Chapter 3

THE PRINCIPLE OF EFFECTIVE DEMAND

I

We need, to start with, a few terms which will be defined
precisely later. In a given state of technique, resources and
costs, the employment of a given volume of labour by an
entrepreneur involves him in two kinds of expense: first of all,
the amounts which he pays out to the factors of production
(exclusive of other entrepreneurs) for their current services,
which we shall call the *factor cost *of the employment in
question; and secondly, the amounts which he pays out to other
entrepreneurs for what he has to purchase from them together with
the sacrifice which he incurs by employing the equipment instead
of leaving it idle, which we shall call the *user cost *of
the employment in question.
The excess of the value of the resulting output over the sum of
its factor cost and its user cost is the profit or, as we shall
call it, the *income *of the entrepreneur. The factor cost
is, of course, the same thing, looked at from the point of view
of the entrepreneur, as what the factors of production regard as
their income. Thus the factor cost and the entrepreneur's profit
make up, between them, what we shall define as the *total
income *resulting from the employment given by the
entrepreneur. The entrepreneur's profit thus defined is, as it
should be, the quantity which he endeavours to maximise when he
is deciding what amount of employment to offer. It is sometimes convenient, when we are looking
at it from the entrepreneur's standpoint, to call the aggregate
income (i.e. factor cost *plus *profit) resulting from a
given amount of employment the *proceeds *of that
employment. On the other hand, the aggregate supply
price
of the output of a given amount of employment is the expectation
of proceeds which will just make it worth the while of the
entrepreneurs to give that employment.

It follows that in a given situation of technique, resources
and factor cost per unit of employment, the amount of employment,
both in each individual firm and industry and in the aggregate,
depends on the amount of the proceeds which the entrepreneurs
expect to receive from the corresponding output.
For entrepreneurs will endeavour to fix the amount of employment at the level which they expect to maximise the excess of
the proceeds over the factor cost.

Let *Z* be the aggregate supply price of the output from
employing *N* men, the relationship between *Z* and *N*
being written *Z* = f(*N*),
which can be called the *aggregate supply function*.
Similarly, let *D* be the proceeds which entrepreneurs
expect to receive from the employment of *N* men, the
relationship between *D* and *N* being written *D*
= *f*(*N*), which can be called the *aggregate
demand function*.

Now if for a given value of N the expected proceeds are
greater than the aggregate supply price, i.e. if *D* is
greater than *Z*, there will be an incentive to
entrepreneurs to increase employment beyond *N* and, if
necessary, to raise costs by competing with one another for the
factors of production, up to the value of *N* for which *Z*
has become equal to *D*. Thus the volume of employment is
given by the point of intersection between the aggregate demand
function and the aggregate supply function; for it is at this
point that the entrepreneurs' expectation of profits will be
maximised. The value of *D* at the point of the aggregate
demand function, where it is intersected by the aggregate supply
function, will be called *the effective demand*. Since this
is the substance of the General Theory of Employment, which it
will be our object to expound, the succeeding chapters will be
largely occupied with examining the various factors upon which
these two functions depend.

The classical doctrine, on the other hand, which used to be
expressed categorically in the statement that 'Supply creates its
own Demand' and continues to underlie all orthodox economic
theory, involves a special assumption as to the relationship
between these two functions. For 'Supply creates its own Demand'
must mean that *f*(N) and f(N)
are equal for *all *values of *N*, i.e. for all levels of output and employment; and
that when there is an increase in *Z*( = f(*N*)) corresponding to an increase in
*N*, *D*( = *f*(*N*)) necessarily increases
by the same amount as *Z*. The classical theory assumes, in
other words, that the aggregate demand price (or proceeds) always
accommodates itself to the aggregate supply price; so that,
whatever the value of *N* may be, the proceeds *D*
assume a value equal to the aggregate supply price *Z* which
corresponds to *N*. That is to say, effective demand,
instead of having a unique equilibrium value, is an infinite
range of values all equally admissible; and the amount of
employment is indeterminate except in so far as the marginal
disutility of labour sets an upper limit.

If this were true, competition between entrepreneurs would
always lead to an expansion of employment up to the point at
which the supply of output as a whole ceases to be elastic, i.e.
where a further increase in the value of the effective demand
will no longer be accompanied by any increase in output.
Evidently this amounts to the same thing as full employment. In
the previous chapter we have given a definition of full
employment in terms of the behaviour of labour. An alternative,
though equivalent, criterion is that at which we have now
arrived, namely a situation in which aggregate employment is
inelastic in response to an increase in the effective demand for
its output. Thus Say's law, that the aggregate demand price of
output as a whole is equal to its aggregate supply price for all
volumes of output, is equivalent to the proposition that there is
no obstacle to full employment. If, however, this is not the true
law relating the aggregate demand and supply functions, there is
a vitally important chapter of economic theory which remains to
be written and without which all discussions concerning the
volume of aggregate employment are futile.

A brief summary of the theory of employment to be worked out
in the course of the following chapters may, perhaps, help the
reader at this stage, even though it may not be fully
intelligible. The terms involved will be more carefully defined
in due course. In this summary we shall assume that the
money-wage and other factor costs are constant per unit of labour
employed. But this simplification, with which we shall dispense
later, is introduced solely to facilitate the exposition. The
essential character of the argument is precisely the same whether
or not money-wages, etc., are liable to change.

The outline of our theory can be expressed as follows. When
employment increases, aggregate real income is increased. The
psychology of the community is such that when aggregate real
income is increased aggregate consumption is increased, but not
by so much as income. Hence employers would make a loss if the
whole of the increased employment were to be devoted to
satisfying the increased demand for immediate consumption. Thus,
to justify any given amount of employment there must be an amount
of current investment sufficient to absorb the excess of total
output over what the community chooses to consume when employment
is at the given level. For unless there is this amount of
investment, the receipts of the entrepreneurs will be less than
is required to induce them to offer the given amount of
employment. It follows, therefore, that, given what we shall call
the community's propensity to consume, the equilibrium level of
employment, i.e. the level at which there is no inducement to
employers as a whole either to expand or to contract employment,
will depend on the amount of current investment. The amount of
current investment will depend, in turn, on what we shall call
the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the
marginal efficiency of capital and the complex of rates of
interest on loans of various maturities and risks.

Thus, given the propensity to consume and the rate of new
investment, there will be only one level of employment consistent
with equilibrium; since any other level will lead to inequality
between the aggregate supply price of output as a whole and its
aggregate demand price. This level cannot be *greater *than
full employment, i.e. the real wage cannot be less than the
marginal disutility of labour. But there is no reason in general
for expecting it to be *equal *to full employment. The
effective demand associated with full employment is a special
case, only realised when the propensity to consume and the
inducement to invest stand in a particular relationship to one
another. This particular relationship, which corresponds to the
assumptions of the classical theory, is in a sense an optimum
relationship. But it can only exist when, by accident or design,
current investment provides an amount of demand just equal to the
excess of the aggregate supply price of the output resulting from
full employment over what the community will choose to spend on
consurnption when it is fully employed.

This theory can be summed up in the following propositions:

(1) In a given situation of technique, resources
and costs, income (both money-income and real income) depends on
the volume of employment *N*.

(2) The relationship between the community's income
and what it can be expected to spend on consumption, designated
by *D*_{1}, will depend on the psychological
characteristic of the community, which we shall call its *propensity
to consume*. That is to say, consumption will depend on the
level of aggregate income and, therefore, on the level of
employment *N*, except when there is some change in the
propensity to consume.

(3) The amount of labour *N* which the
entrepreneurs decide to employ depends on the sum (*D*) of *two
*quantities, namely *D*_{1}, the amount which the
community is expected to spend on consumption, and *D*_{2},
the amount which it is expected to devote to new investment. *D*
is what we have called above the effective demand.

(4) Since *D*_{1} + *D*_{2} = *D* = f(*N*), where is the aggregate supply
function, and since, as we have seen in (2) above, *D*_{1}
is a function of *N*, which we may write c(*N*),
depending on the propensity to consume, it follows that f(*N*) - c(*N*) = *D*_{2}.

(5) Hence the volume of employment in equilibrium
depends on (i) the aggregate supply function, , (ii) the
propensity to consume, , and (iii) the volume of investment, *D*_{2}.
This is the essence of the General Theory of Employment.

(6) For every value of *N* there is a
corresponding marginal productivity of labour in the wage-goods
industries; and it is this which determines the real wage. (5)
is, therefore, subject to the condition that *N* cannot *exceed
*the value which reduces the real wage to equality with the
marginal disutility of labour. This means that not all changes in
*D* are compatible with our temporary assumption that
money-wages are constant. Thus it will be essential to a full
statement of our theory to dispense with this assumption.

(7) On the classical theory, according to which *D* = f(*N*) for all values of *N*, the
volume of employment is in neutral equilibrium for all values of *N*
less than its maximum value; so that the forces of competition
between entrepreneurs may be expected to push it to this maximum
value. Only at this point, on the classical theory, can there be
stable equilibrium.

(8)* When employment increases, D*_{1}*
will increase, but not by so much as D*; since when our income
increases our consumption increases also, but not by so much. The
key to our practical problem is to be found in this psychological law. For it follows from this that the greater
the volume of employment the greater will be the gap between the
aggregate supply price (*Z*) of the corresponding output and
the sum (*D*_{1}) which the entrepreneurs can expect
to get back out of the expenditure of consumers. Hence, if there
is no change in the propensity to consume, employment cannot
increase, unless at the same time *D*_{2} is
increasing so as to fill the increasing gap between *Z* and *D*_{1}.
Thus¾except on the special
assumptions of the classical theory according to which there is
some force in operation which, when employment increases, always
causes *D*_{2} to increase sufficiently to fill the
widening gap between *Z* and *D*_{1}¾the economic system may find itself in
stable equilibrium with *N* at a level below full
employment, namely at the level given by the intersection of the
aggregate demand function with the aggregate supply function.

Thus the volume of employment is not determined by the
marginal disutility of labour measured in terms of real wages,
except in so far as the supply of labour available at a given
real wage sets a maximum level to employment. The propensity to
consume and the rate of new investment determine between them the
volume of employment, and the volume of employment is uniquely
related to a given level of real wages¾not
the other way round. If the propensity to consume and the rate of
new investment result in a deficient effective demand, the actual
level of employment will fall short of the supply of labour
potentially available at the existing real wage, and the
equilibrium real wage will be *greater *than the marginal
disutility of the equilibrium level of employment.

This analysis supplies us with an explanation of the paradox
of poverty in the midst of plenty. For the mere existence of an
insufficiency of effective demand may, and often will, bring the
increase of employment to a standstill before a level of full
employment has been reached. The insufficiency of effective demand
will inhibit the process of production in spite of the fact that
the marginal product of labour still exceeds in value the
marginal disutility of employment.

Moreover the richer the community, the wider will tend to be
the gap between its actual and its potential production; and
therefore the more obvious and outrageous the defects of the
economic system. For a poor community will be prone to consume by
far the greater part of its output, so that a very modest measure
of investment will be sufficient to provide full employment;
whereas a wealthy community will have to discover much ampler
opportunities for investment if the saving propensities of its
wealthier members are to be compatible with the employment of its
poorer members. If in a potentially wealthy community the
inducement to invest is weak, then, in spite of its potential
wealth, the working of the principle of effective demand will
compel it to reduce its actual output, until, in spite of its
potential wealth, it has become so poor that its surplus over its
consumption is sufficiently diminished to correspond to the
weakness of the inducement to invest.

But worse still. Not only is the marginal propensity to
consume
weaker in a wealthy community, but, owing to its accumulation of
capital being already larger, the opportunities for further
investment are less attractive unless the rate of interest falls
at a sufficiently rapid rate; which 'brings us to the theory of
the rate of interest and to the reasons why it does not
automatically fall to the appropriate level, which will occupy
Book IV.

Thus the analysis of the propensity to consume, the definition
of the marginal efficiency of capital and the theory of the rate
of interest are the three main gaps in our existing knowledge
which it will be necessary to fill. When this has been
accomplished, we shall find that the theory of prices falls into its proper
place as a matter which is subsidiary to our general theory. We
shall discover, however, that money plays an essential part in
our theory of the rate of interest; and we shall attempt to
disentangle the peculiar characteristics of money which
distinguish it from other things.

III

The idea that we can safely neglect the aggregate demand
function is fundamental to the Ricardian economics, which
underlie what we have been taught for more than a century.
Malthus, indeed, had vehemently opposed Ricardo's doctrine that
it was impossible for effective demand to be deficient; but
vainly. For, since Malthus was unable to explain clearly (apart
from an appeal to the facts of common observation) how and why
effective demand could be deficient or excessive, he failed to
furnish an alternative construction; and Ricardo conquered
England as completely as the Holy Inquisition conquered Spain.
Not only was his theory accepted by the city, by statesmen and by
the academic world. But controversy ceased; the other point of
view completely disappeared; it ceased to be discussed. The great
puzzle of effective demand with which Malthus had wrestled
vanished from economic literature. You will not find it mentioned
even once in the whole works of Marshall, Edgeworth and Professor
Pigou, from whose hands the classical theory has received its
most mature embodiment. It could only live on furtively, below
the surface, in the underworlds of Karl Marx, Silvio Gesell or
Major Douglas.

The completeness of the Ricardian victory is something of a
curiosity and a mystery. It must have been due to a complex of
suitabilities in the doctrine to the environment into which it
was projected. That it reached conclusions quite different from what the ordinary
uninstructed person would expect, added, I suppose, to its
intellectual prestige. That its teaching, translated into
practice, was austere and often unpalatable, lent it virtue. That
it was adapted to carry a vast and consistent logical
superstructure, gave it beauty. That it could explain much social
injustice and apparent cruelty as an inevitable incident in the
scheme of progress, and the attempt to change such things as
likely on the whole to do more harm than good, commended it to
authority. That it afforded a measure of justification to the
free activities of the individual capitalist, attracted to it the
support of the dominant social force behind authority.

But although the doctrine itself has remained unquestioned by
orthodox economists up to a late date, its signal failure for
purposes of scientific prediction has greatly impaired, in the
course of time, the prestige of its practitioners. For
professional economists, after Malthus, were apparently unmoved
by the lack of correspondence between the results of their theory
and the facts of observation;¾a
discrepancy which the ordinary man has not failed to observe,
with the result of his growing unwillingness to accord to
economists that measure of respect which he gives to other groups
of scientists whose theoretical results are confirmed by
observation when they are applied to the facts.

The celebrated optimism of traditional economic theory, which
has led to economists being looked upon as Candides, who, having
left this world for the cultivation of their gardens, teach that
all is for the best in the best of all possible worlds provided
we will let well alone, is also to be traced, I think, to their
having neglected to take account of the drag on prosperity which
can be exercised by an insufficiency of effective demand. For
there would obviously be a natural tendency towards the optimum
employment of resources in a society which was functioning after
the manner of the classical postulates. It may well be that the
classical theory represents the way in which we should like our
economy to behave. But to assume that it actually does so is to
assume our difficulties away.