Chapter10
THEMARGINALPROPENSITYTOCONSUME
ANDTHEMULTIPLIER
Weestablishedinchapter8thatemploymentcanonlyincreaseparipassuwithinvestmentunlessthereisachangeinthepropensitytoconsume。Wecannowcarrythislineofthoughtastagefurther。Foringivencircumstancesadefiniteratio,tobecalledthemultiplier,canbeestablishedbetweenincomeandinvestmentand,subjecttocertainsimplifications,betweenthetotalemploymentandtheemploymentdirectlyemployedoninvestmentwhichweshallcalltheprimaryemployment。
Thisfurtherstepisanintegralpartofourtheoryofemployment,sinceitestablishesapreciserelationship,giventhepropensitytoconsume,betweenaggregateemploymentandincomeandtherateofinvestment。TheconceptionofthemultiplierwasfirstintroducedintoeconomictheorybyMrR。F。Kahninhisarticleon\'TheRelationofHomeInvestmenttoUnemployment\'EconomicJournal,June1931。Hisargumentinthisarticledependedonthefundamentalnotionthat,ifthepropensitytoconsumeinvarioushypotheticalcircumstancesistogetherwithcertainotherconditions
takenasgivenandweconceivethemonetaryorotherpublicauthoritytotakestepstostimulateortoretardinvestment,thechangeintheamountofemploymentwillbeafunctionofthenetchangeintheamountofinvestment;
anditaimedatlayingdowngeneralprinciplesbywhichtoestimatetheactualquantitativerelationshipbetweenanincre-
[Page114]THE
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mentofnetinvestmentandtheincrementofaggregateemploymentwhichwillbeassociatedwithit。Beforecomingtothemultiplier,however,itwillbeconvenienttointroducetheconceptionofthemarginalpropensitytoconsume。
I
Thefluctuationsinrealincomeunderconsiderationinthisbookarethosewhichresultfromapplyingdifferentquantitiesofemploymenti。e。
oflabour-unitstoagivencapitalequipment,sothatrealincomeincreasesanddecreaseswiththenumberoflabour-unitsemployed。If,asweassumeingeneral,thereisadecreasingreturnatthemarginasthenumberoflabour-unitsemployedonthegivencapitalequipmentisincreased,incomemeasuredintermsofwage-unitswillincreasemorethaninproportiontotheamountofemployment,which,inturn,willincreasemorethaninproportiontotheamountofrealincomemeasuredifthatispossibleintermsofproduct。Realincomemeasuredintermsofproductandincomemeasuredintermsofwage-unitswill,however,increaseanddecreasetogetherintheshortperiodwhencapitalequipmentisvirtuallyunchanged。Since,therefore,realincome,intermsofproduct,maybeincapableofprecisenumericalmeasurement,itisoftenconvenienttoregardincomeintermsofwage-unitsYwasanadequateworkingindexofchangesinrealincome。Incertaincontextswemustnotoverlookthefactthat,ingeneral,Ywincreasesanddecreasesinagreaterproportionthanrealincome;butinothercontextsthefactthattheyalwaysincreaseanddecreasetogetherrendersthemvirtuallyinterchangeable。
Ournormalpsychologicallawthat,whentherealincomeofthecommunityincreasesordecreases,itsconsumptionwillincreaseordecreasebutnotsofast,can,therefore,betranslated¾;not,indeed,withabsoluteaccuracybutsubjecttoqualificationswhichareobvious[Page115]THE
MARGINALPROPENSITYTOCONSUME
andcaneasilybestatedinaformallycompletefashionintothepropositionsthatDCwandDYwhavethesamesign,butDYw>DCw,whereCwistheconsumptionintermsofwage-units。Thisismerelyarepetitionofthepropositionalreadyestablishedonp。29above。Letusdefine,then,dCw/dYwasthemarginalpropensitytoconsume。
Thisquantityisofconsiderableimportance,becauseittellsushowthenextincrementofoutputwillhavetobedividedbetweenconsumptionandinvestment。ForDYw=DCwDIw,whereCwandIwaretheincrementsofconsumptionandinvestment;sothatwecanwriteDYw=kDIw,where1-1/kisequaltothemarginalpropensitytoconsume。
Letuscallktheinvestmentmultiplier。Ittellsusthat,whenthereisanincrementofaggregateinvestment,incomewillincreasebyanamountwhichisktimestheincrementofinvestment。
II
MrKahn\'smultiplierisalittledifferentfromthis,beingwhatwemaycalltheemploymentmultiplierdesignatedbyk\',sinceitmeasurestheratiooftheincrementoftotalemploymentwhichisassociatedwithagivenincrementofprimaryemploymentintheinvestmentindustries。
Thatistosay,iftheincrementofinvestmentDIwleadstoanincrementofprimaryemploymentDN2intheinvestmentindustries,theincrementoftotalemploymentDN
=k\'DN2。
Thereisnoreasoningeneraltosupposethatk=k\'。
Forthereisnonecessarypresumptionthattheshapesoftherelevantportionsoftheaggregatesupplyfunctionsfordifferenttypesofindustryaresuchthattheratiooftheincrementofemploymentintheonesetofindustriestotheincrementofdemandwhichhas[Page116]THE
GENERALTHEORYOFEMPLOYMENT
stimulateditwillbethesameasintheothersetofindustries。[
72]Itiseasy,indeed,toconceiveofcases,as,forexample,wherethemarginalpropensitytoconsumeiswidelydifferentfromtheaveragepropensity,inwhichtherewouldbeapresumptioninfavourofsomeinequalitybetweenDYw/DNandDIw/DN2,sincetherewouldbeverydivergentproportionatechangesinthedemandsforconsumption-goodsandinvestment-goodsrespectively。Ifwewishtotakeaccountofsuchpossibledifferencesintheshapesoftherelevantportionsoftheaggregatesupplyfunctionsforthetwogroupsofindustriesrespectively,thereisnodifficultyinrewritingthefollowingargumentinthemoregeneralisedform。Buttoelucidatetheideasinvolved,itwillbeconvenienttodealwiththesimplifiedcasewherek=k\'。
Itfollows,therefore,that,iftheconsumptionpsychologyofthecommunityissuchthattheywillchoosetoconsume,e。g。nine-tenthsofanincrementofincome,[73]thenthemultiplierkis10;andthetotalemploymentcausedbye。g。increasedpublicworkswillbetentimestheprimaryemploymentprovidedby[Page117]THE
MARGINALPROPENSITYTOCONSUME
thepublicworksthemselves,assumingnoreductionofinvestmentinotherdirections。Onlyintheeventofthecommunitymaintainingtheirconsumptionunchangedinspiteoftheincreaseinemploymentandhenceinrealincome,willtheincreaseofemploymentberestrictedtotheprimaryemploymentprovidedbythepublicworks。If,ontheotherhand,theyseektoconsumethewholeofanyincrementofincome,therewillbenopointofstabilityandpriceswillrisewithoutlimit。Withnormalpsychologicalsuppositions,anincreaseinemploymentwillonlybeassociatedwithadeclineinconsumptionifthereisatthesametimeachangeinthepropensitytoconsume¾;astheresult,forinstance,ofpropagandaintimeofwarinfavourofrestrictingindividualconsumption;
anditisonlyinthiseventthattheincreasedemploymentininvestmentwillbeassociatedwithanunfavourablerepercussiononemploymentintheindustriesproducingforconsumption。
Thisonlysumsupinaformulawhatshouldbynowbeobvioustothereaderongeneralgrounds。Anincrementofinvestmentintermsofwage-unitscannotoccurunlessthepublicarepreparedtoincreasetheirsavingsintermsofwage-units。Ordinarilyspeaking,thepublicwillnotdothisunlesstheiraggregateincomeintermsofwage-unitsisincreasing。Thustheirefforttoconsumeapartoftheirincreasedincomeswillstimulateoutputuntilthenewlevelanddistributionofincomesprovidesamarginofsavingsufficienttocorrespondtotheincreasedinvestment。Themultipliertellsusbyhowmuchtheiremploymenthastobeincreasedtoyieldanincreaseinrealincomesufficienttoinducethemtodothenecessaryextrasaving,andisafunctionoftheirpsychologicalpropensities。[74]Ifsavingisthepillandconsumptionisthejam,theextrajamhastobeproportionedtothesizeofthe[Page118]THE
GENERALTHEORYOFEMPLOYMENT
additionalpill。Unlessthepsychologicalpropensitiesofthepublicaredifferentfromwhatwearesupposing,wehavehereestablishedthelawthatincreasedemploymentforinvestmentmustnecessarilystimulatetheindustriesproducingforconsumptionandthusleadtoatotalincreaseofemploymentwhichisamultipleoftheprimaryemploymentrequiredbytheinvestmentitself。
Itfollowsfromtheabovethat,ifthemarginalpropensitytoconsumeisnotfarshortofunity,smallfluctuationsininvestmentwillleadtowidefluctuationsinemployment;but,atthesametime,acomparativelysmallincrementofinvestmentwillleadtofullemployment。If,ontheotherhand,themarginalpropensitytoconsumeisnotmuchabovezero,smallfluctuationsininvestmentwillleadtocorrespondinglysmallfluctuationsinemployment;but,atthesametime,itmayrequirealargeincrementofinvestmenttoproducefullemployment。Intheformercaseinvoluntaryunemploymentwouldbeaneasilyremediedmalady,thoughliabletobetroublesomeifitisallowedtodevelop。Inthelattercase,employmentmaybelessvariablebutliabletosettledownatalowlevelandtoproverecalcitranttoanybutthemostdrasticremedies。Inactualfactthemarginalpropensitytoconsumeseemstoliesomewherebetweenthesetwoextremes,thoughmuchnearertounitythantozero;withtheresultthatwehave,inasense,theworstofbothworlds,fluctuationsinemploymentbeingconsiderableand,atthesametime,theincrementininvestmentrequiredtoproducefullemploymentbeingtoogreattobeeasilyhandled。Unfortunatelythefluctuationshavebeensufficienttopreventthenatureofthemaladyfrombeingobvious,whilstitsseverityissuchthatitcannotberemediedunlessitsnatureisunderstood。
Whenfullemploymentisreached,anyattempttoincreaseinvestmentstillfurtherwillsetupatendencyinmoney-pricestorisewithoutlimit,irrespectiveofthemarginalpropensitytoconsume;i。e。weshall[Page119]THE
MARGINALPROPENSITYTOCONSUME
havereachedastateoftrueinflation。[75]Uptothispoint,however,risingpriceswillbeassociatedwithanincreasingaggregaterealincome。
III
Wehavebeendealingsofarwithanetincrementofinvestment。
If,therefore,wewishtoapplytheabovewithoutqualificationtotheeffectofe。g。increasedpublicworks,wehavetoassumethatthereisnooffsetthroughdecreasedinvestmentinotherdirections,¾;andalso,ofcourse,noassociatedchangeinthepropensityofthecommunitytoconsume。MrKahnwasmainlyconcernedinthearticlereferredtoaboveinconsideringwhatoffsetsweoughttotakeintoaccountaslikelytobeimportant,andinsuggestingquantitativeestimates。Forinanactualcasethereareseveralfactorsbesidessomespecificincreaseofinvestmentofagivenkindwhichenterintothefinalresult。If,forexample,agovernmentemploys100,000additionalmenonpublicworks,andifthemultiplierasdefinedaboveis4,itisnotsafetoassumethataggregateemploymentwillincreaseby400,000。Forthenewpolicymayhaveadversereactionsoninvestmentinotherdirections。
ItwouldseemfollowingMrKahnthatthefollowingarelikelyinamoderncommunitytobethefactorswhichitismostimportantnottooverlookthoughthefirsttwowillnotbefullyintelligibleuntilafterBookIV
hasbeenreached:
iThemethodoffinancingthepolicyandtheincreasedworkingcash,requiredbytheincreasedemploymentandtheassociatedriseofprices,mayhavetheeffectofincreasingtherateofinterestandsoretardinginvestmentinotherdirections,unlessthemonetaryauthoritytakesstepstothecontrary;whilst,atthesametime,theincreasedcostofcapitalgoodswillreducetheirmarginalefficiencytotheprivatein-
[Page120]THE
GENERALTHEORYOFEMPLOYMENT
vestor,andthiswillrequireanactualfallintherateofinteresttooffsetit。
iiWiththeconfusedpsychologywhichoftenprevails,thegovernmentprogrammemay,throughitseffecton\'confidence\',increaseliquidity-preferenceordiminishthemarginalefficiencyofcapital,which,again,mayretardotherinvestmentunlessmeasuresaretakentooffsetit。
iiiInanopensystemwithforeign-traderelations,somepartofthemultiplieroftheincreasedinvestmentwillaccruetothebenefitofemploymentinforeigncountries,sinceaproportionoftheincreasedconsumptionwilldiminishourowncountry\'sfavourableforeignbalance;
sothat,ifweconsideronlytheeffectondomesticemploymentasdistinctfromworldemployment,wemustdiminishthefullfigureofthemultiplier。
Ontheotherhandourowncountrymayrecoveraportionofthisleakagethroughfavourablerepercussionsduetotheactionofthemultiplierintheforeigncountryinincreasingitseconomicactivity。
Furthermore,ifweareconsideringchangesofasubstantialamount,wehavetoallowforaprogressivechangeinthemarginalpropensitytoconsume,asthepositionofthemarginisgraduallyshifted;andhenceinthemultiplier。Themarginalpropensitytoconsumeisnotconstantforalllevelsofemployment,anditisprobablethattherewillbe,asarule,atendencyforittodiminishasemploymentincreases;whenrealincomeincreases,thatistosay,thecommunitywillwishtoconsumeagraduallydiminishingproportionofit。
Therearealsootherfactors,overandabovetheoperationofthegeneralruleJustmentioned,whichmayoperatetomodifythemarginalpropensitytoconsume,andhencethemultiplier;andtheseotherfactorsseemlikely,asarule,toaccentuatethetendencyofthegeneralruleratherthantooffsetjt。For,inthefirstplace,theincreaseofemploymentwilltend,owing[Page121]THE
MARGINALPROPENSITYTOCONSUME
totheeffectofdiminishingreturnsintheshortperiod,toincreasetheproportionofaggregateincomewhichaccruestotheentrepreneurs,whoseindividualmarginalpropensitytoconsumeisprobablylessthantheaverageforthecommunityasawhole。Inthesecondplace,unemploymentislikelytobeassociatedwithnegativesavingincertainquarters,privateorpublic,becausetheunemployedmaybelivingeitheronthesavingsofthemselvesandtheirfriendsoronpublicreliefwhichispartlyfinancedoutofloans;withtheresultthatre-employmentwillgraduallydiminishtheseparticularactsofnegativesavingandreduce,therefore,themarginalpropensitytoconsumemorerapidlythanwouldhaveoccurredfromanequalincreaseinthecommunity\'srealincomeaccruingindifferentcircumstances。
Inanycase,themultiplierislikelytobegreaterforasmallnetincrementofinvestmentthanforalargeincrement;sothat,wheresubstantialchangesareinview,wemustbeguidedbytheaveragevalueofthemultiplierbasedontheaveragemarginalpropensitytoconsumeovertherangeinquestion。
MrKahnhasexaminedtheprobablequantitativeresultofsuchfactorsastheseincertainhypotheticalspecialcases。But,clearly,itisnotpossibletocarryanygeneralisationveryfar。Onecanonlysay,forexample,thatatypicalmoderncommunitywouldprobablytendtoconsumenotmuchlessthan80percentofanyincrementofrealincome,ifitwereaclosedsystemwiththeconsumptionoftheunemployedpaidforbytransfersfromtheconsumptionofotherconsumers,sothatthemultiplierafterallowingforoffsetswouldnotbemuchlessthan5。Inacountry,however,whereforeigntradeaccountsfor,say,20percentofconsumptionandwheretheunemployedreceiveoutofloansortheirequivalentupto,say,50percentoftheirnormalconsumptionwheninwork,themultipliermayfallaslowas2or3timestheemploymentpro-
[Page122]THE
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videdbyaspecificnewinvestment。Thusagivenfluctuationofinvestmentwillbeassociatedwithamuchlessviolentfluctuationofemploymentinacountryinwhichforeigntradeplaysalargepartandunemploymentreliefisfinancedonalargerscaleoutofborrowingaswasthecase,e。g。inGreatBritainin1931,thaninacountryinwhichthesefactorsarelessimportantasintheUnitedStatesin1932。[76]
Itis,however,tothegeneralprincipleofthemultipliertowhichwehavetolookforanexplanationofhowfluctuationsintheamountofinvestment,whichareacomparativelysmallproportionofthenationalincome,arecapableofgeneratingfluctuationsinaggregateemploymentandincomesomuchgreaterinamplitudethanthemselves。
IV
Thediscussionhasbeencarriedon,sofar,onthebasisofachangeinaggregateinvestmentwhichhasbeenforeseensufficientlyinadvancefortheconsumptionindustriestoadvanceparipassuwiththecapital-goodsindustrieswithoutmoredisturbancetothepriceofconsumption-goodsthanisconsequential,inconditionsofdecreasingreturns,onanincreaseinthequantitywhichisproduced。
Ingeneral,however,wehavetotakeaccountofthecasewheretheinitiativecomesfromanincreaseintheoutputofthecapital-goodsindustrieswhichwasnotfullyforeseen。Itisobviousthataninitiativeofthisdescriptiononlyproducesitsfulleffectonemploymentoveraperiodoftime。Ihavefound,however,indiscussionthatthisobviousfactoftengivesrisetosomeconfusionbetweenthelogicaltheoryofthemultiplier,whichholdsgoodcontinuously,withouttime-lag,atallmomentsoftime,andtheconsequencesofanexpansioninthecapital-goodsindustrieswhichtakegradualeffect,subjecttotime-lagandonlyafteraninterval。
[Page123]THE
MARGINALPROPENSITYTOCONSUME
Therelationshipbetweenthesetwothingscanbeclearedupbypointingout,firstlythatanunforeseen,orimperfectlyforeseen,expansioninthecapital-goodsindustriesdoesnothaveaninstantaneouseffectofequalamountontheaggregateofinvestmentbutcausesagradualincreaseofthelatter;and,secondly,thatitmaycauseatemporarydepartureofthemarginalpropensitytoconsumeawayfromitsnormalvalue,followed,however,byagradualreturntoit。
Thusanexpansioninthecapital-goodsindustriescausesaseriesofincrementsinaggregateinvestmentoccurringinsuccessiveperiodsoveranintervaloftime,andaseriesofvaluesofthemarginalpropensitytoconsumeinthesesuccessiveperiodswhichdifferbothfromwhatthevalueswouldhavebeeniftheexpansionhadbeenforeseenandfromwhattheywillbewhenthecommunityhassettleddowntoanewsteadylevelofaggregateinvestment。Butineveryintervaloftimethetheoryofthemultiplierholdsgoodinthesensethattheincrementofaggregatedemandisequaltotheproductoftheincrementofaggregateinvestmentandthemultiplierasdeterminedbythemarginalpropensitytoconsume。
Theexplanationofthesetwosetsoffactscanbeseenmostclearlybytakingtheextremecasewheretheexpansionofemploymentinthecapital-goodsindustriesissoentirelyunforeseenthatinthefirstinstancethereisnoincreasewhateverintheoutputofconsumption-goods。Inthiseventtheeffortsofthosenewlyemployedinthecapital-goodsindustriestoconsumeaproportionoftheirincreasedincomeswillraisethepricesofconsumption-goodsuntilatemporaryequilibriumbetweendemandandsupplyhasbeenbroughtaboutpartlybythehighpricescausingapostponementofconsumption,partlybyaredistributionofincomeinfavourofthesavingclassesasaneffectoftheincreasedprofitsresultingfromthehigherprices,andpartlybythehigherpricescausingadepletion[Page124]THE
GENERALTHEORYOFEMPLOYMENT
ofstocks。Sofarasthebalanceisrestoredbyapostponementofconsumptionthereisatemporaryreductionofthemarginalpropensitytoconsume,i。e。
ofthemultiplieritself,andinsofarasthereisadepletionofstocks,aggregateinvestmentincreasesforthetimebeingbylessthantheincrementofinvestmentinthecapital-goodsindustries,¾;i。e。
thethingtobemultiplieddoesnotincreasebythefullincrementofinvestmentinthecapital-goodsindustries。Astimegoeson,however,theconsumption-goodsindustriesadjustthemselvestothenewdemand,sothatwhenthedeferredconsumptionisenjoyed,themarginalpropensitytoconsumerisestemporarilyaboveitsnormallevel,tocompensatefortheextenttowhichitpreviouslyfellbelowit,andeventuallyreturnstoitsnormallevel;whilsttherestorationofstockstotheirpreviousfigurecausestheincrementofaggregateinvestmenttobetemporarilygreaterthantheincrementofinvestmentinthecapital-goodsindustriestheincrementofworkingcapitalcorrespondingtothegreateroutputalsohavingtemporarilythesameeffect。
Thefactthatanunforeseenchangeonlyexercisesitsfulleffectonemploymentoveraperiodoftimeisimportantincertaincontexts;¾;inparticularitplaysapartintheanalysisofthetradecycleonlinessuchasIfollowedinmyTreatiseonMoney。Butitdoesnotinanywayaffectthesignificanceofthetheoryofthemultiplierassetforthinthischapter;norrenderitinapplicableasanindicatorofthetotalbenefittoemploymenttobeexpectedfromanexpansioninthecapital。
goodsindustries。Moreover,exceptinconditionswheretheconsumptionindustriesarealreadyworkingalmostatcapacitysothatanexpansionofoutputrequiresanexpansionofplantandnotmerelythemoreintensiveemploymentoftheexistingplant,thereisnoreasontosupposethatmorethanabriefintervaloftimencedelapsebeforeemploymentintheconsumptionindustriesisadvancingparipassuwith[Page125]THE
MARGINALPROPENSITYTOCONSUME
employmentinthecapital-goodsindustrieswiththemultiplieroperatingnearitsnormalfigure。
V
Wehaveseenabovethatthegreaterthemarginalpropensitytoconsume,thegreaterthemultiplier,andhencethegreaterthedisturbancetoemploymentcorrespondingtoagivenchangeininvestment。Thismightseemtoleadtotheparadoxicalconclusionthatapoorcommunityinwhichsavingisaverysmallproportionofincomewillbemoresubjecttoviolentfluctuationsthanawealthycommunitywheresavingisalargerproportionofincomeandthemultiplierconsequentlysmaller。
Thisconclusion,however,wouldoverlookthedistinctionbetweentheeffectsofthemarginalpropensitytoconsumeandthoseoftheaveragepropensitytoconsume。Forwhilstahighmarginalpropensitytoconsumeinvolvesalargerproportionateeffectfromagivenpercentagechangeininvestment,theabsoluteeffectwill,nevertheless,besmalliftheaveragepropensitytoconsumeisalsohigh。Thismaybeillustratedasfollowsbyanumericalexample。
Letussupposethatacommunity\'spropensitytoconsumeissuchthat,solongasitsrealincomedoesnotexceedtheoutputfromemploying5,000,000
menonitsexistingcapitalequipment,itconsumesthewholeofitsincome;
thatoftheoutputofthenext100,000additionalmenemployeditconsumes99percent,ofthenext100,000afterthat98percent,ofthethird100,000
97percentandsoon;andthat10,000,000menemployedrepresentsfullemployment。Itfollowsfromthisthat,when5,000,000n100,000
menareemployed,themultiplieratthemarginis100/n,and[nni]/[250n]percentofthenationalincomeisinvested。
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Thuswhen5,200,000menareemployedthemultiplierisverylarge,namely50,butinvestmentisonlyatriflingproportionofcurrentincome,namely,0。06percent;withtheresultthatifinvestmentfallsoffbyalargeproportion,sayabouttwo-thirds,employmentwillonlydeclineto5,100,000,i。e。byabout2percent。Ontheotherhand,when9,000,000menareemployed,themarginalmultiplieriscomparativelysmall,namely2½;,butinvestmentisnowasubstantialproportionofcurrentincome,namely,9percent;
withtheresultthatifinvestmentfallsbytwo-thirds,employmentwilldeclineto6,900,000,namely,by19percent。Inthelimitwhereinvestmentfallsofftozero,employmentwilldeclinebyabout4percentintheformercase,whereasinthelattercaseitwilldeclineby44percent。[77]
Intheaboveexample,thepoorerofthetwocommunitiesundercomparisonispoorerbyreasonofunder-employment。Butthesamereasoningappliesbyeasyadaptationifthepovertyisduetoinferiorskill,techniqueorequipment。Thuswhilstthemultiplierislargerinapoorcommunity,theeffectonemploymentoffluctuationsininvestmentwillbemuchgreaterinawealthycommunity,assumingthatinthelattercurrentinvestmentrepresentsamuchlargerproportionofcurrentoutput。[78]
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Itisalsoobviousfromtheabovethattheemploymentofagivennumberofmenonpublicworkswillontheassumptionsmadehaveamuchlargereffectonaggregateemploymentatatimewhenthereissevereunemployment,thanitwillhavelateronwhenfullemploymentisapproached。Intheaboveexample,if,atatimewhenemploymenthasfallento5,200,000,anadditional100,000menareemployedonpublicworks,totalemploymentwillriseto6,400,000。Butifemploymentisalready9,000,000whentheadditional100,000
menaretakenonforpublicworks,totalemploymentwillonlyriseto9,200,000。
Thuspublicworksevenofdoubtfulutilitymaypayforthemselvesoverandoveragainatatimeofsevereunemployment,ifonlyfromthediminishedcostofreliefexpenditure,providedthatwecanassumethatasmallerproportionofincomeissavedwhenunemploymentisgreater;buttheymaybecomeamoredoubtfulpropositionasastateoffullemploymentisapproached。
Furthermore,ifourassumptioniscorrectthatthemarginalpropensitytoconsumefallsoffsteadilyasweapproachfullemployment,itfollowsthatitwillbecomemoreandmoretroublesometosecureafurthergivenincreaseofemploymentbyfurtherincreasinginvestment。Itshouldnotbedifficulttocompileachartofthemarginalpropensitytoconsumeateachstageofatradecyclefromthestatisticsiftheywereavailable
ofaggregateincorneandaggregateinvestmentatsuccessivedates。Atpresent,however,ourstatisticsarenotaccurateenoughorcompiledsufficientlywiththisspecificobjectinviewtoallowustoinfermorethanhighlyapproximateestimates。Thebestforthepurpose,ofwhichIamaware,areMrKuznets\'figuresfortheUnitedStatesalreadyreferredto,p。103above,thoughtheyare,nevertheless,veryprecarious。Takeninconjunctionwithestimatesofnationalincomethesesuggest,forwhattheyareworth,bothalowerfigureandamorestablefigurefortheinvestmentmultiplier[Page128]THE
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thanIshouldhaveexpected。Ifsingleyearsaretakeninisolation,theresultslookratherwild。Butiftheyaregroupedinpairs,themultiplierseemstohavebeenlessthan3andprobablyfairlystableintheneighbourhoodof2。5。Thissuggestsamarginalpropensitytoconsumenotexceeding6oto70percent¾;afigurequiteplausiblefortheboom,butsurprisingly,and,inmyjudgment,improbablylowfortheslump。Itispossible,however,thattheextremefinancialconservatismofcorporatefinanceintheUnitedStates,evenduringtheslump,mayaccountforit。Inotherwords,if,wheninvestmentisfallingheavilythroughafailuretoundertakerepairsandreplacements,financialprovisionismade,nevertheless,inrespectofsuchwastage,theeffectistopreventtheriseinthemarginalpropensitytoconsumewhichwouldhaveoccurredotherwise。IsuspectthatthisfactormayhaveplayedasignificantpartinaggravatingthedegreeoftherecentslumpintheUnitedStates。Ontheotherhand,itispossiblethatthestatisticssomewhatoverstatethedeclineininvestment,whichisallegedtohavefallenoffbymorethan75percentin1932comparedwith1929,whilstnet\'capitalformation\'
declinedbymorethan95percent;¾;amoderatechangeintheseestimatesbeingcapableofmakingasubstantialdifferencetothemultiplier。
VI
Wheninvoluntaryunemploymentexists,themarginaldisutilityoflabourisnecessarilylessthantheutilityofthemarginalproduct。Indeeditmaybemuchless。Foramanwhohasbeenlongunemployedsomemeasureoflabour,insteadofinvolvingdisutility,mayhaveapositiveutility。Ifthisisaccepted,theabovereasoningshowshow\'wasteful\'loanexpenditure[79]mayneverthelessenrichthecom-
[Page129]THE
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munityonbalance。Pyramid-building,earthquakes,evenwarsmayservetoincreasewealth,iftheeducationofourstatesmenontheprinciplesoftheclassicaleconomicsstandsinthewayofanythingbetter。
Itiscurioushowcommonsense,wrigglingforanescapefromabsurdconclusions,hasbeenapttoreachapreferenceforwholly\'wasteful\'
formsofloanexpenditureratherthanforpartlywastefulforms,which,becausetheyarenotwhollywasteful,tendtobejudgedonstrict\'business\'principles。Forexample,unemploymentrelieffinancedbyloansismorereadilyacceptedthanthefinancingofimprovementsatachargebelowthecurrentrateofinterest;whilsttheformofdiggingholesinthegroundknownasgold-mining,whichnotonlyaddsnothingwhatevertotherealwealthoftheworldbutinvolvesthedisutilityoflabour,isthemostacceptableofallsolutions。
IftheTreasuryweretofilloldbottleswithbanknotes,burythematsuitabledepthsindisusedcoalmineswhicharethenfilleduptothesurfacewithtownrubbish,andleaveittoprivateenterpriseonwell-triedprinciplesoflaissez-fairetodigthenotesupagaintherighttodosobeingobtained,ofcourse,bytenderingforleasesofthenote-bearingterritory,thereneedbenomoreunemploymentand,withthehelpoftherepercussions,therealincomeofthecommunity,anditscapitalwealthalso,wouldprobablybecomeagooddealgreaterthanitactuallyis。Itwould,indeed,bemoresensibletobuildhousesandthelike;butiftherearepoliticalandpracticaldifficultiesinthewayofthis,theabovewouldbebetterthannothing。
Theanalogybetweenthisexpedientandthegold-
[Page130]THE
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minesoftherealworldiscomplete。Atperiodswhengoldisavailableatsuitabledepthsexperienceshowsthattherealwealthoftheworldincreasesrapidly;andwhenbutlittleofitissoavailableourwealthsuffersstagnationordecline。Thusgold-minesareofthegreatestvalueandimportancetocivilisation。Justaswarshavebeentheonlyformoflarge-scaleloanexpenditurewhichstatesmenhavethoughtjustifiable,sogold-miningistheonlypretextfordiggingholesinthegroundwhichhasrecommendeditselftobankersassoundfinance;andeachoftheseactivitieshasplayeditspartinprogress¾;failingsomethingbetter。Tomentionadetail,thetendencyinslumpsforthepriceofgoldtoriseintermsoflabourandmaterialsaidseventualrecovery,becauseitincreasesthedepthatwhichgold-diggingpaysandlowerstheminimumgradeoforewhichispayable。
Inadditiontotheprobableeffectofincreasedsuppliesofgoldontherateofinterest,gold-miningisfortworeasonsahighlypracticalformofinvestment,ifweareprecludedfromincreasingemploymentbymeanswhichatthesametimeincreaseourstockofusefulwealth。Inthefirstplace,owingtothegamblingattractionswhichitoffersitiscarriedonwithouttooclosearegardtotherulingrateofinterest。Inthesecondplacetheresult,namely,theincreasedstockofgold,doesnot,asinothercases,havetheeffectofdiminishingitsmarginalutility。Sincethevalueofahousedependsonitsutility,everyhousewhichisbuiltservestodiminishtheprospectiverentsobtainablefromfurtherhouse-buildingandthereforelessenstheattractionoffurthersimilarinvestmentunlesstherateofinterestisfallingparipassu。Butthefruitsofgold-miningdonotsufferfromthisdisadvantage,andacheckcanonlycomethroughariseofthewage-unitintermsofgold,whichisnotlikelytooccurunlessanduntilemploymentissubstantiallybetter。Moreover,thereisnosubsequentreverseeffectonaccountofprovisionfor[Page131]THE
MARGINALPROPENSITYTOCONSUME
userandsupplementarycosts,asinthecaseoflessdurableformsofwealth。
AncientEgyptwasdoublyfortunate,anddoubtlessowedtothisitsfabledwealth,inthatitpossessedtwoactivities,namely,pyramid-buildingaswellasthesearchforthepreciousmetals,thefruitsofwhich,sincetheycouldnotservetheneedsofmanbybeingconsumed,didnotstalewithabundance。TheMiddleAgesbuiltcathedralsandsangdirges。Twopyramids,twomassesforthedead,aretwiceasgoodasone;butnotsotworailwaysfromLondontoYork。Thuswearesosensible,haveschooledourselvestosocloseasemblanceofprudentfinanciers,takingcarefulthoughtbeforeweaddtothe\'financial\'burdensofposteritybybuildingthemhousestolivein,thatwehavenosucheasyescapefromthesufferingsofunemployment。
WehavetoacceptthemasaninevitableresultofapplyingtotheconductoftheStatethemaximswhicharebestcalculatedto\'enrich\'anindividualbyenablinghimtopileupclaimstoenjoymentwhichhedoesnotintendtoexerciseatanydefinitetime。
TheMarginalEfficiencyofCapital[Page135]
Chapter11
THEMARGINALEFFICIENCYOFCAPITAL
I
Whenamanbuysaninvestmentorcapital-asset,hepurchasestherighttotheseriesofprospectivereturns,whichheexpectstoobtainfromsellingitsoutput,afterdeductingtherunningexpensesofobtainingthatoutput,duringthelifeoftheasset。ThisseriesofannuitiesQ1,Q2,……Qnitisconvenienttocalltheprospectiveyieldoftheinvestment。
Overagainsttheprospectiveyieldoftheinvestmentwehavethesupplypriceofthecapital-asset,meaningbythis,notthemarket-priceatwhichanassetofthetypeinquestioncanactuallybepurchasedinthemarket,butthepricewhichwouldjustinduceamanufacturernewlytoproduceanadditionalunitofsuchassets,i。e。whatissometimescalleditsreplacementcost。Therelationbetweentheprospectiveyieldofacapital-assetanditssupplypriceorreplacementcost,i。e。therelationbetweentheprospectiveyieldofonemoreunitofthattypeofcapitalandthecostofproducingthatunit,furnishesuswiththemarginalefficiencyofcapitalofthattype。Moreprecisely,Idefinethemarginalefficiencyofcapitalasbeingequaltothatrateofdiscountwhichwouldmakethepresentvalueoftheseriesofannuitiesgivenbythereturnsexpectedfromthecapital-assetduringitslifejustequaltoitssupplyprice。
Thisgivesusthemarginalefficienciesofparticulartypesofcapital-assets。
Thegreatestof[Page136]THE
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thesemarginalefficienciescanthenberegardedasthemarginalefficiencyofcapitalingeneral。
Thereadershouldnotethatthemarginalefficiencyofcapitalisheredefinedintermsoftheexpectationofyieldandofthecurrentsupplypriceofthecapital-asset。Itdependsontherateofreturnexpectedtobeobtainableonmoneyifitwereinvestedinanewlyproducedasset;notonthehistoricalresultofwhataninvestmenthasyieldedonitsoriginalcostifwelookbackonitsrecordafteritslifeisover。
Ifthereisanincreasedinvestmentinanygiventypeofcapitalduringanyperiodoftime,themarginalefficiencyofthattypeofcapitalwilldiminishastheinvestmentinitisincreased,partlybecausetheprospectiveyieldwillfallasthesupplyofthattypeofcapitalisincreased,andpartlybecause,asarule,pressureonthefacilitiesforproducingthattypeofcapitalwillcauseitssupplypricetoincrease;thesecondofthesefactorsbeingusuallythemoreimportantinproducingequilibriumintheshortrun,butthelongertheperiodinviewthemoredoesthefirstfactortakeitsplace。Thusforeachtypeofcapitalwecanbuildupaschedule,showingbyhowmuchinvestmentinitwillhavetoincreasewithintheperiod,inorderthatitsmarginalefficiencyshouldfalltoanygivenfigure。Wecanthenaggregatetheseschedulesforallthedifferenttypesofcapital,soastoprovideaschedulerelatingtherateofaggregateinvestmenttothecorrespondingmarginalefficiencyofcapitalingeneralwhichthatrateofinvestmentwillestablish。Weshallcallthistheinvestmentdemand-schedule;or,alternatively,thescheduleofthemarginalefficiencyofcapital。
Nowitisobviousthattheactualrateofcurrentinvestmentwillbepushedtothepointwherethereisnolongeranyclassofcapital-assetofwhichthemarginalefficiencyexceedsthecurrentrateofinterest。
Inotherwords,therateofinvestmentwillbepushedtothe[Page137]THE
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pointontheinvestmentdemand-schedulewherethemarginalefficiencyofcapitalingeneralisequaltothemarketrateofinterest。[80]
Thesamethingcanalsobeexpressedasfollows。IfQristheprospectiveyieldfromanassetattimer,anddristhepresentvalueof£;1deferredryearsatthecurrentrateofinterest,SQrdristhedemandpriceoftheinvestment;andinvestmentwillbecarriedtothepointwhereSQrdrbecomesequaltothesupplypriceoftheinvestmentasdefinedabove。If,ontheotherhand,SQrdrfallsshortofthesupplyprice,therewillbenocurrentinvestmentintheassetinquestion。
Itfollowsthattheinducementtoinvestdependspartlyontheinvestmentdemand-scheduleandpartlyontherateofinterest。OnlyattheconclusionofBookIVwillitbepossibletotakeacomprehensiveviewofthefactorsdeterminingtherateofinvestmentintheiractualcomplexity。Iwould,however,askthereadertonoteatoncethatneithertheknowledgeofanasset\'sprospectiveyieldnortheknowledgeofthemarginalefficiencyoftheassetenablesustodeduceeithertherateofinterestorthepresentvalueoftheasset。Wemustascertaintherateofinterestfromsomeothersource,andonlythencanwevaluetheassetby\'capitalising\'itsprospectiveyield。
II
Howistheabovedefinitionofthemarginalefficiencyofcapitalrelatedtocommonusage?TheMarginalProductivityorYieldorEfficiencyorUtilityofCapitalarefamiliartermswhichwehaveallfrequentlyused。Butitisnoteasybysearchingtheliteratureofeconomicsto[Page138]THE
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findaclearstatementofwhateconomistshaveusuallyintendedbytheseterms。
Thereareatleastthreeambiguitiestoclearup。Thereis,tobeginwith,theambiguitywhetherweareconcernedwiththeincrementofphysicalproductperunitoftimeduetotheemploymentofonemorephysicalunitofcapital,orwiththeincrementofvalueduetotheemploymentofonemorevalueunitofcapital。Theformerinvolvesdifficultiesastothedefinitionofthephysicalunitofcapital,whichIbelievetobebothinsolubleandunnecessary。Itis,ofcourse,possibletosaythattenlabourerswillraisemorewheatfromagivenareawhentheyareinapositiontomakeuseofcertainadditionalmachines;butIknownomeansofreducingthistoanintelligiblearithmeticalratiowhichdoesnotbringinvalues。
Neverthelessmanydiscussionsofthissubjectseemtobemainlyconcernedwiththephysicalproductivityofcapitalinsomesense,thoughthewritersfailtomakethemselvesclear。
Secondly,thereisthequestionwhetherthemarginalefficiencyofcapitalissomeabsolutequantityoraratio。Thecontextsinwhichitisusedandthepracticeoftreatingitasbeingofthesamedimensionastherateofinterestseemtorequirethatitshouldbearatio。Yetitisnotusuallymadeclearwhatthetwotermsoftheratioaresupposedtobe。
Finally,thereisthedistinction,theneglectofwhichhasbeenthemaincauseofconfusionandmisunderstanding,betweentheincrementofvalueobtainablebyusinganadditionalquantityofcapitalintheexistingsituation,andtheseriesofincrementswhichitisexpectedtoobtainoverthewholelifeoftheadditionalcapitalasset;¾;i。e。
thedistinctionbetweenQ1andthecompleteseriesQ1,Q2,……Qr,……Thisinvolvesthewholequestionoftheplaceofexpectationineconomictheory。MostdiscussionsofthemarginalefficiencyofcapitalseemtopaynoattentiontoanymemberoftheseriesexceptQ1。Yetthiscannotbe[Page139]THE
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legitimateexceptinaStatictheory,forwhichalltheQ\'sareequal。Theordinarytheoryofdistribution,whereitisassumedthatcapitalisgettingnowitsmarginalproductivityinsomesenseorother,isonlyvalidinastationarystate。Theaggregatecurrentreturntocapitalhasnodirectrelationshiptoitsmarginalefficiency;whilstitscurrentreturnatthemarginofproductioni。e。thereturntocapitalwhichentersintothesupplypriceofoutputisitsmarginalusercost,whichalsohasnocloseconnectionwithitsmarginalefficiency。
Thereis,asIhavesaidabove,aremarkablelackofanyclearaccountofthematter。AtthesametimeIbelievethatthedefinitionwhichIhavegivenaboveisfairlyclosetowhatMarshallintendedtomeanbytheterm。
ThephrasewhichMarshallhimselfusesis\'marginalnetefficiency\'ofafactorofproduction;or,alternatively,the\'marginalutilityofcapital\'。
ThefollowingisasummaryofthemostrelevantpassagewhichIcanfindinhisPrinciples6thed。pp。519-520。
Ihaveruntogethersomenon-consecutivesentencestoconveythegistofwhathesays:
Inacertainfactoryanextra£;100worthofmachinerycanbeappliedsoasnottoinvolveanyotherextraexpense,andsoastoaddannually£;3worthtothenetoutputofthefactoryafterallowingforitsownwearandtear。Iftheinvestorsofcapitalpushitintoeveryoccupationinwhichitseemslikelytogainahighreward;andif,afterthishasbeendoneandequilibriumhasbeenfound,itstillpaysandonlyjustpaystoemploythismachinery,wecaninferfromthisfactthattheyearlyrateofinterestis3percent。Butillustrationsofthiskindmerelyindicatepartoftheactionofthegreatcauseswhichgovernvalue。Theycannotbemadeintoatheoryofinterest,anymorethanintoatheoryofwages,withoutreasoninginacircle……Supposethattherateofinterestis3percent。perannumonperfectlygoodsecurity;andthatthehat-makingtradeabsorbsacapitalofonemillionpounds。Thisimpliesthatthehat-makingtradecanturnthewholemillionpounds\'worthofcapitaltosogoodaccountthattheywouldpay3percent。perannumnetforthe[Page140]THE
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useofitratherthangowithoutanyofit。Theremaybemachinerywhichthetradewouldhaverefusedtodispensewithiftherateofinteresthadbeen20percent。perannum。Iftheratehadbeen10percent。,morewouldhavebeenused;ifithadbeen6percent。,stillmore;if4percent。
stillmore;andfinally,theratebeing3percent。,theyusemorestill。
Whentheyhavethisamount,themarginalutilityofthemachinery,i。e。
theutilityofthatmachinerywhichitisonlyjustworththeirwhiletoemploy,ismeasuredby3percent。
ItisevidentfromtheabovethatMarshallwaswellawarethatweareinvolvedinacircularargumentifwetrytodeterminealongtheselineswhattherateofinterestactuallyis。[81]Inthispassageheappearstoaccepttheviewsetforthabove,thattherateofinterestdeterminesthepointtowhichnewinvestmentwillbepushed,giventhescheduleofthemarginalefficiencyofcapital。Iftherateofinterestis3percent,thismeansthatnoonewillpay£;100foramachineunlesshehopestherebytoadd£;3tohisannualnetoutputafterallowingforcostsanddepreciation。Butweshallseeinchapter14thatinotherpassagesMarshallwaslesscautious¾;thoughstilldrawingbackwhenhisargumentwasleadinghimontodubiousground。
Althoughhedoesnotcallitthe\'marginalefficiencyofcapital\',ProfessorIrvingFisherhasgiveninhisTheoryofInterest1930adefinitionofwhathecalls\'therateofreturnovercost\'whichisidenticalwithmydefinition。\'Therateofreturnovercost\',hewrites,[82]\'isthatratewhich,employedincomputingthepresentworthofallthecostsandthepresentworthofallthereturns,willmakethesetwoequal。\'ProfessorFisherexplainsthattheextentofinvestmentinanydirectionwilldependonacomparisonbetweentherateofreturnovercostandtherateofinterest。
Toinducenewinvestment\'therateofreturnovercost[Page141]THE
MARGINALEFFICIENCYOFCAPITAL
mustexceedtherateofinterest\'。[83]\'Thisnewmagnitudeorfactor
inourstudyplaysthecentralrô;leontheinvestmentopportunitysideofinteresttheory。\'[84]ThusProfessorFisheruseshis\'rateofreturnovercostinthesamesenseandforpreciselythesamepurposeasIemploy\'themarginalefficiencyofcapital\'。
III
Themostimportantconfusionconcerningthemeaningandsignificanceofthemarginalefficiencyofcapitalhasensuedonthefailuretoseethatitdependsontheprospectiveyieldofcapital,andnotmerelyonitscurrentyield。Thiscanbebestillustratedbypointingouttheeffectonthemarginalefficiencyofcapitalofanexpectationofchangesintheprospectivecostofproduction,whetherthesechangesareexpectedtocomefromchangesinlabourcost,i。e。inthewage-unit,orfrominventionsandnewtechnique。Theoutputfromequipmentproducedto-daywillhavetocompete,inthecourseofitslife,withtheoutputfromequipmentproducedsubsequently,perhapsatalowerlabourcost,perhapsbyanimprovedtechnique,whichiscontentwithalowerpriceforitsoutputandwillbeincreasedinquantityuntilthepriceofitsoutputhasfallentothelowerfigurewithwhichitiscontent。Moreover,theentrepreneur\'sprofitintermsofmoneyfromequipment,oldornew,willbereduced,ifalloutputcomestobeproducedmorecheaply。Insofarassuchdevelopmentsareforeseenasprobable,orevenaspossible,themarginalefficiencyofcapitalproducedto-dayisappropriatelydiminished。
Thisisthefactorthroughwhichtheexpectationofchangesinthevalueofmoneyinfluencesthevolumeofcurrentoutput。Theexpectationofafallinthevalueofmoneystimulatesinvestment,andhenceemploymentgenerally,becauseitraisesthescheduleofthe[Page142]THE
GENERALTHEORYOFEMPLOYMENT
marginalefficiencyofcapital,i。e。theinvestmentdemand-schedule;
andtheexpectationofariseinthevalueofmoneyisdepressing,becauseitlowersthescheduleofthemarginalefficiencyofcapital。
ThisisthetruthwhichliesbehindProfessorIrvingFisher\'stheoryofwhatheoriginallycalled\'AppreciationandInterest\'¾;thedistinctionbetweenthemoneyrateofinterestandtherealrateofinterestwherethelatterisequaltotheformeraftercorrectionforchangesinthevalueofmoney。Itisdifficulttomakesenseofthistheoryasstated,becauseitisnotclearwhetherthechangeinthevalueofmoneyisorisnotassumedtobeforeseen。Thereisnoescapefromthedilemmathat,ifitisnotforeseen,therewillbenoeffectoncurrentaffairs;whilst,ifitisforeseen,thepricesofexistinggoodswillbeforthwithsoadjustedthattheadvantagesofholdingmoneyandofholdinggoodsareagainequalised,anditwillbetoolateforholdersofmoneytogainortosufferachangeintherateofinterestwhichwilloffsettheprospectivechangeduringtheperiodoftheloaninthevalueofthemoneylent。ForthedilemmaisnotsuccessfullyescapedbyProfessorPigou\'sexpedientofsupposingthattheprospectivechangeinthevalueofmoneyisforeseenbyonesetofpeoplebutnotforeseenbyanother。
Themistakeliesinsupposingthatitistherateofinterestonwhichprospectivechangesinthevalueofmoneywilldirectlyreact,insteadofthemarginalefficiencyofagivenstockofcapital。Thepricesofexistingassetswillalwaysadjustthemselvestochangesinexpectationconcerningtheprospectivevalueofmoney。Thesignificanceofsuchchangesinexpectationliesintheireffectonthereadinesstoproducenewassetsthroughtheirreactiononthemarginalefficiencyofcapital。Thestimulatingeffectoftheexpectationofhigherpricesisdue,nottoitsraisingtherateofinterestthatwouldbeaparadoxicalwayofstimulatingoutput¾;insofarastherateofinterestrises,the[Page143]THE
MARGINALEFFICIENCYOFCAPITAL
stimulatingeffectistothatextentoffset,buttoitsraisingthemarginalefficiencyofagivenstockofcapital。Iftherateofinterestweretoriseparipassuwiththemarginalefficiencyofcapital,therewouldbenostimulatingeffectfromtheexpectationofrisingprices。Forthestimulustooutputdependsonthemarginalefficiencyofagivenstockofcapitalrisingrelativelytotherateofinterest。
IndeedProfessorFisher\'stheorycouldbebestre-writtenintermsofa\'realrateofinterest\'definedasbeingtherateofinterestwhichwouldhavetorule,consequentlyonachangeinthestateofexpectationastothefuturevalueofmoney,inorderthatthischangeshouldhavenoeffectoncurrentoutput。[85]
Itisworthnotingthatanexpectationofafuturefallintherateofinterestwillhavetheeffectofloweringthescheduleofthemarginalefficiencyofcapital;sinceitmeansthattheoutputfromequipmentproducedto-daywillhavetocompeteduringpartofitslifewiththeoutputfromequipmentwhichiscontentwithalowerreturn。Thisexpectationwillhavenogreatdepressingeffect,sincetheexpectations,whichareheldconcerningthecomplexofratesofinterestforvarioustermswhichwillruleinthefuture,willbepartiallyreflectedinthecomplexofratesofinterestwhichruleto-day。Neverthelesstheremaybesomedepressingeffect,sincetheoutputfromequipmentproducedto-day,whichwillemergetowardstheendofthelifeofthisequipment,mayhavetocompetewiththeoutputofmuchyoungerequipmentwhichiscontentwithalowerreturnbecauseofthelowerrateofinterestwhichrulesforperiodssubsequenttotheendofthelifeofequipmentproducedto-day。
Itisimportanttounderstandthedependenceofthemarginalefficiencyofagivenstockofcapitalonchangesinexpectation,becauseitischieflythisdepend-
[Page144]THE
GENERALTHEORYOFEMPLOYMENT
encewhichrendersthemarginalefficiencyofcapitalsubjecttothesomewhatviolentfluctuationswhicharetheexplanationofthetradecycle。
Inchapter22belowweshallshowthatthesuccessionofboomandslumpcanbedescribedandanalysedintermsofthefluctuationsofthemarginalefficiencyofcapitalrelativelytotherateofinterest。
IV
Twotypesofriskaffectthevolumeofinvestmentwhichhavenotcommonlybeendistinguished,butwhichitisimportanttodistinguish。Thefirstistheentrepreneur\'sorborrower\'sriskandarisesoutofdoubtsinhisownmindastotheprobabilityofhisactuallyearningtheprospectiveyieldforwhichhehopes。Ifamanisventuringhisownmoney,thisistheonlyriskwhichisrelevant。
Butwhereasystemofborrowingandlendingexists,bywhichImeantherantingofloanswithamarginofrealorpersonalsecurity,asecondtypeofriskisrelevantwhichwemaycallthelender\'srisk。Thismaybedueeithertomoralhazard,i。e。voluntarydefaultorothermeansofescape,possiblylawful,fromthefulfilmentoftheobligation,ortothepossibleinsufficiencyofthemarginofsecurity,i。e。involuntarydefaultduetothedisappointmentofexpectation。Athirdsourceofriskmightbeadded,namely,apossibleadversechangeinthevalueofthemonetarystandardwhichrendersamoney-loantothisextentlesssecurethanarealasset;thoughallormostofthisshouldbealreadyreflected,andthereforeabsorbed,inthepriceofdurablerealassets。
Nowthefirsttypeofriskis,inasense,arealsocialcost,thoughsusceptibletodiminutionbyaveragingaswellasbyanincreasedaccuracyofforesight。Thesecond,however,isapureadditiontothecostofinvestmentwhichwouldnotexistiftheborrowerandlenderwerethesameperson。
Moreover,itinvolvesinpart[Page145]THE
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aduplicationofaproportionoftheentrepreneur\'srisk,whichisaddedtwicetothepurerateofinteresttogivetheminimumprospectiveyieldwhichwillinducetheinvestment。Forifaventureisariskyone,theborrowerwillrequireawidermarginbetweenhisexpectationofyieldandtherateofinterestatwhichhewillthinkitworthhiswhiletoborrow;
whilsttheverysamereasonwillleadthelendertorequireawidermarginbetweenwhathechargesandthepurerateofinterestinordertoinducehimtolendexceptwheretheborrowerissostrongandwealthythatheisinapositiontoofferanexceptionalmarginofsecurity。Thehopeofaveryfavourableoutcome,whichmaybalancetheriskinthemindoftheborrower,isnotavailabletosolacethelender。
Thisduplicationofallowanceforaportionoftheriskhasnothithertobeenemphasised,sofarasIamaware;butitmaybeimportantincertaincircumstances。Duringaboomthepopularestimationofthemagnitudeofboththeserisks,bothborrower\'sriskandlender\'srisk,isapttobecomeunusuallyandimprudentlylow。
V
Thescheduleofthemarginalefficiencyofcapitalisoffundamentalimportancebecauseitismainlythroughthisfactormuchmorethanthroughtherateofinterestthattheexpectationofthefutureinfluencesthepresent。Themistakeofregardingthemarginalefficiencyofcapitalprimarilyintermsofthecurrentyieldofcapitalequipment,whichwouldbecorrectonlyinthestaticstatewherethereisnochangingfuturetoinfluencethepresent,hashadtheresultofbreakingthetheoreticallinkbetweento-dayandto-morrow。Eventherateofinterestis,virtually,[86]a[Page146]THE
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currentphenomenon;andifwereducethemarginalefficiencyofcapitaltothesamestatus,wecutourselvesofffromtakinganydirectaccountoftheinfluenceofthefutureinouranalysisoftheexistingequilibrium。
Thefactthattheassumptionsofthestaticstateoftenunderliepresent-dayeconomictheory,importsintoitalargeelementofunreality。Buttheintroductionoftheconceptsofusercostandofthemarginalefficiencyofcapital,asdefinedabove,willhavetheeffect,Ithink,ofbringingitbacktoreality,whilstreducingtoaminimumthenecessarydegreeofadaptation。
Itisbyreasonoftheexistenceofdurableequipmentthattheeconomicfutureislinkedtothepresent。Itis,therefore,consonantwith,andagreeableto,ourbroadprinciplesofthought,thattheexpectationofthefutureshouldaffectthepresentthroughthedemandpricefordurableequipment。
Long-TermExpectation[Page147]
Chapter12
THESTATEOFLONG-TERMEXPECTATION
I
Wehaveseeninthepreviouschapterthatthescaleofinvestmentdependsontherelationbetweentherateofinterestandthescheduleofthemarginalefficiencyofcapitalcorrespondingtodifferentscalesofcurrentinvestment,whilstthemarginalefficiencyofcapitaldependsontherelationbetweenthesupplypriceofacapital-assetanditsprospectiveyield。Inthischapterweshallconsiderinmoredetailsomeofthefactorswhichdeterminetheprospectiveyieldofanasset。
Theconsiderationsuponwhichexpectationsofprospectiveyieldsarebasedarepartlyexistingfactswhichwecanassumetobeknownmoreorlessforcertain,andpartlyfutureeventswhichcanonlybeforecastedwithmoreorlessconfidence。Amongstthefirstmaybementionedtheexistingstockofvarioustypesofcapital-assetsandofcapital-assetsingeneralandthestrengthoftheexistingconsumers\'demandforgoodswhichrequirefortheirefficientproductionarelativelylargerassistancefromcapital。
Amongstthelatterarefuturechangesinthetypeandquantityofthestockofcapital-assetsandinthetastesoftheconsumer,thestrengthofeffectivedemandfromtimetotimeduringthelifeoftheinvestmentunderconsideration,andthechangesinthewage-unitintermsofmoneywhichmayoccurduringitslife。Wemaysumupthestateofpsychologicalexpectationwhichcoversthe[Page148]THE
GENERALTHEORYOFEMPLOYMENT
latterasbeingthestateoflong-termexpectation;¾;asdistinguishedfromtheshort-termexpectationuponthebasisofwhichaproducerestimateswhathewillgetforaproductwhenitisfinishedifhedecidestobeginproducingitto-daywiththeexistingplant,whichweexaminedinchapter5。
II
Itwouldbefoolish,informingourexpectations,toattachgreatweighttomatterswhichareveryuncertain。[87]Itisreasonable,therefore,tobeguidedtoaconsiderabledegreebythefactsaboutwhichwefeelsomewhatconfident,eventhoughtheymaybelessdecisivelyrelevanttotheissuethanotherfactsaboutwhichourknowledgeisvagueandscanty。
Forthisreasonthefactsoftheexistingsituationenter,inasensedisproportionately,intotheformationofourlong-termexpectations;ourusualpracticebeingtotaketheexistingsituationandtoprojectitintothefuture,modifiedonlytotheextentthatwehavemoreorlessdefinitereasonsforexpectingachange。
Thestateoflong-termexpectation,uponwhichourdecisionsarebased,doesnotsolelydepend,therefore,onthemostprobableforecastwecanmake。Italsodependsontheconfidencewithwhichwemakethisforecast¾;onhowhighlyweratethelikelihoodofourbestforecastturningoutquitewrong。Ifweexpectlargechangesbutareveryuncertainastowhatpreciseformthesechangeswilltake,thenourconfidencewillbeweak。
Thestateofconfidence,astheytermit,isamattertowhichpracticalmenalwayspaytheclosestandmostanxiousattention。Buteconomistshavenotanalyseditcarefullyandhavebeencontent,asarule,todiscuss[Page149]LONG-TERM
EXPECTATION
itingeneralterms。Inparticularithasnotbeenmadeclearthatitsrelevancetoeconomicproblemscomesinthroughitsimportantinfluenceonthescheduleofthemarginalefficiencyofcapital。Therearenottwoseparatefactorsaffectingtherateofinvestment,namely,thescheduleofthemarginalefficiencyofcapitalandthestateofconfidence。Thestateofconfidenceisrelevantbecauseitisoneofthemajorfactorsdeterminingtheformer,whichisthesamethingastheinvestmentdemand-schedule。
Thereis,however,notmuchtobesaidaboutthestateofconfidenceapriori。Ourconclusionsmustmainlydependupontheactualobservationofmarketsandbusinesspsychology。Thisisthereasonwhytheensuingdigressionisonadifferentlevelofabstractionfrommostofthisbook。
Forconvenienceofexpositionweshallassumeinthefollowingdiscussionofthestateofconfidencethattherearenochangesintherateofinterest;
andweshallwrite,throughoutthefollowingsections,asifchangesinthevaluesofinvestmentsweresolelyduetochangesintheexpectationoftheirprospectiveyieldsandnotatalltochangesintherateofinterestatwhichtheseprospectiveyieldsarecapitalised。Theeffectofchangesintherateofinterestis,however,easilysuperimposedontheeffectofchangesinthestateofconfidence。
III
Theoutstandingfactistheextremeprecariousnessofthebasisofknowledgeonwhichourestimatesofprospectiveyieldhavetobemade。Ourknowledgeofthefactorswhichwillgoverntheyieldofaninvestmentsomeyearshenceisusuallyveryslightandoftennegligible。Ifwespeakfrankly,wehavetoadmitthatourbasisofknowledgeforestimatingtheyieldtenyearshenceofarailway,acoppermine,atextilefactory,thegoodwillofapatentmedicine,anAtlantic[Page150]THE
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liner,abuildingintheCityofLondonamountstolittleandsometimestonothing;orevenfiveyearshence。Infact,thosewhoseriouslyattempttomakeanysuchestimateareoftensomuchintheminoritythattheirbehaviourdoesnotgovernthemarket。
Informertimes,whenenterprisesweremainlyownedbythosewhoundertookthemorbytheirfriendsandassociates,investmentdependedonasufficientsupplyofindividualsofsanguinetemperamentandconstructiveimpulseswhoembarkedonbusinessasawayoflife,notreallyrelyingonaprecisecalculationofprospectiveprofit。Theaffairwaspartlyalottery,thoughwiththeultimateresultlargelygovernedbywhethertheabilitiesandcharacterofthemanagerswereaboveorbelowtheaverage。Somewouldfailandsomewouldsucceed。Butevenaftertheeventnoonewouldknowwhethertheaverageresultsintermsofthesumsinvestedhadexceeded,equalledorfallenshortoftheprevailingrateofinterest;though,ifweexcludetheexploitationofnaturalresourcesandmonopolies,itisprobablethattheactualaverageresultsofinvestments,evenduringperiodsofprogressandprosperity,havedisappointedthehopeswhichpromptedthem。Businessmenplayamixedgameofskillandchance,theaverageresultsofwhichtotheplayersarenotknownbythosewhotakeahand。Ifhumannaturefeltnotemptationtotakeachance,nosatisfactionprofitapartinconstructingafactory,arailway,amineorafarm,theremightnotbemuchinvestmentmerelyasaresultofcoldcalculation。
Decisionstoinvestinprivatebusinessoftheold-fashionedtypewere,however,decisionslargelyirrevocable,notonlyforthecommunityasawhole,butalsofortheindividual。Withtheseparationbetweenownershipandmanagementwhichprevailsto-dayandwiththedevelopmentoforganisedinvestmentmarkets,anewfactorofgreatimportancehasenteredin,whichsometimesfacilitatesinvestmentbutsometimesadds[Page151]LONG-TERM
EXPECTATION
greatlytotheinstabilityofthesystem。Intheabsenceofsecuritymarkets,thereisnoobjectinfrequentlyattemptingtorevalueaninvestmenttowhichwearecommitted。ButtheStockExchangerevaluesmanyinvestmentseverydayandtherevaluationsgiveafrequentopportunitytotheindividualthoughnottothecommunityasawholetorevisehiscommitments。Itisasthoughafarmer,havingtappedhisbarometerafterbreakfast,coulddecidetoremovehiscapitalfromthefarmingbusinessbetween10andII
inthemorningandreconsiderwhetherheshouldreturntoitlaterintheweek。ButthedailyrevaluationsoftheStockExchange,thoughtheyareprimarilymadetofacilitatetransfersofoldinvestmentsbetweenoneindividualandanother,inevitablyexertadecisiveinfluenceontherateofcurrentinvestment。Forthereisnosenseinbuildingupanewenterpriseatacostgreaterthanthatatwhichasimilarexistingenterprisecanbepurchased;
whilstthereisaninducementtospendonanewprojectwhatmayseemanextravagantsum,ifitcanbefloatedoffontheStockExchangeatanimmediateprofit。[88]ThuscertainclassesofinvestmentaregovernedbytheaverageexpectationofthosewhodealontheStockExchangeasrevealedinthepriceofshares,ratherthanbythegenuineexpectationsoftheprofessionalentrepreneur。[89]Howthenarethesehighlysignificantdaily,evenhourly,revaluationsofexistinginvestmentscarriedoutinpractice?
[Page152]THE
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IV
Inpracticewehavetacitlyagreed,asarule,tofallbackonwhatis,intruth,aconvention。Theessenceofthisconvention¾;thoughitdoesnot,ofcourse,workoutquitesosimply¾;liesinassumingthattheexistingstateofaffairswillcontinueindefinitely,exceptinsofaraswehavespecificreasonstoexpectachange。Thisdoesnotmeanthatwereallybelievethattheexistingstateofaffairswillcontinueindefinitely。Weknowfromextensiveexperiencethatthisismostunlikely。Theactualresultsofaninvestmentoveralongtermofyearsveryseldomagreewiththeinitialexpectation。Norcanwerationaliseourbehaviourbyarguingthattoamaninastateofignoranceerrorsineitherdirectionareequallyprobable,sothatthereremainsameanactuarialexpectationbasedonequi-probabilities。Foritcaneasilybeshownthattheassumptionofarithmeticallyequalprobabilitiesbasedonastateofignoranceleadstoabsurdities。Weareassuming,ineffect,thattheexistingmarketvaluation,howeverarrivedat,isuniquelycorrectinrelationtoourexistingknowledgeofthefactswhichwillinfluencetheyieldoftheinvestment,andthatitwillonlychangeinproportiontochangesinthisknowledge;though,philosophicallyspeaking,itcannotbeuniquelycorrect,sinceourexistingknowledgedoesnotprovideasufficientbasisforacalculatedmathematicalexpectation。Inpointoffact,allsortsofconsiderationsenterintothemarketvaluationwhichareinnowayrelevanttotheprospectiveyield。
Neverthelesstheaboveconventionalmethodofcalculationwillbecompatiblewithaconsiderablemeasureofcontinuityandstabilityinouraffairs,solongaswecanrelyonthemaintenanceoftheconvention。
Forifthereexistorganisedinvestmentmarketsandifwecanrelyonthemaintenanceoftheconvention,aninvestorcanlegitimatelyencouragehimselfwiththe[Page153]LONG-TERM