The Online Library of Liberty

A project of Liberty Fund, Inc.

• Foreword to Economists and Teachers
• Economic Principles
• Part I: Elements of Value and Price
• Chapter 1: Purpose and Nature of Economics
• Chapter 2: Choice and Value
• Chapter 3: Goods and Psychic Income
• Chapter 4: Principles of Evaluation
• Chapter 5: Trade By Barter
• Chapter 6: Money and Markets
• Chapter 7: Principles of Price
• Chapter 8: Competition and Monopoly
• Part II: Usance and Rent
• Chapter 9: Agents For Changing Stuff and Form
• Chapter 10: Agents For Effecting Changes of Place and Time
• Chapter 11: Consumption and Duration
• Chapter 12: The Principle of Proportionality
• Chapter 13: The Concept of Usance-value
• Chapter 14: The Renting Contract
• Chapter 15: Principles of Rent
• Part III: Valuable Human Services, and Wages
• Chapter 16: Human Beings and Their Economic Services
• Chapter 17: Conditions For Efficient Labor
• Chapter 18: The Value of Labor and the Choice of Occupations
• Chapter 19: Principles of Wages
• Part IV: Time-value and Interest
• Chapter 20: Time-preference
• Chapter 21: Rate of Time-preference
• Chapter 22: Money and Capitalization
• Chapter 23: Capitalization of Monetary Incomes
• Chapter 24: Saving and Borrowing
• Chapter 25: Capitalization and Interest
• Part V: Enterprise and Profit
• Chapter 26: Enterprise
• Chapter 27: Management
• Chapter 28: Profits and Costs
• Chapter 29: Various Shades of Profits
• Chapter 30: Costs and Competitive Prices
• Chapter 31: Monopoly-prices; Large Production
• Part VI: Dynamic Changes In Economic Society
• Chapter 32: The Problem of Population
• Chapter 33: Volitional Doctrine of Population
• Chapter 34: Decreasing and Increasing Returns
• Chapter 35: Basic Material Resources: Their Use, Consumption, and Conservation
• Chapter 36: Machinery and Wages
• Chapter 37: Waste and Luxury
• Chapter 38: Abstinence and Production
• Chapter 39: Value Theory and Social Welfare

PART V

ENTERPRISE AND PROFIT

CHAPTER 26

ENTERPRISE

§ 1. Factors of production must be combined. Every separate thing that enters into the making of goods is called an economic agent; as in agriculture, the seeds, plows, fields, fences, barns, cattle, and labor; in manufacture, the buildings, machines, material, labor, etc. But these numerous agents fall into two great groups called factors of production, variously named as man and nature, labor and material agents, or humanity and wealth. We have studied separately the processes by which value is attributed to these agents, yet we have borne in mind always that they are complementary agents and complementary factors. (See Chapter 18, section 10, and Chapter 19, section 14.) Labor in a void and wealth without labor would be equally useless. The process of valuing uses of goods and services of labor goes on while all of these goods help make up the situation in which the desires exist.

The stock of economic goods of whatever sort is limited, while the upspringing desires are practically unlimited. To increase goods, labor is applied to material objects. Man’s part in production is almost passive when goods come into existence without his effort. One can imagine the indolent savage of the tropics, lying under the banana-tree, letting the fruit drop into his mouth. But at least he must be there ready for it to drop. One can conceive of a tribe living upon manna, where every day the people awoke to discover a certain amount of food provided to each person’s hand. Tho no effort could increase that amount, still, if the food differed in flavor and the better qualities were rare, value would come into existence and exchange would arise. Now there is something analogous to that in daily experience. There are some goods which effort can do little to increase. Usually, however, there is a possibility of change and adaptation to make them better suited to needs, and there is required the use of intelligence to choose among the goods and to employ them in the best way. Further, man can intervene and direct the course of industry; he does not merely gather what is provided. It is this active intervention and effort that is here to be considered.

§ 2. Non-contractual and contractual incomes. It is from this process of combining the factors that the various yields and incomes emerge which have been heretofore treated. The various laborers and kinds of wealth when brought together produce goods and the values attributable respectively to the various agents are their yields. The various persons to whom the yields accrue are said to secure incomes out of these yields. The incomes are of two kinds.

(1) A non-contractual (impersonal or “economic”) income is obtained from the yield of the agents, not from another person to whom the agent has been rented or loaned. The laborer gets an economic income from his labor when he gathers wood for his own fire, or builds a house for himself. Wealth yields an economic income to its owner, as the products of the field, the use of (or the objects made with) the tools of the craftsman. Direct labor-incomes and the usances of wealth appear first as economic incomes. This is the only kind of income possible on Crusoe’s Island and in any non-exchanging economy.

(2) A derivative kind of income appears as soon as men begin to hire labor and borrow the uses of wealth. A contractual income is one received from a person for the right to receive an economic income. For example, the carpenter building a house for another man does not possess the economic yield of his own labor as it is performed. That belongs to the owner of the materials from whom the carpenter gets a contractual income. All wages and rents (as we use the terms) are contractual incomes.

To cases that appear puzzling to classify this test may be easily applied. In whom is the legal title of a use or of a service vested at the instant it is yielded? To him belongs, in first instance, the economic income, subject to the claims of others who must look to him for their pay. Thus the owner of the factory owns the product altho he may have to pay rent to a landlord and wages to his workmen.

People thus are of two classes as regards the mode of receiving income: self-employed, earning economic labor-incomes; and employed, receiving (contractual) wages from active capitalists. Capitalists are of two classes: the active capitalists, risk-takers, getting non-contractual capital-incomes, whom we shall call enterprisers; and the passive capitalists, risk-limiters, getting contractual incomes from active capitalists. The self-employed laborer is in every case to some slight degree an active capitalist. The neediest fisherman must have title to the string of fish before he sells it to change it for a money income. Every economic product that endures an instant, rests in the hands of an active capitalist.

§ 3. From small shop to large factory. Some examples applying these terms may make the matter clearer. A furniture-maker (a joiner) in a village owns his little shop, the land on which it stands, his tools, some lumber, and a few pieces of finished goods. From day to day he sells the ready furniture, or takes orders for which he receives money or lumber or articles of food and other supplies for his own household use. If with his money and goods he can pay for the materials he needs and have left a living for himself, his income of goods is the combined result of his labor and of his capital (that is, of his right to the uses of his shop, tools, and stock of goods). He is enterpriser, manager, and laborer, all in one, and gets one non-contractual income, which as to its value is imputable to several different economic sources. Now this man takes an apprentice or two, hires two or three workmen to keep up with the increasing orders, hires another shop next door for which he pays rent, and borrows some money to buy new tools and more materials so that he can keep a larger stock of ready goods. Less of his time is given to handwork and more to meeting customers, making new designs and patterns, hiring and directing his assistants, buying materials, and keeping his accounts. As the business grows he finds he must employ salesmen to meet customers, a foreman to direct the workmen in the shop, a bookkeeper to relieve him of the mere clerical labors, perhaps finally a special artistic designer and pattern maker. At length there remain for him to do only the larger planning of the business as a whole, the hiring of his subordinates, and the general oversight and criticism of all departments so that everything may be kept smoothly working.

§ 4. The residual share. From the moment the first apprentice was hired or the first dollar was borrowed, the business became the source of a contractual income to some one, and, at last, of many contractual incomes, besides the one non-contractual income of the active enterpriser. These contractual incomes have the familiar price-names of wages (and in special cases, salaries), rents, and interest. The non-contractual income let us call profits, postponing for a time the more exact definition of the term. Before the owner can count his profits at the end of the year he must pay the agreed price of services and usances, wages to his apprentices, workmen, salesmen, bookkeepers, foremen, designers, etc., rent to the owner of the building or of hired machinery, interest to the lender of money or to the seller of lumber, supplies, etc. The contractual incomes of these other persons are prices, expressed in money-terms and paid by the enterpriser; his noncontractual income is what money and other good he has taken out for his own use in that period, plus the net capital remaining that has accrued within the year. In the rare case where the business is bought at the beginning of the year, and is sold at the end, at a definite price, the difference (plus the amount meantime taken out) would exactly express the money income. But in a growing business the active capitalist’s income can only be estimated, by taking careful invoices of all property at the beginning and at the end of the year, making allowances for needed repairs and for depreciation, counting outstanding debts and credits, amounts taken out for the owner’s use, etc., and finding the resulting net excess of capital-value at the end of the year. This balance, if there be any, is the composite income of the owner, who is at the same time manager, and it contains whatever is to be attributed to his own services and to his invested capital of whatever sort. Viewing all the incomes in a legal light, this is the one residual income—it is what remains to the owner after paying all claims against the business. As a matter of bookkeeping also this is the one residual income, being the arithmetic remainder after subtracting from the total value of the products added in the course of the year to the capital, the total outlay (attributable to that year) which includes all of the contractual incomes due.1

§ 5. The typical owner-manager. This union of the function of business manager with that of active investor was at one time well-nigh universal, and it is still common in smaller enterprises. As applied to a small business this organization has the advantage of uniting in one person the one who is most concerned as to the financial outcome and the one whose judgment, energy, and care most largely determines the result. It unites responsibility and power. This plan still obtains generally in agriculture. In the United States in 1910 there were 6,300,000 farms of which 62 per cent were cultivated by the owners, 1 per cent by managers, and 37 per cent by tenants (which implies nearly always a large measure of oversight by the owner). A large proportion of the smaller factories are run in this way by an owner who started the business, or who has succeeded his father, or who, beginning as an apprentice, has advanced step by step in an older factory, getting first a share, and at last becoming head of the establishment. This plan prevails also in the great majority of retail stores and in many wholesale stores. A boy, going into a store, works up to a clerkship, and winning promotion step by step, gets a larger and larger share of the ownership and becomes the chief executive in the business.

§ 6. Empirical methods of estimating and apportioning the residual share. While management and ownership are thus united in one person or in one family, the attributing of the shares due to the personal labors of the management and to the investment is very imperfectly done. Indeed in a small business no effort is made to do so except in a vague and incidental way. (See Chapter 18, section 10.) The simple furniture-maker chose his trade primarily because of the labor-income it would yield—tho the need of tools and some investment in materials enters in some measure into the decision, as a burden (cost) incident to the trade, keeping some men out, and causing others to drop out when they can not keep up their equipment. But when the capital investment in shop, tools, materials, and stock is considerable, it comes to be estimated by comparison with alternative contractual incomes. A shopkeeper who clears $1000 in the year, seeing that he could sell out for $4000 and lend the sum for 5 per cent, counts “a fair return” on his investment as approximately $200 and his services at $800 a year; or having reason to think that he could not get a position working for an employer that would give him more than $700, counts his capital-income as $300, or 7½ per cent; or having an offer of a good permanent position at $900, counts that he is making but $100 on his capital, which is but 2½ per cent of what some one will pay him for it. Even in this case, either the greater independence of being his own master or the prospect of better business may deter him from making the change. It is well known that many small owner-managers both in handicrafts and in agriculture make no more, or even less, than “hired man’s wages.”

§ 7. Utmost possible degree of separation of investment and management. In the case of a growing business (such as that of the furniture-maker, section 3), as the owner-manager transfers one duty after another to an employee, the wage (or salary) paid becomes a part of the definite costs of the business. If his own labor is freed for more important things his final residuum will be greater. He can, however, transfer one duty after another to others without taking upon himself other tasks. Taking now the case of one who is already the owner of an establishment, consider what is the farthest point to which it would be possible to carry this differentiation of ownership (investment) and management. It can go to the point where the only task of management remaining to the owner is the appointment (and removal) of the general manager, all other matters being left to the appointee.

§ 8. Corporations and their control. Rarely when there is a single owner does he so completely divest himself of the managing function. But ownership and management are more nearly and more often separated when the organization is that of a stock company, or corporation, the ownership of which is divided among the holders of shares of stock, or certificates of membership. Many corporations have been organized by the successful single owner (or by partners, or by a family) as a method of enlarging the business, or of selling all or part of it, when the owner wished to retire, or to reduce his responsibilities with advancing years or with failing health. It is often difficult to find one buyer willing to invest the capital needed to acquire a large established business, whereas many persons are ready each to put in small sums if there is outlook for good returns. They are especially attracted either to an established business having reputation (“good will”) and a record of yielding good incomes, or to a new business in which the prime movers and investors are men of known ability and success.

Advantage is taken of this fact by active business men, in fair and in unfair ways, and throughout the nineteenth century the corporate organization proved to be best fitted to attract large amounts of capital for the great industrial, mercantile, and transportation enterprises. Usually these corporations were organized by and around some one man or group of men, who either actually paid for stock, or issued it to themselves in payment for the promotion of the undertaking, retaining thus a majority of the voting power for themselves (each share having one vote). One share over half is the utmost needed for “control,” and when the holdings are scattered in small amounts among stockholders, a very much smaller proportion is enough—sometimes as little as 5 per cent. The control may give the power to one man to elect himself to be president or general manager with power to fix his own salary and to appoint the other employees, and to control much in the way he could if absolute owner.

The capital-income from the stock he owns may be of slight importance to him compared with the control. There have been many ways in which the control of an industrial or transportation corporation gave opportunities, increasing with the size of the enterprise, for the man in control and his friends, to get large additional incomes. Many of these ways were plainly illegal, others unquestionably unfair, and still others in the debatable border zone of morality. These make up a large part of the so-called “corporation problem.” It is not the place here to discuss that; we wish merely to show the nature of the incomes arising under corporate organization.

§ 9. Single investment function of minority stockholders. A minority stockholder who practically has no option but to vote for the officers nominated by the group in control, has in investing but one decision to make: whether to risk his capital in that enterprise managed by that group of men. The only corporations that attract large numbers of minority stockholders are such as for a number of years have paid regular dividends, have followed a pretty definite, well-understood policy, and have in large measure gained and deserved confidence. The Pennsylvania and the New York Central may be named as examples among railroads, whereas the New Haven, which up to about 1910 was in the same class, showed how swift and how great may be the losses inflicted upon minority stockholders as a result of a change of policy by those in control.

The minority stockholder, while he may have no voice practically in electing the management, nevertheless in his investment bears his full share of the risk of financial loss (indeed, he bears even more than his due fractional share of risk). The stockholders collectively make the initial investment, that which bears the main burden of the financial risk (not all, for the other contractual income-receivers are not absolutely secure), and they receive their non-contractual income as a legally residual share after all other outlays have been made.

Thus it appears from the foregoing survey that the peculiar function of enterprise is investment and ownership. In many cases, perhaps most cases, the enterpriser still to-day exercises also the management function, and thus obtains an income that is a complex of an investment profit and a labor-income. In other cases, however, the management function is delegated to an employee, the hired manager, in which case the enterprise and the management functions are more clearly distinct because exercised by different persons. It is our task next to study more closely the function of management.

CHAPTER 27

MANAGEMENT

§ 1. The function of management. The owner of a fund of purchasing power can not leave it to invest itself. The primary function of enterprise is the choice of a business in which to invest; the next, and essentially last function, is to provide competent management. Every act of labor and every use of goods calls for some decision and direction. This is management, which is one of the forms and aspects of labor, quite easily distinguishable from mere physical action. In the simplest kinds of individual production the amount and quality of the goods obtained depends on intelligent choice often far more than on physical force. Even for the solitary worker the choice of the right time, kind, place, and method of work is most important. The first thing Robinson Crusoe did was to go to the ship and to save as much as possible of the cargo before it was dashed to pieces by the waves. If he had begun first to till the soil to provide a future supply of food it would have shown foresight, but very poor judgment. Every moment of delay in recovering the cargo of the wrecked vessel cost him many useful materials. The humblest farmer has a great range of choice and a need of good judgment in fixing the time to sow, to reap, to do each simple task. There is the same need to-day for small producers of all kinds, whether shopkeepers or blacksmiths, to make wise choice of time in the use of their own labor. There is also a wide range of choice in the distributing and combining of labor, agents, and materials. A limited supply of agents can be used to secure a variety of goods, more or less desirable. There is a choice in ways and methods by which a thing may be done. There are many wrong ways, there is but one best way, at any stage of industrial progress. While most work is done in customary ways and little independent judgment is required, yet in every kind of industry new problems constantly arise and call for the exercise of choice as to methods. Moral qualities are continually called for, such as control of impulse and the giving up of the comfort of the moment. The wisdom of our fathers is embodied in a multitude of proverbs that suggest the wise course. Men must “make hay while the sun shines,” and “plow deep while sluggards sleep.” But virtue fails less often from lack of knowledge than from lack of will. As men differ in judgment, character, and will-power, their products differ, even in the simplest circumstances. The ability to choose and to do wisely is an element in personal skill in every economic activity. This quality in the man is managing ability, and the action of directing economic activity is business management.

§ 2. Direction of simple and of interrelated groups. When men work in an associated group, the direction of effort becomes relatively more important. The first and simplest advantage of association is working in unison. Men unite their muscular efforts for a single task, and accomplish what is impossible to them working singly. There must, however, be a foreman to call out “heave ho,” or to lead the song, or to set the stroke for the oarsmen. When many are working together, good judgment in the selection of time and way yields larger results and a mistake wastes more materials and agents than when each works for himself. If association is to yield its advantages, it must go further than working in unison at a single task; there must be division of labor, hence harmony of effort, hence agreement and direction within the industry. While the gain of well-directed association is large, the waste of ill-directed effort is greater when specialization has taken place, than with isolated workers. Most communal societies have failed because of the lack of a good head. The few exceptional successes have been due to the presence of a man of superior ability, such as George Rapp of the Harmonist Community, who, had he lived in this day, could have easily become the head of a great business corporation.

When various industrial groups are associated, direction becomes still more important and the need grows for high ability to manage and direct the great units of industry. In the single group it is an internal harmony alone that is needed. The work of a dozen men must be so arranged that each is in his fitting place. But as this group comes into contact with others, the relationship becomes twofold, and there must be both internal and external harmony. Outlook upon business conditions and commercial ability become necessary. The more complex the economic organization of society, the greater the chance of mistake and the more injurious are the mistakes to a wide range of interests. Large amounts of wealth and labor can be rapidly lost through lack of wise direction of an associated group.

§ 3. Selection of managed and of managers. Ever since the beginning of human society some degree of organization of industry has existed. In every community by some method, however crude, a practical way has been found of determining who shall organize and manage the factors of production, and who shall work under direction. Economic organization has always been more or less connected with and affected by political organization, and in many ages has had a distinctly political character through the institutions of slavery, serfdom, caste, and heredity in politics. But in modern times, under conditions of political freedom, this classifying of men so that those less capable of managing industry come under the direction of those who on the whole are more capable, has grown more and more economic and competitive. This selection is often unsatisfactorily done no doubt, through the quips of chance and through many influences of personal favor and political injustice. In most cases, however, the selection is of a very exact and effective sort. The need of organizing industrial forces is so great that any method that works at all is better than no method. The man who shovels dirt must do it at the right time and place if, in this complex society, it is to count for something and give the effort value. If he can not choose well for himself, he comes under direction. The average man can not decide nearly as well here as he could on a desert island where and when to put in his spade. There it would be to raise food for the current year; here it may be to dig a canal or a tunnel whose uses will not become actual for many years. The more distant the end sought, the more difficult is the choice. To every worker, according to his personal skill, is left some degree of choice in the method of his work, but in a large part of industry the range of choice is very narrow. The man with the shovel and the man with the hoe come under direction.

Likewise there is a constant process of selecting and advancing the efficient managers. There is, to be sure, an element of chance in this selection. The process in general is a rude one. Accidents and unforeseen changes, industrial crises, failure of health at a critical moment, fraud and crime, may defeat men of ability and they may never regain their foothold. Men that have worked their way up from the ranks bequeath their business positions to their sons and grandsons. Lack of experience may lead to disaster a naturally able but youthful heir, too suddenly burdened with the responsibilities of a business. On the other hand, men of limited ability may inherit fortunes and preserve them by caution, without much energy or ability. Often they retain the investment while delegating the management to more capable hands. It is not always true, even in America, that “it is but three generations from shirt-sleeves to shirt-sleeves,” altho many fortunes slip away from the sons of rich fathers. In general, success in retaining either the control or the active management of a business is an evidence of considerable ability. By loss of fortune unwisely risked, through unforeseen changes in methods, and after manifold blunders, the less capable drop out. Thus, by the ceaseless working of competition, the higher places are taken by those fairly capable of filling them, and the efficiency of the management of business as a whole is maintained or increased.

§ 4. Division of labor in management. The management of industry does not usually show itself in entirely simple forms. The directing power in an establishment is not always exercised by one person, but usually by a number of persons. When there is a single owner, he most often is the manager. (See Chapter 26.) There is a virtue in this union of financial responsibility with practical control that favors its survival despite various limitations. But men are constantly failing in health, advancing in years, or becoming unfitted to meet new conditions after acquiring fixed habits of business. Partnerships often are formed by an older man taking into the business a younger man who might assume duties of active management. Yet the frequent difficulty of partnerships is an old story. “We went into partnership. I supplied the money and he supplied the experience. When we quit he had the money and I had the experience.”

Some minor functions of direction must be given to foremen when there are even a few employees; in larger establishments the men are constantly being tested and promoted to higher positions, becoming partners, or, in a corporation, officials. The “indoor man” and the “outdoor man” are clearly marked types. Many a man succeeds admirably in minor tasks of direction, but has his limitations whether due to natural endowment or to defects of education. A man may have just the qualities fitting him to manage a small gang of men whom he can see, know, and direct personally, but be unable to succeed where some power of imagination and some ability at constructive planning is required. A good departmental head may be a poor general manager.

§ 5. A large commercial policy. The highest function of the management, that which properly is performed by the chief of the organization, is to form the general commercial policy of the enterprise. Every active investment is made in some generally predetermined line—it is merchandise, agriculture, manufacture, transportation, etc., and more specifically is wholesale stationery, general farming, iron making, teaming, etc. From the moment the general investment is made the management begins to exercise the power delegated by the enterpriser, investing and reinvesting, shaping and reshaping the business in accordance with a continuous policy. In a degree varying with the kind and size of the business, demand must be anticipated. The trend of changing fashion, in engineering as well as in dress, the shifting of demand for products, must be foreseen and prepared for not too rashly or too cautiously. The process in every kind of undertaking, that of buying and selling, as well as that of manufacturing, requires time. Materials and labor are to be embarked in directions from which they can not be recalled. The widening or narrowing of the scope of the enterprise (as to variety of goods, extent of the market sought, etc.) and the enlargement or reduction of the size of the plant, are decisions wisely made only by a mind with a large business outlook. The larger the investment and the more complex and distant the factors, the greater is the difference of loss or of gain made by the manager’s judgment. The man who has the ability to do this exceptionally well in the largest business merits the title of a “captain of industry.” He is not a mere employee of investors, but a prominent personality, whom investors follow, eager to assume the financial risk under such leadership.1

A special type of manager is the promoter, who makes a plan of enterprise and tries to interest men of capital to invest in it actively. The promotion may be either of a new enterprise of a competitive nature, or of a combination to create a monopoly out of existing enterprises. The latter is the case of promotion most frequently spoken of, and it may be discussed with the trust problem. The promoter as such is a manager in the initial stage of the enterprise only. He is the moving spirit who offers his services to the investors, who are to perform the enterprise function.

§ 6. Obtaining of capital. The conduct of any business may be thought of as consisting of three parts, or processes: (1) buying, (2) alteration (i.e., recombination, elaboration, change in form, place, and time), (3) selling. These are continuous until the last sale is made and the whole business is ended. Buying and selling make up nearly all of mercantile business, alteration being subordinate; whereas alteration is the most striking feature of manufacturing, in which buying and selling appear (often mistakenly) to be quite unimportant.

Almost every business to-day requires from time to time additions of capital, temporary or permanent. Frequent use must be made of credit. The confidence and support of lenders, whether banks, trust companies, individual shareholders, or investors in bonds, must be secured by the management. Good judgment of the money market often is as vital as judgment of the market for the particular product. In some of the largest corporate enterprises this quality becomes the most essential, so that financial “influence,” consisting of personal or official relations with large financial institutions, comes to outweigh in importance most other qualities of management. This is in part the explanation both of the growth and of the evil of “interlocking directorates.” A similar power to get special privileges and opportunities from national, state, and city legislatures, in the form of favoring tariffs or of public franchises, is important for the success of some business enterprises, and this often fosters an evil conspiracy between bad politics and big business.

§ 7. Profit-seeking borrowers and the rate of interest. The enterpriser (and his agent, the manager) is essentially a profit-seeking (so-called productive) borrower. He does not borrow in order to enjoy more in the present in exchange for the future. He borrows to earn more in the present, to spend when he pleases, which may or may not be now. The money which he borrows to invest in business he uses to get better machinery or a larger stock, with which to secure a better or a larger product. The product finally being sold at a profit, the enterpriser is at a point where he can spend without encroaching upon his capital. The consumer of the product pays (or is expected to pay) the interest included in the price, and the final consumer’s payment for enjoyment must be deemed the logical source of the money interest. The business loan is made in view of the rate of interest, of the market-price of the goods in which the loan will be reinvested, and of the probable chances for earning profits in the business.

Evidently the price of these goods, to control which is the real object of the loan, is a general market-price reflection of their earning power. It is merely the sum of the expected prices they will yield, capitalized at the prevailing rate of time-premium. But earning power in whose hands? Not in everybody’s, for the price of the factors can be recovered in the price of the product only when they are applied to certain uses. Whoever buys anything to use and sell again, is venturing his judgment that he can make at least as much in the future as the market-price reflects, and possibly more. The borrower expects either to make these particular goods earn incomes larger than those on the basis of which they have been capitalized, or to transfer them to an economy where goods are capitalized at a higher rate than he is paying. The income yielded by these goods, if the borrower’s expectation is fulfilled, is but the difference between present and future prices that has been wrapped up in their capitalization. As time elapses and the incomes emerge in wisely chosen investments, the borrower has a surplus large enough to pay the contract interest. It appears, therefore, that the motive of the borrower is to get control of future incomes, at prices that already involve, in their capitalization, a discount of the future uses, as he sees them, somewhat greater than the interest he contracts to pay.

§ 8. Buying materials and labor. The large classes of goods which are to be bought are equipment, materials, and labor. In the main the prices of these things are determined by impersonal forces and can be only slightly modified by a particular buyer. This is especially true in the case of many staple goods. The manager can but look upon the price of these materials as fixed, and seek to combine them as economically as possible into other products. But there are many special patterns and qualities which have no true market-price. By close attention, good judgment, skilful bargaining, one man may be able to buy slightly cheaper than his competitors, and thus have an advantage over them at the outset. When he does this, it is usually by searching out a better market in which to buy, buying at a better time, and judging better than his competitors the quality of the goods.

Failure to have merchandise in stock when called for, and every needed material in stock to fill orders in manufacture, is an occasion of great loss. On the other hand, keeping more than is needed is a useless cost. The ability to buy cheap depends largely on being able to use a large quantity, sparing the seller in this way certain usual costs, and reducing the costs of transportation by economies in large shipments. But buying more than can be used within a short time causes costs for storing, insuring, etc., loss by deterioration, and loss of interest on the investment. Finding the golden mean—just enough and not too much—is one of the arts of business management, and requires a good organization of the purchasing department, and constant watchfulness both in mercantile and in manufacturing business.

Not the least important factor to be bought is labor of every grade. The more successful business men are not found usually paying less than their competitors for the various grades of workers. Success is due rather to utilizing the services so as to make them more effective. The chief executive of a large business must have a knowledge of men, ability to judge of human nature, to select his subordinates, and to animate them with his own purposes and plans. Andrew Carnegie has said that an appropriate epitaph for himself would be, “He was a man who knew how to surround himself with men abler than he was himself.” This seems too modest; but in a sense it is not, because he claims for himself, and justly, the highest of all industrial qualities. A great administrator in political or industrial affairs can dispense with everything else rather than with this, the supreme, quality of the great executive.

§ 9. Various policies to upbuild the personnel. Different policies for developing the personnel of an organization are followed in different enterprises. In some there is “inbreeding,” always promoting from those in the establishment; in others this policy is followed in the case of all minor places, but higher positions are filled by getting “new blood” from outside; in others, the best man is chosen wherever he may be found. There are advantages in each plan and corresponding disadvantages. In general a small organization needs to look outside for new blood, and a large organization can more safely fill its higher positions from its own staff.

Favoritism in appointments very quickly causes the degeneration of the management of any organization. The inferiority of public industry must be largely attributed to political favoritism, involving the spoils system with its usual accompaniment, insecurity of tenure. Every government, national, state, city, and county, has a good many business matters to attend to. In Germany, where the municipal governments have been such models of efficiency, the policy in engaging managerial ability is much like that of good corporate business in America. The mayor is a professional business manager, who prepares for the work as he would for medicine or for engineering. A city employs a mayor who has had experience and has shown success in the administration of a smaller city in any part of the empire. A beginning has been made in America in calling men from other states, to serve as municipal experts or to be heads of some state enterprises, commissions, and institutions (such as public school system, state university, prisons, philanthropies, etc.), and this use of the merit system is extending in the national service of health, forestry, irrigation, etc. This policy must develop if the public service is to become efficient.

Private business is not immune to the disease of favoritism, which in some of the railroads and of the industrial corporations is a serious hindrance to efficient operation. It is said that in some parts of the country getting even a minor position on a railroad depends upon having a “pull” with an official; directors provide their poor relations jobs as brakemen and conductors. The efficiency of American railroads in general, however, is doubtless due in large part to the wide open market for talent in management. A good shop foreman or a good master mechanic in any part of the country may hope to get a better position either on that road or on another. And to make a success as a division-superintendent or as president on a small road is to become a possible candidate for a larger superintendency, or for a vice-presidency or for the presidency of one of the larger systems.

§ 10. Management of technical processes. The factors bought—equipment, materials and labor—are to be skilfully and economically combined to secure a product worth more than it cost. Indeed, the very buying of them in certain quantities and of certain qualities implies and requires a decision more or less exact, as to how they will be used. For the performance of this task of combining the factors the management must have, somewhere in the personnel, adequate technical knowledge of methods, processes, and materials, and experience in the art of applying the knowledge. In small undertakings, the owner-manager must personally embody these qualities, but in more complex organizations the chief executive may do without all but the broadest knowledge and ability to judge of the results of different processes, and to compare different plans. The technical knowledge of details must be supplied by numerous specialists, working under his direction—engineers, draftsmen, pattern-makers, chemists, mechanics, efficiency-experts, cost-accountants, etc.

§ 11. Management of men. The management must, with whatever aid it can get, choose the general processes to be used, the kind of machinery, the order and arrangement of it, the kinds of material, etc., and the various technical processes, chemical and mechanical, by which these are to be manipulated. Not less important, the management must choose and direct the corps of workers. Workmen must be selected with a due degree of skill, but not of a grade of skill, and therefore of wage, higher than is needed for the task. In a small business a manager’s tact in handling men is one of the most important qualities, and, as the organization grows, foremen with managing tact must be hired. In one, it is a genial manner that wins the affection of the men; a sense of humor and ability to turn a joke smooths many a difficulty and is said to have obviated many a strike. In another, a dignified but sympathetic attitude toward the men is equally effective. Not infrequently after a new superintendent, experienced and capable in mechanical matters, has taken charge of a large shop, the use of materials increases, the output falls off, and a strike follows. The explanation in such cases usually is that the new manager mistakes a smooth working, efficient organization for a slow moving one. It does not rattle and creak as he thinks it ought, and he begins to prod and irritate the men. The reverse may happen, when a new manager coming into a difficult situation replaces discord with harmony, increases wages per man but reduces greatly the cost per piece, and then has a continual struggle to convince his superiors in authority that he is not making it too easy for the men at the expense of the company. Of late it has been more and more clearly recognized that emphasis had been laid too exclusively upon the manipulation of machinery and material as a means of attaining efficiency in production. The rapid growth of large industry under corporations, separating the men from those in authority, has helped to bring this about. It is now seen that the management of the human material is just as much a part of technical efficiency as is engineering science or skill in the technical arts.

§ 12. The right proportioning of the factors. The right proportioning and skilful substitution of the factors is a delicate technical task for the management. The enterpriser must constantly study the question whether the application of another unit of any one factor at the price will, following the principle of proportionality, add to value of the product as much or more than the cost. This calculation is made for every one of the minor factors entering into the business, and for the business as a whole. The proper proportion varies at different prices, or costs. If wages rise, “it pays” to get machinery; if wages fall, it pays to let some of the machinery deteriorate and to do more by hand-labor. Likewise there is constant substitution of the various materials. The right proportions change constantly with inventions. A model factory is so proportioned that the buildings hold the right number of machines, with the right amount of space for the workmen, and the right amount of power. If there is more of a single factor than the ideal proportion, it is an unnecessary cost. Even the model factory begins to be out of date almost as soon as the walls are dry, and the method now is to build as nearly as possible on the unit system, so that new parts may be added without the loss of harmony and proportion.

§ 13. Adjustment of production to changing conditions. In the adjustment of processes to changing market conditions, many opportunities for business judgment are presented.2 The agents employed in any industry range from the more valuable down to the less valuable grades in a more or less regular series. As the place of agents on the scale of efficiency is constantly shifting, the various agents represent all grades. One depreciates, possibly is restored later and takes a high place, and again depreciates, until finally it is thrown out of use. One loom embodies the latest improvements and corresponds to the most fertile field; another can still be made to yield a little income; the use of a third results in certain loss. A great mass of unused agents lie just below the margin of utilization in every industry. Some of these are permanently abandoned; some will be taken back into use when business conditions improve. When the iron industry is dull, many forges are out of blast; but when iron is again in demand, there is a gradual taking up of the abandoned forges, factories, and machines as they are brought within the margin of profitable utilization. Many agents not actually earning an income, may do so through a change in business conditions. Great quantities of the poorer grades of wealth, even of those things that are relatively fixed in quantity, lie unused. Great areas on the edge of civilization still await the pioneer, the prospector, and the miner.

Here is a source of wealth and a field for enterprise, to take these unused things or things imperfectly used, and convert them into effective agents. A rise in the value of any agent at once causes an attempt to duplicate it or to find a substitute for it; this attempt, if successful, puts a check upon, or sets a limit to, the rise. In this search for new devices the man who can see most quickly and clearly has a key to wealth, and he is helping to meet the wants of his fellows in society. Some inventions suddenly increase the efficiency of some grades of goods to such a degree that less efficient ones are thrown out of use, and the margin of utilization is moved to a higher plane than it was on before. Improved types of machinery in the progressive establishments displace the older, less efficient types, which, therefore, more or less completely lose their earning power long before they are physically worn out. The wish of the individual is to raise the efficiency of his own establishment, but in doing that he affects the agents owned and controlled by others. Inventions and improvements gradually become common property, and increase the free goods and free uses not bearing rent and open to every one. One who improves the quality of a machine or the economy of a process may thus unintentionally injure some of the owners of other agents, but the more lasting effect is to increase the efficiency of all agents on the margin of utilization.

CHAPTER 28

PROFITS AND COSTS

§ 1. The broader meaning of profits. The term profit (or profits) means broadly the residual share, the one noncontractual income in the business. It is what is left as a net gain to that person (or group of persons) who assumes the financial risk of the business, after paying off the claims of every one else for any uses or services rendered. Profit in this broad and popular sense is a complex of incomes from various sources and must fluctuate in nature (as well as in amount) from case to case for reasons that are accidental and personal.

We may see this in reviewing the examples above. In the small furniture shop profits includes all economic incomes in the business, whether from the investment or from the joiner’s own labor. It is an inclusive term for the usances of tools, shop, materials, and land, and for the services of the owner, whether as investor, manager, or handworker. It embraces all the economic yields which by theoretical analysis can be carved out of it. As the business develops, profits, as thus used, means more or less according to circumstances which must be ascertained from the context. If the investor owns all his buildings and land, machinery, and sources of materials, and has no borrowed capital, then profits includes all that is left of cash receipts after paying wages (and salaries), but wages may be more or less according as the investor takes a more or less active part in the management. If in the one business the buildings, water power, lands, etc., are fully owned, and in another business with exactly the same product all these things are hired, profits in the former would be much greater. While the business is owned by an individual or by partners, profits may include whatever is attributable to the owner for his management; or a fair salary may be estimated for this, and only the remainder be counted as profits. Like complications, or even more troublesome ones, are found in the case of corporations. The one company owns all its patents, the other pays royalties; the one has all its capital represented by paid-up stock and the other has more or less of outstanding bonds the interest of which is a “fixed charge” to be deducted before counting the residual share of profits. The possible variations are endless, but these illustrations suffice to show that profit in any such general sense is not a scientific term for the purpose of studying the forms of income; it has not even a precise practical significance.1

§ 2. Conception of pure profits. Is there then, no exacter conception of profits possible? Among these various meanings is there one not preëmpted by another term, one which expresses a sort of income found in practical affairs, which business men are constantly trying to estimate and of which economists must take account? Let us try to express such a conception in this definition: Pure profit is the income of the active capitalist as such, attributable solely to the active capital-investment in the particular enterprise. It is an investment-profit. The amount and rate of investment-profit is peculiar to each business and indeed to each investment. It is never an agreed price, or a contractual payment. It is the residual after the actual contractual dues have been paid, and the estimated value of other factors (such as the services of the manager, etc.) have been deducted. The investment profit concept is most nearly exemplified in practical affairs in the bookkeeping of a corporation. Out of gross receipts must be paid all rents, interest, maintenance and depreciation of the plant, price of materials, wages, salaries of managers and officers, fees of directors, etc.; the residue is the amount which may be paid as dividends to stockholders (or added to surplus) without impairing the capital investment.

§ 3. Dual character of investment profit. Even investment profit usually is subjected to a comparison which divides it into two elements. We have seen (Chapter 26, section 4) that it is of the very essence of the active capital function that it takes the financial risk of the outcome. When therefore at the end of the year (or income period) it appears that a certain profit has resulted (say $1000), this is compared with the capital invested (say $10,000) and expressed as a percentage on the investment (thus 10 per cent). Now this in turn is compared with the rate of interest common on the safest loans (say 4 per cent) and the remainder is the amount (or rate) by which this active-capitalist investment exceeds the current rate of passive capital investments. This merely estimated division influences further choice of investment. The rate of interest is taken to represent about what capital can do by itself (or with a negligible amount of judgment and supervision—an abstract conception) and the excess above that is attributed to the successful act of investment. Thus, however far we attempt to eliminate the personal service element of management from profits, there always remains in any active capital income this one element of investing management together with the carrying of the financial risk. There is a dual character in investment profit; it is a capital-income and a labor-income, combined. The distinctive feature of investment profit, which fastens our attention, is precisely this excess (or deficit) of income in active-capital as compared with the normal prevailing rate of time-price, which can be secured by the most conservative passive investor. It is the hope of an income more than ordinary interest that is the inducement to active capitalists to assume the risk. We may call the amount realized more or less than the imputed yield of passive investment, pure investment profit, attributable to the exercise of pure investment function. The amount may be expressed as a rate on the investment. This is the utmost point that has been attained in the analysis of the complex elements of “profits” as popularly used.2

§ 4. Enterprise and risk. To the person who exercised this function of active capital-investment various names have been applied: undertaker,3 its French equivalent entrepreneur, adventurer (especially used in former times of one who embarked in foreign trade), and enterpriser. Each of these was meant to express the assumption of the financial risk in undertaking the ownership of the various factors and of their results embodied in the products, in paying off other claimants, and in waiting for an income indeterminable in advance, but contingent on all the various fluctuations of the market.

Enterprise is the act, or function, performed by the enterpriser, and in a different but related sense is the particular business establishment, or undertaking, which is carried on by an enterpriser. Business management and enterprise are functions not embodied completely in any individuals, but diffused more or less among groups of men. The active-capitalist and the passive-capitalist are not in contrast absolutely but relatively; the passive capitalist is not, and can not be, completely freed from financial risk. Enterprise is merely in this particular business the assumption of the legal financial responsibility to the extent of the enterpriser’s credit and resources, or in other cases to the extent of the special legal limited liability, as (in most stock companies) to the amount invested, or (often in banking) to double the amount invested.

Risk is more or less everywhere in human affairs, but among various kinds of investments there is a well-recognized gradation in the uncertainty of returns. The enterpriser in a business takes the more exposed frontier of risk, and the various senior securities have prior claims. For example, if the business of a corporation goes badly the first mortgage bonds, getting a low rate of interest, are the first claim on the income and, in case of insolvency, these bonds would be paid out of any assets of the company; so in turn till we come to the common stock which gets nothing until all the other claims are satisfied but which if the business is prosperous may get dividends at any rate permitted by profits. There is thus an investment risk, an element of enterprise even in the safest investment, e.g., government bonds, but this becomes almost negligible in the case of many well-proven investments. This relativity of risk and of the enterprise function may be shown again in the interrelations of different enterprises. (See Figure 42.)

§ 5. Pure profit the most variable income. It is easily seen why the income to enterprise is the most variable from one establishment, and from one time, to another. It contains within it all the non-contractual elements of income. The laborer has taken a fixed wage, the passive capitalist has reduced his risk and accepted a fixed interest. Both wage workers and passive capitalists have taken the easy way, have “played safe,” and have left the enterpriser to bear the brunt of the financial risk. The income of each of these classes tends to conform to a general market-rate, being a medium of the gains and losses when labor and capital are applied with various degrees of risk in various undertakings. Enterprise is the most movable element. It is specialized risk-taking. Enterprise has well been called an economic buffer, which takes up and distributes the strain resulting from variations in the momentum and rate of movement of industry. The enterpriser feels first the influence of changing conditions. If the prices of his products fall, the first loss comes upon him, for the goods already made must be sold. Further loss is avoided as best it can be by paying less for materials and labor. At such times the wage-earners look upon the employer as their evil genius, and usually blame him for lowering their wages, not the public for refusing to buy the product at the former high prices. When, however, prices rise, enterprise gains through selling at higher prices the stock on hand that has been produced at low cost. Enterprise is placed between the forces of competition, between owners of resources and ultimate consumers, between laborers and the final purchasers of labor’s services. The enterpriser’s economic survival is conditioned on vigilance, strength, and self-assertion.

Profits therefore fluctuate more from industry to industry and from man to man than do other incomes. The variations of the market may sweep away not only all “profits,” but all the invested capital. As a consequence, profits may be at other times very high, for enterprise will not take the risk of great losses unless there is a chance of large gains. While the income of the salaried man is occasionally advanced, and then for long periods remains unchanged, the profits of enterprise come in waves. In seasons of prosperity profits in many enterprises swell with a dramatic swiftness while rents and wages move tardily upward. Then again for years profits fall to a level hardly exceeding a low interest on the capital invested or leave many businesses for a time with a loss. Reasons for this result will be shown more in detail under cost of production.

§ 6. Meanings of cost. The profit in enterprise results from the surplus of sales (receipts) over costs (expenses). Few words are more often heard in business than cost, or with more varied shades of meaning.

In a general sense cost always means something given up, parted with, paid, to get something else. Often this outlay takes the form of pain, fatigue, or irksomeness of labor, tho this is a psychic cost, better termed sacrifice. Thus it is said: he got it at the cost of tireless effort; it cost him his health. When the worker who is free to determine the length of his working day stops work, he reveals that his valuation of his labor just at that point is greater than the valuation of the product that will come from further labor—the one negative and the other positive in the balance. Psychic cost thus rises to the level of more or less conscious estimation at certain points and, like psychic income, has its part in many ways in the choices made by individuals. It is not, however, the objective measure of cost in the transactions of trade.

In another sense cost is applied to any objective good or any gratification which could have been chosen, but which was given up when another choice was made. This is alternative cost, called by some, opportunity cost. It is an option relinquished. One may stay at home and read a book or go on a picnic; the pleasure of reading a book will cost the pleasure of the picnic. A good dress may cost a vacation that must be given up for it. In this sense, each thing is a cost of every other thing that might be chosen in the place of it, tho the alternative cost thought of is usually the most important excluded option. Alternative cost, like psychic cost, is individual, and is significant at the moment of choice but is not the measure in which business outlay is expressed.

The sense in which cost is mostly used in business in the common phrase “cost of production” is money cost. It expresses not the pain of the laborer in doing the work, not the sacrifice of the owner of the capital in saving the money, but merely the sum of money paid out by the producer. Costs, proceeds, and profits are all in business practice reckoned in terms of money. The enterpriser invests in order to realize profits. Enterprise is investment, the putting of capital into concrete forms of wealth; and it is in turn the sale of wealth, a process which might be called divestment. The realization of profit means getting out a total sum of capital greater than was put into the business. Capital is thrown into the melting pot, and is taken out crystallized into new forms of wealth which may or may not bear a greater price than the costs. The price of the products depends on the valuations of possible purchasers. The customers may be foolish men with unwholesome desires, and profit-making may result from pandering to their vices; but in any case the enterpriser finds himself limited by this condition: to gain a profit he must produce a surplus of value (as judged by his customers) between costs and selling price.4

§ 7. Superficial view of costs and prices. It is well after this discussion of costs to consider their relation (as a more fundamental problem of theory) to prices and values. The business man, as such, is rarely interested in this question. He knows that many influences unite to determine the cost of the factors he buys, but they are distant; he cannot influence them, and in the single stage of his production his costs seem to fix the price of his products. In some purchases, however, and on the stock exchange, a remarkable power of noting and analyzing the more distant influences is displayed. But in general a superficial view of value is taken in business; it does not pay to do otherwise. The active investor simply takes the price of various factors as he finds them, and seeks to combine them and to sell them when and where he can reap a profit. Yet if he is asked, What determines the prices of goods? he probably replies, “They are fixed by cost-of-production.”5 This is the way it appears from the enterpriser’s point of view as he is deciding whether to extend or contract his production and sales, whether to raise or lower his prices.

§ 8. Costs adjusted to prices of products. But cost sets merely a lower limit of price, below which the enterprise can not sell without loss. Within or above those limits the price is determined by the bidding of the market, buyers and sellers. If any one is so situated that he can regularly get more than cost on any unit, he attributes the gain to whatever agent gives the advantage,—to his patents, his land, his own ability,—and thereafter he adds more to costs on that account. In this case we see plainly that the value (or price) of the factors (that is, the cost) is being marked up (or down) according to the price of the products, and not vice versa.

The rule must be reversed also in the case of many large classes of goods. Some things that can not be multiplied or reproduced, such as autographs, old violins, old paintings, diamonds, bring prices that are not dependent on the cost of production. The same is true of great numbers of natural resources, including all lands taken in a state of nature, whether agricultural, mineral, residential, or commercial. That leaves still to be explained the relation of costs to the prices of the great class of goods which are grown by the art of man, e.g., grain, cotton, cattle, etc., and manufactured, e.g., tools, machines, cloth, etc. Now it is noticeable that every one of these objects has a cost just because it happens to be looked at just when it is in the enterpriser’s hands at an intermediate stage of its production. The cost rule applies only to factors that have been bought at a price, and the total cost is simply the sum of the prices of the factors. But how did the factors, the various qualities of labor, the materials, use of agents, etc., get their price? That question has been answered in earlier chapters: from the value of the expected product, or uses. The business enterpriser is a middleman, buying to sell again, and his costs determine whether or not he can make a profit, but they do not determine the prices of the products. Rather they are seen to be determined by the prices, when a broad enough view of the situation is taken.

§ 9. A single factor of a single product. The tracing of the value of goods through intermediate products to direct enjoyable goods, and finally to the source of value in psychic income, gives the genealogy of value. After the goods enter into the channels of commerce and are once bought and sold, they bear a cost to the owner. In the one direction we seek the “ultimate agent,” or factor, the natural agents and laborers; in the other direction we seek “the ultimate products” or ultimate uses. A single product having a single factor shows most clearly the reflection of value directly from the product. (See Figure 43.) The discovery of a mineral spring or of a good quality of building-stone on worthless land, will cause a value to attach at once to the agent. When a great singer like Adelina Patti commands several thousand dollars for each appearance in concert, the value of the music in the minds of delighted hearers is transmitted to the salary of the singer. Her salary is not determined by cost, but it becomes a cost to the enterpriser who employs her and undertakes a concert tour.

§ 10. The genealogy of value. When the one factor yields several different kinds of products no one product alone accounts for the value of the factor. As any one wishing the factor for any use must bid against the other uses, the factor appears, on a superficial view, to have a price already determined by its other uses. But we know from our previous studies (see Chapters 4-6) that the value in any situation results from all the uses taken together, including the particular use we began to examine. To take a simple illustration: a savage finds in a wreck on the coast a number of bars of iron. He and his fellow tribesmen wish them for various purposes: to make arrow heads, spears, knives, hatchets, hoes, ornaments, nails, needles, etc. The value of a bar used to make a knife is in this case derived, in part, through the ultimate factor, from the alternate uses. Taken jointly and considered as one sum, the values of the products account as completely and exclusively for the value of the factor as if they were merged into one product. The factor (F) is distributed to each of the products in accordance with the marginal principle and therefore the value of the various products from equal quantities of any factor constantly tends to equality. Any unit of product sought for any purpose must be paid for according to a value determined by the costs of the factors under the marginal rule in all the applications. The genesis of the value of ultimate factors is found in the value of the product.

In actual life the problem is far more complex, and yet, through its settlement runs just the same principle. There is constant bidding for factors, and through their prices the claims of rival products are adjusted. A point is reached where it does not pay to use any more of an agent in a certain industry; the production of another unit results in a loss because the factors are worth more in other uses. There is a most complex relation among many different industries using the same factors. Thus in countless ways the values of products of widely different kinds mutually influence each other. The value of no one is an isolated fact, but is ultimately only the reflection of its relative importance in meeting the desires of men in view of the whole situation.

§ 11. Money cost derived from price of products. Products compete with each other for the factors that enter into them. According to location, quality of the soil, and improvements, a certain area of land has various rival uses. These uses bid for the land; that is, put in an economic claim for it. Products of a higher value outbid and exclude those of a lower. If fine wine can be raised on a piece of land, potatoes ordinarily will not be planted in it. But if there is such a supply of that quality of land that it continues to be used side by side for both products, it will have the same value and yield the same rental in both uses. The law of indifference applies. The demand for any factor entering into products is reflected, in an increased price, to its cost in all competing products. Machines are usually made for some product determined in advance, but often they are only partially specialized and within limits they can be adapted. Sewing-machine factories were readily turned to the making of bicycles at the time of greatest demand, and bicycle factories later were used for the making of automobiles. Thus, in general, machinery is used for the product in which it can realize its highest value. Any enterprise seeking it for any other use finds its “cost” affected by its various alternative uses. The same is true of all the materials and of all the grades of labor entering into products. The enterpriser’s cost is therefore the reflection of the ultimate prices of the productive agents in all its other uses as well as in the particular product he desires.

§ 12. Cost an expression of consumers’ estimates. It appears that within the limits of monopoly control prices may be fixed without reference to the costs in the particular enterprise. Even a monopoly, however, is limited by costs, in the range of its price fixing. When cost does appear as the limiting influence in the price of a particular product, the cost is itself fixed by a larger group of influences, the demand for the factor in the totality of its uses. Wherever cost asserts itself the enterpriser must bow to the situation, and must conform closely to costs or suffer a loss. The consumer by deciding to buy this or that product sets into motion waves of value. The enterpriser transmits these to the factors. He is the medium through which consumers express their estimates. The enterpriser who anticipates aright and satisfies the public taste is the good medium. He readily transmits and accurately focuses the rays of public judgment. The enterpriser who misjudges is a poor medium. The one realizes profits, the other incurs a loss.

Notes

On other meanings of profit. It is well to note for caution’s sake other loose uses of profit as any gain or advantage secured by any means in business. In retail business it has the meaning of the gross gain on a given sale, the excess of the selling price over the price at which the merchant bought it from manufacturer or wholesaler. Let us call this sale-profit. Buying an article for one dollar and selling it for two dollars, is said by the merchant to be selling at 100 per cent profit, jocularly called, “The Dutchman’s one per cent.” In different lines of goods there is added regularly to this cost 20, 30, or 50 per cent, as the case may be, as the merchant’s profit on the sale. Sale-profit leaves out of account rent, interest on capital, clerk hire, freight, and many other minor items that enter into the cost of running a store. It often happens that the Dutchman’s way of reckoning is near the truth, and that the sale-profit of 100 per cent leaves at the end of the year hardly 1 per cent of the sales as a true income to the merchant. This meaning is sometimes developed to a yearly sales-profit, the sum of all the separate sale-profits within a year, or the difference between the wholesale and retail prices of goods sold within the year.

Another meaning is given to the term by expressing yearly sales-profits as a percentage of the capital invested. The rate of profit in this case varies partly with the rate of the turnover. To illustrate: if the amount invested in a printing-office is $100,000, and the annual business done is $300,000, the capital is said to be turned over three times; if the yearly sales-profit were 20 per cent, the ratio of sales-profit to investment would be 60 per cent; but, if the capital had been turned over four times, the rate would have been 80 per cent on the investment. In none of these cases is profit used truly as an income.

The source and cause of profits in economic writings. Profits, as used by the English economists from Adam Smith (“Wealth of Nations,” 1776) to John Stuart Mill (“Principles of Political Economy,” 1848) and after, was the residual amount combining the incomes attributable to the personal management together with the capital-investment. These functions were assumed without discussion to be united in one person, as they usually were, stock companies at that time being rare outside of banking and foreign trading companies. The capital-income was assumed to be much the larger part and there was almost no thought of the varying degrees of ability in management as affecting the result. Hence profits in the older English economics often means nearly the same as yield from capital, peculiarly the income of the capitalist; tho usually it means this plus an allowance for risk and services of management. “Normal” profit was thought of as varying from one class of business to another but not very clearly as varying from one establishment to another.

Then the pendulum swung in the other direction and some writers, notably the American, Francis A. Walker, made profit mean almost solely the earnings of management, it being assumed that financial resources naturally rolled into the possession of able business managers. But, as it was assumed that they always had some capital themselves, the concept of profit still had a dual character. Capitalists were thought of as always getting a contractual income, interest, whereas the entrepreneur got an income varying from zero (or a minus quantity) upwards, according to his skill in management.

CHAPTER 29

VARIOUS SHADES OF PROFITS

§ 1. Review of the profit-concept. Profit is the legal residual share of the total income yielded by an enterprise, the share (positive or negative, profit or loss) that is left to the owners of the enterprise. Every enterprise, however simple, involves ownership of agents and product, and between the investing and the accounting at the end of any period, there is financial responsibility and profit or loss. This may be minimized by one owner by contract with another, the one thus becoming more passive and safe, tho still having some risk, and the other, taking at a price the active control of wealth and services and selling the results for whatever he can get. The laborer still runs the risk of becoming incapacitated by illness or accident, or of being thrown out of employment. The lender still has some risk of failure of the debtor, etc. But the laborer sells his labor, and the capitalist sells the use of his wealth—horses, lands, equipment, and of his loanable capital, and accepts a definite income and the legal responsibility of the borrower to repay the loan.

§ 2. Skill in relation to risk. In most enterprises and under normal conditions of business the largest factor in determining whether there will be anything left for profits is the skill with which the business is planned and managed, from the first investment to the last little detail by the wellchosen agents of the enterprisers. There are many chances and risks, but few of them are completely objective, of a kind utterly beyond the control of the enterpriser. Even loss by lightning, flood, fire, and other “acts of God” (in legal phrase) are more or less liable according to the judgment and foresight in the construction and location of buildings, care in their oversight, etc. This power to minimize risk, the restless watchfulness and the intuitive anticipation of dangers, and often the discovery of ways to convert them into advantages, is a large part of what is meant by skill of management. The risk of business is not that of the throwing of dice in which (if it is fair) skill plays no part, and gains in the long run offset losses. Business risk is rather that of the rope-walker in crossing Niagara; the task is easily undertaken by the skilful Blondin, it is fatally dangerous to the man of unsteady nerve and limb. The skilled workman, handling, with sure touch, the delicate and costly materials, can not be said to be incurring a great risk of spoiling his work, however great the risk to the novice or the bungler.

Looking at this large phase of the problem, profits are seen to be due not to the existence of risks, but to comparative skill in taking risks which in many cases is the ability to make the risk dwindle or disappear. Some men are more able to perform the function of enterprise than others, and profits are high or low just as fruits are bountiful on fertile soil and scanty on barren soil. In this aspect profits in the long run are the share (non-contractual) of skill and ability in the function of enterprise; and our illustrations above have largely been drawn from industries in which this seems to be the true view.

§ 3. Union of chance and choice. But there is another aspect of the subject. Profits, just because it is the actual residual, is the most complex and varying share. The enterpriser, to the extent of his credit and financial strength, undertakes to assume the risks for all the other factors. Profits is the catch-all for every unforeseen or variable change of price between each act of investment and the ultimate sale of the goods. Chance therefore has its part; but the temptation is to exaggerate its importance. Many cases of profit said to be due to chance are found on closer knowledge to be due to superior judgment. They result from a union of happy chance with deliberate choice. The adventurer who, on the discovery of gold, goes at once to California or to Alaska, may stumble upon a gold-mine. It is luck; but he has gone to a place where gold-mines are comparatively plentiful. If he stays at home it is more likely that he will stumble over an ash-heap. Throughout life there is constant opportunity, but it must be sought. One who has the good judgment to be ever at the right time at the place where he has the best chance of finding a good thing, usually gets the advantage, and men call it luck. The more the causes of success in general are studied, the larger is found the element of choice, the smaller that of luck.

§ 4. Element of pure chance. But after all these qualifications, cases remain in which profits can only be said to be the result of pure chance or luck. It still sometimes appears better to be born lucky than to be born rich. What is luck? A result that is not calculable, coming to pass in conditions where a rational choice is not possible, is called luck, for lack of another name. There is bad luck as well as good luck. According to the law of chance, in the tossing of a coin for “heads or tails,” one side is as likely to come up as the other, and in the long run the number of heads and tails will be equal. Taking all together the pure accidents of certain kinds, in the community, they are so numerous that losses and gains distribute themselves about a general average by what is called the law of averages, or the law of large numbers. The individual’s risk then may be eliminated by insurance, as that against fire, flood, lightning, against sickness of the employer, which would cripple the business, or against his death, which would check it. But many factors evade all attempts to reduce them to rule and there is no possibility of insuring against them: war, changes in markets, good and bad harvests, financial crises, etc. One year the enterprise gains, another it loses. One man makes a success because he happened to engage in business at that time, another man fails because he happened to undertake it at another time, with no more real judgment in the one case than in the other.

§ 5. Changes in transportation and in land-values. The union of choice and chance in varying proportions is seen in many instances of the increase in the value of land. The rapid changes in transportation since the beginning of the nineteenth century have wrought great changes in the value of lands for many purposes, and thus have brought great chance profits (and often great losses) to individuals. To take a few examples.

The Erie Canal, completed in 1825, increased the trade of the ports of New York and Buffalo, brought prosperity to many cities on its waters, increased the value of agricultural lands on and near the Great Lakes, but reduced the value of many farms in New York and New England. The completion of the Boston and Albany railroad in 1841 and the later opening of the Hoosac tunnel probably helped the mechanical and depressed the agricultural industries of New England. The spread of the railroads in the United States from 1850 to 1880 went on with unparalleled rapidity, and opened up to settlement great areas of rich lands which rose in value. At the same time the large new supplies of agricultural produce so reduced prices in the great markets, and the incomes from lands in eastern America and in western Europe fell so greatly that many farmers were bankrupted. Timber lands bought from the government at fifty cents an acre made enormous fortunes for the so-called “lumber kings” of the Northwest. The Panama Canal raised the efficiency of ships plying between New York and San Francisco, enabling them to carry freight more quickly and in greater amounts. The railroads must lower some freight rates and even then lose a part of their traffic, and many of the lands on the Pacific coast must rise in value.

Changes in transportation alter the location and character of all kinds of enterprises. After the building of the railroads in Pennsylvania new forges were built where deposits were richer or where materials and products could be more cheaply shipped, and many prosperous small forges on the country roads became valueless. A similar change has relocated the flour milling, the mechanical, and the textile industries of a large part of the country. As population has been growing rapidly in Christendom in the past century or more, farms have become villages, villages have become cities, lowpriced residential lots have become expensive business sites.

§ 6. The so-called unearned increment. Such changes and chances as these have resulted in profits and losses to great numbers of landowners, who as investors have seen their lands rise above or fall below the price for which they bought the land. The name “unearned increment” has frequently been applied especially to this kind of profit of the landowner. It is true that in many ways the ownership of a piece of land may give unexpected gains. Farm land of the poorest kind often is found to contain valuable mineral deposits. Such a lucky find lifted the mortgage from a farm in eastern Pennsylvania, from which, in two or three years, feldspar was taken exceeding in value the agricultural products of the same land in the fifty years before. The discovery of building stone, coal, natural gas, or oil beneath the surface has brought riches to many a poor landowner. A mineral spring, because of the supposed or proved healing properties of its waters, may be as good as a mine. Fitness to produce nettles is not ordinarily a virtue in land, but the discovery that certain fields produce a superior quality of the nettle used for heckling cloth, causes them to rise in price. Marsh land, almost valueless, found to be peculiarly fitted for the cultivation of celery, becomes very valuable. While the income of the owners of these lands is increased, that of other owners may be diminished, as a result of the fall of prices and the shift of demand.

The increment of land values seems especially unearned when it arises as an incident to the holding of the land for other purposes, as for farming, or for one’s own residence. The striking fact in the extreme cases of chance increments of land values is that profits accrue to quite unenterprising landowners. Many dramatic changes of fortune have resulted and in many a case some half-miserly old farmer doing nothing to improve the community and opposing all change, has left a fabulous fortune to his heirs. And yet, comparatively speaking, such cases are about as rare among landowners as are capital prizes in a lottery, and there are many cases of profit in things other than lands, where there is a similar profit due to chance. Stocks of goods are worth more or less, horses, cattle, grain, go up and down in price in the hands of farmers or of produce merchants. All profit involves this element. Land profit is but one notable example of a general fact.

Moreover, while the change of land values is on the whole upwards where population is increasing, many pieces of land fall in price; there are undeserved decrements as well as unearned increments. So far as increases in land value can be foreseen they are included in the present worth of the land, and the new purchaser does not thereafter, viewed as an investor, get any “unearned” increment except from unforeseen or miscalculated changes.

As a matter of the theory of profits there is nothing peculiar in the unearned increment of land. A question calling for separate consideration is whether it is expedient to adopt a different policy as to property in land, by special landtaxation, or by appropriating the profit (increment) which now goes to the owners in advancing neighborhoods, or by any other limitations.

§ 7. Element of speculation in business. A still further specialization of risk-taking is effected by means of insurance and of certain forms of speculation. In its broadest sense speculation means looking into things, examining attentively, studying deeply. In a business sense the speculator is one who studies carefully the conditions and the chances of a change of prices; hence arises the thought that speculation is connected with chance. The enterpriser should be able to estimate these chances better than most men. Every enterpriser is to some extent specializing as a risk-taker. He relieves the other agents of part of the risk, and he insures both laborer and capitalist against future fluctuations of prices. Some of the profits of successful enterprise are speculative gains of this sort. Offsetting them, however, in large measure, are the speculative losses, by which in many cases the investment is swept away altogether. The cautious business man tries to reduce chance as much as possible by insurance, where a regular system prevails, and to confine his thought and worry to the parts of the productive process where his ability counts in the result. A man can better concentrate his thought and effort upon running a flour mill, if some one else will, for a price, take the risks of fire, of loss in shipment, and of a rise in the price of grain needed to fill outstanding orders. Insurance being the economical way to cover risk, the reckless will, in the long run, more likely be eliminated from the ranks of enterprisers.1

§ 8. Specialization of risk-taking in produce markets. In some lines the risk of marketing and carrying large stocks becomes highly specialized, so that ordinary enterprisers shift it to a small group of risk-takers. In buying and selling large quantities of produce there is required the closest and most exclusive attention of a small group of men. The marketing of some staple products requires the most minute acquaintance with world conditions. To foretell the price of wheat one must know the rainfall in India, the condition of the crop in Argentina, must be in touch as nearly as possible with every unit of supply that will come into the world market. Such knowledge is sought by the great produce speculators in the central markets. If all means of communication—telegraph, cables, mails—are open to all, competition among these speculators becomes intense, and the result is great efficiency. Their survival depends on the development of acute insight into market conditions. The margin at which farm produce is sold in the great wholesale markets is a very narrow one. These products are marketed along the lines of the least resistance; that is, of the greatest economy. The function of the commercial specialists is to foresee the markets, and to ship to the best place, at the right time, in the right quantities. If a product shipped to Liverpool will, by the time it arrives there, be worth more in Hamburg, there is a loss. Such difficult decisions can be made best by a small group of men selected by competition. When handling actual products they perform a real economic service.

§ 9. Produce speculators as insurers. Many of the speculators in staples, wheat, corn, wool, rarely handle the material things, the real products. They make it their business to study the world conditions and to buy or sell for future delivery. Regular merchants buy and sell “futures” from or to these men; that is, they promise to deliver or take the produce or pay the difference between the contract and the actual price at the time of maturity. Mere speculators on the produce markets may and do at times thus perform service as risk takers. When a miller buys ten thousand bushels of wheat that will remain in the mill three months before they are marketed as actual flour, he “hedges”; that is, he at the same time sells that number of bushels to a speculator for future delivery. If wheat goes down in price the loss on the actual wheat is balanced by the gain on the “future,” and vice versa. Or selling flour for future delivery the miller buys a future in wheat; if wheat goes up in price, the miller’s loss on his contract for flour is offset by the gain on the “future.” In either case he cancels the chance of loss or gain, giving up the chance of profit in the rise of wheat in exchange for protection from the loss of the product on his hands. To him this is legitimate insurance, for he is striving not to create an artificial risk, but to neutralize one that is inseparable from the ordinary conditions of his business.

How can the speculator profit if the miller in the long run benefits? There are unsuccessful speculators and at any rate their losses go to the successful as a sort of gambling profit. But, further, the sales to legitimate purchasers should net a gain to the abler speculator. In proportion as his estimates are correct, there will remain a regular slight margin of profit to him. If he sells wheat at eighty-five cents to be delivered in three months, he expects it to be a little less at that time; if he buys a future he expects the price to be a little more at that time. In the long run the speculator to be successful must buy at a little less and sell at a little more than the price really proves to be. This means that the merchants in the long run pay something for protection against changes in prices, just as they pay something for insurance. And yet this is the cheapest way to reduce risk, and a man engaged in milling is, it is said, at a disadvantage if he neglects this method of insurance.

§ 10. Ignorant and dishonest speculation. What has just been described is the more legitimate phase of buying on margin, not its darker aspect. One who, having no special opportunities to know the market, buys or sells wheat, or other commodities or securities, on margin, is called a “lamb.” He is simply betting. He has no unusual skill; he can not foresee the result. The commission paid to brokers “loads the dice” slightly; the opportunities of the larger dealer of anticipating information load the dice heavily against the “lambs.” Secret combinations and all kinds of false rumors cause fluctuations large enough to use up the margins of the small speculator. At times a number of powerful dealers unite to cause an artificially high or low price, a situation called “a corner,” in which both other professional speculators and the outsiders are made to pay heavily. But this is little other than gambling between bettors.

§ 11. Fraudulent and illicit profits. Interwoven with profits in many cases is a dark thread of fraud. Caveat emptor is by law the rule of the market, and the salesman often uses the subtle arts of misrepresentation. Undoubtedly honesty is the best policy, but it is not always the most profitable policy in a pecuniary sense. Cheating, lying, breaking of contracts, bribery of public officials, and many similar acts may increase individual incomes. One man gains a temporary success by acts that are later punished as crimes; another, guilty of like deeds, escapes conviction for lack of evidence or on technicalities, and enjoys ill-gotten wealth. More fortunes, however, are due to actions on the border-line of law which society is not yet wise enough to condemn or efficient enough to prevent. No code of laws can be framed that will make possible the punishment of all evil acts in trade. Any law that would catch all the guilty would injure many of the innocent. The efforts of social reformers are being directed toward detecting and preventing the fraud, intimidation, and extortion that still make up no inconsiderable part of private profits. It may be noted that under the English common law, for centuries past, monopoly has been tainted with illegality, so that all monopoly profits that are not legally protected (such as incomes from patents, copyrights, fairly obtained franchises, etc.) must be classed under this heading.

CHAPTER 30

COSTS AND COMPETITIVE PRICES

§ 1. Competitive prices and unequal costs of competition. The product of a business must be sold, and for this some special selling management and selling organization is required. In a mercantile business selling is the largest part of the activity, and to this end well-located stores, window displays, clerks, agents, expensive advertising, and delivery wagons are needed. The prime cost of the articles at wholesale, plus certain minor expenses, plus the selling cost, make up the whole cost of doing business. In all other kinds of business whether agricultural, manufacturing, transportation, etc., selling is an important task, which must be well done if all the other labors of management are not to be in vain. The products of a factory will not sell themselves, and the obtaining of a regular series of orders sufficient to use the equipment fully is one of the most essential conditions of a low unit cost of production.

The selling price must as a whole equal cost or there will be a loss. New factories are constantly arising with new and better adjustments and the processes are always changing. No two enterprises have exactly equal advantages of location for materials or markets, etc., or are managed with exactly equal ability. Hence there is always a pressure of competition on some managers who constantly complain that they must sell below the cost of production. Business men say that competition is destructive, and it certainly does destroy the less favorably situated enterprises. Each enterpriser’s price is the highest he can get in the market for his product; it may far exceed his costs; it may fall below them, but only temporarily, for if sales continue to encroach on capital, the sheriff soon closes the doors. Successful competitors are constantly pressing upon the marginal enterpriser, fixing a price that leaves themselves a profit, but is below his cost. Even the most successful manager comes into contact with cost, and seems to be compelled by it. He reaches out for trade, and sells some (not all) goods at a price which leaves him little if any profit. He enlarges his factory and ships goods farther, paying the freight, which means a lower price at the factory. The expanding business, therefore, comes at length to the point where it can not go farther at the prevailing prices. Hence the business man’s view of the costs is that they determine price. It is true in the sense that the supply of a particular product in any market is at last limited by cost to marginal producers or of marginal portions of supply. But it is not true of all the units of product that costs determine, or equal, market-price. There is a margin above costs to the successful enterpriser on a large portion of his output. The margin may be narrow or wide, according to the business. The margin is “profit,” on the particular sale, and helps to determine the true profit remaining at the end of the year.

§ 2. Selling and cost-finding. Speaking generally, there is no upper limit to the selling price the seller would take, but he can never get an unlimited, and rarely what he deems a really liberal price. Buyers are striving to buy as low as they can. The seller must often decide whether to sell at an offered price or to refuse the offer. Success in getting orders requires under most circumstances that the cost of each article to the seller shall be pretty exactly determined, or at least a minimum fixed below which the selling agent must not go. The ascertaining of the cost of particular articles, which before a study of the facts appears so simple, is in a literal sense well nigh impossible. It is easiest where the whole undertaking is treated as one transaction, as the buying of a house, perhaps making some improvements in it, and selling it. There the total of first cost, plus costs of improvements, taxes, insurance, repairs, fixed charges, etc., subtracted from selling-price plus other receipts as rents, etc., give the balance as profit. Similarly it is easy to determine with sufficient practical accuracy the cost of the whole business in a year, which, subtracted from total receipts (and taking due account of the difference in inventory and appraisement of the plant at the beginning and end of the year), gives the profit. But the difficulty is in deciding how much of this total cost should be allotted to particular units of product, for most of the costs have been incurred for a number of different units which must be produced at once. The costs are joint, and not several. Some simple illustrations will make this clearer.

§ 3. Examples of joint costs. A woman at the death of her husband is left with an excellent, well-furnished house and a scanty income. For sentimental or family reasons, whatever they be, she is determined to keep the house in any case, tho it is larger than she needs. To lighten the burden of taxes, repairs, and family expenses, she wishes to let some rooms if she can at anything above cost. Now what is cost in that case? To her it would consist of, first, the price of the extra service that must be hired, of the extra washing, light, and heat, of the extra wear and tear on furniture, linen, etc., as compared with leaving the rooms empty, and secondly, enough additional to make it “worth while” for herself—either in merely psychic terms, trouble, or in this plus the worth of her time in doing something else that might pay better. She would not need to count a fair normal return on the original cost, or the present cost, of new rooms and furniture, for she has them and intends to keep them in any case. It is only the extra cost attributable to taking roomers that need be considered, and the minimum addition to her income need be no more than the meagerest pay at which she values her own services. This minimum price of bare cost, yielding nothing to the main investment, may be also the maximum she can get if there is little demand for rooms in the neighborhood. If, however, there is a brisk or growing demand for rooms of that kind, the price she can get may be higher in any degree, up to the point where more houses will be built, and rooms let at prices that include a full estimate of the cost of building, of new furniture, etc. The price at that point may be called a normal supply price, or normal cost price; but before there has been time to build new houses the price of room rent might go much above, as it had before been much below, this normal cost.

Another illustration of the same problem in a different set of conditions may be helpful. An autobus service was begun between a small city and a village a few miles away. A few months later the proprietor declared it did not pay the cost of running it, which he estimated to be $7.50 a day, including repairs, interest on the cost of the car, depreciation, etc. This was $1.87½ for each of the four round trips, whereas on some trips the receipts were nothing at all. He admitted, however, that it would be a mistake to count the cost and receipts of each trip separately, and that the success of the whole enterprise depended on maintaining a regular, dependable service, even tho sometimes the car traveled empty. The light trips were helping to secure the traffic that paid on the heavy trips, on some of which, every week, receipts were as much as $5. Taking all the receipts of the service together, however, there was still a deficit of a few dollars a week on the average, which the owner had to make up out of the earnings of his garage. After the auto service was started it helped to advertise the garage, and many bicyclists and autoists along that line who had never come to the garage found it a very convenient place to send for repairing and for supplies. The increased profits of the garage about offset the loss on the bus service. Another new kind of business was developed, as the autobus in summer was often hired for parties to the shore at $15 to $20 a day, and at such times a smaller car could be sent on the regular trip. And there were some other incidental advantages that at length converted a tale of loss into a story of business success.

§ 4. Main classes of costs. These two cases present in comparatively simple form the problem which every larger business involves in very much more difficult form. The total costs of any business are roughly distinguishable as fixed costs (or fixed charges) and variable costs. Fixed costs are those which remain unchanged on the business as a whole, or on some department, no matter what the size of the output. There are some costs, as the rent of office, factory and store, salary of manager and clerks, etc., which would go on if nothing were sold, unless the business were closed. Variable costs are those which are attributable solely and exactly to particular units of product, rising and falling exactly in proportion to the output.1 In truth, costs share these characteristics in a great many degrees, are more or less fixed or variable, and are never (or with very meager exceptions) either absolutely fixed or absolutely variable.

The variable costs are also called direct because put upon the particular unit of goods, and the fixed costs are correspondingly called indirect, or overhead charges. It is a very difficult matter, and yet one of very great importance, to arrive at principles and practical working rules by which in each business the various elements of cost may be allocated to different departments, classes of goods, and particular units of output. For this end a special art of cost accounting has been developed, and a special class of expert cost accountants. The principal elements of costs distinguished in cost accounting are represented in Figure 46.

§ 5. The problem of cost accounting. The difficult task of cost accounting is to break up this annual total into minute fractions and to distribute them in due proportion so as to tell if need be the cost and profit on any unit of product. Sometimes a large undertaking turns out a single, homogeneous physical product, as gas, electricity, water, bricks, salt, paper of a certain grade, spools, pig iron, etc. Here a unit cost and profit can easily be estimated from the total annual figures; but if the management desires to ascertain the cost of each of the series of processes through which each unit goes, the problem becomes more complex. Another type of undertaking makes numerous kinds of goods, but in standard patterns, such as tools, machines, stoves, wooden furniture, carpets, cloth, etc. Here the unit cost is estimated by following the product through the various departments, and this cost figure once fixed can be used continuously and repeatedly tested. Another type of business does all its work on special orders, such as job printing, electric installation, house contracting, etc. The constant recurrence of somewhat similar kinds of jobs tests the estimates and permits a pretty exact allowance to be made for the usual delays and losses.

§ 6. Homogeneous products with unequal costs. But no matter how carefully these unit-cost figures are worked out, the salesman is tempted repeatedly to ignore them. He sees a chance to sell below cost and still make a profit. This is the paradox of price cutting. It is an ever-besetting temptation of the business man, sometimes leading him to profits, but often to his undoing. The key to the mystery is already in our hands: it is that all costs are in some measure joint-costs, and that every estimated several-cost has something of arbitrariness in it. Take a case where this would seem to be least true, where the entire output of a large industry is a single homogeneous product, such as water, electric current, etc. Here surely, if anywhere, the unit cost is certain, being the simple arithmetic quotient of total cost divided by the number of units. But, no, as frequently here as in any business the seller finds differences of a real character and is forced to assume differences in other cases in order to make a sale. In some cases he finds the estimated cost to be incorrect, in others he finds it to be futile. The cost of reading meters, keeping up the service pipes, and rendering bills is greater per unit of water, gas, or electricity, for small users than for larger ones. This can be adjusted by making a flat fixed charge to each consumer for meter and labor, little if any more for large than for small consumers, and a separate charge per unit of product alike to all. For example, if electricity is charged at 13 cents a kilowatt hour, the bills would be

If a charge of $1 a month per customer is made for meter, etc., and a separate charge of 3 cents per kilowatt hour, the bills would be

§ 7. Principle of charging what the traffic will bear. But where no such reasonable explanation can be found,2 and the outward conditions all point to a uniform cost, the seller is repeatedly faced with a situation where at the moment and, as he says, “for practical purposes,” he is impelled to assume a difference. The business is there as “a going concern,” a large part of the charges are, or appear to be, fixed charges—in any event will not be increased by the particular increase of product in question, which will more fully and proportionally utilize certain parts of the equipment. The new business can not be secured at the average rate paid by a similar class of customers (possibly because of this customer’s advantageous position to buy somewhere else, or because he can produce for himself more cheaply than the average customer, etc.). A lower rate is made to get the new business, while the old customers continue to pay the old rates, the result being that the total profits of the enterprise are increased. There is scarcely an enterprise, large or small, in which essentially this situation does not sometimes present itself.

But note this: unless the price to the other customers is reduced to the new rate, there is here discrimination in prices, unlike charges to like customers, for substantially the same service. The price is on the principle of charging what the traffic will bear. A portion of the customers may be bearing all or nearly all the fixed charges, while another portion is bearing little more than the variable charges occasioned by their part of the output. By a sort of historical accident the late comers get the benefit of the economies of an established business which the early comers made possible. Altho the old customers are charged no more than they were before, they are now charged more than are other customers, possibly their competitors; and this may have practical effects quite as serious to them as if they were charged absolutely more than they were before.

§ 8. How prices are limited under competition. The phrase “charging what the traffic will bear” is usually heard in connection with monopoly-price. Yet every competitive seller gets all he can for his goods, and still make a sale. This is “charging all the traffic will bear,” but under competition the traffic will not bear as much as under monopoly. Each buyer is following the same principle, giving as little of the price-good as he needs to give to get the sale-good; in popular phrase, he is trying to get the most for his money. Still out of these various desires to get indefinitely high prices, emerges, under true competitive conditions in a market, one common market-price. (See above, Chapter 7.) This is the best price any trader can get on the principle of charging what the traffic will bear in a truly competitive market. In a market for homogeneous products where there are on each side of the market at least two truly competing traders, the attempt of any trader to discriminate, to get more than the common market-price, simply deprives him of that sale. He eliminates himself as a seller in respect to that unit.

This condition of two-sided competition is lacking in countless cases and in many respects in the business world. The slightest lack of homogeneousness in the goods to be sold breaks the market up into more or less separate markets, and there is a chance for the seller to sell the different qualities at different prices, still, however, at a competitive price, alike to all for the same quality.

§ 9. Borderland of monopoly. Ownership of a particular knife, pencil, book, makes one the unique seller of it, but confers no monopoly power, as the power of substitution is practically absolute; the welfare of no one depends in any appreciable measure on that particular pencil. The simplest substitution a buyer can make, ordinarily, is that of a commodity of the same kind, offered by another seller. The effective limitation of the competitive seller is that if he tries to charge more than the fair market price, the buyer is able to buy of some one else.

In many enterprises in this same manner the surplus of selling price over costs as a whole is ruled by a very strict competition in the long run, and yet the prices of the separate products of the enterprise have the appearance of being quite noncompetitive. The organizers of an entertainment, whether for private profit or for charity, hire a hall and assume the expense of the entertainment, the whole cost becoming thus a fixed charge. The prices of the various seats are then fixed with a view to getting the maximum total receipts. As regards that particular entertainment there is literally a monopoly. If half the seats are likely to be empty it will not “pay” to reduce the prices so low that all the seats could be sold. That might cause the price to be a negative one—payment for attending. It pays better to have a graded scale of prices to different parts of the house, and let some seats go unsold.

These examples serve to show that in a literal sense every man is the exclusive seller of the identical thing he has to sell and yet may have no monopoly power to raise prices above a normal, competitive rate. He may withhold the sale-good or place any reserve valuation upon it that he pleases, and a customer must pay that or go without that particular unit of labor or product. But this in most cases gives to the seller a quite negligible degree of power to influence price, and in many other cases where there is some power, there is no motive. There is, therefore, despite some measure of power to restrict supply, no exercise of the power sufficient to constitute a social problem of monopoly.

§ 10. Difficulty of departing from average costs in competition. Consider the case of a manufacturer who has no advantages not open to capable competitors and who can sell his small and easily transported products over a wide area. Such products, which by their nature seem typically competitive, are shoes, hardware specialties, writing tablets, etc. The manufacturer makes and sells them through agents both to wholesale and retail merchants, realizing a good average profit on the whole. Let him apply the principle (paradox) of price cutting to one pattern and sell it at a price which is nearer to bare cost. He will sell it more easily but it will contribute little or nothing to profits except as it may be an advertisement, “a leader.” Another pattern gives a large unit-profit, and is “a money maker.” This will be the special target of competition, and will be more difficult to sell. If each competitor has his leaders, keen buyers can make leaders a good share of their purchases. Thus real competition searches out each inconsistency of cost accounting and is constantly leveling down the “money-makers” to a normal profit. Again and again a growing and seemingly prosperous business fails. The management have produced and sold the goods, but have cut the margin of profit too close. Meantime other more conservative competitors, trying to maintain prices, have been pushed almost if not quite into bankruptcy. Many a firm with a stable policy, a golden mean between rash and timid, has passed through many such an ordeal, and has won a substantial success through generations from grandsire to grandson, while competitors have risen and fallen.

In a competitive market, there being several sellers, the buyer stands ready to take from any one of the sellers. If any one of the sellers, whether formerly marginal or not, dropped out, and no one took his place, the price would rise. But the very essence of a condition of competition is this, that it would not pay any one seller to drop out for the purpose of raising the general market-price. He would lose more because of withholding these units (or ceasing to produce them) than he could gain by the additional profit he would make on the units he continued to sell. He has, virtually, to take the market-price as a fixed fact for the time, so far as he is concerned, and to decide whether at that price and the profit it yields him, he cares to continue selling. To put the same thing slightly differently: if he does not continue, other competitors stand ready to sell at the same price, or at a price so little higher that he will not profit on the whole by the change. His limitation of production yields a net gain to his competitors but a net loss to himself.

CHAPTER 31

MONOPOLY-PRICES; LARGE PRODUCTION

§ 1. Tests of monopoly control. The essential condition that distinguishes monopoly from competition is the buyer’s lack of the power of substitution of one seller for another. The test of the degree of monopoly control is the seller’s power to continue raising prices without thereby driving enough buyers to other goods or to other sellers to prevent his making some net profit by raising the price. A seller is competitive when he must take the general market-price as a fixed fact, and can decide only whether and how much to sell at that price. A seller is a monopolist when he represents such a large proportion of the offers that he may withhold a part, raise the market-price, and make a larger profit on the smaller sale. The competitive seller makes his profit by selling all he can at the market-price; the monopolist makes his profit by selling less and altering the whole price equilibrium.

Ownership of an important fraction of an entire species of goods may give some power to affect price. If the control is slight, a very small rise of price will bring in competitors. The monopoly profits in this case either must be very small or they will be very brief. Those outside, controlling a large supply, will be tempted by large profits to market it at once and to increase it as fast as possible. One owning a large part of the desirable building sites or houses in a town may gain by occasionally letting one stand vacant in order to drive better bargains with tenants. A trade-union, controlling most of the labor supply of one kind in a town, may gain as a whole by keeping some of their members unemployed at times. But the test of monopoly is that a gain results from a higher price and fewer sales. It begins at the point where there is a motive to limit the supply in accordance with the paradox of value. The control of an entire species of goods gives price-fixing power limited only by substitution of goods. Even tho one person controlled all the coal in any market, its price still would be limited by the substitution of wood, oil, etc. If there were but one possible source of meat supply, most people could live without meat, but if one person owned all food of every kind, control of price would be as complete as is conceivable. The monopolist would be the absolute despot of the lives of his fellows. The monopoly of great species of goods can thus be seen gradually to merge from one grade into another. Monopoly is a matter of quality as well as quantity. There is more or less of it in the different industries, and it varies over time and territory. The monopolist aims, just as the competitor does, to get the price that gives the maximum gain. The monopolist, however, is in a more or less favored position, as he can raise his price and yet retain enough of his customers to gain by the change.

§ 2. Uniform monopoly-price in relation to costs. Now the monopolist also in his sales is limited by cost, but not so often or in such a compelling way as is the competitive seller. Within the range of his monopoly power he may either sell his whole product at a price well above cost plus a profit or he may discriminate more successfully than can the seller exposed to competition, and thus sell all but a small part of his product at a wide margin of profit. Let us see how monopoly price-fixing is affected by cost. The crude monopoly-price (see above, Chapter 8), is that which yields the largest total selling price (this giving the largest profit) only when cost is zero.1

The highest uniform price which it is to the interest of a monopoly to charge is that which yields the largest profit; that is, the largest difference between total price and total cost. This is the product of the profit (not price) per unit by the number of units sold.2 This never can be less than crude monopoly-price. In cases of very inelastic demand it may with certain ranges of price be no greater; that is, the entire cost in such cases is a subtraction from what would otherwise be monopoly profit.

§ 3. General principles of uniform monopoly-price and cost. Inspection of Figure 47 and of the figure showing a medium demand (Figure 48) and a more elastic demand (Figure 49) reveals certain general effects. Except in some peculiar situations an increase of cost raises the theoretical monopoly-price and reduces sales, and decrease of cost lowers theoretical monopoly-price and increases sales. The more elastic the demand for an article, the less is the difference between competitive price and monopoly-price. The less elastic the demand the greater the motive for monopoly, and the more elastic the demand the less the motive for a general monopoly-price. In some cases, where demand is very inelastic, the first increments of cost have slight effect either on monopoly-price or on the amount advantageously produced; cost within a certain range of monopoly falls largely upon profits and at certain situations may within a narrow range fall entirely upon them. The profits per unit being large, the price can not be raised without reducing sales. Choice will be made to give the largest profits (unit profit multiplied by sales). In this it is generally true that the greater the ratio of the cost to the crude monopoly-price (other things equal) the less is the range of monopoly power. The amount of sales that is possible with the higher monopoly-price is always less than with a competitive price. Monopoly-price at any level of costs from zero upwards is always higher than a competitive price (when costs are the same for competitors and for monopoly). We must note later the peculiar case where monopoly cost is lower; that is, where cost falls with quantity of output, and where large output is dependent on monopoly.

§ 4. Temporary and limited monopoly, and discrimination. The foregoing applies to uniform monopoly-price. This is sometimes the problem presented to the monopolist, as to the manufacturer of a patented article in determining the advertised price of an article. Even then, however, some variation in price may be made by paying freights, giving cut prices to wholesale dealers in some localities, because of distance, or of peculiar condition of competition with a similar article, or on the principle of dumping, etc. Again and again the monopolist is tempted to depart from the uniform monopoly-price—to maintain it within the range of monopoly power, but to cut it by successive reductions as the conditions shade off toward competition, as they always do, more or less.

If, however, the better quality or the particular thing needed is in the hands of one seller, there is a temporary and limited measure of monopoly. For example, a cabman’s business as a whole is usually competitive, as any one is free to engage in it if profits seem high. (There are, however, cases of monopoly through exclusive rights to certain locations, etc.). But in many cases the cabman has a distinct bargaining advantage over a passenger, as when no other cab is in sight, or on a rainy day. However, it may not always be “good business” to yield to the temptation to get the higher price. In a small town where men know each other, the cab fares charged to residents are not often discriminatory, for regular patrons resent this and the cabman would lose patronage. The sole druggist in a small town might occasionally get very high prices from particular customers at times of illness, but he would thus drive away much of his custom, and would tempt a fairer and less grasping competitor to come in. Public opinion develops as to what is a fair price to be asked alike of all. The customary price has both a moral and a legal sanction. Thus, when men and capital are free to come and go, there results an average or normal return for ability and agents of a certain grade. Prices come to equilibrium and continue pretty regularly to be virtually competitive, for they are determined by forces of competition, ever ready to appear where charging more than a normal supply price yields more than ordinary returns to active investors.

§ 5. Theory of discriminatory monopoly-prices. That a field of monopoly exists may be very certain, when it may be very difficult to find just who are the buyers who could be charged a higher price, and just how to make them pay it. If, however, in the measure that it can be done, it is done, there results a series of prices; highest to those buyers in the field of monopoly, low in the field of competitive prices, and possibly still lower in a price-cutting, rate-war field, where the monopoly is striving to drive some competitors out of certain businesses. (See Figure 50.) Assuming that the normal unit cost is 4, that being the price at which normal returns on all factors result, but only the minimum of price profit, there would at this price at once be a wide field, a broad plateau, for sales for the monopolist, and as some of the competitors were driven out of certain fields, the range of monopoly control of the market would gradually widen. The shape of the demand curve would thus change.

The region from 12 to 15, would, as soon as competitors were ruined, be transferred to the other end of the diagram. Where prices had been very low they would become very high, and remain so indefinitely until competition again threatened. Altho competitors see the lure of high profits, they fear the loss of their whole investment. Thus the threat of price cutting by the monopoly can paralyze potential competition for a long period following a price-war, as has often been shown by experience. The price-war policy should not be mistaken, as it often is, for typical competition, where the motive is to sell at a profit, however meager. The price-war policy is only undertaken to force a competitor to an agreement either to withdraw from the territory, or to maintain a higher scale of prices, or to sell out his business, etc. Usually selling at less than cost for a time is deliberately done with the purpose of selling at more than a normal profit later.

§ 6. Problem of the economy of large production. Size of the enterprise is a condition affecting unit cost in most important ways. There are in many cases advantages in large production; there are economies in large plants.3 We have already studied the principle of proportionality (Chapter 12) and have seen how the proper proportion of the various factors to each other within the enterprise must be maintained. But further, the industry as a whole may be in better or worse proportion to the outside conditions, to the size of the market which it has a chance to supply. There is here a problem of the most economic size for an enterprise. As the size of the whole enterprise grows, the various parts (factors and costs) of it must grow in some proportion, but not in precisely the same proportion. Some parts do not need to increase proportionally to the output of the plant, and herein lies the economy. The advantages of large production should not be assumed to be necessarily conditioned on monopoly control, even where monopoly is the only condition in which it seems that a large enough unit of enterprise can be secured to get the full economies of large production. In such cases the two problems coexist, but must be kept logically distinct if confusion is to be avoided.

§ 7. Economy of labor in large production. The economy of large production is a particular case of the advantages of division of labor, and we need consider only a few of the features peculiar to it. There are certain technical advantages that are possible only by physical concentration; that is, by producing a large output in a single plant at one place. This makes possible the subdivision of tasks among a large number of men so that specialization of trades is carried to the furthest possible point of advantage. Each worker can become skilful at his work in less time, having but one thing to do, lower paid workers can be used on many parts of the work, and less time is lost in changing from one thing to another. Division of labor decreases in some ways the difficulty of supervision in larger factories, where the processes are divided, systematized, and made a matter of routine. The necessary inspection of the results is more rapid and easy. The lower cost of labor per unit of product in a large group as compared with a small group is especially noticeable in producing form-value. In certain cases it appeared that in making plows nine men working separately could average 66 plows each per year, while one hundred and eighty men working together will average 110 each per year, the output per man being increased 66⅔ per cent. In a rifle-factory with a daily output of one thousand, three men could turn out the same product that required eight men in a factory with a daily output of fifty, an increase per man of 166⅔ per cent.

§ 8. Economical use of machinery in large production. In these examples the saving in labor is not merely the result of increased personal skill, but of the use of machinery. There is economy in the use of machinery partly because with a large output more complex, more nearly automatic, machinery can be used. Even when the same kinds of machines are used they can be kept specially adjusted for each pattern and process, whereas in a small factory much time and energy are wasted in adjusting one machine for various processes. The machinery in a large factory is thus better and more fully utilized. A comparison has been made of the machinery that would be used in one large ax-factory and in twenty-five small ax-factories having, it is assumed, the same number of workmen and the same total output, as follows:

The difference in cost due to machinery is not so great as these figures indicate, as the unused machine lasts longer; but in the small factory there is more depreciation from rust and decay, and a larger investment of capital for each unit of product. The average amount of stock and materials required in a small factory is greater in proportion to the output.

The cost of producing steam power is usually less per horse power in a large plant, because of automatic devices for unloading and handling coal and ashes, and because of greater efficiency of larger boilers and engines, etc. The use of power is, by the law of averages, distributed more evenly in a large plant than in a small one. Water power in some places may be developed at low cost per unit for a very large plant, by construction of large reservoirs, etc., where the cost would be prohibitive in a small plant.

§ 9. Economy of buying and selling in large quantities. Materials can be more exactly standardized as to quality when bought regularly and in larger amounts, and in many cases more cheaply. Shipments in carload and trainload and shipload lots make freight rates per unit less for large amounts even without illegal concessions.

The cost per unit of selling the product in many cases becomes less as the output increases. Advertising to make a name “a household term” would be ruinous for a small enterprise, but becomes a minute item of unit cost when divided by a multitude of sales. Often more orders come unsolicited as a business grows. A larger organization of commercial travelers, carrying a larger line of goods, and each covering a smaller territory more thoroly, makes the unit selling cost lower.

§ 10. Certain limitations of large production. Not one of these advantages is absolute and unlimited, and for most of them there are offsetting disadvantages which at length put an end to the economy of size. Labor can not be indefinitely divided, and when the factory is large enough to keep running one each of the best machines known, there is little or no economy in duplicating machines. As the factory grows the head manager can have less and less complete oversight; the eye of the master can not be over all as in the smaller establishment. This defect soon proves disastrous unless mended by more elaborate methods of organization, reporting, records, bookkeeping, etc., and the best of these prove expensive. In a small perfectly equipped factory making a patented specialty, and employing about one hundred men all of whom are personally known to the executive, the office “overhead” is only about 5 per cent; whereas in very large factories this item sometimes amounts to 20 per cent.

The cost of transmitting steam power by shafts and pulleys puts a limit to the economy of large steam power; and in many locations electric power is or can be supplied as cheaply to the small factory as to the large one. The natural limit of water power sometimes gives a maximum of power economy to a factory while it is small, and as it grows additional power from coal costs more per horse power. As large factories tend to create cities around them, land rises in value and higher wages must be paid the workmen in large cities. Small factories are constantly seeking out lower rents, taxes, wages, salaries, cheaper local sources of materials, cheap tho limited sources of power, and thus they compete successfully in many markets.

§ 11. Certain disadvantages of large buying and selling. In many cases growth in size is in some respects a disadvantage both in buying and in selling. To serve a local market a small establishment has certain advantages which no large competitor can equal. A factory using materials found in the locality, as lumber for wagons and furniture, wheat for flour, etc., has an advantage in costs by saving of freights and the cost of this item increases with the output. In selling, likewise, the nearest market is partially a protected field, to which distant competitors can come only at greater cost. It costs more to send agents further, and either prices must be reduced or freights paid by the seller, and this cost of overcoming the limits of the market finally must offset all the other advantages of large industry. These facts help to explain the survival and modest success of many thousands of retail stores, most notably grocery and drug stores, and of small factories such as griest mills, lumber and planing mills, wagon and furniture factories, fruit canneries, and thousands of small local shops for repairs and local orders in all the various crafts, working in gold, silver, iron, tin, wood, leather, etc. Further, it may be observed that the advantages of size are greatest where the production is the multiplication of a few patterns, most fully standardized; small production holds its place most successfully where there is need of individuality, variety, art, personal attention to the consumer’s wishes, and prompt service that can be rendered only in a narrow neighborhood.

It is evident that most of these limitations to growth apply to a single local factory as regards its internal economies, but do not apply fully to the buying and selling of a combination under one management of geographically scattered plants. The federative plan has thus been applied to the “chain store” of various kinds—groceries, drugs, tobacco, shoes, clothing, five and ten cent, general department. It has been applied to manufacturing on an enormous scale in such corporations as the U. S. Steel Corporation. These enterprises often, but not always, contain an element of monopoly. There are also cases where the necessary size for minimum cost is dependent on the existence of a condition of monopoly, as in most so-called “public utilities.”4

§ 12. Large production and the two types of prices. If there is a situation where two or more establishments are able steadily to decrease unit costs by the economy of size, and there is normal competition among them, the result should be a decrease of price. When furniture is made in small shops, where most of the work is done with hand tools, the radius and area of the market are small; the improvement of transportation widens the markets and makes possible large production with its economies. These two conditions might be represented in a map, or ground-plan, as in Figure 51.

Prices both in the small and the large market may vary according to two main principles shown in Figures 52-55. (1) The prices may be uniform to every one at the factory, or at the nearest railroad station. Such a price is called f.o.b. (free on board, i.e., of the cars), the buyer having to pay the freight (Figure 52). The price to the various buyers’ doors varies throughout the territory in accordance with the differences in freights, and at the outer edge of each area the advantage of buying in one market or the other falls to zero. The cost is reckoned by the maker to be uniform on all the output and each factory has by this rule what appears to be its natural, or normal territory. (2) The prices may be uniform to all buyers for goods delivered within specified areas (Figure 53); as one manufacturer of scales at Binghamton, N. Y., advertised widely for many years, “Jones pays the freight.” Here the different units of products contribute unequally to profits, and the market extends to the point where price will cover variable costs and little more.

§ 13. Monopoly element in price-fixing. These two principles of price-fixing may be combined in various proportions, and especially in the case of goods not sold at an advertised price, but by agents, there is a strong temptation to depart from the f.o.b. price, not regularly but as appears necessary to effect a sale. Factory B (in Figure 54) may maintain the f.o.b. price within its own natural territory, and cut prices so as to invade the rival’s territory. If this is successful it may so limit the output of rival A, as to raise the average cost (Figure 55). The wider the territory over which a factory gets a market the greater its degree of monopoly control in the inner portions of its own territory. Instead of making its own costs a basis of price, it may make its smaller competitors’ costs the standard. Establishment A’s uniform price f.o.b. plus freight to destination is shown (Figure 55) on line ab. If B just meets these prices, a gross profit shown at be would be possible at the center of its territory, falling to zero at d. Under such conditions the price in a large portion of the territory of large production would be much higher than before with smaller production, and the large profit would offer a motive to some one to start a small factory, even if its costs would be higher per unit than those of B. But the fear, the certainty, that prices would be reduced could, after a few lessons, effectually prevent such an extra-hazardous investment.

This conquest of the market by one establishment can hardly happen in as simple and complete a way as that supposed. The competitor can play at the same game, and even tho smaller (as A in Figure 55) would struggle with like price-tactics to retain or recover the border territory (that between d and e). Then the competitors are not always divided territorially. Smaller factories exist alongside of larger ones in districts well suited to the kind of industry (iron, textiles, woodworking, etc.), and maintain their existence by serving special classes of customers in a special way. They are latent competitors for related lines of business in case prices are raised much above those yielding usual profits. For most kinds of goods some substitutes, or some other source of supply, can be had, if prices are greatly raised by monopoly power. With all these limitations, however, there still remains a considerable measure of monopoly power in many cases, and a wide range of apparent caprice in prices. Any one of the large competitors by a change in his policy may greatly alter the price situation in a certain territory, introduce a period of what may be called abnormal competition and abnormally low prices, and bring upon himself and others either loss or an increased monopoly power. In either case there is a return to higher prices later. The search for a prevention of this irregularity constitutes the large part of the practical problem of monopoly.

[1 ]It must not be thought, however, that viewed as a value-problem, as a question of logic, this share is a mere residual. That is, it must not be thought that all the other contractual shares (wages, rents, etc.) are determined prior to, and independent of, this share of the active capitalist, who takes what is left without having had any choice in the matter. That would be so if he could do nothing whatever about readjusting and rearranging hisinvestments. The various contractual incomes are determined in an economic equilibrium of which the prospect of active capitalists getting a more or less definitely estimated minimum return is an essential part. The expectation of income has guided the enterpriser’s choice of a business just as it guides the laborers (see ch. 18, sec. 3). For this particular year and business this kind of share is an arithmetic residual, but year in and year out it is as much subject to adjustment by investors’ valuations as is any other share. (Of this, more below, under cost of production.)

[* ]The separation of enterprise and management may be seen in this simple type of organization. The enterpriser (a person or group of persons) selects the manager, who in turn appoints his subordinates. Each person in the organization receives directions from one immediate superior.

[* ]Division of labor and specialization in management may be by some such plan as is here graphically shown. The foreman may receive directions regarding the machines and their operation from an engineer, regarding special chemical processes from an industrial chemist, and regarding other matters from the superintendent of production. A modification of this plan is shown below in fig. 40.

[1 ]Among the men receiving salaries of $100,000 a year or more in the United States in 1914 were the following: Pope Yeatman, expert mining engineer for the Guggenheims; Theodore P. Shonts, civil engineer, president of the Interborough Metropolitan Co., in control of the great rapid transit system of New York City; Theodore N. Vail, president of American Telephone and Telegraph Co. (the Bell telephone); Lewis E. Pierson, banker, president of the Irving Exchange National Bank, New York; Samuel Insull, president of the Commonwealth Edison Company, which controls nearly the whole electric system in Chicago; William M. Wood, president of the American Woolen Company, owning forty mills; and David W. Griffith, manager of the Mutual Film Corporation, of Los Angeles, manufacturers of moving pictures. See articles on $100,000 salaries, in McClure’s, April to October, 1914, by E. M. Woolley.

[* ]This is an attempt in large enterprises to unite the benefits of specialization with directness and unity of responsibility. The president is responsible for the larger policies, and to him are responsible directly such officials as treasurer, chief salesman, chief engineer, and factory manager. By the work of committees and conferences the various functions and departments are brought into coöperation as far as is necessary and practicable, and the eye of the specialist is on every part and process of the business.

[2 ]See, for example, ch. 7, sec. 6; ch. 9, sec. 11-13; ch. 10, sec. 8-9; ch. 11, sec. 11; ch. 12, sec. 7-14; ch. 13, sec. 5, 7; and Part VI passim. The opportunities are so great that some have been inclined to exaggerate their importance, and to see in this meeting of dynamic conditions the only opportunities for profit.

[1 ]See note, On other meanings of profit, at end of chapter.

[2 ]See note on The source and cause of profits in economic writings, at end of chapter.

[3 ]The old English word undertaker, once so used, seems to have been driven out by a rival use; perhaps after “funeral director” displaces it there, it may be reclaimed by economics.

[* ]The rates given are, of course, only illustrative of the proportions in which they might vary in a particular case. In fact the common stock might pay no dividends for years while dividends and interest on all the other classes of securities were regularly paid.

[4 ]Compare note on value vs. utility of labor in ch. 19.

[5 ]Economists long took that proposition as sound, and tried to build upon it a scientific explanation of prices and values as they are. It always has been recognized that there are difficulties in such an explanation. We shall not enter into the controversy, but briefly indicate the point of view we now take.

[* ]A factor F (it may be a concert singer, an acre of land, or a mineral spring) derives its entire value (usance and capital value) from the price of the product, is valuable or worthless according as the product is so. If two or more products (p′, p″, p″′) are attributable to it, its value is the sum of their prices (less costs, that is, the prices paid for other factors). But inasmuch as the use of F for one product takes it away from the use of another, the value of its use must be accounted as a cost whenever it is a question of increasing the output of any one of the products. Therefore, at that moment the cost seems primary and price derived.

[* ]The figure shows how the value of a unit of product at a is reflected up to the source, and through successive links to the most distant product z. The effect of this is to reduce the sale of z and correspondingly the use made of the agent in question. A higher price of leather, p″, due to the increased use of shoes (f), raises the value of hides and cattle (F) and raises thus the cost of carriage-trimmings, pocketbooks, footballs, leather belts, and every other leather product (b, c, d, e). As the price rises, substitutes for leather, and imitations of it, are used for such of the products as can not bear the increased cost of leather. As more cattle are raised to provide the leather, the value of meat (p′″) falls, and likewise soap (g) and oleomargarine (z).

[1 ]Insurance will be treated in the following volume.

[* ]The statistics cover only the kinds of enterprises that are reported upon by the large commercial agencies and therefore do not include farming and numerous petty enterprises. The total number of business concerns reported was about one sixtieth of the population. The general yearly average of failures was about 1 in 100 business concerns. If enterprisers are in business on the average 33 years, the chance of any one of them failing sometime in his career is 1 in 3. The increase of failures in or just after a year of financial trouble appears in 1893, 1907-98, and 1914, but the stock-exchange panic of 1903 showed no effects. The rate continued high in the long financial depression of 1893-98, was low in the generally prosperous years 1899-1906, and rose steadily from 1911 to 1914.

[1 ]“Variable” does not mean that the unit price of the factor necessarily changes, e.g., that the wage paid per piece for making the articles varies; nor “fixed” that the unit price of these factors is unchanging. The meaning is that in the one case more are needed, and in the other the amount needed remains unchanged, regardless of the size of the output.

[2 ]There are numerous other reasons for classifying customers, which must be reserved for discussion with practical problems. The example is sufficient for our present purpose of explaining the principle.

[1 ]It is represented by the largest rectangle (product of price per unit by number of units sold) which can be inscribed within the coördinates and the hypothetical demand curve. (Figure 14, ch. 8.)

[2 ]This may be represented by the largest rectangle that can be inscribed within the price line and the cost line, drawn above the base line, and parallel with it.

[* ]In each case the line marked a is the level of monopoly-price, and b that of competitive price on the assumption that one unit is a fair competitive profit (“fair” meaning enough to give a motive to enterprise).

(1) Under the assumed conditions of demand as represented by the figure, crude monopoly-price is 6, sales are 3, and total profits 18.

(2) If cost is 3, monopoly-price is 8, sales are 2 and profits 10. Competitive price being 4, sales would be 4, and profits 4.

(3) If cost is 4, monopoly-price is 8, sales are 2, and profits 8. Competitive price would be 5 and sales 3½.

(4) If cost is 5, monopoly-price is still 8, and sales 2, but profits fall to 6. Competitive price would be 6, and sales 3.

(5) If cost is 6, monopoly-price is 9, sales 1½, and profits 4½. Competitive price would be 7, and sales 2½.

(Because of the very small numbers used in the scale, quantities have been expressed in half units.)

[* ]Represents conditions as in the preceding figure, except that demand is somewhat more elastic.

(1) If cost is zero, monopoly-price would be 4. Competitive price must sink to nothing, but, if, with limited supplies, demand continues, the amount of the price would eventually all be imputed to cost (plus the minimum profit).

(2) If cost is 2, monopoly price is 5, sales are 3, and profits 9. (Competitive price 3, and sales 5.)

(3) If cost is 3, monopoly-price is 5½, sales are 2½, and profits 6½. (Competitive price 4, sales 4.)

(4) If cost is 4, monopoly-price is 6, sales 2, and profits 4. (Competitive price 5, sales 3.)

[* ]In comparing this with the preceding figures the general principles in sec. 3 appear.

[* ]The monopoly-price figure represents at its left, in the region of higher price, that field within which the monopoly under the particular conditions has a certain degree of control, and at the right in the region of lower prices, the successive levels at which either substitutes would be adopted or competitors would come in and take away the trade.

[3 ]This often is spoken of as the “law of increasing returns,” especially in manufacturing, and it is contrasted with the principle of diminishing returns which was believed to be peculiar to agriculture. This is an erroneous contrast. See note at end of ch. 34.

[4 ]The discussion of these cases must be left until the treatment of the trust problem.

[* ]This shows a cross section of prices to buyers at each point along the diameter of the market supplied from the factory at the middle. The next figure (53) is on the same plan, with the factory at the middle; but in the two following figures (54 and 55) the factories A and B respectively are at the edges of the figures, and only the radii of their markets are shown.