
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[1]. 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[2] 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[3].
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[4]. 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 = φ(N), which can be called the aggregate supply
function[5]. 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 φ(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 ( = φ(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.
II
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 consumption 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 D1, 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 D1, the amount which the community is expected to
spend on consumption, and D2, the amount which it is expected to devote to new
investment. D is what we have called above the effective demand.
(4) Since D1 + D2 = D = φ(N), where is the aggregate supply function, and since, as
we have seen in (2) above, D1 is a function of N, which we may write χ(N), depending on
the propensity to consume, it follows that φ(N) − χ(N) = D2.
(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, D2. 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 = φ(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, D1will 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 (D1) 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 D2 is
increasing so as to fill the increasing gap between Z and D1. Thus—except on the special
assumptions of the classical theory according to which there is some force in operation
which, when employment increases, always causes D2 to increase sufficiently to fill the
widening gap between Z and D1—the 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 wages—not 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[6] 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; a 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.
1. A precise definition of user cost.
2. Not to be confused (vide infra) with the supply price of a unit of output in the ordinary sense of
this term.
3. The reader will observe that I am deducting the user cost both from the proceeds and from the
aggregate supply price of a given volume of output, so that both these terms are to be interpreted
net of user cost; whereas the aggregate sums paid by the purchasers are, of course, gross of user
cost. The reasons why this is convenient ,the essential point is that the
aggregate proceeds and aggregate supply price net of user cost can be defined uniquely and
unambiguously; whereas, since user cost is obviously dependent both on the degree of integration
of industry and on the extent to which entrepreneurs buy from one another, there can be no
definition of the aggregate sums paid by purchasers, inclusive of user cost, which is independent of
these factors. There is a similar difficulty even in defining supply price in the ordinary sense for an
individual producer; and in the case of the aggregate supply price of output as a whole serious
difficulties of duplication are involved, which have not always been faced. If the term is to be
interpreted gross of user cost, they can only be overcome by making special assumptions relating
to the integration of entrepreneurs in groups according as they produce consumption-goods or
capital-goods which are obscure and complicated in themselves and do not correspond to the facts.
If, however, aggregate supply price is defined as above net of user cost, the difficulties do not arise.
The reader is advised, however, to await the fuller discussion in Chapter 6 and its appendix.
4. An entrepreneur, who has to reach a practical decision as to his scale of production, does not, of
course, entertain a single undoubting expectation of what the sale-proceeds of a given output will
be, but several hypothetical expectations held with varying degrees of probability and definiteness.
By his expectation of proceeds I mean, therefore, that expectation of proceeds which, if it were
held with certainty, would lead to the same behaviour as does the bundle of vague and more
various possibilities which actually makes up his state of expectation when he reaches his decision.
5. Function closely related to the above will be called the employment function.


