way, he can chart for himself the relationships we have dwelt on in the text.

The richly complicated theory of monopoly price belongs to one of the most intensively developed sectors of modern economics. It is a field which is especially suited to mathematical analysis (Pantaleoni, Edgeworth, Pigou, Stackelberg, et al). An excellent survey of the subject of monopolistic price differentiationwill be found in the monograph of my student Kurt Michalski, Das Prinzip der Preisdifferenzierung (Marburger sozialökonomische Forschungen, No. 1, 1932). See also: R. Bordaz, Coûts constants et prix multiples (Paris, 1942).

5 (P. 157) Price Formation under Imperfect Competition

Perfect competition may be precisely defined as that situation which obtains when demand for the output of each producer is perfectly elastic. Otherwise expressed, under perfect competition no producer can ask more than another without risking the loss of all his customers; should he demand less than other producers, they would lose all their patronage to him. These being the prerequisites of perfect competition, it is understandable how rarely such a market situation occurs. In most cases, competition is in fact more or less imperfect. The ensuing problems are just those which have been most searchingly analyzed in recent economic literature. In particular, there has been much attention given to the importance of advertising as a cause of “imperfect (monopolistic) competition.” See especially: E. Chamberlin, The Theory of Monopolistic Competition (Cambridge [Mass.], 1933); J. Robinson, The Economics of Imperfect Competition (London, 1933); R. Triffin, Monopolistic Competition and General Equilibrium (Cambridge [Mass.], 1940); A. Kozlik, “Monopol oder Monopolistische Konkurrenz?” Zeitschrift für Schweizerische Statistik und Volkswirtschaft, 1941; H. von Stackelberg, op. cit.; W. Fellner, Competition Among the Few (New York, 1950); Monopoly and Competition and their Regulation, ed. W. H. Chamberlin (London, 1953); F. Machlup, The Economics of Sellers’ Competition (Baltimore, 1952).

6 (p. 160) The Harmfulness of Monopoly

To the list of the evils of monopoly already cited we can add still others to which reference will be made in a later chapter. At the same time, we ought not to lose sight of the fact that in a restricted number of cases monopoly is economically superior to competition. We refer here to those enterprises termed “public utilities.” Such enterprises have a twofold character: on the one hand they serve to provide the public with goods and services of vital importance (electricity, gas, water, railroads, streetcars, busses, postal services, etc.); on the other, the very essence of these enterprises is such that to permit the establishment of competing units would be uneconomical, if not also technically impossible in view of the large amounts of capital involved as well as the complicated network of property rights which public utilities require (e.g., the underground conduits for wires and cables required by the telephone company).

The politico-economic problem of public utilities resides in the fact that while their monopoly character is more or less unavoidable, it is at the same time particularly dangerous since these enterprises serve to satisfy urgent (i.e., inelastic) public needs. For the solution of this problem there are two possibilities: either we allow the public utilities to exist as private enterprises, though still requiring them to submit to governmental regulation, or we establish in their place official state or community monopolies. Which of the two solutions would be the more purposeful can be determined only with difficulty, since much depends on the special circumstances obtaining in each country and on the particular type of public utility in question. The experience of the United States, where the system of regulated private monopoly prevails, has shown that efficacious supervision is difficult to realize and may well involve serious inconveniences. The over-all disadvantages of state-managed enterprises, on the other hand, argue against the system of state monopolies. (We may note, however, that it is precisely in the case of [publicly operated] public utilities that management is subjected to a salutary scrutiny. The enterprises in question are daily and hourly in intimate and sensitive contact with the public. It is the prestige of the state or of the community which is at stake when complaints are directed against the public utilities of overcharging or poor service, while a well-administered public utility may prove to a particularly effective advertisement of the virtues of public ownership of enterprise.)

7 (p. 167) Joint Production

Price formation in joint production is interesting from a theoretical standpoint for it is one of those cases in which the classical economists had already been forced to recognize the impossibility of explaining price behavior by means of a cost-of-production theory and the necessity of returning to the concept of demand for such an explanation. It was Marshall who undertook the first thorough investigation of the problem.

In the text, it was assumed that the quantitative ratio obtaining as between a pair of jointly produced commodities is determined by the technical peculiarities of the productive process in question. However, we find frequent instances in which this proportion can be changed by the producers, for example, by the breeding of sheep for wool instead of for meat and vice versa. In these cases, there is a perceptible loosening of the link that binds the jointly produced commodities together. Cf. Henderson, op. cit., Chapter V.

The practical importance of joint production is very great and is in the way of becoming even more so. We see its significance with especial clarity in agriculture (Cf. H. Marquardt, Die Ausrichtung der Landwirtschaflichen Produktion an den Preisen (Jena, 1934). Indeed, even the different floors of an apartment house can, save the top floor,^* be considered as jointly produced goods. Here, too, the production costs of one floor cannot be distinguished from the production costs of another, with the result that rents are graduated according to the intensity of demand, the first floors (“beletage”) generally getting more.

8 (p. 168) The Theory of Foreign Trade

International trade has always occupied a large place in economic theory. Even as far back as the classical period, it was a well-developed branch of economic science, its aim being the investigation of those special characteristics of the economic process which derive from the nature of international trade (the conquest of distance, the relative immobility of the factors of production, the differences in monetary systems, political factors, etc.). Much attention has been devoted to analysis of the monetary factors, as we have indicated above (Chapter V, Note 10). In addition to the books mentioned there, see: G. Haberler, Theory of International Trade (London, 1950); G. Haberler, article “Aussenhandel,” Handwörterbuch der Sozialwissenschaften, 1954; B. Ohlin, Interregional and International Trade (Cambridge [Mass.], 1933), deals especially with the problem of foreign trade as a special case of the general economic problem of distance; W. Beveridge, et al, Tariffs: The Case Examined (London, 1931), a very instructive combination of theoretical and practical problems; J. W. Angell, The Theory of International Prices (Cambridge [Mass.], 1926), a thorough treatment of the monetary aspects; R. F. Harrod, International Economics (London, 1939); P. T. Ellsworth, The International Economy (New York, 1950); W. Röpke, International Economic Disintegration, op. cit.; W. Röpke, International Order and Economic Integration, op. cit. Outside of what may be said to fall into the category of simple denunciations or invective, the attempts (made in these books) to overthrow classical theory are surprisingly rare. Most such attempts amount merely to corrections, greater or lesser as the case may be, of classical theory. A case in point is Friedrich List’s National System of Political Economy (1841) which was said to have had the merit of effectively combating, from an historical and evolutionary standpoint, the “long run” formulae of the classical economists. In fact, List’s work represented only an important stage in the perfecting of classical theory. A more recent and more radical attempt of this sort is that of M. Manoilesco, Théorie du protectionnisme et de l’échange international (Paris, 1929), effectively criticized by B. Ohlin in “Protection and Non-Competing Groups,” Weltwirtschaftliches Archiv, Vol. 33, January 1931. Those who oppose to the pure theory of foreign trade politicomilitary arguments will find they are forcing an open door. Adam Smith long since assigned a preeminent place to such arguments. One can subscribe fully to the scientific theory of foreign trade and still take sides for a closed economy; in such case one has at least the advantage of being perfectly aware of the “costs” involved. Most of the attacks against economic theory in general, and against the theory of foreign trade in particular, stem from nothing else than a fear of clarity: the attackers try by the sheer loudness of their polemics to give the impression that their arguments are weighty.

9 (p. 171) The National Gain from Foreign Trade

Taking a closer look we find that foreign trade procures the following advantages: (1) Certain products are obtainable only by means of foreign trade, viz., those which do not exist inside the country or which can be produced there only at enormous cost (e.g., the greater part of the industrial raw materials used in Europe’s industrialized regions). (2) Foreign trade provides us with goods which, though it may be economically possible to produce them at home, will cost us still more than if we imported them from abroad. Hence, it is preferable to import such goods in exchange for those products which can be produced more economically at home. (3) In the distribution of goods through space and time foreign trade acts as a compensatory mechanism by means of which an international balance is established as between the several national markets, thus putting an end to a situation (of frequent occurrence in former times) in which surpluses prevailed in one country and famine in another. It is a sort of escape valve which assures a practically constant “atmospheric pressure,” a kind of insurance against the enormous fluctuations to which, otherwise, economic life—were it subject only to the influence of harvests—would be exposed. How important this function is, becomes clear when the mechanism of the world economy breaks down. (4) Foreign trade is an effective antidote to the monopolistic hardening of the arteries of the several national economies, for it subjects the attempts of business units to “coalesce” to the pressure of foreign competition, thus tending to prevent a degeneration of our economic system through “capitalist” exploitation.

Each country participates in these advantages of foreign trade. Naturally, this does not exclude the possibility of one country having a numerical gain greater than that of another country; that is determined by the ratio of export to import prices or, by what amounts to the same thing, the quantity of imports which can be had for a given quantity of exports (the “real ratio of exchange,” Taussig’s “barter terms of trade”). How important this concept is, is shown by the example of such countries as National Socialist Germany where, thanks to export subsidies on the one hand and the increased price of raw materials (resulting from clearing and compensation agreements) on the other, the barter terms of trade underwent substantial deterioration. The “undervaluation” of a country’s currency on the world’s exchanges has the same effect. There can be no doubt but that the terms of trade is an important factor in national prosperity.

10 (p. 174) The Law of Comparative Costs

The interrelationships which we sought to clarify in our discussion of Israel’s economy are usually considered as deriving from the law of comparative costs, first formulated by Ricardo in his Principles of Political Economy and Taxation, Chapter VII. Strict interpretation of his (in its general outlines still accepted) concept gives rise to difficulties, as shown by the more recent literature on the subject. These difficulties, however, in no way affect the essential truth of the law. It is to be observed that it is also as applicable within a country in which there are regions possessing different economic characteristics as it is between different countries. Thus, conditions of production in eastern Germany were certainly more unfavorable, under almost every head, than in western Germany, a fact which in no way prevented both halves of the country from enjoying the benefits of a close economic relationship, unencumbered by any internal tariff walls. No doubt eastern Germany, in order to be able to compete with other suppliers, had to content itself with a lower wage level, but it cannot be denied that if it had erected a customs barrier against western Germany, it would have placed itself in an even worse position. In spite of the almost complete economic inferiority of eastern Germany, both East and West were mutually advantaged by the resulting division of labor, the East limiting itself to that branch of production in which it could best meet competition, namely, agriculture.

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* The German is bäuerliche Wirtschaft. Literally translated this means “peasant economy.” But the author writes in his International Economic Disintegration (3rd ed.; London, 1959) : “I am fully aware that the word ‘peasant,’ having clearly disparaging connotations, is no real equivalent to the French word ‘paysan’ or the German word ‘Bauer.’ Other terms which have been suggested to the author by his Anglo-Saxon friends—like ‘agricultural freeholder’ or ‘farmer yeoman’—sound too artificial and labored. The only possibility left, then, would seem to be to retain the word ‘peasant/ and to ask the Anglo-Saxon reader to forget for the moment its pejorative sense until a better term is suggested.”—Translator’s Note.

^*In Switzerland, and formerly in Germany, the top floor is used as a storeroom.—Translator’s Note.