Front Page Titles (by Subject) Part I, Chapter II: Theories of Profit;13 Change and Risk in Relation to Profit - Risk, Uncertainty, and Profit
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Part I, Chapter II: Theories of Profit;13 Change and Risk in Relation to Profit - Frank H. Knight, Risk, Uncertainty, and Profit 
Risk, Uncertainty, and Profit (Boston MA: Hart, Schaffner and Marx; Houghton Mifflin, 1921).
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Part I, Chapter II
Theories of Profit;13 Change and Risk in Relation to Profit
In view of the facts set forth in the introductory chapter as to the relation of profit to theoretical economics, and the vagueness in the minds of economic writers as to fundamental postulates, it is not surprising that the theory of profit has remained one of the most unsatisfactory and controversial divisions of economic doctrine. Considering, however, the universal recognition of the "tendency" of competition to eliminate profit, it is perhaps somewhat remarkable that the problem of profit itself has not, with one important exception,14 been attacked from the direct point of view adopted in this essay, of an inquiry into the causes of the failure of ideal competition to be fully realized in fact. It is, indeed, only within comparatively recent years that the existence of profit as a really distinct share has become established and the problem of its explanation given definite status.
As in the case of most sciences whose subject matter is some field of human activity, economic theory has been much influenced by practice, and in particular the loose use of terms in everyday affairs has given rise to serious confusions in terminology. The concept of profit is bound up in a certain type of organization of industry, a type realized in various degrees in different places and times, and always undergoing modification and development.
At the time when the English classical school of economists were writing—i.e., in the later eighteenth and early nineteenth centuries—corporations were relatively unimportant, being practically restricted to a few banks and trading companies. There was, of course, some lending at interest, but in the dominant form of industry men used their own capital, hiring labor, and renting land from others. The managerial function centered in the capitalist. Moreover, English industries were new and rapidly expanding; competition was not highly developed; the possession of capital seemed to be and was the dominant factor in the situation. Only in more recent times has the accumulation of capital, the perfection of financial institutions, and the growth of competition transferred the center of interest to business ability, made it easy or at least generally possible for ability to secure capital when not in possession of it by direct ownership, and made common the carrying-on of business predominantly with borrowed resources.
Under these early conditions it was natural to connect the income of the business manager with the ownership of capital, and in all the classical writings we find the word "profit" used in this sense. A further source of confusion was the indefiniteness of the conception and use of the ideas of natural and market price in the minds of the early writers. It is natural and inevitable that a distinction which goes to the heart of the fundamental problems of the nature and methodology of economic science should be but imperfectly worked out in the initial stages of the speculation. Only recently, again, has the analysis of long-time normal price by Marshall and of the "static state" by Clark and Schumpeter begun to give to economists a clearer notion of what is really involved in "natural" or normal conditions. To the earlier classical writers this obscurity hid the fundamental difference between the total income of the capitalist manager and contract interest. The only separation considered necessary in the explanation of distribution was to restrict the theory of the business manager's income to the explanation of "normal profit," which was regarded as substantially equivalent to contract interest. Another barrier to the formulation of a clear statement of the relations between interest and profit was the lack of an adequate understanding of the productivity of capital, which also these authors did not possess and which has first been worked out in recent years.
The qualification of "near" or "substantial" identification of normal profit and interest is necessary, however, in referring to the classical treatments. Even Adam Smith and his immediate followers recognized that profits even normally contain an element which is not interest on capital. Remuneration for the work and care of supervising the business was always distinguished. Reference was also made to risk, but in the sense of risk of loss of capital, which does not clearly distinguish profit from interest.15 Adam Smith is explicit in regard to these elements, while Malthus and M'Culloch were more so. J. S. Mill pointed out in a somewhat groping way that the wages of management are determined in a different way from other wages, and noted also that profits, so called, include as a third element a payment for risk, as well as wages of management (and interest). The inclusion of interest in profit was opposed by Bagehot, and in the United States by Walker, but the use of the term is still somewhat loose in England, as is seen in Marshall. Even in this country the development of corporation accounting, while separating wages of management from profit, has tended to a new confusion of profit and interest.
The early French writers, beginning with J. B. Say, adopted a different view of profit, or at least a different use of the word, insisting on a separation of profit from interest and defining the former explicitly as a wage. The difference in procedure may have been due, as v. Mangoldt suggests,16 to the different character of typical French industry and the greater importance of the manager's personality in it relatively to the capital factor. It is worthy of note that in the fourth edition of his "Traité," Say included in profit the reward for risk-taking; he had in the earlier editions viewed this income as accruing to the capitalist as such, but now transferred it to the entrepreneur. Especial mention should be made of Courcelle-Seneuil, who insisted that profit is not a wage, but is due to the assumption of risk.17
The older German economists varied widely in their treatment of profits. Some, of whom Schäffle is perhaps the most notable example, follow the "English" view in classing profit as essentially a return to capital. Others, notably Roscher, adopt the "French"18 attitude and treat it as a form of wages. Roscher does not even use the term "profit," but substitutes Unternehmerlohn. Other writers, such as Hermann and Rau, took a more or less intermediate position.
Still another group, of more importance for our purposes, contended that profit should be recognized as a unique form of income, not susceptible of reduction to remuneration for either capital or labor. This position was taken in a somewhat timid way by Hufeland19 and more definitely by Riedel,20 but its most notable advocates were Thünen and v. Mangoldt. Thünen's great work, "Der Isolirte Staat,"21 defines profit as what is left after (a) interest, (b) insurance, and (c) wages of management, are met. This residuum consists of two parts: (1) payment for certain risks, especially changes in values and the chance of failure of the whole enterprise, which cannot be insured against, and (2) the extra productivity of the manager's labor due to the fact that he is working for himself, his "sleepless nights" when he is planning for the business. Thünen called these elements respectively Industriebelohnung and Unternehmergewinn, and their sum Gewerbsprofit.
A most careful and exhaustive analysis of profit is contained in the monograph of H. v. Mangoldt, already referred to. Proceeding on the basis of an elaborate classification of the forms of industrial organization and a discussion of the economic advantages of the entrepreneur form, this writer finds in the income of the business enterpriser a complex group of unique elements. He divides it first into three parts: (1) a premium on those risks which are of such a nature that he cannot shift them by insurance; (2) entrepreneur interest and wages, including only payments for special forms of capital or productive effort which do not admit of exploitation by any other than their owner; (3) entrepreneur rents. These last again fall into four subdivisions: (a) capital rents, (b) wage rents, (c) large enterprise rent, and (d) "entrepreneur rent in the narrower sense." They are all due to the limitation of special capacities or characteristics (the last to special combinations of such) and are called "premiums on scarcity" (Seltenheits prämeien). This is, of course, a question-begging term (though many writers have used it) since all incomes depend in the same way on the limitation of the agencies to which they are imputed. It would seem that every imaginable source of income is included in this minute and subtle classification.
A special place in the history of theories of profit should be given to the German socialist school, the so-called "scientific" socialists, Rodbertus, Marx, Engels, Lassalle, and their followers. These writers take the English classical treatment of profit in a narrowly literal (one must say wholly uncritical and superficial) sense as including all income accruing to capital, to which they add land. Combining this with an equally blind reading of the labor theory of value which was the starting-point of Smith and Ricardo, they derive a simple classification of income in which all that is not wages is a profit which represents exploitation of the working classes. Capital is equivalent to property, which is to be regarded as mere power over the economic activities of others due to the strategic position of ownership over the implements of labor. It is analogous to a robber baron's crag, a toll-gate on a natural highway, or a political franchise to exploit. Pierstorff, in the monograph referred to above, follows Rodbertus in the main, after criticizing alternative views.22
After the publication in 1871 of Menger's "Grundsätze" had given a new interest and new turn to value theory in Austria and Germany, a notable series of discussions of profit appeared in those countries. Those calling for especial mention are the monographs of Gross23 and Mataja24 and the treatments by Mithoff25 and Kleinwächter26 in Schönberg's "Handbuch," the last-named elaborated in the author's book already referred to. Gross takes as his starting-point the plain fact that profit is the difference between the cost of goods and their value, and studies the position of the entrepreneur in the two markets in which he buys productive services and raw materials and sells his finished product. He may be said to reduce profit to bargaining power, in which, of course, superior knowledge and foresight are recognized as playing a large part, but Gross does not work out a systematic treatment of the nature and significance of risk or uncertainty. He thinks an income which is a premium for taking risks is inherently impossible, as gains and losses would necessarily balance. Few other writers agree with this proposition. Socially, profit is for Gross the inducement to follow closely the economic law of cheapest possible production and most effective utilization of goods.
Mataja's analysis of profit is a more literal application of Menger's utility theory of value. He seeks to explain price differences by means of the differences between the various uses of "goods of higher order" in making different kinds of "goods of lower order" and ultimately different consumption goods. His discussion does not get beyond a statement of the problem.
Mithoff holds that the entrepreneur's income consists of rents, wages, etc., at market rates for the productive services which he furnishes to the business, plus a "profit" which may be regarded as remuneration for taking the risk of its failure. He contends, however, that this profit is at best a mere abstraction, a complex of a number of indeterminate surpluses, and that the entrepreneur income as a whole alone has definite meaning or practical significance.
Körner is another writer who explains the entrepreneur's income in terms of superior bargaining power. His position is figured as that of a watchman on a tower and is summed up in the expression that his is a wider market than that of the men he buys from and sells to, especially the laborer whom he hires. The essential mystery of why the competition of other watchmen on similar towers does not eliminate his peculiar gain is not touched upon. The nonsocialistic German writers are usually particularly concerned to combat the allegations of the socialists and furnish a social justification of profit.
Kleinwächter views profit from the social standpoint as pay for taking the twofold risk of production—technical and economic, a distinction made by Gross—and for the care of supervision. From the individual point of view it is a speculative gain arising from advantage taken of differences between the prices of economic goods and the prices of the agents necessary to their production. In his fuller treatment in his book on distribution, Kleinwächter devotes most of his energy to a sarcastic polemic against the English classical economic theory, according to which the prices of commodities should equal their costs of production or the sum of the wages, interest, and rent paid the agents employed to produce them. No serious criticism of this theory is attempted, however, nor any sign displayed of a comprehension of its real meaning as a statement of the limits of tendencies. The general conclusion that the existence of profit follows from a divergence between the conditions of theory and those of fact is the starting-point of the present study. It is, of course, a statement of the problem, and not a solution of it; Kleinwächter virtually explains profit by ridiculing the idea that it should be thought to call for explanation.
In other than the German-speaking countries the subject of profit has not been prolific of independent monographs and treatises, but has usually been dealt with as an integral part of the general theory of distribution (though there are some exceptions in France and Italy which would have to be noticed in a fuller historical treatment). It is, of course, impossible to take up even the important theorists in all countries and summarize their views, while any brief treatment by schools or groups would be misleading rather than helpful. The writers already mentioned pretty well cover the fundamental theories and standpoints, with exceptions yet to be noted.27 A very common procedure is to treat profit as a special case of monopoly gain, or to combine elements of monopoly position with other factors. This method is apt to degenerate into a mere confusion of the two income categories. The common use of the term "monopoly profit" to designate monopoly revenue directly incites to this confusion.
The first notable development in the field of profit theory in America was the work of General Francis A. Walker.28 Walker effectually emphasized the place and importance of the entrepreneur or "captain of industry," and helped to free economic treatises in English from the careless handling of profit as an element in interest. His own "rent theory," however, in spite of its vogue at the time of its promulgation, need not now detain us. Walker wrote before Marshall, Clark,29 and Hobson30 had shown that all incomes are like rent in the mode of their determination, and with that point once made clear the rent theory is reduced to a wage theory merely, and its special significance disappears.
More recently the center of interest in the discussion of profit has shifted from Walker's theory to two other opposed views, the "dynamic theory" and the "risk theory" respectively. The former is the view upheld by Professor J. B. Clark and his followers and the latter is sponsored in particular by Mr. F. B. Hawley.31 Neither the connection between profit and changes in conditions nor that between profit and risk is an entirely new idea, but hitherto neither had been erected into a definite and ostensibly sufficient principle of explanation of the peculiar income of the entrepreneur. These two theories call for somewhat fuller treatment.
The dynamic theory is a correlate of Professor J. B. Clark's theory of distribution in the profitless "static state."32 Professor Clark outlines a systematic structure of theoretical economics in three main divisions.
The first treats of universal phenomena, and the second of static social phenomena. Starting with those laws of economics which act whether humanity is organized or not, we next study the forces that depend on organization but do not depend on progress. Finally it is necessary to study the forces of progress. To influences that would act if society were in a stationary state, we must add those which act only as society is thrown into a condition of movement and disturbance. This will give us a science of Social Economic Dynamics.33
The static state is the state of "natural" adjustments of Ricardo and the early classical writers.
What are called "natural" standards of values and "natural" or normal rates of wages, interest, and profits are in reality, static rates. They are identical with those which would be realized, if a society were perfectly organized, but were free from the disturbances that progress causes.... Reduce society to a stationary state, let industry go on with entire freedom, make labor and capital absolutely mobile... and you will have a régime of natural values.34
To realize the static state, we should have to eliminate five kinds of change which are constantly in progress:
Five generic changes are going on, every one of which reacts on the structure of society, by changing the arrangements of that group system which it is the work of catallactics to study:
In the static state each factor secures what it produces, and since cost and selling price are always equal there can be no profits beyond wages for the routine work of supervision.
The prices of goods are in these older theories said to be "natural" when they equal the cost of producing them;... in reality their "natural prices" were static prices.36 The prices that conform to the cost of production are, of course, those which give no clear profit to the entrepreneur. A business man whose goods sell at such rates will get wages for whatever amount of labor he may perform, and interest for any capital that he may furnish; but he will have nothing more to show in the way of gain. He will sell his product for what the elements that compose it have really cost him, if his own labor and the use of his capital be counted among the costs. We shall see that this condition of no-profit prices exactly corresponds to the one that would result from the static adjustment of the producing groups.37
Profits are, then, the result exclusively of dynamic change. "Obviously, from all these changes two general results must follow: first, values, wages and interest will differ from the static standards; secondly, the static standards themselves will always be changing."38 The type of dynamic change is invention; "an invention makes it possible to produce something more cheaply. It first gives a profit to entrepreneurs and then... adds something to wages and interest.... Let another invention be made.... It also creates a profit; and this profit, like the first, is an elusive sum, which entrepreneurs grasp but cannot hold." It "slips through their fingers and bestows itself on all members of society."39 Thus the effect of any one dynamic change is to produce temporary profits. But in actual society such changes constantly occur, and the readjustments are always in process. "As a result, we... have the standard of wages moving continuously upward and actual wages steadily pursuing the standard rate in its upward movement, but always remaining by a certain interval behind it."40
In another sense profit is dependent on "friction": "The interval between actual wages and the static standard is the result of friction; for, if competition worked without let or hindrance, pure business profit would be annihilated as fast as it could be created...."41 "Were it not for that interval, entrepreneurs as such would get nothing, however much they might add to the world's productive power."42
The fatal criticism of this procedure of taking changes in conditions as the explanation and cause of profit is that it overlooks the fundamental question of the difference between a change that is foreseen a reasonable time in advance and one that is unforeseen. Now, if we merely assume that all the "dynamic changes" which Professor Clark enumerates, and any others which may be named, are foreknown for a sufficient time before they take place, or that they take place continuously in accordance with laws generally and accurately known, so that their course may be predicted as far into the future as occasion may require, then the whole argument based on the effects of change will fall completely to the ground. If the retort is made that this is a supposition contrary to fact and illicit, the answer is that it is only partly contrary to fact. Some changes are foreseen and some are not, the laws of some are tolerably accurately known, of others hardly at all;43 and the variation in foreknowledge makes it clearly indispensable to separate its effects from those of change as such if any real understanding of the elements of the situation is to be attained. It is evident that a society might be ever so dynamic, as Professor Clark defines the term, and yet have all its prices "natural" or constantly equal to production costs, excluding any chance for the entrepreneur to secure a net profit. It is fallacious to define "natural" conditions as "static" conditions.
No a priori argument is necessary to prove that with general foreknowledge of progressive changes no losses and no chance to make profits will arise out of them. This is the first principle of speculation, and is particularly familiar in the capitalization of the anticipated increase in the value of land. The effect of any change which can be foreseen will be adequately discounted in advance, any "costs" connected with it will be affected in exactly the same way as the corresponding "values" and no separation between the two will take place.
It will be interesting to follow this line of thought somewhat farther, as suggested above in connection with Professor Clark's characterization of profit as the lure that causes men to make the efforts and take the risks involved in progress. It is in fact but a short step from the foreknowledge of change to the fact that change in reality does not usually just happen, but is largely itself the result of human activity. It is evident that if the laws of economically significant changes are known, those human actions which give rise to such changes will be governed by the same motives as the operations productive of immediate utilities, and in the competition of resources for profitable employment returns will be adjusted to equality between the two fields of use. Industrial progress would certainly take place under these conditions quite as readily as where the operations giving rise to it gave highly unpredictable results, but the rewards of making inventions, discovering new natural resources, etc., with the speculative character of the operations once removed, would be in no wise different from wages, interest, and rent in any other line of productive activity. They would be equal in amount, determined in the same way, in the same competitive market, and in short would be wages, interest, and rent merely, and not profit. And this is what does come about to the extent that progress can be foreseen, which is to say in very large measure. Dynamic changes give rise to a peculiar form of income only in so far as the changes and their consequences are unpredictable in character.
It cannot, then, be change, which is the cause of profit, since if the law of the change is known, as in fact is largely the case, no profits can arise. The connection between change and profit is uncertain and always indirect. Change may cause a situation out of which profit will be made, if it brings about ignorance of the future. Without change of some sort there would, it is true, be no profits, for if everything moved along in an absolutely uniform way, the future would be completely foreknown in the present and competition would certainly adjust things to the ideal state where all prices would equal costs. It is this fact that change is a necessary condition of our being ignorant of the future (though ignorance need not follow from the fact of change and only to a limited extent does so) that has given rise to the error that change is the cause of profit.
Not only may change take place without occasioning profit, but profit may also arise in the entire absence of any "dynamic" or progressive changes of the kind enumerated by Professor Clark. If conditions are subject to unpredictable fluctuations,44 ignorance of the future will result in the same way and inaccuracies in the competitive adjustment and profits will be the inevitable consequence. And the failure of an anticipated change to occur is the same in effect as the occurrence of an unanticipated one. It is not dynamic change, nor any change, as such, which causes profit, but the divergence of actual conditions from those which have been expected and on the basis of which business arrangements have been made. For a satisfactory explanation of profit we seem to be thrown back from the "dynamic" theory to the Uncertainty of the Future, a condition of affairs loosely designated by the term "risk" in ordinary language and in business parlance.
Except for one or two passing references, Professor Clark does not take up the subject of risk in the treatise from which we have quoted. In a short article on "Insurance and Profits"45 (written in refutation of Mr. Hawley) he takes the position that risk-taking gives rise to a special category of income, but that it accrues to the capitalist, and cannot go to the entrepreneur, as such. How he would treat this income, what relation it would bear to interest, he does not tell us. But it is no part of profit, which is defined as "the excess of the price of goods over their cost."46 "It goes without saying that the hazard of business falls on the capitalist. The entrepreneur, as such, is empty-handed. No man can carry risk who has nothing to lose."47 In his later work, the "Essentials of Economic Theory," the subject of risk again receives scant attention.48 Risks are simply ruled out of the discussion, since "the greater part of them arise from dynamic causes," and the "unavoidable remainder" of static risk can be taken care of by setting aside "a small percentage of the annual gains [of each establishment, which]... will make good these losses as they occur and leave the businesses in a condition in which they can yield as a steady return to owners of stock, to lenders of... capital, and to laborers all of their real product."
It is clear that Professor Clark admits that his perfectly competitive state implies substantially perfect knowledge on the part of all members of society of present and future facts significant for the ordering of their business conduct. Dr. A. H. Willett49 has supplemented the theory of the static state in this field, and Dr. A. S. Johnson has some discussion of it in his study of rent.50 Willett recognizes that the disturbing effects of progress do not constitute the sole cause of divergence between actual society and the theoretical ideal; "the conception of the static state is reached by a process of abstraction," which "cannot stop" with the elimination of the five dynamic changes:
If all dynamic changes were to cease, the ideal static state would never be realized in human society. There are other assumptions which have to be made, such as a high degree of mobility of capital and labor, the universal prevalence of the economic motive, and the power of accurately foreseeing the future....
It is the influence of the last of these disturbing factors on static rates of wages and interest that we are to seek to determine. The ideal adjustment could be realized only on the condition that there were no discrepancies between the anticipated and the actual results of economic activity. Production and consumption must go on either with absolute uniformity or with a regular periodicity.51
From the above admission that the static state is not an adequate formulation of the conditions of ideal competition, it would be an easy inference in line with static theory as a whole that some modification in the treatment of profit would be called for. But this inference is not drawn by the author quoted. He is not looking for and does not find any connection between profit and risk. He agrees explicitly with Clark that the entrepreneur takes risk only as a capitalist, and that the income resulting is therefore not profit. In his discussion of the reward for risk-taking, Willett states even more emphatically than Clark had done the contention that only the capitalist as such can take risk or get the reward of risk-assumption. To him this "seems to be a self-evident proposition,"52 but he fails to take account of the familiar fact that men may secure their obligations in other ways than through pledging material resources already owned and invested, as for example by mortgaging their current income from all sources and their future earning power.
In his discussion of profits referred to above, Dr. Johnson makes some reference to risk, but he also makes no attempt to find in it an explanation of profit. He discovers four elements in "the income of a fortunate and capable entrepreneur."
(1) A gain due to chance, offset by a smaller loss (borne, however, by some other entrepreneur); (2) a gain due to his own power of combining labor and capital in ways more effective than those usually employed in the community; (3) a certain share in the first fruits of economic improvements; (4) a part of the gains which entrepreneurs as a class secure through the fact that their services are limited in proportion to the demand for them.
We need not stop to criticize this analysis in detail; it might be pointed out that shares (2) and (4) are identical, and that neither formulation would distinguish profit from wages (and (4) not from any other income, as we have remarked above); (3) is a reference to the "dynamic" explanation of profit and is unclear without further elaboration; (1) seems to point to a connection between profit and risk, but this is not worked out. It is clear that these discussions of risk, as emendations of the dynamic theory, make no pretense of explaining the connection between profit and uncertainty which our discussion of Professor Clark's treatment showed to be necessary. Both writers are, indeed, opposed to and attempt to refute the doctrine that profit is the result of assuming risk.
The doctrine that profit is to be explained exclusively in terms of risk has been vigorously upheld by Mr. F. B. Hawley,53 who finds in risk-taking the essential function of the entrepreneur and therefore the basis of his peculiar income. In Mr. Hawley's distributive theory the entrepreneur, or "enterpriser" as he is called, plays a rôle of unique importance. Enterprise is the only really productive factor, strictly speaking, land, labor, and capital being relegated to the position of "means" of production. In regard to profit, the reward of enterprise, Hawley says:54
...the profit of an undertaking, or the residue of the product after the claims of land, capital, and labor (furnished by others or by the undertaker himself) are satisfied, is not the reward of management or coördination, but of the risks and responsibilities that the undertaker... subjects himself to. And as no one, as a matter of business, subjects himself to risk for what he believes the actuarial value of the risk amounts to—in the calculation of which he is on the average correct—a net income accrues to Enterprise, as a whole, equal to the difference between the gains derived from undertakings and the actual losses incurred in them. This net income, being manifestly an unpredetermined residue, must be a profit, and as there cannot be two unpredetermined residues in the same undertaking, profit is identified with the reward for the assumption of responsibility, especially, though not exclusively, that involved in ownership.55
Mr. Hawley is in agreement with Professor Clark and his followers in defining profit as "residual income," and as to the nature and basis of the special income connected with the assumption of risk as an excess of payment above the actuarial value of the risk, demanded because exposure to risk is "irksome"; but Hawley insists that residual income and uncertain income are interchangeable concepts,56 while Clark is equally sure that the reward of risk-taking necessarily goes to the capitalist as such and that the pure profit of the entrepreneur is a species of monopoly gain arising in connection with dynamic disturbances, and that his only income under static conditions would be wages of management or coördination. Hawley contends that such income is wages merely, and not profit, and does not distinguish between "static" and "dynamic" conditions. Coördination, however, is in his view distinguished from labor by the fact of proprietorship, "which is the very essence of the matter in dispute."57 Profit cannot be the reward of management, for this can be performed by hired labor if the manager takes no risk, but this individual is no longer an entrepreneur.
It is admitted that the entrepreneur may get rid of risk in some cases for a fixed cost, by means of insurance. But by the act of insurance the business man abdicates so much of his entrepreneurship, "for it is manifest that an entrepreneur who should eliminate all his risks by means of insurance would have left no income at all which was not resolvable into wages of management and monopoly gains" (i.e., no profit).58 To the extent to which the business man insures, he restricts the exercise of his peculiar function, but the risk is merely transferred to the insurer, who by accepting it becomes himself an enterpriser and the recipient of an unpredetermined residue or profit." The reward of an insurer is not the premium he receives, but the difference between that premium and the loss he eventually suffers."59
The clue to the disagreement and to the straightening-out of the facts as well is to be found in a confusion fallen into by those on both sides of the controversy, in assuming that the "actuarial value" of the risks taken is known to the entrepreneur. There is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known. It is so fundamental, indeed, that, as we shall see, a known risk will not lead to any reward or special payment at all. Though Willett distinguishes between "uncertainty" and "risk" and the mathematical probability of loss,60 he still treats uncertainty throughout his study as a known quantity.61 The same applies to Johnson; he also implicitly recognizes at various points that the true chance or actuarial value of the risk may not be known, and devotes some space62 to Thünen's emphasis on the distinction between insurable and uninsurable risks; but he also fails entirely to take account in his discussion of profit of the fact that the risk involved in entrepreneurship is not and cannot be a known quantity.
In a similar way Hawley repeatedly refers to the fact of uninsurable risk as well as to "pure luck" and to "changes that no one could have foreseen," but he fails to inquire into its meaning or to recognize its theoretical import.63 Once he goes so far as to say that "the great source of monopoly profit is to be found in the fact that the actuarial risk of any given undertaking is not the same for different entrepreneurs, owing to differences among them in ability and environment";64 and again, that "profit is the result of risks wisely selected."65 Even here, however, he fails to develop the point and draw the consequences from the fact that the actuarial value of the risk undergone by any venturer is not known, either to himself or to his competitors.
In a sense Mr. Hawley comes still nearer to the crux of the matter in his insistence on the responsibility and risk of proprietorship as the essential attributes of entrepreneurship. The entrepreneur is the owner of all real wealth, and ownership involves risk; the coördinator "makes decisions," but it is the entrepreneur who "accepts the consequences of decisions."66 He admits that others than the recognized entrepreneur are subject to risk; the landlord is also a proprietor, and his land may change in value; the capitalist especially requires payment for the large risks he runs, and a part of both rent and interest is accordingly profit. A person who invests his own capital in any form of opportunity necessarily combines the two functions of capitalist and enterpriser. The same should apparently apply to the laborer, who is also admitted to run risks.
Mr. Hawley does not regard the term "risk" as calling for special definition, but it is clear that, like the other writers, he treats it as a known quantity; he says this much explicitly.67 He and his opponents alike have failed to appreciate the fundamental difference between a determinate uncertainty or risk and an indeterminate, unmeasurable one. The only practical bearing of the question as to whether the value of the risk is known which is recognized by Hawley is to determine whether it is likely to be insured, which is to say merely who will get the "profit" for assuming it; even this point is not very explicitly made. Now a little consideration will show that there can be no considerable "irksomeness" attached to exposure to an insurable risk, for if there is it will be insured; hence there can be no peculiar income arising out of this alleged indisposition. If risk were exclusively of the nature of a known chance or mathematical probability, there could be no reward of risk-taking; the fact of risk could exert no considerable influence on the distribution of income in any way. For if the actuarial chance of gain or loss in any transaction is ascertainable, either by calculation a priori or by the application of statistical methods to past experience, the burden of bearing the risk can be avoided by the payment of a small fixed cost limited to the administrative expense of providing insurance.
The fact is that while a single situation involving a known risk may be regarded as "uncertain," this uncertainty is easily converted into effective certainty; for in a considerable number of such cases the results become predictable in accordance with the laws of chance, and the error in such prediction approaches zero as the number of cases is increased. Hence it is simply a matter of an elementary development of business organization to combine a sufficient number of cases to reduce the uncertainty to any desired limits. This is, of course, what is accomplished by the institution of insurance.
It is true that the person subject to such a risk may voluntarily choose not to insure, but it is hard to distinguish such a course from deliberate gambling, and economists have not felt constrained to recognize gambling gains in general as a special income category in the theory of distribution. If it is objected that practical difficulties may prevent insurance even where the risk is determinate, the reply is that insurance, in the technical sense, is only one method of applying the same principle. We shall show at length in our general discussion of risk and uncertainty that if the risk is measurable, but the "moral factor" or some other consideration makes ordinary insurance inapplicable, some other method of securing the same result will be developed and employed. When the technique of business organization has reached a fairly high stage of development a known degree of uncertainty is practically no uncertainty at all, for such risks will be borne in groups large enough to reduce the uncertainty to substantially negligible proportions.
The result of the foregoing analysis should be to show the inadequacy of the two opposed theories of profit and to indicate the reasons for it and the direction in which a tenable solution of the problem of profit is to be sought. It has been seen, first, that change as such cannot upset the competitive adjustment if the law of the change is known; and now, secondly, that an unpredictable change will be similarly ineffective if the chance of its occurrence can be measured in any way. In a well-organized society, if business men know either (1) what actual changes are impending or (2) the "risks" they run—i.e., what is the probability of any particular occurrence,—the effect in the long run is the same; the only result of such changes will be a certain redistribution of productive energy which will take place continuously and without any disturbance of perfect competitive conditions.68 The fact that prediction may involve costs, and likewise the organization for grouping risks and eliminating their uncertainty, does not negate the truth of the proposition, so long as these costs are given elements in the competitive situation.
Yet it is equally evident that there is a principle of truth in both the "dynamic" and the "risk" theories, and the true theory must to a considerable degree reconcile the two views. On the one hand, profit is in fact bound up in economic change (but because change is the condition of uncertainty), and on the other, it is clearly the result of risk, or what good usage calls such, but only of a unique kind of risk, which is not susceptible of measurement. The Clark school has confused change with a common but not universal or necessary implication of change, and both schools have followed everyday speech into the fallacy of treating risk as a substantially homogeneous category, where a fundamental difference in kinds of risk is in fact the key to the whole mystery.
The meaning of "uncertainty," and of the different kinds of uncertainties, and their significance in competitive economic relations, will therefore constitute the principal subject which we have finally to investigate in the present study. The next step in the progress of the argument will be to lay a comparative basis for this investigation by attempting to gain a clear view of the mechanism of competitive valuation and distribution as they would be if uncertainty and its correlative profit were entirely absent. The next three chapters will therefore be taken up with an examination of the conditions and workings of a perfectly competitive society; of these conditions the crucial one will constantly appear as the possession of accurate and certain knowledge of the whole economic situation by all the competitors.
[13.]Excellent histories of profit theory are to be found in the introductory sections of several monographs on profit and make it superfluous to go into this phase of the subject in detail. See especially the following:
[14.]The exception is Professor Clark's theory of perfect competition as equivalent to the "static state" and the corresponding "dynamic theory" of profit as the result of progress. This view will presently be taken up and criticized.
[15.]For a fuller discussion of the views of the English writers, with citations, see Cannan, Theories of Production and Distribution, chap. VI, sec. 2; also the same author's article on "Profit" in Palgrave's Dictionary of Political Economy. In opposition to the German historians and critics, who take the classical economists very literally, Cannan is sure that they really held, like their French followers, a wage theory of profit. Between the two views this seems the fairer on the whole, but it could hardly be maintained that the difference in expression does not represent some difference in thought. However, much of the contrast is undoubtedly due to differences in the use of terms. Old words used to designate new things necessarily become ambiguous, and "profit" is still correctly used with several different meanings.
[16.]Op. cit., p. 19, note.
[17.]Article, "Profit," in Coquelin and Guillaumin's Dictionnaire de l'économie politique, Paris, 1852. It is true that in another work (Traité d'économie politique, 2d ed., 1867) Courcelle was not so explicit, and also that in the same article he says that profit depends on the intelligence of the entrepreneur and the favorable or unfavorable conditions under which he works. This hesitation may explain Kleinwächter's classifying him with the followers of Say and adherents of the wages theory. (See Das Einkommen and seine Verteilung, p. 278.) It seems more probable, however, that Courcelle glimpsed the fact (which Kleinwächter did not) that the assumption of a "risk" of error in one's own judgment, inherent in the making of a responsible decision, is a phenomenon of a different character from the assumption of "risk" in the insurance sense. We shall build largely upon this distinction later.
[18.]These national designations of the two schools hold closely. The only notable exceptions (aside from Courcelle) are on the one side, Rossi, a French (naturalized Italian) writer, who strongly espoused the capitalistic or English view, and on the other Samuel Read who, while agreeing with the current English treatment in terminology, broke with it in substance and agreed with Say and his followers. Read insisted on identifying "profit" with the return to capital, or interest, and treating the distinctive income of the entrepreneur as a wage. He also emphasized the "compensation for risk" element in his "profit" (really interest), but thought it due to no determinate causes and "outside the pale of science." This last phrase shows at least an insight into the unique character of this sort of risk, since the assertion would certainly not have been made of an insurance premium. See his Political Economy, Edinburgh, 1829, pp. 263 and 269, note.
[19.]Neue Grundlage der Staatswissenschaft, vol. I. Giessen, 1807.
[20.]National Ökonomie, 1839.
[21.]Appeared 1826. 3d ed., 1876. See 3d ed., vol. II, pp. 83 ff.
[22.]See also the article "Unternehmergewinn," by Pierstorff in Conrad's Handwörterbuch der Staatswissenschaften. Dr. Thorstein Veblen's conceptions of capital and profit show strong leanings toward the same views.
[23.]Referred to above, p. 22 n.
[25.]G. Schönberg, Handbuch der PolitischenÖkonomie, 2d ed. (Tübingen, 1885), pp. 670 ff.
[26.]Ibid., pp. 220 ff.
[27.]A noteworthy innovation in the treatment of profit has been made by a recent French writer, M. B. Lavergne, in his Théorie des marchées économiques (Paris, 1910). In his view profit is the remuneration of the idée productrice, which is elevated to the position of an independent productive factor. His book outlines an ingenious and suggestive theory of distribution. See review by Professor A. A. Young, American Economic Review, vol. I, pp. 549 ff.
[28.]Political Economy, part IV, chap. IV. See also "The Source of Business Profits and Reply to Mr. Macvane," Quarterly Journal of Economics, vol. I, pp. 265 ff., and vol. II, pp. 263 ff. (Macvane held a monopoly theory; cf. Quarterly Journal of Economics, vol. II, pp. 1 ff. and 453 ff.) A view similar to that of Walker has been advocated in France by Leroy-Beaulieu (Sr.). See Mémories de l'Academie des sciences morales et politiques, vol. I, pp. 717 ff, and Traité d'économie politique, part IV, chap. IX.
[29.]"Distribution as Determined by a Law of Rent," Quarterly Journal of Economics, vol. V, pp. 289 ff.
[30.]"The Law of the Three Rents," ibid., vol. V, pp. 263 ff.
[31.]It is not meant that these are the only noteworthy advocates of the views in question, nor that other American writers on distribution have not been in some degree original in their treatment of profit. The discussions by the various authors—Davenport, Ely, Fetter, Fisher, Johnson, Seager, Seligman, Taussig, and others—are accessible everywhere. Perhaps especial mention should be made of the chapter on profit in Carver's Distribution of Wealth. Carver's distinction between compensation for risk-taking and the results of successful risk-taking points to the direction in which a solution of the problem is to be sought. Other writers also have seen the importance of a critical dissection of the risk concept, but none have so far carried out the work. Unquestionably the best of these textbook discussions is that of Professor F. M. Taylor in his unpublished Principles of Economics, a work characterized throughout by correctly reasoned and accurately stated theoretical argument.
[32.]See The Distribution of Wealth, 1900; and Essentials of Economic Theory, 1907.
[33.]The Distribution of Wealth, pp. 30, 31.
[34.]The Distribution of Wealth, p. 29.
[35.]Ibid., p. 66.
[36.]Ibid., pp. 68-69.
[37.]Ibid. Professor Joseph Schumpeter, who has carried the static analysis farther in some respects than Professor Clark, points out that in the static state there is no entrepreneur, properly speaking. The consumer, he adds, is really the entrepreneur; but it would seem preferable to say that the function is absent and let it go at that. (Theorie der Wirtschaftliche Entwickelung.)
[38.]The Distribution of Wealth, p. 404.
[39.]Ibid., p. 405.
[40.]Ibid., p. 406.
[41.]Ibid., p. 410. This is fallacious even under the assumptions, since the profits of change come largely in the form of readjustments of capital values. The difficulty is, of course, avoided if "friction" be so broadly defined that "perfect mobility" means the absence of all resistance to the human will. But in a world where a breath could transform a brick factory building into a railway yard or an ocean greyhound there would be no need for economic activity or economic science.
[42.]The Distribution of Wealth, p. 411. At this point Professor Clark makes a statement which if followed out would lead to serious questionings in regard to his analysis: "Profit," he says (p. 411), "is the lure that insures improvement, and improvement is the source of permanent additions to wages. To secure progress, this lure must be sufficient to make men overcome obstructions and take risks." (My italics.) It would seem that effort and risk have some connection with the income of the "entrepreneur as such," as well as change and friction. Along the same line is the statement in his first chapter (p. 3) that "free competition tends to give to labor what labor creates, to capitalists what capital creates, and to entrepreneurs what the coördinating function creates." When we ask, as we presently shall, whether the "effort" and "risk" connected with making progress, or the income to which they give rise, are essentially different from any other effort and risk and their incomes, we shall find ourselves forced to answer in the negative, and to look outside the fact of change altogether for an explanation of the unique income of the entrepreneur.
[43.]It may be objected that in regard to some changes it is an absurdity to imagine their being foreseen, since this would cause them to take place at once. The statement doubtless holds in regard to some discoveries of fact which to anticipate would be to make them now. But not many of the dynamic economic changes are of this sort. The accumulation of capital and increase in population are in fact relatively predictable and the broader features in the development of wants are known and the knowledge has no effect on the changes themselves. It is possible even to predict discovery of natural resources without saying just where they will be found, and the making of an invention without actually writing the specifications. The probability that inventions will be made and processes improved is in fact very frequently taken into account in making valuations and determining business policies. The assumption that all change might be predictable is contrary to fact, but not self-contradictory, and we leave it to the argument as a whole to justify its usefulness as well as legitimacy.
[44.]It is necessary to stipulate that the fluctuations must be of sufficient extent and irregularity that they do not cancel out and reduce to uniformity or regular periodicity in a time-interval short in comparison with the length of human life.
[45.]Quarterly Journal of Economics, vol. VII, pp. 40-54.
[46.]Ibid., p. 41.
[47.]Ibid., p. 46.
[48.]Footnote, pp. 122-23.
[49.]The Economic Theory of Risk and Insurance, Columbia University Studies in Political Science, vol. XIV, no. 2.
[50.]Rent in Modern Economic Theory. Publications of the American Economic Association, 3d Series, vol. III, no. 4. See chapter VI: "Rent. Profit, and Monopoly Return." (Both these monographs are doctoral dissertations written under Professor Clark's supervision.)
[51.]Willett, op. cit., pp. 13-14. (My italics.)
[52.]Ibid., p. 72.
[53.]The most complete exposition of Hawley's theory is in his book. Enterprise and the Productive Process (1907). Articles of earlier date in the Quarterly Journal of Economics contain briefer statements.
[54.]An earlier attempt by Mr. Hawley to present the essentials of his theory in the most compact form is superior in some respects and is worth quoting:
[55.]Op. cit., pp. 106-07.
[56.]Quarterly Journal of Economics, vol. VII, p. 465; vol. XV, p. 88.
[57.]"Enterprise and Profit," Quarterly Journal of Economics, vol. XV, p. 86.
[58.]Quarterly Journal of Economics, vol. VII, p. 464. It should be explained that "monopoly gain" for Mr. Hawley includes all income due to limitation, and he finds that it forms a considerable portion of wages and interest, all of rent, and a large part of profit. We have repeatedly observed examples of this fallacy and remarked that there is no income which is not due to the "scarcity" of the agent securing it.
[59.]Enterprise and the Productive Process, p. 111.
[60.]Op. cit., pp. 27 ff.
[61.]Risk is defined as "the objective correlative of the subjective uncertainty" (p. 29), which varies with the mathematical chance of loss in such a way as to be at a maximum when the chances for and against the event are exactly even. But it is still to be regarded as a known quantity, since the mathematical chance is assumed to be known. Willett nowhere makes an explicit statement on this point, as Hawley does (see quotation in text on p. 42 above), but his discussion clearly shows that it is viewed as a known quantity. He takes his illustrations from games of chance or from the field of insurance, speaks of the influence of "a given degree of risk" (p. 65) on investors, etc. He does recognize the fact that the degree of risk is not always known in fact, and discusses methods of estimating the degree of risk; but (pp. 66 and 76) he expressly eliminates from the discussion the consequences of error in estimating the true value of the risk.
[62.]Op. cit., p. 112.
[63.]The reader will recall that many of the early discussions of profit (discussed in the early pages of this chapter), notably those of v. Mangoldt and v. Thünen, recognized the fact that some risks are insurable and others are not. No explanation of the fact, however, has been given, beyond phrases such as "in the nature of the case," which imply that it does not call for explanation.
[64.]"The Risk Theory of Profit," Quarterly Journal of Economics, vol. VII, p. 468.
[65.]Enterprise and the Productive Process, p. 108. Cf. Carver, "Risk Theory of Profits," Quarterly Journal of Economics, vol. XV, pp. 456 ff., and The Distribution of Wealth, chap. VII. Also A. A. Young in Ely's Outlines of Economics, 3d ed., chap. XXV. The phrase "successful risk-taking," used by both Carver and Young, like Hawley's "risks wisely selected," is certainly descriptive of the origin of profits. What is wanted is an examination of the meaning of risk-taking which will elucidate the conditions under which it will be successful and show the significant differences between cases of success and cases of failure.
[66.]"Enterprise and Profit," Quarterly Journal of Economics, vol. XV, p. 88.
[67.]See above, p. 42.
[68.]It must be understood that by laws and chances being "known," we mean that they are generally known, known to all to whom they are of any concern.