- Author's Preface
- Part I: Introductory
- Part I, Chapter I: The Place of Profit and Uncertainty In Economic Theory
- Part I, Chapter II: Theories of Profit;13 Change and Risk In Relation to Profit
- Part II: Perfect Competition
- Part Ii, Chapter III: The Theory of Choice and of Exchange
- Part Ii, Chapter IV: Joint Production and Capitalization
- Part Ii, Chapter V: Change and Progress With Uncertainty Absent
- Part Ii, Chapter VI: Minor Prerequisites For Perfect Competition
- Part III: Imperfect Competition Through Risk and Uncertainty
- Part Iii, Chapter VII: The Meaning of Risk and Uncertainty
- Part Iii, Chapter VIII: Structures and Methods For Meeting Uncertainty
- Part Iii, Chapter IX: Enterprise and Profit
- Part Iii, Chapter X: Enterprise and Profit (continued) the Salaried Manager
- Part Iii, Chapter XI: Uncertainty and Social Progress
- Part Iii, Chapter XII: Social Aspects of Uncertainty and Profit
IMPERFECT COMPETITION THROUGH
RISK AND UNCERTAINTY
Part III, Chapter VII
The Meaning of Risk and Uncertainty
Starting with the individual psychology of valuation and adding new factors step by step, we have now built up a competitive industrial society involving valuation and distribution under the highly simplified conditions necessary to perfect competition. The drastic assumptions made were necessary to show the operation of the forces at work free from all disturbing influences; and impossible as the presuppositions have been, the principles involved have not been falsified or changed, but merely exhibited in purity and isolation. Chief among the simplifications of reality prerequisite to the achievement of perfect competition is, as has been emphasized all along, the assumption of practical omniscience on the part of every member of the competitive system. The task of the present chapter is to inquire more fully into the meaning of this assumption. We must take a brief excursion into the field of the theory of knowledge and clarify our ideas as to its nature and limitations, and the relation between knowledge and behavior. On the basis of the insight thus gained, it will be possible to illuminate that large group of economic phenomena which are connected with the imperfection of knowledge.
The problem may be set in view and its significance made clear by recalling certain points already brought out in the previous discussion. In chapter II it was pointed out that the failure of competition and the emergence of profit are connected with changes in economic conditions, but that the connection is indirect. For profit arises from the fact that entrepreneurs contract for productive services in advance at fixed rates, and realize upon their use by the sale of the product in the market after it is made. Thus the competition for productive services is based upon anticipations. The prices of the productive services being the costs of production, changes in conditions give rise to profit by upsetting anticipations and producing a divergence between costs and selling price, which would otherwise be equalized by competition. If all changes were to take place in accordance with invariable and universally known laws, they could be foreseen for an indefinite period in advance of their occurrence, and would not upset the perfect apportionment of product values among the contributing agencies, and profit (or loss) would not arise. Hence it is our imperfect knowledge of the future, a consequence of change, not change as such, which is crucial for the understanding of our problem.
Again, in chapters III and IV, it was found necessary to assume static conditions in order to realize perfect competition. But, as expressly stated, this assumption was made because it follows from it as a corollary that the future will be foreknown, and not for the sake of the proposition itself. It is conceivable that all changes might take place in accordance with known laws, and in fact very many changes do occur with sufficient regularity to be practically predictable in large measure. Hence the justification and the necessity for separating in our study the effects of change from the effects of ignorance of the future. And chapter V was devoted to a study of the effects of change as such with uncertainty absent. Here it was found that under such conditions distribution or the imputation of product values to production services will always be perfect and exhaustive and profit absent.
Furthermore, as also argued in chapter II, it is unnecessary to perfect, profitless imputation that particular occurrences be foreseeable, if only all the alternative possibilities are known and the probability of the occurrence of each can be accurately ascertained. Even though the business man could not know in advance the results of individual ventures, he could operate and base his competitive offers upon accurate foreknowledge of the future if quantitative knowledge of the probability of every possible outcome can be had. For by figuring on the basis of a large number of ventures (whether in his own business alone or in that of business in general) the losses could be converted into fixed costs. Such special costs would, of course, have to be given full weight, but they would be costs merely, like any other necessary outlays, and would not give rise to profit, which is a difference between cost and selling price. Such situations in more or less pure form are also common in everyday life, and various devices for dealing with them form an important phase of contemporary business organization. Some of the more important of these devices will come up for brief discussion later. At present we are concerned only to emphasize the fact that knowledge is in a sense variable in degree and that the practical problem may relate to the degree of knowledge rather than to its presence or absence in toto.
The facts of life in this regard are in a superficial sense obtrusively obvious and are a matter of common observation. It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity. The essence of the situation is action according to opinion, of greater or less foundation and value, neither entire ignorance nor complete and perfect information, but partial knowledge. If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary.
The first datum for the study of knowledge and behavior is the fact of consciousness itself. Apparently the higher mental operations of reason are different only in degree, only elaborations of what is inherent in the first spark of "awareness." The essence of mentality from a functional standpoint seems to be its forward-looking character. Life has been described as internal adaptations to external coexistences and sequences. On the vegetable or unconscious plane, the internal changes are simultaneous with the external. The fundamental difference in the case of animal or conscious life is that it can react to a situation before that situation materializes; it can "see things coming." This is what the whole complicated mechanism of the nervous system is "for," in the biological sense. The readjustments by which the organism adapts itself to the environment require time, and the farther ahead the organism can "see," the more adequately it can adapt itself, the more fully and competently it can live.
Just what consciousness as such has to do with it is a mystery which will doubtless remain inscrutable. It is a mere brute fact that wherever we find complicated adaptations we find consciousness, or at least are compelled to infer it. Science can find no place for it, and no rôle for it to perform in the causal sequence. It is epiphenomenal. An explanation of the readjustment necessarily runs in terms of stimulus and reaction, in this temporal order. Yet in our own experience we know that we do not react to the past stimulus, but to the "image" of a future state of affairs; and for common sense, consciousness, the "image," is both present and operative wherever adaptations are dissociated from any immediate stimulus; i.e., are "spontaneous" and forward-looking. It is evident that all organic reactions relate to future situations, farther in the future as the type of life and activity is "higher." However successful mechanistic science may be in explaining the reaction in terms of a past cause, it will still be irresistibly convenient for common sense to think of it as prompted by a future situation present to consciousness. The rôle of consciousness is to give the organism this "knowledge" of the future. For all we can see or for all that science can ever tell us, we might just as well have been unconscious automata, but we are not. At least the person speaking is not, and he cannot help attributing to other creatures similarly constituted and behaving in the same way with himself "insides," to use Descartes' picturesque term, like his own. We perceive the world before we react to it, and we react not to what we perceive, but always to what we infer.
The universal form of conscious behavior is thus action designed to change a future situation inferred from a present one. It involves perception and, in addition, twofold inference. We must infer what the future situation would have been without our interference, and what change will be wrought in it by our action. Fortunately or unfortunately, none of these processes is infallible, or indeed ever accurate and complete. We do not perceive the present as it is and in its totality, nor do we infer the future from the present with any high degree of dependability, nor yet do we accurately know the consequences of our own actions. In addition, there is a fourth source of error to be taken into account, for we do not execute actions in the precise form in which they are imaged and willed. The presence of error in these processes is perhaps a phase of the fundamental mystery of the processes themselves. It seems to be an earnest of their non-mechanical character, for machines, generally speaking, do not make mistakes. (Though it may not be legitimate to draw inferences from the crude machines of our own construction to the infinitely more sensitive and intricate physico-chemical complexes which make up organic systems.) In any case the fact of liability to err is painfully familiar and is all that concerns us here. It is interesting to note that the perceptive faculties seem often to be less acute and dependable in the higher forms of life than in some of the lower. At least civilized man is often weak in this respect in comparison with primitive man and the higher animals. Higher powers of inference may take the place of perceptive faculties to a large extent, and we have undoubtedly developed reasoning power and lost ground with respect to keenness of sense.
It must be recognized further that no sharp distinction can be drawn between perception and reason. Our perceptive faculties are highly educated and sophisticated, and what is present to consciousness in the simplest situation is more the product of inference, more an imaginative construct than a direct communication from the nerve terminal organs. A rational animal differs from a merely conscious one in degree only; it is more conscious. It is immaterial whether we say that it infers more or perceives more. Scientifically we can analyze the mental content into sense data and imagination data, but the difference hardly exists for consciousness itself, at least in its practical aspects. Even in "thought" in the narrow sense, when the object of reflection is not present to sense at all, the experience itself is substantially the same. The function of consciousness is to infer, and all consciousness is largely inferential, rational. By which, again, we mean that things not present to sense are operative in directing behavior, that reason, and all consciousness, is forward-looking; and an essential element in the phenomena is its lack of automatic mechanical accuracy, its liability to error.
The statement that a situation not in physical relations with an organism, not even in existence, influences that organism, is of course in a sense figurative; the influence is indirect, operating through a situation with which the organism is in contact at the moment. Hence, as already pointed out, it is always theoretically possible to ignore the form of the conscious relation, and interpret the reaction as a mechanical effect of the cause actually present. But it remains true that practically we must regard the situation present to consciousness, not the one physically present, as the controlling cause. In spite of rash statements by over-ardent devotees of the new science of "behavior," it is preposterous to suppose that it will ever supersede psychology (which is something very different) or the theory of knowledge, in something like their historic forms.
It is evident that the possibility of a situation not present, operating through one which is present, is conditioned upon some sort of dependable relation between the two. This postulate of all knowledge and thought has been variously formulated as the "law" or "principle" of "causality," and "uniformity" or "regularity" of nature, etc. Remembering that we are speaking of the surface facts, not metaphysical interpretations, we may say that all reasoning rests on the principle of analogy. We know the absent from the present, the future from the now, by assuming that connections or associations among phenomena which have been valid will be so; we judge the future by the past. Experience has taught us that certain time and space relations subsist among phenomena in a degree to be depended upon. This dogma of uniformity of coexistence and sequence among phenomena is a fairly satisfactory statement of the postulate of thought and forward-looking action from the standpoint of the philosopher. But from the more superficial standpoint of common sense (and hence of an inquiry such as the present) the term "phenomenon" is rather vague and elusive, and a more serviceable formulation seems possible. Common sense works in terms of a world of objects or merely "things." Consequently the idea of things manifesting constant modes of behavior seems to be a better "category" than that of uniformity of relation among phenomena. This may be unsatisfactory to the philosopher, who will protest at once that the thing is merely a sum of its modes of behavior, that no such separation is really possible. It is the ancient riddle which so puzzled Locke, of the attribute and substratum, the substratum, of course, tending to evaporate under critical scrutiny. But this weakness may prove rather a source of strength for the use which we intend to make of the notion, as will be argued.
We have, then, our dogma which is the presupposition of knowledge, in this form; that the world is made up of things, which, under the same circumstances, always behave in the same way. The practical problem of inference or prediction in any particular situation centers around the first two of these three factors: what things are we dealing with, and what are the circumstances which condition their action? From knowledge of these two sets of facts it must be possible to say what behavior is to be expected. The chief logical problem, as already noticed, lies in the conception of a "thing." For it is obvious that the "circumstances" which condition the behavior of any particular thing are composed of other things and their behavior. The assumption that under the same circumstances the same things behave in the same ways thus raises the single question of how far and in what sense the universe is really made up of such "things" which preserve an unvarying identity (mode of behavior). It is manifest that the ordinary objects of experience do not fit this description closely, certainly not such "things" as men and animals and probably not even rocks and planets in the strict sense. Science has rested upon the further assumption that this superficial divergence of fact from theory arises because the "things" of everyday experience are not the "ultimate" things, but are complexes of things which really are unchanging. And the progress of science has consisted mostly in analyzing variable complexes into unvarying constituents, until now we have with us the electron.
But workable knowledge of the world requires much more than the assumption that the world is made up of units which maintain an unvarying identity in time. There are far too many objects to be dealt with by a finite intelligence, however unvarying they might be, if they were all different. We require the further dogma of identical similarity between large numbers of things. It must be possible not merely to assume that the same thing will always behave in the same way, but that the same kind of thing will do the same, and that there is in fact a finite, practically manageable number of kinds of things. Hence the fundamental rôle which classification has always played in thought and the theory of thought. For our limited intelligence to deal with the world, it must be possible to infer from a perceived similarity in the behavior of objects to a similarity in respects not open to immediate observation. That is, we must assume that the properties of things are not shuffled and combined at random in nature, but that the number of groupings is limited or that there is constancy of association. This is the dogma of the "reality of classes," familiar to students of logic.
But even this is not enough. If the classification of objects be restricted to the grouping of things in all respects similar or substantially identical, there would still be a quite impossible number of kinds of things for intelligence to grasp. Even in the sense of practical degrees of completeness of similarity, identity to ordinary observation, our groups would be far too small and too numerous. It is questionable whether classification would be carried far enough on this basis to be of substantial assistance in simplifying our problems to the point of manageability. It is not that kind of a world. And even abstracting from mere differences in degree such as size and the like, for which intelligence readily makes allowance, the same would still hold true. It is clear that to live intelligently in our world,—that is, to adapt our conduct to future facts,—we must use the principle that things similar in some respects will behave similarly in certain other respects even when they are very different in still other respects. We cannot make an exhaustive classification of things, but must take various and shifting groupings according to the purpose or problem in view, assimilating things now on the basis of one common property (mode of behavior) and now on the basis of another. The working assumption of practical inference about the environment is thus a working number of properties or modes of resemblance between things, not a workable number of kinds of things; this latter we do not have. That is, the properties of things which influence our reactions toward them must be sufficiently limited in number and in modes of association for intelligence to grasp.
We may sum up these facts about the environment of our lives which are fundamental for conduct in the following propositions:
- 1. The world is made up of objects which are practically infinite in variety as aggregates of sensible qualities and modes of behavior not immediately sensible. And when we consider the number of objects which function in any particular conduct situation, and their possible variety, it is evident that only an infinite intelligence could grasp all the possible combinations.
- 2. Finite intelligence is able to deal with the world because
- a. The number of distinguishable properties and modes of behavior is limited, the infinite variety in nature being due to different combinations of the attributes in objects.
- b. Because the properties of things remain fairly constant; and
- c. Such changes in them as take place occur in fairly constant and ascertainable ways.
- d. The non-sensible properties and modes of behavior of things are associated with sensible properties in at least fairly uniform ways.
It is to be noted under (a) that differences in kind are referred to rather than differences in degree, and we should add that
- 3. The quantitative aspect of things and the power of intelligence to deal with quantity is a fundamental element in the situation.
- 4. It is also fundamental that in regard to certain properties objects differ only in degree, that mass and spacial magnitude are universal qualities of things, which do not exhibit differences in kind.
- 5. Following out the same principle of (4) many of the most significant properties are common to very large groups; in respect to the qualities most important for conduct, there are a very few kinds. The intelligibility of the world is enormously increased if not actually made possible by the simplicity of the great divisions into solid, liquid, and gas, into living and not-living things, and the like. And there is a hierarchy of attributes in order of generality down to the slight peculiarities which probably distinguish in some manner and degree (other than mere situation) every nameable thing in the universe from every other, giving it individuality.
- 6. The postulates of intelligent behavior would be very incomplete without formal insistence on the rôle played by the fact of consciousness in "objects" outside ourselves, human beings and animals. The behaviorist notwithstanding, the inferences as to the behavior to be anticipated which we draw from the configuration of the lines about the mouth, the gleam or "twinkle" of an eye or a shrill or "soft" vocal sound, are not made from these physical features as such or alone, but through "sympathetic introspection" into what is going on in the "mind" of the "object" contemplated, and would be impossible without this mysterious capacity of interpretation. It is always possible for the scientist to argue the contrary, as it is for him to demonstrate that we are not really conscious ourselves, but common sense properly revolts against the one conclusion as against the other.
- 7. It goes without saying that we must know ourselves as well as the world. Hence we must list our sense of our own powers of movement, etc.
It is perhaps superfluous to speak here of the syllogism and its place in logical theory. Empirical logicians such as Mill and Venn have ventilated the subject sufficiently and shown that no real inference is involved in the syllogism itself, that the inference takes place in the formulation of the premises and consists in the recognition of a constant factual connection between the predicates denoted by the different terms.
We are rather concerned here with pointing out that the theory of knowledge as it is worked out by logicians is primarily a theory of exact knowledge, of rigorous demonstration. It has become somewhat the fashion, especially since Bergson came into vogue, to be irrationalistic, and question the validity of logical processes. It seems to the writer that there is much ground for this position, but that its implications are very liable to be misunderstood. There is to my mind no question of understanding the world by any other method. There is, however, much question as to how far the world is intelligible at all. This will be seen to be a question of the facts as to the uniformity of behavior of natural objects and the similarities subsisting between them, on the ground of which inference is made from one to another. In so far as there is "real change" in the Bergsonian (i.e., Heracleitean) sense it seems clear that reasoning is impossible. In addition we have to make the still more questionable assumption that the situation elements or fundamental kinds of object properties upon which we fall back for simplicity (practically finitude) in view of the unmanageable number of kinds of objects as wholes, are unvarying from one "combination" (i.e., one object) to another. This assumption is doubtless valid in some connections. Thus weight, inertia, etc., are undoubtedly the same in a living as in a non-living object. But that the quality "living" is really the same in any two kinds of living things is more open to doubt. In so far as these general attributes are not uniform and cannot be given a definite meaning which is the same for all the objects in the class which they designate, reasoning from one member of the class to another is clearly invalid. That is, valid classification assumes identity in some respect. It is not absolutely certain that the ground on which we ascribe similarity to things and class them together and reason from the behavior of one to that of the other is always of this character. The power of one thing to suggest another is often quite mysterious, and may possibly not rest upon the possession of any common real qualities which will support a valid inference.
The practical limitation of knowledge, however, rests upon very different grounds. The universe may not be ultimately knowable (we speak, of course, only of objective phenomena, of behavior, not of problems which transcend ordinary experience of fact); but it is certainly knowable to a degree so far beyond our actual powers of dealing with it through knowledge that any limitations of knowledge due to lack of real consistency in the cosmos may be ignored. It probably occasions surprise to most persons the first time they consider seriously what a small portion of our conduct makes any pretense to a foundation in accurate and exhaustive knowledge of the things we are dealing with.
It is only when our interest is restricted to a very narrow aspect of the behavior of an object, dependent upon its physical attributes of size, mass, strength, elasticity, or the like, that exact determination is theoretically possible; and only by refined laboratory technique that the determination can be actually made. The ordinary decisions of life are made on the basis of "estimates" of a crude and superficial character. In general the future situation in relation to which we act depends upon the behavior of an indefinitely large number of objects, and is influenced by so many factors that no real effort is made to take account of them all, much less estimate and summate their separate significances. It is only in very special and crucial cases that anything like a mathematical (exhaustive and quantitative) study can be made.
The mental operations by which ordinary practical decisions are made are very obscure, and it is a matter for surprise that neither logicians nor psychologists have shown much interest in them. Perhaps (the writer is inclined to this view) it is because there is really very little to say about the subject. Prophecy seems to be a good deal like memory itself, on which it is based. When we wish to think of some man's name, or recall a quotation which has slipped our memory, we go to work to do it, and the desired idea comes to mind, often when we are thinking about something else—or else it does not come, but in either case there is very little that we can tell about the operation, very little "technique." So when we try to decide what to expect in a certain situation, and how to behave ourselves accordingly, we are likely to do a lot of irrelevant mental rambling, and the first thing we know we find that we have made up our minds, that our course of action is settled. There seems to be very little meaning in what has gone on in our minds, and certainly little kinship with the formal processes of logic which the scientist uses in an investigation. We contrast the two processes by recognizing that the former is not reasoned knowledge, but "judgment," "common sense," or "intuition." There is doubtless some analysis of a crude type involved, but in the main it seems that we "infer" largely from our experience of the past as a whole, somewhat in the same way that we deal with intrinsically simple (unanalyzable) problems like estimating distances, weights, or other physical magnitudes, when measuring instruments are not at hand.
The foregoing discussion of reasoning relates to ideal or complete inference based on uniformity of association of predicates and which can be formulated in universal propositions. The theory of formal deductive logic has, of course, always recognized also reasoning from what are undescriptively called "particular" propositions—"occasional" would be a better term—asserting that two predicates sometimes belong to the same subject, or that two classes of objects overlap. The goal of science is always to get rid of this form of assertion, to "explain" the occurrence and non-occurrence of the quality by finding some other general fact in the past history of the object with which the association is universal. But there are large classes of cases in which this cannot be done even scientifically, and the rough operations of everyday unscientific thinking employ the form quite commonly. In the crude form of "someX is Y," such generalizations are very unsatisfactory to the scientific mind and practically useless except as a challenge and starting-point for further inquiry. But when, as is so commonly the case, it is impossible or impracticable to do better, the data can often be put in a form of a great deal of scientific utility. This is done by ascertaining the numerical proportion of the cases in which X is associated with Y, which yields the familiar probability judgment. If, say, ninety per cent of X is Y,—i.e., if that fraction of objects characterized by property X shows also property Y,—the fact may obviously have much the same significance for conduct as if the association were universal.
Furthermore, even if the proportion is not approximately one hundred per cent, even if it is only half or less, the same fact may hold good. If in a certain class of cases a given outcome is not certain, nor even extremely probable, but only contingent, but if the numerical probability of its occurrence is known, conduct in relation to the situation in question may be ordered intelligently. Business operations, as already observed, illustrate the point perfectly. Thus, in the example given by von Mangoldt, the bursting of bottles does not introduce an uncertainty or hazard into the business of producing champagne; since in the operations of any producer a practically constant and known proportion of the bottles burst, it does not especially matter even whether the proportion is large or small. The loss becomes a fixed cost in the industry and is passed on to the consumer, like the outlays for labor or materials or any other. And even if a single producer does not deal with a sufficiently large number of cases of the contingency in question (in a sufficiently short period of time) to secure constancy in its effects, the same result may easily be realized, through an organization taking in a large number of producers. This, of course, is the principle of insurance, as familiarly illustrated by the chance of fire loss. No one can say whether a particular building will burn, and most building owners do not operate on a sufficient scale to reduce the loss to constancy (though some do). But as is well known, the effect of insurance is to extend this base to cover the operations of a large number of persons and convert the contingency into a fixed cost. It makes no difference in the principles whether the grouping of cases is effected through a mutual organization of the persons directly affected or through an outside commercial agency.
It will be evident that the practical difficulties of ordering conduct intelligently are enormously increased where the inference is contingent instead of being positive. The difficulties of establishing an association between predicates are great enough where the association is universal; so great, as we have already seen, that it is never done with any approach to accuracy except for critical cases of very special importance justifying extensive study in laboratory or "field." Where the connection is occasional, demonstration of a dependable connection is vastly more difficult, and there is the added problem of ascertaining the precise proportion of cases in which the connection occurs. In relation to everyday problems, where rigorous scientific procedure is excluded, the difficulty and chance of error are, of course, multiplied in still greater degree. We have to "estimate" not merely factors whose associates, implications, or effects are known, but in addition the degree of dependability of the association between the (estimated) factors (the immediately perceptible attributes or modes of behavior) and the inferred factors with relation to which our action in the case is to be controlled. Most of the real decisions of life are based on "reasoning" (if such it may be called) of this still more tenuous and uncertain character, and not even that which has already been described. We have to estimate the given factors in a situation and also estimate the probability that any particular consequence will follow from any of them if present in the degree assumed.
For logical accuracy and in order to understand the different kinds of situations and modes of dealing with them in practice, a further distinction must be drawn, a distinction of far-reaching consequences and much neglected in the discussion of economic problems. There are two fundamentally different ways of arriving at the probability judgment of the form that a given numerical proportion of X's are also Y's. The first method is by a priori calculation, and is applicable to and used in games of chance. This is also the type of case usually assumed in logical and mathematical treatments of probability. It must be strongly contrasted with the very different type of problem in which calculation is impossible and the result is reached by the empirical method of applying statistics to actual instances. As an illustration of the first type of probability we may take throwing a perfect die. If the die is really perfect and known to be so, it would be merely ridiculous to undertake to throw it a few hundred thousand times to ascertain the probability of its resting on one face or another. And even if the experiment were performed, the result of it would not be accepted as throwing any light on the actual probability. The mathematician can easily calculate the probability that any proposed distribution of results will come out of any given number of throws, and no finite number would give certainty as to the probable distribution. On the other hand, consider the case already mentioned, the chance that a building will burn. It would be as ridiculous to suggest calculating from a priori principles the proportion of buildings to be accidentally destroyed by fire in a given region and time as it would to take statistics of the throws of dice.
The import of this distinction for present purposes is that the first, mathematical or a priori, type of probability is practically never met with in business, while the second is extremely common. It is difficult to think of a business "hazard" with regard to which it is in any degree possible to calculate in advance the proportion of distribution among the different possible outcomes. This must be dealt with, if at all, by tabulating the results of experience. The "if at all" is an important reservation, which will be discussed presently. It is evident that a great many hazards can be reduced to a fair degree of certainty by statistical grouping—also that an equally important category cannot. We should note, however, two other facts. First, the statistical treatment never gives closely accurate quantitative results. Even in such simple cases as mechanical games of chance it would never be final, short of an infinite number of instances, as already observed. Furthermore, the fact that a priori methods are inapplicable is connected with a much greater complication in the data, which again carries with it a difficulty, in fact impossibility, of securing the same degree of homogeneity in the instances classed together. This point will have to be gone into more fully. The second fact mentioned in regard to the two methods is that the hazards or probabilities met with in business do admit of a certain small degree of theoretical treatment, supplementing the application of experience data. Thus in the case of fire risk on buildings, the fact that the cases are not really homogeneous may be offset in part by the use of judgment, if not calculation. It is possible to tell with some accuracy whether the "real risk" in a particular case is higher or lower than that of a group as a whole, and by how much. This procedure, however, must be treated with caution. It is not clear that there is an ultimate separation between the calculation of departures from a standard type and more minute classification of types. There is, however, a difference in form, and insurance companies constantly follow both practices, that of defining groups as accurately as possible and also that of modifying or adjusting the coefficient applied within a class according to special circumstances which are practically always present.
We thus find that there are two logically different types of inference included in the probability judgment. We shall refer to these for brevity under the names of the "a priori" and the "statistical" respectively. The relations between the two concepts as employed in the crude usage of common sense are much confused and the ideas themselves blurred, so that it is important to emphasize the contrast. The precise meaning of "real probability" will have to be examined more in detail presently, but we can see that there is a difference in this respect in our feelings toward the two classes of cases. It seems clear that the probability of getting a six in throwing a die is "really" one in six, no matter what actually happens in any particular number of throws; but no one would assert confidently that the chance of a particular building burning on a particular day is "really" of any definite assigned value. The first statement has intuitive certainty with reference to a particular instance; in case of the second it is merely an empirical generalization with reference to a group. Possibly the difference is partly a matter of habit in our thinking and to some extent illusory, but it is none the less real and functional in our thinking. There is, indeed, a sort of logical paradox in the problem. If the probability in a game of chance is questioned, there is no test except that of experimental trial of a large number of cases, and under some circumstances we should conclude that the die was probably "loaded." This would itself be a probability judgment, to be sure, and would depend on the fact of our ignorance of the composition and manufacture of the die. Given this ignorance, a mathematician could tell the probability that the die is false, indicated by any given number and distribution of throws.
The practical difference between a priori and statistical probability seems to depend upon the accuracy of classification of the instances grouped together. In the case of the die, the successive throws are held to be "alike" in a degree and a sense which cannot be predicated of the different buildings exposed to fire hazard. There is, of course, a constant effort on the part of the actuary to make his classifications more exact, dividing groups into subgroups to secure the greatest possible homogeneity. Yet we can hardly conceive this process being carried so far as to make applicable the idea of real probability in a particular instance.
There is a further difficulty, amounting to paradox, in the idea of homogeneous grouping. Much is made of this point in treatises on statistics, the student being warned against drawing conclusions from distributions in nonhomogeneous groups. Perhaps the most familiar example is the age and sex distribution of population aggregates. An illustration (used by Secrist) is the death rate of the American soldiers in the Philippines, which was lower than that of the general population in the United States. The fallacy in the inference as to healthfulness of environment is, of course, that the "general population" is not a homogeneous group, but is made up of numerous age, sex, race, and occupation classes, "naturally" subject to widely different death rates. The paradox, which carries us at once into the heart of the logical problem of probability, is that if we had absolutely homogeneous groups we should have uniformity and not probability in the result, or else we must repudiate the dogma of the ultimate uniformity of nature, the persistence of identity in things. If the idea of natural law is valid at all, it would seem that men exactly alike and identically circumstanced would all die at once; in any particular interval either all or none would succumb, and the idea of probability becomes meaningless. So even in the case of the dice; if we believe in the postulates which make knowledge possible, then dice made alike and thrown alike will fall alike, and that is the end of it.
Yet practically there is no danger, figuratively speaking, that any of these phenomena will ever be amenable to prediction in the individual instance. The fundamental fact underlying probability reasoning is generally assumed to be our ignorance. If it were possible to measure with absolute accuracy all the determining circumstances in the case it would seem that we should be able to predict the result in the individual instance, but it is obtrusively manifest that in many cases we cannot do this. It will certainly not be proposed in the typical insurance situations, the chance of death and of fire loss, probably not even in the case of gambling devices. The question arises whether we should draw a distinction between necessary and only factual ignorance of the data in a given case. Take the case of balls in an urn. One man knows that there are red and black balls, but is ignorant of the numbers of each; another knows that the numbers are three of the former to one of the latter. It may be argued that "to the first man" the probability of drawing a red ball is fifty-fifty, while to the second it is seventy-five to twenty-five. Or it may be contended that the probability is "really" in the latter ratio, but that the first man simply does not know it. It must be admitted that practically, if any decision as to conduct is involved, such as a wager, the first man would have to act on the supposition that the chances are equal. And if the real probability reasoning is followed out to its conclusion, it seems that there is "really" no probability at all, but certainty, if knowledge is complete. The doctrine of real probability, if it is to be valid, must, it seems, rest upon inherent unknowability in the factors, not merely the fact of ignorance. And even then we must always consult the empirical facts, for it will not do to assume out of hand that the unknown causes in a case will distribute themselves according to the law of indifference among the different instances. We seem to be driven back to a logical impasse. The postulates of knowledge generally involve the conclusion that it is really determined in the nature of things which house will burn, which man die, and which face of the thrown die will come uppermost. The logic which we actually use, however, assumes that the result is really indeterminate, that the unknowable causes actually follow a law of indifference. The phenomenal constancy of distribution to which we are forced to appeal justifies this reasoning on the whole, but clearly is not its actual basis in our thinking. Wherever we find that there is not indifference, that the results show "bias," we assume some determinable cause at work; and the results of experience on the whole justify this assumption also.
There is a further point of some interest in regard to our probability reasoning. Examination of the mathematical theory of probability will show that the argument always proceeds on the assumption that there is no middle ground between complete determination and complete indifference. That is, the elementary probabilities in any form of problem must always be equal. If the chance of any particular result is more or less than one half, it is held to be axiomatic that there is a greater number of possible alternatives which yield this result (or do not yield it) than of the other kind; the alternatives themselves must be equally probable. The whole mathematical theory of probability is obviously a simple application of the principles of permutations and combinations for finding out the number of alternatives. Absolute indifference between the alternatives is taken for granted. Wherever the results do not show complete indifference between alternatives it is assumed that these are not simple, and further analysis is applied to reduce them to combinations of equally possible ones. And experience confirms these assumptions also.
Are we, then, to assume real indeterminateness, in the cosmos itself? This was the view of Cournot, and the mere ignorance theory common among writers on probability seems inadequate and untenable. There are, to be sure, cases which it seems to fit, like that referred to, where the probability of drawing a red or black ball is even to one who knows only that there are balls of the two colors in the urn, but is ignorant of the numbers of each. But the case of the man who does know the numbers of each seems to be different. The dogmatic determinist can always maintain that there are causes at work which decide the result, but common sense is not satisfied. How does it "happen" that experience justifies the calculation of probabilities unless these unknown causes are really indifferent? Whenever we find "bias" in the results, a divergence from the anticipations on the basis of probability theory, we assume the presence of some cause which is not indifferent, and this procedure is also justified of its fruits. When we can be sure that we have eliminated every circumstance which can be measured or which might act consistently, we feel confident in assuming that in a large number of trials the results will come out in accordance with the assumption that the factors not subject to measurement or elimination are in fact indifferent. And not merely do we feel this way, but "it works."
It is interesting to observe that the common applications of probability in games of chance relate to some action of the human organism itself, the drawing of a card from a deck or ball from an urn after random manipulations, the impulse given to a wheel or coin or die, etc. The facts suggest a connection with that other age-old bone of contention, the freedom of the will. If there is real indeterminateness, and if the ultimate seat of it is in the activities of the human (or perhaps organic) machine, there is in a sense an opening of the door to a conception of freedom in conduct. And when we consider the mystery of the rôle of consciousness in behavior and the repugnance which is felt by common sense to the epiphenomenal theory, we feel justified in further contending for at least the possibility that "mind" may in some inscrutable way originate action. Just how much or what sort of significance the admission may have for practical ethics is another question, which must be passed over here. Of course we cannot prove that the exact distribution of all the coups of the roulette wheels at Monte Carlo was not stowed away somewhere in the primeval nebula; the final appeal must be to "intrinsic reasonableness," the inveterate and necessary preference of intelligence for the simplest formulation which conforms to the facts. And about this, there may indeed be differences of opinion, and from these there is apparently no appeal.
There may be different brands of "common sense" (which some wag has averred is so called because so very uncommon). In the writer's view the doctrine of ignorance or "insufficient reason" is untrue to the feelings of unsophisticated intelligence. We do not merely feel that we know no reason why the coin shall fall heads or tails; we know in a positive sense that there is no reason, and only under this condition do we make the probability judgment with any confidence. And furthermore, as already argued, it appears that only on condition that there is no reason would the results of experience, confirm the judgment, as they do. The entire science of probability in the mathematical sense is based on the dogmatic assumption that the ultimate alternatives are really equally probable, which seems to the writer to mean real indeterminateness.
Professor Irving Fisher's view of probability as "always an estimate" becomes conditionally valid, however, on two interpretations. In the first place, it may be saved "theoretically" if the term "estimate" is construed broadly enough. If there is no difference between our a priori judgment of the absence of any cause which should lead a coin or a die to fall on one face rather than another and an "estimate" of equal probability, then there is no opposition between the two views. This is, however, repugnant to common sense (the present writer's brand). We seem to experience an "apodeictic certainty" about the situation of a game of chance, on a level with our confidence in the axioms of mathematics, and quite different from an "estimate." To illustrate, suppose we are allowed to look into the urn containing a large number of black and red balls before making a wager, but are not allowed to count the balls; this would give rise to an estimate of probability in the correct sense; it is something very different from either the mere consciousness or ignorance on which we act if we know only that there are balls of both colors without any knowledge or opinion as to the numbers or the exact knowledge of real probability attained by an accurate counting of the balls. In the second place, we must admit that the actual basis of action in a large proportion of real cases is an estimate. Neither of these interpretations, however, justifies identifying probability with an estimate.
But the probability in which the student of business risk is interested is an estimate, though in a sense different from any of the propositions so far considered. To discuss the question from this new point of view we must go back for a moment to the general principles of the logic of conduct. We have emphasized above that the exact science of inference has little place in forming the opinions upon which decisions of conduct are based, and that this is true whether the implicit logic of the case is prediction on the ground of exhaustive analysis or a probability judgment, a priori or statistical. We act upon estimates rather than inferences, upon "judgment" or "intuition," not reasoning, for the most part. Now an estimate or intuitive judgment is somewhat like a probability judgment, but very different from either of the types of probability judgment already described. The relations between the two sorts are in fact amazingly complex and as fraught with logical paradox as the probability judgment itself. If the term "probability" is to be applied to an estimate—and the usage is so well established that there is no hope of getting away from it—a third species under that genus must be recognized. Such a third type of probability fits very nicely in a scheme of classification with the two already discussed. We have insisted that there is a fundamental difference between "a priori" probability, on the one hand, and "statistical," on the other. In the former the "chances" can be computed on general principles, while in the latter they can only be determined empirically. This distinction is in opposition to the views of writers such as Venn and Edgeworth, who reduce the former type to the latter on the basis of an empirical law of large numbers and accept practically the assumption of real indeterminateness. We have already raised the question of accuracy of classification in this connection, suggesting that the "instances," "throws," or "coups" in a game of chance form a homogeneous group in a higher sense than can be predicated on life or fire hazards. This view and our entire theory tend to be confirmed by the attempt to secure complete homogeneity through more minute classification. The end result of this endeavor would be groupings in which only really indeterminate factors should differ from one instance to another.
Taking, then, the classification point of view, we shall find the following simple scheme for separating three different types of probability situation:
- 1.A priori probability. Absolutely homogeneous classification of instances completely identical except for really indeterminate factors. This judgment of probability is on the same logical plane as the propositions of mathematics (which also may be viewed, and are viewed by the writer, as "ultimately" inductions from experience).
- 2. Statistical probability. Empirical evaluation of the frequency of association between predicates, not analyzable into varying combinations of equally probable alternatives. It must be emphasized that any high degree of confidence that the proportions found in the past will hold in the future is still based on an a priori judgment of indeterminateness. Two complications are to be kept separate: first, the impossibility of eliminating all factors not really indeterminate; and, second, the impossibility of enumerating the equally probable alternatives involved and determining their mode of combination so as to evaluate the probability by a priori calculation. The main distinguishing characteristic of this type is that it rests on an empirical classification of instances.
- 3. Estimates. The distinction here is that there is no valid basis of any kind for classifying instances. This form of probability is involved in the greatest logical difficulties of all, and no very satisfactory discussion of it can be given, but its distinction from the other types must be emphasized and some of its complicated relations indicated.
We know that estimates or judgments are "liable" to err. Sometimes a rough determination of the magnitude of this "liability" is possible, but more generally it is not. In general, any determination of the value of an estimate must be merely empirical, secured by the tabulation of instances, thus reducing it to a probability of the second or statistical type. Indeed, since, as we have noticed, entirely homogeneous classification of instances is practically never possible in dealing with statistical probability, it is clear that the divergence from it of this third type where all classification is excluded is a matter of degree only. There are all gradations from a perfectly homogeneous group of life or fire hazards at one extreme to an absolutely unique exercise of judgment at the other. All gradations, we should say, except the ideal extremes themselves; for as we can never in practice secure completely homogeneous classes in the one case, so in the other it probably never happens that there is no basis of comparison for determining the probability of error in a judgment.
The theoretical difference between the probability connected with an estimate and that involved in such phenomena as are dealt with by insurance is, however, of the greatest importance, and is clearly discernible in nearly any instance of the exercise of judgment. Take as an illustration any typical business decision. A manufacturer is considering the advisability of making a large commitment in increasing the capacity of his works. He "figures" more or less on the proposition, taking account as well as possible of the various factors more or less susceptible of measurement, but the final result is an "estimate" of the probable outcome of any proposed course of action. What is the "probability" of error (strictly, of any assigned degree of error) in the judgment? It is manifestly meaningless to speak of either calculating such a probability a priori or of determining it empirically by studying a large number of instances. The essential and outstanding fact is that the "instance" in question is so entirely unique that there are no others or not a sufficient number to make it possible to tabulate enough like it to form a basis for any inference of value about any real probability in the case we are interested in. The same obviously applies to the most of conduct and not to business decisions alone.
Yet it is true, and the fact can hardly be overemphasized, that a judgment of probability is actually made in such cases. The business man himself not merely forms the best estimate he can of the outcome of his actions, but he is likely also to estimate the probability that his estimate is correct. The "degree" of certainty or of confidence felt in the conclusion after it is reached cannot be ignored, for it is of the greatest practical significance. The action which follows upon an opinion depends as much upon the amount of confidence in that opinion as it does upon the favorableness of the opinion itself. The ultimate logic, or psychology, of these deliberations is obscure, a part of the scientifically unfathomable mystery of life and mind. We must simply fall back upon a "capacity" in the intelligent animal to form more or less correct judgments about things, an intuitive sense of values. We are so built that what seems to us reasonable is likely to be confirmed by experience, or we could not live in the world at all.
Fidelity to the actual psychology of the situation requires, we must insist, recognition of these two separate exercises of judgment, the formation of an estimate and the estimation of its value. We must, therefore, disagree with Professor Irving Fisher's contention that there is only one estimate, the subjective feeling of probability itself. Moreover, it appears that the original estimate may be a probability judgment. A man may act upon an estimate of the chance that his estimate of the chance of an event is a correct estimate. To be sure, after the decision is made he will be likely to sum all up in a certain degree of confidence that a certain outcome will be realized, and in practice may go farther and assume that the outcome itself is a certainty.
Two sorts of difficulty tend to obscure the relation between our second and third types of probability, that which rests upon an empirical classification of instances and that which rests upon no classification, but is an estimate of an estimate. In the first place, nothing in the universe of experience is absolutely unique any more than any two things are absolutely alike. Consequently it is always possible to form classes if the bars are let down and a loose enough interpretation of similarity is accepted. Thus, in the case above mentioned, it might or might not be entirely meaningless to inquire as to the proportion of successful factory extensions and the proportion of those which are not. In this particular case it is hard to imagine that any one would base conduct upon a judgment of the probability of success arrived at in this way, but in other situations the method could conceivably have more or less validity. We must keep in mind that for conduct a probability judgment based on mere ignorance may be determining if it is the best that can be had. It would be a question, however, whether the person placed in the position of our business manager should regard the probability for him of success as that indicated by statistics of "similar" instances or simply even chances each way based on the fact, of pure ignorance. What does appear certain is that his own estimate of the value of his own judgment would be given far greater weight than either sort of computation.
A still more interesting complication, and one of much greater practical significance, is the possibility of forming a class of similar instances on entirely different grounds. That is, instead of taking the decisions of other men in situations more or less similar objectively, we may take decisions of the same man in all sorts of situations. It is indisputable that this procedure is followed in fact to a very large extent and that an astounding number of decisions actually rest upon such a probability judgment, though it cannot be placed in the form of a definite statistical determination. That is, men do form, on the basis of experience, more or less valid opinions as to their own capacity to form correct judgments, and even of the capacities of other men in this regard. To be sure, both bases of classification are more or less taken into account; the estimate (by A or any one else) of the probability that the outcome of a situation will be that which A has predicted is not based on a perfectly general estimate of A's capacity to form judgments, but of his powers in a more or less defined field of prediction. It will at once occur to the reader that this capacity for forming correct judgments (in a more or less extended or restricted field) is the principal fact which makes a man serviceable in business; it is the characteristic human activity, the most important endowment for which wages are received. The stability and success of business enterprise in general is largely dependent upon the possibility of estimating the powers of men in this regard, both for assigning men to their positions and for fixing the remunerations which they are to receive for filling positions. The judgment or estimate as to the value of a man is a probability judgment of a complex nature, indeed. More or less based on experience and observation of the outcome of his predictions, it is doubtless principally after all simply an intuitive judgment or "unconscious induction," as one prefers.
It seems likely that a still further distinction may be drawn, leading to the recognition of another basis of classification of instances in order to reach a probability judgment. We mean the subjective feeling of confidence of the person making a prediction. I may have an intuitive feeling or "hunch" that a situation will eventuate in a certain way, and this feeling may inspire a more or less deliberative confidence by its very strength and persistence. The confidence in a prediction which is based on the strength of an intuition may appear to be compounded to the point of nonsense, but in so far as there exist such feelings reached unconsciously or without deliberation and in so far as they may become the objects of deliberative contemplation, the situation is none the less real. However, we cannot extend our inquiry to cover all the grounds on which men, even educated men, actually make decisions, or it will degenerate into a catalogue of superstitions. Let us try, then, to sum up the conclusions, significant for present purposes, to which the argument of the chapter leads.
The importance of uncertainty as a factor interfering with the perfect workings of competition in accordance with the laws of pure theory necessitated an examination of foundations of knowledge and conduct. The most important result of this survey is the emphatic contrast between knowledge as the scientist and the logician of science uses the term and the convictions or opinions upon which conduct is based outside of laboratory experiments. The opinions upon which we act in everyday affairs and those which govern the decisions of responsible business managers for the most part have little similarity with conclusions reached by exhaustive analysis and accurate measurement. The mental processes are entirely different, in the two cases. In everyday life they are mostly subconscious. We know as little why we expect certain things to happen as we do the mechanism by which we recall a forgotten name. There is doubtless some analogy between the subconscious processes of "intuition" and the structure of logical deliberation, for the function of both is to anticipate the future and the possibility of prediction seems to rest upon the uniformity of nature. Hence there must be, in the one case as in the other, some sort and amount of analysis and synthesis; but the striking feature of the judging faculty is its liability to error.
The real logic or psychology of ordinary conduct is rather a neglected branch of inquiry, logicians having devoted their attention more to the structure of demonstrative reasoning. This is in a way inevitable, since the processes of intuition or judgment, being unconscious, are inaccessible to study. Such attention as has been given to the problem of intuitive estimation has been connected with and largely vitiated by confusion with the logic of probability. A brief examination of the probability judgment shows it to fall into two types, which we called the a priori and the statistical. In the latter type of situation, we cannot, as we can in the former, calculate the true probability from external data, but must derive it from an inductive study of a large group of cases. This limitation involves a serious logical weakness, since at best statistics give but a probability as to what the true probability is. In practice we are still further handicapped by the impossibility of attaining complete homogeneity in our groups of instances, in the sense in which the "coups" in a priori probability are homogeneous; that is, that the divergences are practically indeterminate as well as undetermined.
The liability of opinion or estimate to error must be radically distinguished from probability or chance of either type, for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability. Business decisions, for example, deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable. The confusion arises from the fact that we do estimate the value or validity or dependability of our opinions and estimates, and such an estimate has the same form as a probability judgment; it is a ratio, expressed by a proper fraction. But in fact it appears to be meaningless and fatally misleading to speak of the probability, in an objective sense, that a judgment is correct. As there is little hope of breaking away from well-established linguistic usage, even when vicious, we propose to call the value of estimates a third type of probability judgment, insisting on its differences from the other types rather than its similarity to them.
It is this third type of probability or uncertainty which has been neglected in economic theory, and which we propose to put in its rightful place. As we have repeatedly pointed out, an uncertainty which can by any method be reduced to an objective, quantitatively determinate probability, can be reduced to complete certainty by grouping cases. The business world has evolved several organization devices for effectuating this consolidation, with the result that when the technique of business organization is fairly developed, measurable uncertainties do not introduce into business any uncertainty whatever. Later in our study we shall glance hurriedly at some of these organization expedients, which are the only economic effect of uncertainty in the probability sense; but the present and more important task is to follow out the consequences of that higher form of uncertainty not susceptible to measurement and hence to elimination. It is this true uncertainty which by preventing the theoretically perfect outworking of the tendencies of competition gives the characteristic form of "enterprise" to economic organization as a whole and accounts for the peculiar income of the entrepreneur.
Part III, Chapter VIII
Structures and Methods for Meeting Uncertainty
To preserve the distinction which has been drawn in the last chapter between the measurable uncertainty and an unmeasurable one we may use the term "risk" to designate the former and the term "uncertainty" for the latter. The word "risk" is ordinarily used in a loose way to refer to any sort of uncertainty viewed from the standpoint of the unfavorable contingency, and the term "uncertainty" similarly with reference to the favorable outcome; we speak of the "risk" of a loss, the "uncertainty" of a gain. But if our reasoning so far is at all correct, there is a fatal ambiguity in these terms, which must be gotten rid of, and the use of the term "risk" in connection with the measurable uncertainties or probabilities of insurance gives some justification for specializing the terms as just indicated. We can also employ the terms "objective" and "subjective" probability to designate the risk and uncertainty respectively, as these expressions are already in general use with a signification akin to that proposed.
The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of past experience), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique. The best example of uncertainty is in connection with the exercise of judgment or the formation of those opinions as to the future course of events, which opinions (and not scientific knowledge) actually guide most of our conduct. Now if the distribution of the different possible outcomes in a group of instances is known, it is possible to get rid of any real uncertainty by the expedient of grouping or "consolidating" instances. But that it is possible does not necessarily mean that it will be done, and we must observe at the outset that when an individual instance only is at issue, there is no difference for conduct between a measurable risk and an unmeasurable uncertainty. The individual, as already observed, throws his estimate of the value of an opinion into the probability form of "a successes in b trials" (a/b being a proper fraction) and "feels" toward it as toward any other probability situation.
As so commonly in this subject fraught with logical difficulty and paradox, reservations must be made to the above statement. In the first place, it does not matter how unique the instance, if a real probability can be calculated, if we can know with certainty how many successes there would be in (say) one hundred trials if the one hundred trials could be made. If we know the odds against us it does not matter in the least whether we place all our wagers in one kind of game or in as many different games as there are wagers; the laws of probability hold in the second case just as well as in the first. But in business situations it so rarely happens that a probability can be computed for a single unique instance that this qualification has less weight than might be supposed. However, in so far as objective probability enters into a calculation, it is hard to imagine an intelligent individual considering any single case as absolutely isolated. The only exception would be a decision in which one's whole fortune (or his life) were at stake. The importance of the contingency and probable frequency of recurrence in the individual lifetime of situations similar in the magnitude of the issues involved should make a difference in the attitude assumed toward any one case as well as the mathematical probability of success or failure.
A second reservation of more importance is connected with the possibility referred to in the preceding chapter, of forming classes of cases by grouping the decisions of a given person. That is, even though we do not get a quantitative probability by the process of grouping, still there is some tendency for fluctuations to cancel out and for the result to approach constancy in some degree. There appear to be in the making of judgments the same two kinds of elements that we find in probability situations proper; i.e., (a) determinate factors (the quality of the judging faculty, which is more or less stable) and (b) truly accidental factors varying from one decision to another according to a principle of indifference. The difference between the uncertainty of an opinion and a true probability is that we have no means of separating the two and evaluating them, either by calculation a priori or by empirical sorting. But in the second case the difference is not absolute; the sorting method does apply to some extent, though within narrow limits. Life is mostly made up of uncertainties, and the conditions under which an error or loss in one case may be compensated by other cases are bafflingly complex. We can only say that "in so far as" one confronts a situation involving uncertainty and deals with it on its merits as an isolated case, it is a matter of practical indifference whether the uncertainty is measurable or not.
The problem of the human attitude toward uncertainty (not for the present purpose distinguishing kinds) is as beset with difficulties as that of uncertainty itself. Not merely is the human reaction to situations of this character apt to be erratic and extremely various from one individual to another, but the "normal" reaction is subject to well-recognized deviations from the conduct which sound logic would dictate. Thus it is a familiar fact, well discussed by Adam Smith, that men will readily risk a small amount in the hope of winning a large when the adverse probability (known or estimated) against winning is much in excess of the ratio of the two amounts, while they commonly will refuse to incur a small chance of losing a larger amount for a virtual certainty of winning a smaller, even though the actuarial value of the chance is in their favor. To this bias must be added an inveterate belief on the part of the typical individual in his own "luck," especially strong when the basis of the uncertainty is the quality of his own judgment. The man in the street has little more sense of the real value of his opinions than he has knowledge of the "logic" (if such it may be called) on which they rest. In addition, we must consider the almost universal prevalence of superstitions. Any coincidence that strikes attention is likely to be elevated into a law of nature, giving rise to a belief in an unerring "sign." Even a mere "hunch" or "something tells me," with no real or imaginary basis in the mind of the person himself, may readily be accepted as valid ground for action and treated as an unquestionable verity.
Doubtless in the long run of history there is a tendency toward rationality even in men's whims and impulses. And if for no other reason than the impossibility of intelligently dealing with conduct on any other hypothesis, we seem justified in limiting our discussion to rational grounds of action. We shall assume, then, that if a man is undergoing a sacrifice for the sake of a future benefit, the expected reward must be larger in order to evoke the sacrifice if it is viewed as contingent than if it is considered certain, and that it will have to be larger in at least some general proportion to the degree of felt uncertainty in the anticipation. It is clearly the subjective uncertainty which is decisive in such a case, what the man believes the chances to be, whether his degree of confidence is based upon an objective probability in the situation itself or in an estimate of his own powers of prediction. We hold also that both the objective and subjective types may be involved at the same time, though no doubt most men do not carry their deliberations so far; the man's opinion or prediction may be an estimate of an objective probability, and the estimate itself be recognized as having a certain degree of validity, so that the degree of felt uncertainty is a product of two probability ratios. It is to be emphasized again that practically all decisions as to conduct in real life rest upon opinions, and doubtless the greater part rest upon opinions which on scrutiny easily resolve themselves into an opinion of a probability—though as noted this "scrutiny" may not in most cases be given to the judgment by the individual making it.
The normal economic situation is of this character: The adventurer has an opinion as to the outcome, within more or less narrow limits. If he is inclined to make the venture, this opinion is either an expectation of a certain definite gain or a belief in the real probability of a larger one. Outside the limits of the anticipation any other result becomes more and more improbable in his mind as the amount thought of diverges either way. Hence it is correct to treat all instances of economic uncertainty as cases of choice between a smaller reward more confidently and a larger one less confidently anticipated.
At the bottom of the uncertainty problem in economics is the forward-looking character of the economic process itself. Goods are produced to satisfy wants; the production of goods requires time, and two elements of uncertainty are introduced, corresponding to two different kinds of foresight which must be exercised. First, the end of productive operations must be estimated from the beginning. It is notoriously impossible to tell accurately when entering upon productive activity what will be its results in physical terms, what (a) quantities and (b) qualities of goods will result from the expenditure of given resources. Second, the wants which the goods are to satisfy are also, of course, in the future to the same extent, and their prediction involves uncertainty in the same way. The producer, then, must estimate (1) the future demand which he is striving to satisfy and (2) the future results of his operations in attempting to satisfy that demand.
It goes without saying that rational conduct strives to reduce to a minimum the uncertainties involved in adapting means to ends. This does not mean, be it emphasized, that uncertainty as such is abhorrent to the human species, which probably is not true. We should not really prefer to live in a world where everything was "cut and dried," which is merely to say that we should not want our activity to be all perfectly rational. But in attempting to act "intelligently" we are attempting to secure adaptation, which means foresight, as perfect as possible. There is, as already noted, an element of paradox in conduct which is not to be ignored. We find ourselves compelled to strive after things which in a "calm, cool hour" we admit we do not want, at least not in fullness and perfection. Perhaps it is the manifest impossibility of reaching the end which makes it interesting to strive after it. In any case we do strive to reduce uncertainty, even though we should not want it eliminated from our lives.
The possibility of reducing uncertainty depends again on two fundamental sets of conditions: First, uncertainties are less in groups of cases than in single instances. In the case of a priori probability the uncertainty tends to disappear altogether, as the group increases in inclusiveness; with statistical probabilities the same tendency is manifest in a less degree, being limited by defectiveness of classification. And even the third type, true uncertainties, show some tendency toward regularity when grouped on the basis of nearly any similarity or common element. The second fact or set of facts making for a reduction of uncertainty is the differences among human individuals in regard to it. These differences are of many kinds and an enumeration of them will be undertaken presently. We may note here that they may be differences in the men themselves or differences in their position in relation to the problem. We may call the two fundamental methods of dealing with uncertainty, based respectively upon reduction by grouping and upon selection of men to "bear" it, "consolidation" and "specialization," respectively. To these two methods we must add two others which are so obvious as hardly to call for discussion: (3) control of the future, and (4) increased power of prediction. These are closely interrelated, since the chief practical significance of knowledge is control, and both are closely identified with the general progress of civilization, the improvement of technology and the increase of knowledge. Possibly a fifth method should be named, the "diffusion" of the consequences of untoward contingencies. Other things equal, it is a gain to have an event cause a loss of a thousand dollars each to a hundred persons rather than a hundred thousand to one person; it is better for two men to lose one eye than for one to lose two, and a system of production which wounds a larger number of workers and kills a smaller number is to be regarded as an improvement. In practice this diffusion is perhaps always associated with consolidation, but there is a logical distinction between the two and they may be practically separable in some cases. We must observe also that consolidation and specialization are intimately connected, a fact which will call for repeated emphasis as we proceed. In addition to these methods of dealing with uncertainty there is (6) the possibility of directing industrial activity more or less along lines in which a minimal amount of uncertainty is involved and avoiding those involving a greater degree.
One of the most immediate and most important consequences of uncertainty in economics may be disposed of as a preliminary to a detailed technical discussion. The essence of organized economic activity is the production by certain persons of goods which will be used to satisfy the wants of other persons. The first question which arises then is, which of these groups in any particular case, producers or consumers, shall do the foreseeing as to the future wants to be satisfied. It is perhaps obvious that the function of prediction in the technological side of production itself inevitably devolves upon the producer. At first sight it would appear that the consumer should be in a better position to anticipate his own wants than the producer to anticipate them for him, but we notice at once that this is not what takes place. The primary phase of economic organization is the production of goods for a general market, not upon direct order of the consumer. With uncertainty absent it would be immaterial whether the exchange of goods preceded or followed actual production. With uncertainty (in the two fields, production and wants) present it is still conceivable that men might exchange productive services instead of products, but the fact of uncertainty operates to bring about a different result. To begin with, modern society is organized on the theory (whatever the facts, about which some doubt may be expressed) that men predict the future and adapt their conduct to it more effectively when the results accrue to themselves than when they accrue to others. The responsibilities of controlling production thus devolve upon the producer.
But the consumer does not even contract for his goods in advance, generally speaking. A part of the reason might be the consumer's uncertainty as to his ability to pay at the end of the period, but this does not seem to be important in fact. The main reason is that he does not know what he will want, and how much, and how badly; consequently he leaves it to producers to create goods and hold them ready for his decision when the time comes. The clue to the apparent paradox is, of course, in the "law of large numbers," the consolidation of risks (or uncertainties). The consumer is, to himself, only one; to the producer he is a mere multitude in which individuality is lost. It turns out that an outsider can foresee the wants of a multitude with more ease and accuracy than an individual can attain with respect to his own. This phenomenon gives us the most fundamental feature of the economic system, production for a market, and hence also the general character of the environment in relation to which the effects of uncertainty are to be further investigated. Before continuing the inquiry into other phases and methods of the consolidation of risks, we shall turn briefly to consider the differences among individuals in their attitudes and reactions toward measurable or unmeasurable uncertainty.
We assume, as already observed, that although life is no doubt more interesting when conduct involves a certain amount of uncertainty,—the proper amount varying with individuals and circumstances,—yet that men do actually strive to anticipate the future accurately and adapt their conduct to it. In this respect we may distinguish at least five variable elements in individual attributes and capacities. (1) Men differ in their capacity by perception and inference to form correct judgments as to the future course of events in the environment. This capacity, furthermore, is far from homogeneous, some persons excelling in foresight in one kind of problem situations, others in other kinds, in almost endless variety. Of especial importance is the variation in the power of reading human nature, of forecasting the conduct of other men, as contrasted with scientific judgment in regard to natural phenomena. (2) Another, though related, difference is found in men's capacities to judge means and discern and plan the steps and adjustments necessary to meet the anticipated future situation. (3) There is a similar variation in the power to execute the plans and adjustments believed to be requisite and desirable. (4) In addition there is diversity in conduct in situations involving uncertainty due to differences in the amount of confidence which individuals feel in their judgments when formed and in their powers of execution; this degree of confidence is in large measure independent of the "true value" of the judgments and powers themselves. (5) Distinct from confidence felt is the conative attitude to a situation upon which judgment is passed with a given degree of confidence. It is a familiar fact that some individuals want to be sure and will hardly "take chances" at all, while others like to work on original hypotheses and seem to prefer rather than to shun uncertainty. It is common to see people act on assumptions in ways which their own opinions of the value of the assumption do not warrant; there is a disposition to "trust in one's luck."
The amount of uncertainty effective in a conduct situation is the degree of subjective confidence felt in the contemplated act as a correct adaptation to the future—number 4 above. It is clear that we may speak in some sense of the "true value" of judgment and of capacity to act, but it is the person's own opinion of these values which controls his activities. Hence the five variables are, from the standpoint of the person concerned, reduced to two, the (subjective or felt) uncertainty and his conative feeling toward it. For completeness we should perhaps add a sixth uncertainty factor, in the shape of occurrences so revolutionary and unexpected by any one as hardly to be brought under the category of an error in judgment at all.
In addition to the above enumeration of five or six distinct elements in the uncertainty situation we must point out that the first three variables named are themselves not simple. Judgment or foresight and the capacity for planning and the ability to execute action are each the product of at least four distinguishable factors, in regard to which the faculties in question may vary independently. These are (a) accuracy, (b) promptness or speed, (c) time range, and (d) space range, of the capacity or action. The first two of these require no explanation; it is evident that accuracy and rapidity of judgment and execution are more or less independent endowments. The third refers to the length of time in the future to which conduct is or may be adjusted, and the fourth to the scope or magnitude of the situation envisaged and the operations planned. Familiar also is the difference between individuals who have a mind for detail and those who confine their attention to the larger outlines of a situation. Even this rather complex outline is extremely simplified as compared with the facts of life in that it compasses only a rigidly "static" view of the problem. Quite as important as differences obtaining at any moment among individuals in regard to the attributes mentioned are their differences in capacity for change or development along the various lines.
We have classified the possible reactions to uncertainty under some half-dozen heads, each of which gives rise to special problems, though the social structures for dealing with these problems overlap a good deal. The most fundamental facts regarding uncertainty from our point of view are, first, the possibility of reducing it in amount by grouping instances; and, second, the differences in individuals in relation to uncertainty, giving rise to a tendency to specialize the function of meeting it in the hands of certain individuals and classes. The most fundamental effect of uncertainty on the social-economic organization—production for a general market on the producer's responsibility—has already been taken up; it is primarily a case of reduction of uncertainty by consolidation or grouping of cases. In the mere fact of production for a market, there is little specialization of uncertainty-bearing, and what there is is on a basis of the producer's position in relation to the problem, not his peculiar characteristics as a man. To isolate the phenomenon of production for a market from other considerations we must picture a pure "handicraft stage" of social organization. In such a system every individual would be an independent producer of some one finished commodity, and a consumer of a great variety of products. The late Middle Ages afford a picture of an approximation to such a state of affairs in a part of the industrial field.
The approximation is rather remote, however. A handicraft organization shows an irresistible tendency to pass over, even before well established, into a very different system, and this further development is also a consequence of the presence of uncertainty. The second system is that of "free enterprise" which we find dominant to-day. The difference between free enterprise and mere production for a market represents the addition of specialization of uncertainty-bearing to the grouping of uncertainties, and takes place under pressure of the same problem, the anticipation of wants and control of production with reference to the future. Under free enterprise the solution of this problem, already removed from the consumer himself, is further taken out of the hands of the great mass of producers as well and placed in charge of a limited class of "entrepreneurs" or "business men." The bulk of the producing population cease to exercise responsible control over production and take up the subsidiary rôle of furnishing productive resources (labor, land, and capital) to the entrepreneur, placing them under his sole direction for a fixed contract price.
We shall take up this phenomenon of free enterprise for detailed discussion in the next chapter, though we may note here two further facts regarding it; first, the "specialization" of uncertainty-bearing in the hands of entrepreneurs involves also a further consolidation; and, second, it is closely connected with changes in technological methods which (a) increase the time length of the production process and correspondingly increase the uncertainty involved, and (b) form producers into large groups working together in a single establishment or productive enterprise and hence necessitates concentration of control. The remainder of the present chapter will be devoted to a survey of the social structures evolved for dealing with uncertainty. Some of the phenomena will thus be finally disposed of, so far as the present work is concerned, especially those which already have a literature of their own and whose general bearings and place in a systematic treatment of uncertainty alone call for notice here. Other problems will be merely sketched in outline and reserved for fuller treatment in subsequent chapters, as has just been done with the subject of entrepreneurship.
Following the order of the classification already given of methods of dealing with uncertainty, the first subject for discussion is the institutions or special phenomena arising from the tendency to deal with uncertainty by consolidation. The most obvious and best known of these devices is, of course, insurance, which has already been repeatedly used as an illustration of the principle of eliminating uncertainty by dealing with groups of cases instead of individual cases. In our discussion of the theory of uncertainty in the foregoing chapter and at other points in the study we have emphasized the radical difference between a measurable and an unmeasurable uncertainty. Now measurability depends on the possibility of assimilating a given situation to a group of similars and finding the proportions of the members of the group which may be expected to exhibit the various possible outcomes. This assimilation of cases into classes may be exceedingly accurate, and the proportions of the various outcomes may be computable on a priori grounds by the application of the theory of permutations and combinations to determine the possible groupings of equally probable alternatives; but this rarely if ever happens in a practical business situation. The classification will be of all degrees of precision, but the ascertainment of proportions must be empirical. The application of the insurance principle, converting a larger contingent loss into a smaller fixed charge, depends upon the measurement of probability on the basis of a fairly accurate grouping into classes. It is in general not enough that the insurer who takes the "risk" of a large number of cases be able to predict his aggregate losses with sufficient accuracy to quote premiums which will keep his business solvent while at the same time imposing a burden on the insurer which is not too large a fraction of his contingent loss. In addition he must be able to present a fairly plausible contention that the particular insured is contributing to the total fund out of which losses are paid as they accrue in an amount corresponding reasonably well with his real probability of loss; i.e., that he is bearing his fair share of the burden.
The difficulty of a satisfactory logical discussion of the questions we are dealing with has repeatedly been emphasized, due to the fact that distinctions of the greatest importance tend to run together through intermediate degrees and become blurred. This is conspicuously the case with the measurability of uncertainty through classification of instances. We hardly find in practice really homogeneous classifications (in the sense in which mathematical probability implies, as in the case of successive throws of a perfect die) and at the other extreme it is hard to find cases which do not admit of some possibility of assimilation into groups and hence of measurement. Indeed, the very concept of contingency seems to preclude absolute uniqueness (as for that matter there is doubtless nothing absolutely unique in the universe). For to say that a certain event is contingent or "possible" or "may happen" appears to be equivalent to saying that "such things " have been known to happen before, and the "such things" manifestly constitute a class of cases formed on some ground or other. The principal subject for investigation is thus the degree of assimilability, or the amount of homogeneity of classes securable, or, stated inversely, the degree of uniqueness of various kinds of business contingencies. Insurance deals with those which are "fairly" classifiable or show a relatively low degree of uniqueness, but the different branches of insurance show a wide range of variation in the accuracy of measurement of probability which they secure.
Before taking up various types of insurance we may note in passing a point which it is superfluous to elaborate in this connection, namely, that different forms of organization in the insurance field all operate on the same principle. It matters not at all whether the persons liable to a given contingency organize among themselves into a fraternal or mutual society or whether they separately contract with an outside party to bear their losses as they fall in. Under competitive conditions and assuming that the probabilities involved are accurately known, an outside insurer will make no clear profit and the premiums will under either system be equal to the administrative costs of carrying on the business.
The branch of insurance which is most highly developed, meaning that its contingencies are most accurately measured because its classifications are most perfect, and which is thus on the most nearly "mathematical" basis is, of course, what is called "life insurance." (In so far as it is "insurance" at all, and not a mere investment proposition, it is clear that it is insurance against "premature" loss of earning power, and not against death.) It is possible, on the basis of medical examinations, and taking into account age, sex, place of residence, occupation, and habits of life, to select "risks" which closely approximate the ideal of mechanical probability. The chance of death of two healthy individuals similarly circumstanced in the above regards seems to be about as near an objective equality, the life or death of one rather than the other about as nearly really indeterminate, as, anything in nature. To be sure, when we pass outside the relatively narrow circle of "normal" individuals, difficulties are encountered, but the extension of life insurance outside this circle has also been restricted. Some development has taken place in the insurance of sub-standard lives at higher rates, but it is limited in amount and could be characterized as exceptional.
The very opposite situation from life insurance is found in insurance against sickness and accident. Here an objective description and classification of cases is impossible, the business is fraught with great difficulties and susceptible of only a limited development. It is notorious that such policies cost vastly more than they should; indeed, the companies find it profitable to adopt a generous attitude in the adjustment of claims, raising the premium rates accordingly, it is needless to say. Accident compensation for workingmen, under social control, is on a somewhat better footing, but only on condition that the payments are restricted to not too large a fraction of the actual economic loss to the individual, with nothing for discomfort, pain, or inconvenience. In the whole field of personal, physical contingencies, however, there is nothing that is strictly of the nature of a "business risk," unless it be the now happily obsolescent phenomenon of commercial employers' liability insurance.
The typical application of insurance to business hazards is in the protection against loss by fire, and the theory of fire insurance rates forms an interesting contrast with the actuarial mathematics of life insurance. The latter, as we have observed, is a fairly close approximation to objective probability; it is in fact so close to this ideal that life insurance problems are worked by the formulæ derived from the binomial law, in the same way as problems in mechanical probability. Fire insurance rating is a very different proposition; only in rather recent years has any approach been made to the formation of fairly homogeneous classes of risks and the measurement of real probability in a particular case. At best there is a large field for the exercise of "judgment" even after literally thousands of classes of risks have been more or less accurately defined. More important is the fact that, in consequence, insurance does not take care of the whole risk against loss by fire. On account of the "moral hazard" and practical difficulties, it is necessary to restrict the amount of insurance to the "direct loss or damage" or even to a part of that, while of course there are usually large indirect losses due to the interruption of business and dislocation of business plans which are entirely unprovided for. Thus there is a large margin of uncertainty both to insurer and insured, in consequence of the impossibility of objectively homogeneous groupings and accurate measurement of the chance of loss. Corresponding to this margin of uncertainty in the calculations there is a chance for a profit or loss to either party, in connection with the fire hazard. The probabilities in the case of fire are, of course, complicated by the fact that risks are not entirely independent. A fire once started is likely to spread and there is a tendency for losses to occur in groups. In so far, however, as fire losses in the aggregate are calculable in advance, they are or may be converted into fixed costs by every individual exposed to the possibility of loss, and in so far no profit, positive or negative, will be realized by any one on account of this uncertainty in his business.
The principle of insurance has also been utilized to provide against a great variety of business hazards other than fire—the loss of ships and cargoes at sea, destruction of crops by storms, theft and burglary, embezzlement by employees (indirectly through bonding, the employee doing the insuring), payment of damages to injured employees, excessive losses through credit extension, etc. The unusual forms of policies issued by some of the Lloyd's underwriters have attained a certain amount of publicity as popular curiosities. These various types of contingencies offer widely divergent possibilities for "scientific" rate-making, from something like the statistical certainty of life insurance at one extreme to almost pure guesswork at the other, as when Lloyd's insures the business interests concerned that a royal coronation will take place as scheduled, or guarantees the weather in some place having no records to base calculations upon. Even in these extreme cases, however, there is a certain vague grouping of cases on the basis of intuition or judgment; only in this way can we imagine any estimate of a probability being arrived at.
It is therefore seen that the insurance principle can be applied even in the almost complete absence of scientific data for the computation of rates. If the estimates are conservative and competent, it turns out that the premiums received for insuring the most unique contingencies cover the losses; that there is an offsetting of losses and gains from one venture to another, even when there is no discoverable kinship among the ventures themselves. The point seems to be, as already noticed, that the mere fact that judgment is being exercised in regard to the situations forms a fairly valid basis for assimilating them into groups. Various instances of the exercise of (fairly competent) judgment even in regard to the most heterogeneous problems, show a tendency to approach a constancy and predictability of result when aggregated into groups.
The fact which limits the application of the insurance principle to business risks generally is not therefore their inherent uniqueness alone, and the subject calls for further examination. This task will be undertaken in detail in the next chapter, which deals with entrepreneurship. At this point we may anticipate to the extent of making two observations: first, the typical uninsurable (because unmeasurable and this because unclassifiable) business risk relates to the exercise of judgment in the making of decisions by the business man; second, although such estimates do tend to fall into groups within which fluctuations cancel out and hence to approach constancy and measurability, this happens only after the fact and, especially in view of the brevity of a man's active life, can only to a limited extent be made the basis of prediction. Furthermore, the classification or grouping can only to a limited extent be carried out by any agency outside the person himself who makes the decisions, because of the peculiarly obstinate connection of a moral hazard with this sort of risks. The decisive factors in the case are so largely on the inside of the person making the decisions that the "instances" are not amenable to objective description and external control.
Manifestly these difficulties, insuperable when the "consolidation" is to be carried out by an external agency such as an insurance company or association, fall away in so far as consolidation can be effected within the scale of operations of a single individual; and the same will be true of an organization if responsibility can be adequately centralized and unity of interest secured. The possibility of thus reducing uncertainty by transforming it into a measurable risk through grouping constitutes a strong incentive to extend the scale of operations of a business establishment. This fact must constitute one of the important causes of the phenomenal growth in the average size of industrial establishments which is a familiar characteristic of modern economic life. In so far as a single business man, by borrowing capital or otherwise, can extend the scope of his exercise of judgment over a greater number of decisions or estimates, there is a greater probability that bad guesses will be offset by good ones and that a degree of constancy and dependability in the total results will be achieved. In so far uncertainty is eliminated and the desideratum of rational activity realized.
Not less important is the incentive to substitute more effective and intimate forms of association for insurance, so as to eliminate or reduce the moral hazard and make possible the application of the insurance principle of consolidation to groups of ventures too broad in scope to be "swung" by a single enterpriser. Since it is capital which is especially at risk in operations based on opinions and estimates, the form of organization centers around the provisions relating to capital. It is undoubtedly true that the reduction of risk to borrowed capital is the principal desideratum leading to the displacement of individual enterprise by the partnership and the same fact with reference to both owned and borrowed capital explains the substitution of corporate organization for the partnership. The superiority of the higher form of organization over the lower from this point of view consists both in the extension of the scope of operations to include a larger number of individual decisions, ventures, or "instances," and in the more effective unification of interest which reduces the moral hazard connected with the assumption by one person of the consequences of another person's decisions.
The close connection between these two considerations is manifest. It is the special "risk" to which large amounts of capital loaned to a single enterpriser are subject which limits the scope of operations of this form of business unit by making it impossible to secure the necessary property resources. On the other hand, it is the inefficiency of organization, the failure to secure effective unity of interest, and the consequent large risk due to moral hazard when a partnership grows to considerable size, which in turn limit its extension to still larger magnitudes and bring about the substitution of the corporate form of organization. With the growth of large fortunes it becomes possible for a limited number of persons to carry on enterprises of greater and greater magnitude, and to-day we find many very large businesses organized as partnerships. Modifications of partnership law giving this form more of the flexibility of the corporation with reference to the distribution of rights of control, of participation in income, and of title to assets in case of dissolution have also contributed to this change.
With reference to the first of our two points above mentioned, the extension of the scope of operations, the corporation may be said to have solved the organization problem. There appears to be hardly any limit to the magnitude of enterprise which it is possible to organize in this form, so far as mere ability to get the public to buy the securities is concerned. On the second score, however, the effective unification of interests, though the corporation has accomplished much in comparison with other forms of organization, there is still much to be desired. Doubtless the task is impossible, in any absolute sense; nothing but a revolutionary transformation in human nature itself can apparently solve this problem finally, and such a change would, of course, obliterate all moral hazards at once, without organization. In the meanwhile the internal problems of the corporation, the protection of its various types of members and adherents against each other's predatory propensities, are quite as vital as the external problem of safeguarding the public interests against exploitation by the corporation as a unit.
Another important aspect of the relations of corporate organization to risk involves what we have called "diffusion" as well as consolidation. The minute divisibility of ownership and ease of transfer of shares enables an investor to distribute his holdings over a large number of enterprises in addition to increasing the size of a single enterprise. The effect of this distribution on risk is evidently twofold. In the first place, there is to the investor a further offsetting through consolidation; the losses and gains in different corporations in which he owns stock must tend to cancel out in large measure and provide a higher degree of regularity and predictability in his total returns. And again, the chance of loss of a small fraction of his total resources is of less moment even proportionally than a chance of losing a larger part.
There are other aspects of the question which must be passed over in this summary view. Doubtless a significant fact is the greater publicity attendant upon the organization, resources, and operations of a corporation, due to its being a creature of the State and to legal safeguards. It must be emphasized that this type of organization actually reduces risks, and does not merely transfer them from one party to another, as might seem at first glance to be the case. Superficial discussions of limited liability tend to give the impression, or at least leave the way open to the conclusion, that this is the main advantage over the partnership. But it must be evident that the mere fact of limited liability only serves to transfer losses in excess of invested resources from the owners of the concern to its creditors; and if this were the only effect of incorporation, the loss in credit standing should offset the gain in security to the owners. The vital facts are the twofold consolidation of risks, together with greater publicity, and diffusion in a minor rôle, not really separable from the tact of consolidation.
It is particularly noteworthy that large-scale organization has shown a tendency to grow in fields where division of labor is absent and consolidation or grouping of uncertainties is the principal incentive. Occupations in which the work is of an occasional and intermittent character tend to run into partnerships and even corporations where there is no capital investment, or relatively little, and the members work independently at identical tasks. Examples are the syndicating of detectives, stenographers, and even lawyers and doctors.
The second of the two main principles for dealing with uncertainty is Specialization. The most important instrument in modern economic society for the specialization of uncertainty, after the institution of free enterprise itself, is Speculation. This phenomenon also combines different principles, and the mere specialization of uncertainty-bearing in the hands of persons most willing to assume the function is probably among the lesser rather than the greater sources of gain. It seems best to postpone for the present a detailed theoretical analysis of the factors of specialization of uncertainty-bearing in the light of the many ways in which individuals differ in their relations to uncertainty; this discussion will be taken up in the next chapter, in connection with the treatment of enterprise and entrepreneurship. At this point we wish merely to emphasize the association in several ways between specialization and actual reduction of uncertainty.
Most fundamental among these effects in reducing uncertainty is its conversion into a measured risk or elimination by grouping which is implied in the very fact of specialization. The typical illustration to show the advantage of organized speculation to business at large is the use of the hedging contract. By this simple device the industrial producer is enabled to eliminate the chance of loss or gain due to changes in the value of materials used in his operations during the interval between the time he purchases them as raw materials and the time he disposes of them as finished product, "shifting" this risk to the professional speculator. It is manifest at once that even aside from any superior judgment or foresight or better information possessed by such a professional speculator, he gains an enormous advantage from the sheer magnitude or breadth of the scope of his operations. Where a single flour miller or cotton spinner would be in the market once, the speculator enters it hundreds or thousands of times, and his errors in judgment must show a correspondingly stronger tendency to cancel out and leave him a constant and predictable return on his operations.
The same reasoning holds good for any method of specializing uncertainty-bearing. Specialization implies concentration, and concentration involves consolidation; and no matter how heterogeneous the "cases" the gains and losses neutralize each other in the aggregate to an extent increasing as the number of cases thrown together is larger. Specialization itself is primarily an application of the insurance principle; but, like large-scale enterprise, it grows up to meet uncertainty situations where, on account of the impossibility of objective definition and external control of the individual ventures or uncertainties, a "moral hazard" prevents insurance by an external agency or a loose association of venturers for this single purpose.
Besides organized speculation as carried on in connection with produce and security exchanges, the principle of specialization is exemplified in the tendency for the highly uncertain or speculative aspects of industry to become separated from the stable and predictable aspects and be taken over by different establishments. This is, of course, what has really taken place in the ordinary form of speculation already noticed, namely, the separation of the marketing function from the technological side of production, the former being much more speculative than the latter. A separation perhaps equally significant in modern economic life is that which so commonly takes place between the establishment or founding of new enterprises and their operation after they are set going. To be sure, by no means all the business of promotion comes under this head, but still the tendency is manifest. A part of the investors in promoted concerns look to the future earnings from regular operations for their return, but a large part expect to sell out at a profit after the business is established, and to devote their capital to some new venture of the same sort. A considerable and increasing number of individual promoters and corporations give their exclusive attention to the launching of new enterprises, withdrawing entirely as soon as the prospects of the business become fairly determinate. The gain from arrangements of this sort arises largely from the consolidation of uncertainties, their conversion by grouping into measured risks which are for the group of cases not uncertainties at all. Such a promoter takes it as a matter of course that a certain proportion of his ventures will be failures and involve heavy losses, while a larger proportion will be relatively unprofitable, and counts on making his gains from the occasional conspicuous successes. That is—to face frankly that paradoxical element which is really involved in such calculations—he does not "expect" to have his "expectations" verified by the results in every case; the expectations on which he really counts are based on an average, on an "estimate" of the long-run value of his "estimates." The specialization in the speculative phase of the business enables a single man or firm to deal with a larger number of ventures, and is clearly a mode of applying the same principle which underlies ordinary insurance.
Other illustrations of the same phenomenon will come to the reader's mind. Industries which utilize land whose value is largely speculative are more likely to rent rather than own their sites where the nature of the utilization makes such a procedure practicable. Even expensive machines and articles of equipment of other sorts, ownership of which involves heavy risks to a small concern, may be rented instead of bought outright. The owner of leased land or equipment is presumably a specialist in that sort of business and his risks are reduced by the grouping of a larger number of ventures.
Other advantages of specialization of speculative functions in addition to the reduction of uncertainty through consolidation are manifest, and no intention of belittling or concealing them is implied in the separation of the latter aspect of the case in the foregoing discussion. It is apparent in particular that the specialist in any line of risk-taking naturally knows more about the problem with which he deals than would a venturer who dealt with them only occasionally. Hence, since most of these uncertainties relate chiefly to the exercise of judgment; the uncertainty itself is reduced by this fact also. There is in this respect a fundamental difference between the speculator or promoter and the insurer, which must be kept clearly in view. The insurer knows more about the risk in a particular case—say of a building burning—but the real risk is no less because he assumes it in that particular case. His risk is less only because he assumes a large number. But the transfer of the "risk" of an error in judgment is a very different matter. The "insurer" (entrepreneur, speculator, or promoter) now substitutes his own judgment for the judgment of the man who is getting rid of the uncertainty through transferring it to the specialist. In so far as his knowledge and judgment are better, which they almost certainly will be from the mere fact that he is a specialist, the individual risk is less likely to become a loss, in addition to, the gain from grouping. There is better management, greater economy in the use of economic resources, as well as a mere transformation of uncertainty into certainty.
The problem of meeting uncertainty thus passes inevitably into the general problem of management, of economic control. The fundamental uncertainties of economic life are the errors in predicting the future and in making present adjustments to fit future conditions. In so far as ignorance of the future is due to practical indeterminateness in nature itself we can only appeal to the law of large numbers to distribute the losses, and make them calculable, not to reduce them in amount, and this is only possible in so far as the contingencies to be dealt with admit of assimilation into homogeneous groups; i.e., in so far as they repeat themselves. When our ignorance of the future is only partial ignorance, incomplete knowledge and imperfect inference, it becomes impossible to classify instances objectively, and any changes brought about in the conditions surrounding the formation of an opinion are nearly sure to affect the intrinsic value of the opinion itself. This is true even of the method of grouping by extending the scale of operations of a single entrepreneur, for the quality of his estimates will not be independent of the number he has to make and the mass of the data involved. But it is especially true of grouping by specialization, as we have seen. The inseparability of the uncertainty problem and the managerial problem will be especially important in the discussion (in the next chapter) of entrepreneurship, which is the characteristic phenomenon of modern economic organization and is essentially a device for specializing uncertainty-bearing or the improvement of economic control. The relation between management, which consists of making decisions, and taking the consequences of decisions, which is the most fundamental form of risk-taking in industry, will be found to be a very intricate as well as intimate one. When the sequence of control is followed through to the end, it will be found that from the standpoint of the ultimately responsible manager, the two functions are always inseparable.
We are thus brought naturally around to a discussion of the most thoroughgoing methods of dealing with uncertainty; i.e., by securing better knowledge of and control over the future. As previously observed, however, these methods represent merely the objective of all rational conduct from the outset, and they call for discussion in such a work as the present only in so far as they affect the general outline of the social economic structure. Thus it is fundamental to the entrepreneur system that it tends to promote better management in addition to consolidating risks and throwing them into the hands of those most disposed to assume them. The only further comment here called for is to point out the existence of highly specialized industrial structures performing the functions of furnishing knowledge and guidance.
One of the principal gains through organized speculation is the provision of information on business conditions, making possible more intelligent forecasting of market changes. Not merely do the market associations or exchanges and their members engage in this work on their own account. Its importance to society at large is so well recognized that vast sums of public money are annually expended in securing and disseminating information as to the output of various industries, crop conditions, and the like. Great investments of capital and elaborate organizations are also devoted to the work as a private enterprise, on a profit-seeking basis, and the importance of trade journals and statistical bureaus and services tends to increase, as does that of the activities of the Government in this field. The collection, digestion, and dissemination in usable form of economic information is one of the staggering problems connected with our modern large-scale social organization. It goes without saying that no very satisfactory solution of this problem has been achieved, and it is safe to predict that none will be found in the near future. But all these specialized agencies for the supply of information help to bridge the wide gap between what the individual business manager knows or can find out by the use of his own resources and what he would have to know to conduct his business in a perfectly intelligent fashion. Their output increases the value of the intuitive "judgments" on the basis of which his decisions are finally made after all, and greatly extends the scope of the environment in relation to which he can more or less intelligently react.
The foregoing relates chiefly to the production side of the problem of economic information. In the field of information for consumers, we have the still more staggering development of advertising. This complex phenomenon cannot be discussed in detail here, beyond pointing out its connection with the fact of ignorance and the necessity of knowledge to guide conduct. Only a part of advertising is in any proper sense of the term informative. A larger part is devoted to persuasion, which is a different thing from conviction, and perhaps the stimulation or creation of new wants is a function distinguishable from either. In addition to advertising, most of the social outlay for education is connected with informing the population about the means of satisfying wants, the education of taste. The outstanding fact is that the ubiquitous presence of uncertainty permeating every relation of life has brought it about that information is one of the principal commodities that the economic organization is engaged in supplying. From this point of view it is not material whether the "information" is false or true, or whether it is merely hypnotic suggestion. As in all other spheres of competitive economic activity, the consumer is the final judge. If people are willing to pay for "Sunny Jim" poetry and "It Floats" when they buy cereals and soap, then these wares are economic goods. If a certain name on a fountain pen or safety razor enables it to sell at a fifty per cent higher price than the same article would otherwise fetch, then the name represents one third of the economic utility in the article, and is economically no different from its color or design or the quality of the point or cutting edge, or any other quality which makes it useful or appealing. The morally fastidious (and naïve) may protest that there is a distinction between "real" and "nominal" utilities; but they will find it very dangerous to their optimism to attempt to follow the distinction very far. On scrutiny it will be found that most of the things we spend our incomes for and agonize over, and notably practically all the higher "spiritual" values, gravitate swiftly into the second class.
Somewhat different from the production and sale of information is the dealing in actual instructions for the guidance of conduct directly. Modern society is characterized by the rapid growth of this line of industry also. There have always been a few professions whose activities consisted essentially of the sale of guidance, notably medicine and the law, and more or less the preaching and teaching professions. Recent years, however, have witnessed a veritable swarming of experts and consultants in nearly every department of industrial life. The difference from dealing in information is that these people do not stop at diagnosis; in addition they prescribe. They are equally conspicuous in the fields of business organization, accounting, the treatment of labor, the lay-out of plants, and the processing of materials; they are the scientific managers of the managers of business; and though they by no means serve business or its managers for naught, and in spite of a large amount of quackery, they probably pay their way and more on the whole in increasing the efficiency of production. Certainly they do a useful work in forcing the intelligent, critical consideration of business problems instead of a blind following of tradition or the use of guesswork methods.
The last of the alternatives named for meeting uncertainty relates to the problem of a tendency to prefer relatively predictable lines of activity to more speculative operations. It is common to assume that society pays for the assumption of risk in the form of higher prices for commodities whose production involves uncertainty and a deficient supply of these in comparison with goods of an opposite character. This subject will come up again in connection with the closely related question of a tendency of profit to zero, and it seems best to postpone discussion of it for the present. We shall find reasons for being very skeptical as to the reality of any such abhorrence of uncertainty as to decrease productivity in any line below the level that an equivalent fixed cost would bring about.
Part III, Chapter IX
Enterprise and Profit
We must now consider more concretely and in detail the effects of uncertainty on the general form of organization of economic life. The best method seems to be to take up a society in which uncertainty is absent, imagine uncertainty introduced, and try to ascertain what changes will take place in its structure. We therefore return to the argument of chapter IV in which the mechanics of exchange and competition were studied with uncertainty (and progress) absent. The same method will be followed, beginning with the problem in as simple a form as possible and studying the effects of different factors separately, analyzing the complexity of real life "synthetically" by building it up in imagination out of its elements.
To secure the minimum degree of uncertainty and at the same time keep the discussion as close to reality as possible, it is necessary to exercise some care in defining the assumptions with which we are working. The most obvious initial requirement is to eliminate the factors of social progress from consideration and consider first a static society. But this postulate calls for discrimination in handling. In an absolutely unchanging social life there would, as we have repeatedly observed, be no uncertainty whatever, and our analysis in chapter IV proceeded on this assumption. Such conditions are thoroughly incompatible with the most fundamental facts of the world in which we live, but their study serves the analytic purpose of isolating the effects of uncertainty. For different kinds of change and different degrees of change are real facts, and it will therefore involve less abstraction to study hypothetical conditions under which change is restricted to the most fundamental and ineradicable kind and amount. Societies may be and have been nearly unprogressive, and the obvious simplification to make is therefore the elimination of progressive change.
After abstracting all the elements of general progressive change enumerated in chapter V a large amount of uncertainty will be left in human life, due to changes of the character of fluctuations which cannot be thought away without violence to material possibility. Strictly accurate formulation of conditions involving a realistic minimum of uncertainty cannot be made, but are not necessary; it is sufficient to indicate in a rough way the situation we propose to discuss. Several factors affect the amount of uncertainty to be recognized, and have to be taken into account. The first to be noted is the time length of the production process, for the longer it is, the more uncertainty will naturally be involved. Of very great importance also is the general level of economic life. The lower wants of man, those having in the greatest degree the nature of necessities, are the most stable and predictable. The higher up the scale we go, the larger the proportion of the æsthetic element and of social suggestion there is involved in motivation, the greater becomes the uncertainty connected with foreseeing wants and satisfying them. On the production side, on the other hand, most manufacturing processes are more controllable and calculable as to outcome than are agricultural operations under usual conditions. We must notice also the development of science and of the technique of social organization. Greater ability to forecast the future and greater power to control the course of events manifestly reduce uncertainty, and of still greater importance is the status of the various devices noted in the last chapter for reducing uncertainty by consolidation.
All these perplexities about which some more or less definite assumption must be made can be disposed of by being as realistic as possible. Let us say simply that we are talking about the United States in the early years of the twentieth century, but with abstraction made of progressive changes. That is, we assume a population static in numbers and composition and without the mania of change and advance which characterizes modern life. Inventions and improvements in technology and organization are to be eliminated, leaving the general situation as we know it to-day to remain stationary. Similarly in regard to the saving of new capital, development of new natural resources, redistribution of population over the soil or redistribution of ownership of goods, education, etc., among the people. But we shall not assume that men are omniscient and immortal or perfectly rational and free from caprice as individuals. We shall neglect natural catastrophes, epidemics, wars, etc., but take for granted the "usual" uncertainties of the weather and the like, along with the "normal" vicissitudes of mortal life, and uncertainties of human choice.
Returning now to the kind of social organization described in chapter IV, let us inquire as to what will be the effects of introducing the minimum degree of uncertainty into the situation. The essential features of the hypothetical society as thus far constructed need to be kept clearly in mind. Acting as individuals under absolute freedom but without collusion, men are supposed to have organized economic life with primary and secondary division of labor, the use of capital, etc., developed to the point familiar in present-day America. The principal fact which calls for exercise of the imagination is the internal organization of the productive groups or establishments. With uncertainty entirely absent, every individual being in possession of perfect knowledge of the situation, there would be no occasion for anything of the nature of responsible management or control of productive activity. Even marketing operations in any realistic sense would not be found. The flow of raw materials and productive services through productive processes to the consumer would be entirely automatic.
We do not need to strain the imagination by supposing supernatural powers of prescience on the part of men. We can think of the adjustment as the result of a long process of experimentation, worked out by trial-and-error methods alone. If the conditions of life and the people themselves were entirely unchanging a definite organization would result, perfect in the sense that no one would be under an incentive to change. So in the organization of the productive groups, it is not necessary to imagine every worker doing exactly the right thing at the right time in a sort of "preëstablished harmony" with the work of others. There might be managers, superintendents, etc., for the purpose of coördinating the activities of individuals. But under conditions of perfect knowledge and certainty such functionaries would be laborers merely, performing a purely routine function, without responsibility of any sort, on a level with men engaged in mechanical operations.
With the introduction of uncertainty—the fact of ignorance and necessity of acting upon opinion rather than knowledge—into this Eden-like situation, its character is completely changed. With uncertainty absent, man's energies are devoted altogether to doing things; it is doubtful whether intelligence itself would exist in such a situation; in a world so built that perfect knowledge was theoretically possible, it seems likely that all organic readjustments would become mechanical, all organisms automata. With uncertainty present, doing things, the actual execution of activity, becomes in a real sense a secondary part of life; the primary problem or function is deciding what to do and how to do it. The two most important characteristics of social organization brought about by the fact of uncertainty have already been noticed. In the first place, goods are produced for a market, on the basis of an entirely impersonal prediction of wants, not for the satisfaction of the wants of the producers themselves. The producer takes the responsibility of forecasting the consumers' wants. In the second place, the work of forecasting and at the same time a large part of the technological direction and control of production are still further concentrated upon a very narrow class of the producers, and we meet with a new economic functionary, the entrepreneur.
When uncertainty is present and the task of deciding what to do and how to do it takes the ascendancy over that of execution, the internal organization of the productive groups is no longer a matter of indifference or a mechanical detail. Centralization of this deciding and controlling function is imperative, a process of "cephalization," such as has taken place in the evolution of organic life, is inevitable, and for the same reasons as in the case of biological evolution. Let us consider this process and the circumstances which condition it. The order of attack on the problem is suggested by the classification worked out in chapter VII of the elements in uncertainty in regard to which men may in large measure differ independently.
In the first place, occupations differ in respect to the kind and amount of knowledge and judgment required for their successful direction as well as in the kind of abilities and tastes adapted to the routine operations. Productive groups or establishments now compete for managerial capacity as well as skill, and a considerable rearrangement of personnel is the natural result. The final adjustment will place each producer in the place where his particular combination of the two kinds of attributes seems to be most effective.
But a more important change is the tendency of the groups themselves to specialize, finding the individuals with the greatest managerial capacity of the requisite kinds and placing them in charge of the work of the group, submitting the activities of the other members to their direction and control. It need hardly be mentioned explicitly that the organization of industry depends on the fundamental fact that the intelligence of one person can be made to direct in a general way the routine manual and mental operations of others. It will also be taken into account that men differ in their powers of effective control over other men as well as in intellectual capacity to decide what should be done. In addition, there must come into play the diversity among men in degree of confidence in their judgment and powers and in disposition to act on their opinions, to "venture." This fact is responsible for the most fundamental change of all in the form of organization, the system under which the confident and venturesome "assume the risk" or "insure" the doubtful and timid by guaranteeing to the latter a specified income in return for an assignment of the actual results.
Uncertainty thus exerts a fourfold tendency to select men and specialize functions: (1) an adaptation of men to occupations on the basis of kind of knowledge and judgment; (2) a similar selection on the basis of degree of foresight, for some lines of activity call for this endowment in a very different degree from others; (3) a specialization within productive groups, the individuals with superior managerial ability (foresight and capacity of ruling others) being placed in control of the group and the others working under their direction; and (4) those with confidence in their judgment and disposition to "back it up" in action specialize in risk-taking. The close relations obtaining among these tendencies will be manifest. We have not separated confidence and venturesomeness at all, since they act along parallel lines and are little more than phases of the same faculty—just as courage and the tendency to minimize danger are proverbially commingled in all fields, though they are separable in thought. In addition the tendencies numbered (3) and (4) operate together. With human nature as we know it it would be impracticable or very unusual for one man to guarantee to another a definite result of the latter's actions without being given power to direct his work. And on the other hand the second party would not place himself under the direction of the first without such a guaranty. The result is a "double contract" of the type famous in the history of the evasion of usury laws. It seems evident also that the system would not work at all if good judgment were not in fact generally associated with confidence in one's judgment on the part both of himself and others. That is, men's judgment of their own judgment and of others' judgment as to both kind and grade must in the large be much more right than wrong.
The result of this manifold specialization of function is enterprise and the wage system of industry. Its existence in the world is a direct result of the fact of uncertainty; our task in the remainder of this study is to examine this phenomenon in detail in its various phases and divers relations with the economic activities of man and the structure of society. It is not necessary or inevitable, not the only conceivable form of organization, but under certain conditions has certain advantages, and is capable of development in different degrees. The essence of enterprise is the specialization of the function of responsible direction of economic life, the neglected feature of which is the inseparability of these two elements, responsibility and control. Under the enterprise system, a special social class, the business men, direct economic activity; they are in the strict sense the producers, while the great mass of the population merely furnish them with productive services, placing their persons and their property at the disposal of this class; the entrepreneurs also guarantee to those who furnish productive services a fixed remuneration. Accurately to define these functions and trace them through the social structure will be a long task, for the specialization is never complete; but at the end of it we shall find that in a free society the two are essentially inseparable. Any degree of effective exercise of judgment, or making decisions, is in a free society coupled with a corresponding degree of uncertainty-bearing, of taking the responsibility for those decisions.
With the specialization of function goes also a differentiation of reward. The produce of society is similarly divided into two kinds of income, and two only, contractual income, which is essentially rent, as economic theory has described incomes, and residual income or profit. But the differentiation of contractual income, like that of profit, is never complete; neither variety is ever met with in a pure form, and every real income contains elements of both rent and profit. And with uncertainty present (the condition of the differentiation itself) it is not possible even to determine just how much of any income is of one kind and how much of the other; but a partial separation can be made, and the causal distinction between the two kinds is sharp and clear.
We may imagine a society in which uncertainty is absent transformed on the introduction of uncertainty into an enterprise organization. The readjustments will be carried out by the same trial-and-error methods under the same motives, the effort of each individual to better himself, which we have already described. The ideal or limiting condition constantly in view would still be the equalization of all available alternatives of conduct by each individual through the distribution of efforts and of expenditure of the proceeds of effort among the lines open. Under the new system labor and property services actually come into the market, become commodities and are bought and sold. They are thus brought into the comparative value scale and reduced to homogeneity in price terms with the fund of values made up of the direct means of want satisfaction.
Another feature of the new adjustment is that a condition of perfect equilibrium is no longer possible. Since productive arrangements are made on the basis of anticipations and the results actually achieved do not coincide with these as a usual thing, the oscillations will not settle down to zero. For all changes made by individuals relate to the established value scale and this price-system will be subject to fluctuations due to unforeseen causes; consequently individual changes in arrangements will continue indefinitely to take place. The experiments by which alone the value of human judgment is determined involve a proportion of failures or errors, are never complete, and in view of human mortality have constantly to be recommenced at the beginning.
We turn now to consider in broad outline the two types of individual income implied in the enterprise system of organization, contractual income and profit. We shall try as hitherto to explain events by placing ourselves in the actual positions of the men acting or making decisions and interpreting their acts in terms of ordinary human motives. The setting of the problem is a free competitive situation in which all men and material agents are competing for employment, including all men at the time engaged as entrepreneurs, while all entrepreneurs are competing for productive services and at the same time all men are competing for positions as entrepreneurs. The essential fact in understanding the reaction to this situation is that men are acting, competing, on the basis of what they think of the future. To simplify the picture and make it concrete we shall as before assume that there exists some sort of grouping of men and things under the control of other men as entrepreneurs (a random grouping will do as a start) and that entrepreneurs and others are in competition as above stated.
The production-distribution system is worked out through offers and counter-offers, made on the basis of anticipations, of two kinds. The laborer asks what he thinks the entrepreneur will be able to pay, and in any case will not accept less than he can get from some other entrepreneur, or by turning entrepreneur himself. In the same way the entrepreneur offers to any laborer what he thinks he must in order to secure his services, and in any case not more than he thinks the laborer will actually be worth to him, keeping in mind what he can get by turning laborer himself. The whole calculation is in the future; past and even present conditions operate only as grounds of prediction as to what may be anticipated.
Since in a free market there can be but one price on any commodity, a general wage rate must result from this competitive bidding. The rate established may be described as the socially or competitively anticipated value of the laborer's product, using the term "product" in the sense of specific contribution, as already explained. It is not the opinion of the future held by either party to an employment bargain which determines the rate; these opinions merely set maximum and minimum limits outside of which the agreement cannot take place. The mechanism of price adjustment is the same as in any other market. There is always an established uniform rate, which is kept constantly at the point which equates the supply and demand. If at any moment there are more bidders willing to employ at a higher rate than there are employees willing to accept the established rate, the rate will rise accordingly, and similarly if there is a balance of opinion in the opposite direction. The final decision by any individual as to what to do is based on a comparison of a momentarily existing price with a subjective judgment of significance of the commodity. The judgment in this case relates to the indirect significance derived from a twofold estimate of the future, involving both technological and price uncertainties. The employer in deciding whether to offer the current wage, and the employee in deciding whether to accept it, must estimate the technical or physically measured product (specific contribution) of the labor and the price to be expected for that product when it comes upon the market. The estimation may involve two sorts of calculation or estimate of probability. The venture itself may be of the nature of a gamble, involving a large proportion of inherently unpredictable factors. In such a case the decision depends upon an "estimate" of an "objective probability" of success, or of a series of such probabilities corresponding to various degrees of success or failure. And normally, in the case of intelligent men, account will be taken of the probable "true value" of the estimates in the case of all estimated factors.
The meaning of the term "social" or "competitive" anticipation will now be clear. The question in the mind of either party to an employment agreement relates simply to the fact of a difference between the current standard of remuneration for the services being bargained for and his own estimate of their worth, discounted by probability allowances. The magnitude of the difference is altogether immaterial. The prospective employer may know absolutely that the service has a value to him ever so much greater than the price he is paying, but he will have to pay only the competitively established rate, and his purchase will affect this rate no more than if he were ever so hesitant about the bargain, just so he makes it. It is the general estimate of the magnitudes involved, in the sense of a "marginal" demand price, which fixes the actual current rate.
In many respects the nature of the organization we are now dealing with is the same as that described in chapter IV, with uncertainty and progress absent. The value of a laborer or piece of material equipment to a particular productive group is determined by the specific physical contribution to output under the principle of diminishing returns with increase in the proportion of that kind of agency in the combination, and on the price of this contribution under the principle of diminishing utility with increase in the proportion of productive energy devoted to making the particular product turned out by the establishment in question. But the facts upon which the working-out of the organization depends can no longer be objectively determined with accuracy by experiment; all the data in the case must be estimated, subject to a larger or smaller margin of error, and this fact causes differences more fundamental than the resemblances in the two situations. The function of making these estimates and of "guaranteeing" their value to the other participating members of the group falls to the responsible entrepreneur in each establishment, producing a new type of activity and a new type of income entirely unknown in a society where uncertainty is absent.
Even in the hypothetical situation dealt with in chapter IV there would be likely to be a concentration of certain control and coördinating functions in a separate person or group of persons in each productive group. But the duties of such persons would be of a routine character merely, in no significant respect different from those of any other operatives; they would be laborers among laborers and their incomes would be wages like other wages. When, however, the managerial function comes to require the exercise of judgment involving liability to error, and when in consequence the assumption of responsibility for the correctness of his opinions becomes a condition prerequisite to getting the other members of the group to submit to the manager's direction, the nature of the function is revolutionized; the manager becomes an entrepreneur. He may, and typically will, to be sure, continue to perform the old mechanical routine functions and to receive the old wages; but in addition he makes responsible decisions, and his income will normally contain in addition to wages a pure differential element designated as "profit" by the economic theorist. This profit is simply the difference between the market price of the productive agencies he employs; the amount which the competition of other entrepreneurs forces him to guarantee to them as a condition of securing their services, and the amount which he finally realizes from the disposition of the product which under his direction they turn out.
The character of the entrepreneur's income is evidently complex, and the relations of its component elements subtle. It contains an element which is ordinary contractual income, received on the ground of routine services performed by the entrepreneur personally for the business (wages) or earned by property which belongs to him (rent or capital return). And the differential element is again complex, for it is clear that there is an element of calculation and an element of luck in it. An adequate examination and analysis of this phenomenon requires time and careful thinking. The background of the problem should now be clear: the uncertainty of all life and conduct which call for the exercise of judgment in business, the economy of division of labor which compels men to work in groups and to delegate the function of control as other functions are specialized, the facts of human nature which make it necessary for one who directs the activities of others to assume responsibility for the results of the operations, and finally the competitive situation which pits the judgment of each entrepreneur against that of the extant business world in adjusting the contractual incomes which he must pay before he gets anything for himself.
The first step in attacking the problem is to inquire into the meaning of entrepreneur ability and its conditions of demand and supply. In regard to the first main division of the entrepreneur's income, the ordinary wage for the routine services of labor and property furnished to the business, no comment is necessary. This return is merely the competitive rate of pay for the grade of ability or kind of property in question. To be sure, it may not be possible in practice to say exactly what this rate is. Not merely is perfect standardization of things and services unattainable under the fluctuating conditions of real life, but in addition the conditions of the entrepreneur specialization may well bring it about that the same things are not done under closely comparable conditions by entrepreneurs and non-entrepreneurs. Hence the separation between the pure wage or rent element and the elements arising out of uncertainty cannot generally be made with complete accuracy. The serious difficulty comes with the attempt to deal with the relation between judgment and luck in determining that part of the entrepreneur's income which is associated with the performance of his peculiar twofold function of (a) exercising responsible control and (b) securing the owners of productive services against uncertainty and fluctuation in their incomes. Clearly this special income is also connected with a sort of effort and sacrifice and into the nature and conditions of supply and demand of the capacities and dispositions for these efforts and sacrifices it must be pertinent to inquire.
It is unquestionable that the entrepreneur's activities effect an enormous saving to society, vastly increasing the efficiency of economic production. Large-scale operations, highly organized industry, and minute division of labor would be impossible without specialization of the managerial function, and human nature being as it is, the guaranteeing function must apparently go along with that of control; indeed, in the ultimate sense of control the two are not even theoretically separable. Thus there would be a large saving even outside of any question of the superior abilities of certain individuals over other individuals for the performance of this function. And there is still another gain of large magnitude through the reduction of uncertainty by the principle of consolidation, which also is independent of the personal attributes of the entrepreneur. But these economies, due to the system as such, and not to activities of the individuals performing a special function, accrue to society; no cause can be discovered in this connection alone which would give rise to a special distributive share.
As to the actual comparative magnitude of the various elements of gain secured through the enterprise system it would be rash to guess, but certainly a very large real gain is secured through the selection of managers having superior fitness for the work. Now it is of supreme importance that such selection is possible only because and in so far as such fitness can be identified in advance of its demonstration in each particular case. The prospective entrepreneur himself has an opinion of his own suitability, in so far as he forms an estimate of the true value of his prognostications and policies. Other persons may or may not agree with his opinion of himself. A man may actually get into the position of entrepreneur in several ways. If he has property or known personal productive powers of a technological sort he may assume the functions of entrepreneur without convincing any one outside himself of any special fitness to exercise them. As long as his own resources safeguard the interests of the persons to whom he agrees to pay contractual incomes these persons need not worry about the correctness of the judgments on which the entrepreneur's policies are based. If he cannot make such guarantees he must, of course, convince either the persons with whom he makes wage or rent bargains or some outside party who will underwrite the guarantees for him. The effect of this transfer of the guarantee function on the nature of entrepreneurship is a subtle question and will be taken up presently. It might even conceivably happen, in the third place, that a person not judging himself especially fit to control industrial policies would get into the place of entrepreneur, if other persons have a sufficiently high opinion of his abilities and trustworthiness. This case is more complicated still and its treatment must also be deferred. Discussion of divided entrepreneurship will lead naturally to the problem of the hired manager, most difficult of all. Let us consider first the simple case of unique and undivided exercise of the function, the control and uncertainty-bearing being all concentrated in the same individual, under the assumption that outsiders whether employed by him or not have neither opinions upon nor interest in the question of his competence. It will further simplify the problem if we begin by assuming that this is the only type of entrepreneurship in our society.
First, a further word as to the character of the process by which the entrepreneur's income is fixed. It may be distinguished from the contractual returns received for services not involving the exercise of judgment, and which are paid by the entrepreneur, by pointing out that the latter are imputed, while his own income is residual. That is, in a sense, the entrepreneur's income is not "determined" at all; it is "what is left" after the others are "determined." The competition of entrepreneurs bidding in the market for the productive services in existence in the society "fix" prices upon these; the entrepreneur's income is not fixed, but consists of whatever remains over after the fixed incomes are paid. Hence we must examine the entrepreneur's income indirectly, by inquiring into the forces which determine the fixed incomes, in relation to the whole product of an enterprise or of society.
Assuming perfect competition in the market for productive services, the contractual incomes are fixed for every entrepreneur by the competitive or marginal anticipations of entrepreneurs as a group in relation to the supply of each kind of agency in existence. Whether any particular individual becomes an entrepreneur or not depends on his believing (strongly enough to act upon the conviction) that he can make productive services yield more than the price fixed upon them by what other persons think they can make them yield (with the same provision that the belief must lead to action). After any individual has become an entrepreneur, the amount of his income depends on his success in producing the anticipated excess, and in this sense is a matter of the correctness of his judgment. But it is clear that his success is equally a matter of (a) the failure of the judgment, or (b) an inferiority in capacity, on the part of his competitors. The two factors of (a) capacity and (b) judgment of one's capacity are inseparably connected, and business capacity is again compounded of judgment (of factors external to the person judging) and executive capacity.
Moreover, there is in the exercise of the best judgment and highest capacity an inevitable margin of error. A successful outcome in any particular case cannot be attributed entirely to judgment and capacity even taken together. The best men would fail in a certain proportion of cases and the worst perhaps succeed in a certain proportion. The results of one trial or of a small number of trials can at most establish a certain presumption in favor of the view that ability has or has not been shown. A dependable estimate of ability can only come from a considerable number of trials. Even then there are differences in kind of ability, as well as degree. And in business management no two instances, perhaps, are ever very closely alike, in any objective, describable sense. It is one of the mysteries of the workings of mind that we are able to form estimates of "general ability" which have any value, but the fact that we do is of course indisputable.
Still further, the venture itself may be a gamble, as we have repeatedly pointed out. Most decisions calling for the exercise of judgment in business or responsible life in any field involve factors not subject to estimate and which no one makes any pretense of estimating. The judgment itself is a judgment of the probability of a certain outcome, of the proportion of successes which would be achieved if the venture could be repeated a large number of times. The allowance for luck is therefore twofold. It requires a large number of trials to show the real probabilities in regard to which judgment is exercised in any given kind of case as well as to distinguish between intrinsic quality in the judgment and mere accident. And bearing in mind again the extreme crudeness of the classification of instances at best, the marvel grows that we are able to live as intelligently as we do. Let us now attempt to state the principles determining entrepreneur income more accurately and in the form of laws of demand and supply.
The demand for a productive service depends upon the steepness of the curve of diminishing returns from increasing amounts of other kinds of services applied to the first. In the familiar case of land, the more rapidly the returns from increased applications of labor and capital applied to a given plot of land fall off, the higher will be the rent on land. Now there is evidently a law of diminishing returns governing the combination of productive services with entrepreneurs. It is based on the fact already stated of limitation in the space range of foresight and executive capacity. The greater the magnitude of operations which any single individual attempts to direct the less effective in general he will be—"beyond a certain point," as in other cases of the law. The demand for entrepreneurs, again, like that for any productive agency, depends directly upon the supply of other agencies.
The supply of entrepreneurs involves the factors of (a) ability, with the various elements therein included, (b) willingness, (c) power to give satisfactory guarantees, and (d) the coincidence of these factors. If society as a whole secures a high quality of management for its enterprises it will be through a coincidence of ability with willingness, or of all three factors, as well as through an abundant supply of the elements separately. Willingness plus power to give guarantees, not backed up by ability, will evidently lead to a dissipation of resources, while ability without the other two factors will be merely wasted. To find men capable of managing business efficiently and secure to them the positions of responsible control is perhaps the most important single problem of economic organization on the efficiency side.
The supply of entrepreneur qualities in society is one of the chief factors in determining the number and size of its productive units. It is a common and perhaps justifiable opinion that most of the other factors tend toward greater economy with increasing size in the establishment, and that the chief limitation on size is the capacity of the leadership. If this is true the ability to handle large enterprises successfully, when it is met with, must tend to secure very large rewards. The income of any particular entrepreneur will in general tend to be larger: (1) as he himself has ability, and good luck; but (2), perhaps more important, as there is in the society a scarcity of self-confidence combined with the power to make effective guarantees to employees. The abundance or scarcity of mere ability to manage business successfully exerts relatively little influence on profit; the main thing is the rashness or timidity of entrepreneurs (actual and potential) as a class in bidding up the prices of productive services. Entrepreneur income, being residual, is determined by the demand for these other services, which demand is a matter of the self-confidence of entrepreneurs as a class, rather than upon a demand for entrepreneur services in a direct sense. We must see at once that it is perfectly possible for entrepreneurs as a class to sustain a net loss, which would merely have to be made up out of their earnings in some other capacity. This would be the natural result in a population combining low ability with high "courage." On the other hand, if men generally judge their own abilities well, the general rate of profit will probably be low, whether ability itself is low or high, but much more variable and fluctuating for a low level of real capacity. The condition for large profits is a narrowly limited supply of high-grade ability with a low general level of initiative as well as ability.
The analysis of profit is much simplified for students of political economy by the fact that the conventional distribution has placed such (misguided) emphasis on the concept of residual income, notably, of course, in the treatment of rent. Yet it will not do to press the parallel too far, for there is this important difference: Rent—and as every one now understands, any other share as well—is residual after the products of the other shares are deducted (product being the marginal contribution of a single unit multiplied by the number of units). But profit (under the simplified conditions we are now dealing with) is the residue after deduction of the payment for the other agencies, determined by the marginal bid of entrepreneurs as a class for all agencies as aggregates. The residue in the latter case is not a product residue, but a margin of error in calculation on the part of the non-entrepreneurs and entrepreneurs who do not force the successful entrepreneurs to pay as much for productive services as they could be forced to pay.
As the argument is quite complicated, it will be well to recapitulate. We have assumed in this first approximation that each man in society knows his own powers as entrepreneur, but that men know nothing about each other in this capacity. The division of social income between profits and contractual income then depends on the supply of entrepreneur ability in the society and the rapidity of diminishing returns from (other factors applied to) it, the size of the profit share increasing as the supply of ability is small and as the returns diminish more rapidly. If men are poor judges of their own powers as well as ignorant of those of other men, the size of the profit share depends on whether they tend on the whole to overestimate or underestimate the prospects of business operations, being larger if they underestimate. These statements abstract from the question of possession of means to guarantee the fixed incomes which they contract to pay; limitations in this respect act as limitations on the supply of entrepreneur ability. If entrepreneur ability is of such high quality that it practically is not subject to diminishing returns, the competition among even a very few such men will raise the rate of contractual returns and lower the residual share, if they know their own powers. If they do not, the size of their profits will again depend on their "optimism," varying inversely with the latter.
A man's knowledge of his own powers involves knowledge of the amount of uncertainty he deals with in trusting his own judgment, which, if the scale of operations is large enough, means the absence of uncertainty in the effective sense, if the knowledge is complete. Even if judgment itself subject to error is exercised in regard to the real probabilities in an intrinsic gambling situation, we have for the uncertainty in the situation as a whole an objective probability with predictable results for a large number of cases. The presence of true profit, therefore, depends on an absolute uncertainty in the estimation of the value of judgment, or on the absence of the requisite organization for combining a sufficient number of instances to secure certainty through consolidation. With men in complete ignorance of the powers of judgment of other men it is hard to see how such organization could be effected. Yet so elusive is the mechanism by which we know our world, so great the capacity of mind for seizing upon indirect methods of increasing certainty, that a further sweeping reservation must be made. If men, ignorant of other men's powers, know that these other men themselves know their own powers, the results of general knowledge of all men's powers may be secured; and this is true even if such knowledge is (as it is in fact) very imperfectly or not at all communicable. If those who furnish productive services for a contractual remuneration know that those who bid for the services know what they are worth to themselves, the bidders, or if each bidder knows this to be true of the others, the latter will be forced to pay all that they are willing to pay, which is to say all that they can pay. To be sure, competition under such conditions would be likely to take on the character of a poker game, a bluffing contest. But it must be admitted that actual wage bargains are in no slight degree of this character.
The case of European exploiters among primitive peoples illustrates the possibility of large profits to be made by a small number of men who know what they are doing among a large number who do not. But if they compete among themselves there must come a time, if their number increases, when they will force prices to their competitive level without any action on the part of the exploited masses more shrewd than that of accepting a larger offer in preference to a smaller one. The number of competitors required to bring about this result depends upon the steepness of the curve of diminishing returns from entrepreneurship, upon the limitation of the scope of enterprise one man can deal with effectively. And the idea of scope must be extended to include the variety of situations to be dealt with. The question of diminishing returns from entrepreneurship is really a matter of the amount of uncertainty present. To imagine that one man could adequately manage a business enterprise of indefinite size and complexity is to imagine a situation in which effective uncertainty is entirely absent.
The entire foregoing argument has dealt with a simplified situation inasmuch as the members of our society have been assumed to know something about the true value, each of his own judgment and ability to control events in accordance with it, but to know these things about each other only as the other man's own opinion of himself is manifested in his dispositions to act. In fact men form judgments of other men on the basis of watching their performances over a period of time, and in addition form impressions having some claim to validity from mere personal appearance, conversation, etc. Such knowledge of others is one of the most important factors in our efforts to live together intelligently in organized society. It is the most difficult to discuss scientifically of all the data connected with the practical bearings of knowledge and uncertainty.
Estimates of the worth of other men's opinions and capabilities probably form by far the largest part of the data on which any individual makes decisions in his own life, at least in the sphere of economic activity where such activity is highly organized. Such estimates function as an indirect indication of what we may expect to happen in any set of conditions; we know and give ourselves credit for knowing nothing of value about the problem itself, but we know what is the belief of other men whose judgment we respect and which we accept in place of an opinion of our own. The degree of confidence which we feel in our own situation is simply the degree of confidence we feel in the value of the judgment of the "authority" whose pronouncement we accept as the best information available on the merits of the case. To be sure, the mode of formation of these opinions of others' opinions is complex and obscure, and is rarely free from all passing of judgment on the case itself independently. There is a mutual reinforcement; we have some ideas of our own in the premises, and these agree with the views of some authority. We often if not in general believe what we do because the authority believes it, but to some extent we believe in the authority because he holds the view to which we were already inclined. In large measure we even believe in ourselves because and in the measure that we think others believe in us, though, on the other hand, again, . . . But it is enough to indicate the complexity of the relations between our own and others' opinions without attempting to set all these relations out in logical statements. The importance of indirect knowledge of fact through knowledge of others' knowledge is the point we wish to emphasize.
Correspondingly, the uncertainty of the knowledge on the basis of which we act is in large measure the margin of error in our estimates of the authorities whom we elect to follow. The uncertainties of business are predominantly of this character, and the genus calls for particularly careful study. Our discussion hitherto has assumed pure and undivided entrepreneurship, which would follow from the impossibility of knowledge by one person of another person's capabilities. In the absence of such knowledge it is clear that no one would put his resources under the direction of another without a valid guarantee of the payment agreed upon, and no one could become an entrepreneur who was not in a position to make such guarantees without assistance, it being equally clear that no one would make such a guarantee for another. That is, entrepreneurship would be completely specialized in a pure form, responsibility and control completely associated. When men have knowledge, or opinions on which they are willing to act, of other men's capacities for the entrepreneur function, all this is changed; entrepreneurship is no longer a simple and sharply isolated function. This is, of course, the state of affairs in real life, and it is this partially specialized and more or less distributed entrepreneurship which merits most careful consideration. Several forms of organization distribution of the function call for notice.
The simplest division of entrepreneurship which we can think of is the separation of the two elements of control and guarantee and their performance by different individuals. This is a natural arrangement, for it must often happen that entrepreneur ability will not be associated with a situation on the part of its possessor enabling him to make satisfactory guarantees of the contractual incomes promised. Under such circumstances it may be mutually profitable for him to enter into agreement with some one in a position to underwrite his employment contracts, but not himself possessed of the ability or disposition to undertake the direction of enterprises. The form of this partnership and conditions of division of the profit may be highly various. As a matter of fact we know that it commonly takes the shape of a new wage bargain, the guarantor hiring the director in much the same way as the latter hires the productive services which he organized and controls. This transfer of function involves a transformation in character also which must be considered at length, and will be taken up in the next chapter. Let us note here that it is usually impracticable to separate all the guaranteeing responsibility from the control of the enterprise. It is rare that a hired entrepreneur receives a contractual income as his only interest in the business. He is usually a part owner, or at least his salary is so adjusted as to make it clear that his continuance in the position is contingent upon its prosperity under his direction.
An effect of the evaluation of ability nearly as important as the transformation in entrepreneurship with its partial transfer to another individual is that the specialization of the function within the enterprise may be quite incomplete. That is, it is no longer true that men are necessarily unwilling to entrust productive services, of person or property, to an outsider without an effective material guarantee of the fixed payment agreed upon. If they have confidence in the manager's ability and integrity they may gladly work with only a partial or imperfect security for their remunerations. To the extent that this is the case such owners of productive services manifestly share in bearing the uncertainty or "taking the risk" involved in the undertaking. That they also share in the effective control will appear in the course of a more careful examination of the entrepreneur function under the complicated, vague, and shifting conditions of real life (except that progress is still abstracted), which is the next stage in our inquiry.
Part III, Chapter X
Enterprise and Profit (continued)
The Salaried Manager
The typical form of business unit in the modern world is the corporation. Its most important characteristic is the combination of diffused ownership with concentrated control. In theory the organization is a representative democracy, of an indirect type. The owners elect directors whose main function is to choose the officials who are said actually to carry on the business of the company. The directors themselves, however, exercise real direction over the general policies of the corporation. Moreover, if it is a large enterprise, the executive officials chosen by the directors have only a general oversight over business policy, and their chief function in turn is to select subordinates who make most of the actual decisions involved in the control of the concern. And of course the process does not stop there; there may be many stages in the hierarchy of functionaries whose chief duties consist of choosing still other subordinates.
The first necessary step in understanding the distribution of control and responsibility in modern business is to grasp this fact: What we call "control" consists mainly of selecting some one else to do the "controlling." Business judgment is chiefly judgment of men. We know things by knowledge of men who know them and control things in the same indirect way. Nor can this conclusion be escaped, as there is some tendency to pretend, by distinguishing between judgment of ends and judgment of means. The only problems with which we have any concern are all problems of means. There is only one end, finally, to business activity, and this is already decided upon before the business is founded; that is, to make money. The decisions made by members of the business organization all relate to means, at whatever state of "generality" they may be taken; the difference between decisions as to general policy and operative detail is one of degree only, in which all degrees exist; it is an arbitrary distinction. Decisions as to ends in any proper sense are made only by consumers—persons outside the productive organization altogether.
These statements hold good in fact for all other departments of organized social activity as well as for business. They are even more true of political organization. It is hardly an exaggeration to say that the political officeholder's business is to get the job and then find some one else to perform its duties. In the field of organization, the knowledge on which what we call responsible control depends is not knowledge of situations and problems and of means for effecting changes, but is knowledge of other men's knowledge of these things. So fundamental to our problem is this fact that human judgment of things has in an effective sense a "true value" which can be estimated more or less correctly by the man possessing it and by others—so fundamental is it for understanding the control of organized activity, that the problem of judging men's powers of judgment overshadows the problem of judging the facts of the situation to be dealt with. And if this is true of knowledge it is manifestly true of uncertainty. Under organized dealings with our environment, attention and interest shift from the errors in men's opinions of things to the errors in their opinions of men. Organized control of nature in a real sense depends less on the possibility of knowing nature than it does on the possibility of knowing the accuracy of other men's knowledge of nature, and their powers of using this knowledge.
The fundamental principle underlying organized activity is therefore the reduction of the uncertainty in individual judgments and decisions by grouping the decisions of a particular individual and estimating the proportion of successes and failures, or the average quality of his judgments as a group. It is an application of the broader principle of consolidation of risks, but the circumstances are peculiar. The result can never be calculated, either from a priori data or from tabulations of instances observed. It is an estimate in the purest sense, an estimate into which previous observation may enter little. We form our opinions of the value of men's opinions and powers through an intuitive faculty of judging personality, with relatively little reference to observation of their actual performance in dealing with the kind of problems we are to set them at. Of course we use this sort of direct evidence as far as possible, but that is usually not very far. The final decision comes as near to intuition as we can well imagine; it constitutes an immediate perception of relations, as mysterious as reading another person's thoughts or emotions from subtle changes in the lines of his face.
The great complexity and difficulty in the analysis of business uncertainty and of profit as the remuneration connected with meeting it arises from this peculiar distribution of responsibility in the organization. There is an apparent separation of the functions of making decisions and taking the "risk" of error in decisions. The separation appears quite sharp in the case of the hired manager, as in a corporation, where the man who makes decisions receives a fixed salary, taking no "risk," and those who take the risk and receive profits—the stockholders—make no decisions, exercise no control. Yet a little examination in the light of the preceding discussion of indirect knowledge and indirect responsibility will show that the separation is illusory; when control is accurately defined and located, the functions of making decisions and assuming the responsibility for their correctness will be found to be one and indivisible.
The phenomena can be best elucidated by beginning at the very "bottom" of the scale, with the "routine" duties of the common, unskilled laborer. It will be evident on reflection that even the coarsest and most mechanical labor involves in some sense meeting uncertainty, dealing with contingencies which cannot be exactly foreseen. It seems to be the function of all conscious life to deal with "new situations." Consciousness would never have developed if the environment of living organisms were perfectly uniform and monotonous, conformable to mechanical laws. In such a world organisms would be automata. There is a manifest tendency to economize consciousness, to make all possible adaptations by unconscious reflex response. In human life we see complex adaptations such as performing on a musical instrument drop below the threshold when learned. If the requisite movements were constant from generation to generation there is little doubt that they would become fixed in the germ plasm by the slow process of natural selection if we eliminate the more direct method by inheritance of acquired characters.
Moreover, in industrial life, purely routine operations are inevitably taken over by machinery. The duties of the machine tender may seem mechanical and uniform, but they are really not so throughout the operation. His function is to complete the carrying-out of the process to the point where it becomes entirely uniform so that the machine can take hold of it, or else to begin with the uniform output of the machine and start it on the way of diversification. Some part of the task will practically always be found to require conscious judgment, which is to say the meeting of uncertainty, the exercise of responsibility, in the ordinary sense of these terms.
But from the standpoint of organization the work of the common laborer does not involve uncertainty or responsibility in the effective sense, on account of the principle of indirect knowledge and transfer of responsibility discussed above. Even when it is impossible to reduce the work itself to routine sufficiently for a machine to handle it—due usually to lack of uniformity (i.e., uncertainty) in the material worked with—it is possible to judge with a high degree of accuracy the capacity of a human individual to deal with the sort of irregularities to be met with in the occupation. It is the function of the operative in industry to deal with uncertainty as a matter of routine! The exact movements he shall have to perform cannot be foretold, but his ability to perform them can be, and so the uncertainty is eliminated as an element in the calculations; ignorance of the environmental situation gives place to knowledge of human judgment.
The contrast again, even in case of the humblest operative, is not absolute. Most such persons occasionally meet with contingencies in regard to which they are expected to appeal to judgment and ability superior to their own. Nor can the operative's ability to handle his job be known with complete accuracy to his superior. The operative must exercise judgment over his own capacities in knowing when to go ahead independently and when to appeal for guidance. And the official who assigns the operative to his job and fixes his remuneration for performing it must exercise a rather higher quality of judgment in estimating the powers of the operative. The net effect is that uncertainty and responsibility are not quite eliminated, but are partially transferred to the superior in the scale of organization. The true uncertainty in the case relates to this official's judgment of his man in relation, of course, to the position he is to fill. As far as the lowest man in the scale is concerned, he is freed from all responsibility beyond the ("routine") duty of using his best judgment as occasion requires. His superior is responsible for him, and he accordingly receives a fixed wage.
It will already be clear that this process of transferring responsibility does not end with the first step at the bottom of the scale, and the goal to which the argument will lead is in fairly plain view. The foreman (let us say) who passes judgment on the abilities of operatives and takes the responsibility for their performing in accordance with his expectations finds himself in turn in a similar relation to his own ranking superior in the organization. His capacity to judge operatives is passed upon and reduced to a routine function in the same way that he passes upon their capacities to do their work, and likewise his capacity to deal with those more exceptional contingencies in which operatives are likely to appeal to him; and his responsibility is in turn transferred to the higher official (superintendent or what-not) who selects him, assigns him to his work, and hears appeals in those still rarer questions which he refers higher up for decision. The knowledge on which the higher control is based is again, and still more, knowledge of a man's capacity to deal with a problem, not concrete knowledge of the problem itself. The higher official may in fact be very competent to deal with the problem directly, but he does not do so. And it is noteworthy that he may not be competent in this sense. Some superintendents would doubtless make better foremen than their foremen, and only serve in the higher capacity because of the still greater rarity and value of the ability to judge and handle foremen. But it is unquestionable that a great many men make very good superintendents who would not make good foremen at all, and perhaps this is the more common case.
On up the scale the same relations hold good until we come to the supreme head of the business. For simplicity we may suppose that this individual combines all the managerial functions in his single person, that he is president, general manager, and so forth, that his directors exercise no control over him whatever beyond giving him his place and salary and a perfectly free hand. Even such an individual is in a position similar in essential respects, as far as the problem of organization is concerned, to that of the lowly machine tender. His capacities to deal with the kind of situations he has to deal with are subject to evaluation, are evaluated. His work is also a "routine" task of exercising his best judgment—and leaving the consequences to others. The real responsibility is again shifted back, as the effective uncertainty is in the judgment which placed him in his position. The responsible decision is not the concrete ordering of policy, but ordering an orderer as a "laborer" to order it. And this final responsibility necessarily takes the consequences of its decisions. The apparent separation between control and risk taken turns out, as predicted, to be illusory. The paradox of the hired manager, which has caused endless confusion in the analysis of profit, arises from the failure to recognize the fundamental fact that in organized activity the crucial decision is the selection of men to make decisions, that any other sort of decision-making or exercise of judgment is automatically reduced to a routine function. All of which follows from the very nature of large-scale control, based on the replacement of knowledge of things by knowledge of men, as our analysis has shown.
We must refuse to be misled by the superficial similarity between the daily work of the hired manager and that of the man in business on his own account. The difference is far more fundamental. The former has had his task cut out for him by others and been set to perform it; the latter has cut out his own task to fit his own measure of himself, and set himself at it. Here is the really responsible decision, made for the hired manager, by the independent enterpriser. Whenever we find an apparent separation between control and uncertainty-bearing, examination will show that we are confusing essentially routine activities with real control.
Like a large proportion of the practical problems of business life, as of all life, this one of selecting human capacities for dealing with unforeseeable situations involves paradox and apparent theoretical impossibility of solution. But like a host of impossible things in life, it is constantly being done. Though we cannot anticipate a concrete situation accurately enough to meet it without the intervention of conscious judgment at that moment, it can be foreseen that under certain circumstances the kind of things that will turn up will be of a character to be dealt with by a kind of capacity which can be selected and evaluated. That large-scale organizations are formed and operate successfully demonstrates that this principle is sound, that for these impossible problems solutions more right than wrong are actually found. Partly through operation of the principle of reduction of uncertainty by consolidation, partly for reasons embodied in our faculties of interpreting personality and which seem to be inscrutable, knowledge of men's capacities to know turns out to be more accurate than direct knowledge of things.
Another phase of entrepreneurship based on the same fundamental facts of transfer of responsibility, and which still further complicates its analysis, is the incompleteness of specialization. We may introduce the problem as a continuation of the above argument by inquiring into the question, To whom is the responsibility ultimately transferred when the entire conduct and policy of a business are in the hands of a hired manager? The answer is obvious: to the owners of the productive services used in the business; i.e., to the very shoulders from which the same responsibility is taken in the case of the specialization of function involved in contracting with an independent entrepreneur. In the latter case the entrepreneur, who selects himself, takes over all the uncertainty of the business along with control over it. But in view of the difficulty of any single individual giving adequate security for the performance of his contracts in the case of a large undertaking, such a form of organization has a very limited opportunity for growth. For it is clear that only the possessor of transferable wealth already produced (consumers' or producers' goods) or of future productive capacity in some form can make guarantees or really bear uncertainty or take risks for other persons. And it is nearly inevitable that the man who "undertakes" any line of business as entrepreneur will commit a part of his own wealth or productive powers to that business. What naturally happens, then, in any case is that the control of enterprise falls into the hands of the owner (or owners) of a part of the productive services used in the enterprise, which resources are placed in an exposed position with regard to losses in the business and so guarantee the owners of the remaining "land, labor, and capital" against failure to receive their full contractual remuneration.
It is impossible for entrepreneurship to be completely specialized or exist in a pure form, except in the rare and improbable case of a man who owns nothing in a particular business and contributes nothing to it but responsibility. Even a man who conducted a business entirely with borrowed funds and hired labor, but managing it himself, would not exemplify pure entrepreneurship, for a large part of the work of management is as we have seen reducible to routine and can be paid for with a fixed wage. The nearest approach to an entrepreneur only would be a man who borrowed all the resources for operating a business and then hired a manager and gave him an absolutely free hand. And such a man would have to be more than an entrepreneur in relation to some other business, or he would not be a true entrepreneur, making responsible decisions, in the business in question.
The natural result is a complicated division or diffusion of entrepreneurship, distributed in the typical modern business organization by a hierarchy of security issues carrying every conceivable gradation and combination of rights to control and to freedom from uncertainty as to income and vested capital. The feature of the system apt to be overlooked is a large element of real control disguised under a nominal contract for a fixed return. It is seldom true that the guarantees given can be regarded as absolute. If they are not, the owner of resources is taking a certain share of responsibility or risk, obviously. That he is also exercising control becomes apparent if we consider that his decision to allow the use of his labor or property under the conditions affects the scale of operations of the business. Control is completely absent from the function of furnishing productive services to a business only in case an accurately determined competitive value of the services is effectively guaranteed, so that everything but the money remuneration is made completely indifferent to their owner.
As a matter of fact we know that it is common for those who furnish resources to an enterprise to retain a large amount of direct consultative authority in regard to the conduct of the business. The voting trust is a device for securing this end and owes its importance to the necessity of providing for security owners an assurance of competent control when adequate protection of their interests cannot otherwise be achieved, especially when the value of the property depends largely on its intelligent employment in the particular use to which it has been committed. With the increasing specialization of industry such conditions become more and more common, effective guarantees become harder and harder to make, and investors find it necessary to insist more and more on sharing in the control of business. The distinction between stocks and bonds tends to fade out. It is hard to find an illustration of an unconditional transfer of productive resources to a business for its use for a pecuniary consideration alone without an outright transfer of ownership. The owners of limited issues of first-mortgage bonds have an ultimate recourse to the courts to compel honest management of the concern if their interests are jeopardized. Only in such a case as the lease of pure site value which is indestructible and not changed in any way by use can we find an example of an income entirely freed from the element of responsible control.
The case of labor is somewhat peculiar, owing to the disposition of laboring people to gamble recklessly with life and limb as well as income. Under free competition there is little doubt that a considerable proportion of the losses of enterprise would fall upon labor, since laborers show themselves ready to engage in hazardous enterprises at their own risk for an increase in wages which is a fraction of an adequate compensation for the chances they take. But the social interest in the man who cannot afford the loss comes to the rescue with prior claim laws, mechanics' liens, and the like, so that the wages of labor are in fact generally a fair approximation to a guaranteed contractual return. The element of control which would be involved in a dependence of business upon laborers' choice of the ventures they would engage in, is correspondingly absent, as the effective contracting-out of the risk places different lines of employment on a plane of indifference at the wages fixed.
The relations between profit and the contractual shares call for a few further remarks. As observed in our historical introduction (chapter II) the older English economists used the term "profit" to designate the income of the owner of a business, who was regarded as essentially an investor. Hence, as the classical economics was essentially a long-time theoretical treatment, little distinction was drawn between profit and interest. A wage element was recognized in the income, and also a risk factor. Little was made of the latter as constituting a distinction between profit and interest, as ordinary contract interest so obviously contains an element of payment for risk also. And in view of our argument above that the assumption of risk in this connection involves the exercise of effective control to the same extent, the relegation of this factor into the background is still further justified.
American economic discussion developed under the influence of the marginal utility theory, which is essentially a short time view of the valuation problem. There is some connection between this fact and the greater emphasis given in this country to "wages of management" and the separation of this element from the entrepreneur's income, leaving "profit" or "pure profit" in a narrower sense than that given the term by the older writers. For management is more conspicuous in American industry, due to the more "dynamic" conditions of this country. In a long-time view or "static state" it would be relatively much less important. The greater emphasis given the risk factor in American (as in German) discussions is explained in the same way, a more dynamic background and greater interest in short-period changes.
With the recent development of accounting theory, the question whether interest on investment should be counted in profit has become acute from another point of view and has tended to constitute an issue between accountants and economic theorists. This is of course entirely uncalled-for, as the difference in position is a matter of obvious difference in standpoint. Economic theory is interested in the forces which determine the prices of goods, and in costs of production as a condition of supply. It goes without saying that, in the long run again, a return on capital equal to the competitive rate of interest is a condition of production, and so from this point of view a cost. (That things may be different from a short-time viewpoint serves to increase the confusion.) The accountant is interested in proprietorship, the relations between a business and its owners, and in cost as a deduction from the owner's income. Moreover, scientific accounting is an outgrowth of corporation problems, and in the corporation the responsible owner is thought of as an investor, his interest as a capital interest, whether he has put any money in the business or not and whether or not it has any value above its debts. And profit, being a return on investment, is naturally thought of as a rate of return.
In most cases it would not be fruitful to attempt an accurate separation of profit from interest. For on the other side of the relation, pure interest is almost as rare a phenomenon and as elusive a concept as pure profit. The specialization of the entrepreneur function is a fundamental fact in business organization, but for reasons which should already be clear, it cannot be carried to theoretical completeness. The entrepreneur must almost of necessity own some property and the owner of property used in a business can hardly be freed from all risk and responsibility. It is useful, however, to distinguish between the return actually realized by an entrepreneur and the "competitive" rate of interest on high-class "gilt-edge" securities where the risk and responsibility factor is negligible. The difference would be profit, or "pure profit" in the sense in which economic theory uses the term.
Even at last some reservation must be made in calling interest on the entrepreneur's investment a cost of producing the commodity. It is generally admitted that if this rate of return is not realized on the average and in the long run the investment will not be held in the business in question. But the truth accurately stated evidently is that the owner must expect in the future to receive a return equal to that which he can be sure of elsewhere, on the investment which he is free to transfer to other uses. And of course allowance must be made for the connection between different elements of investment as well as technological fluidity. If half the investment in an enterprise represents machinery, working-capital, land, or what-not which can be transferred to other lines, and the other half represents permanent commitment, worthless outside the particular business, the cost of producing the output of that business (after the commitment has been made) is only the (anticipation of the) competitive return on the removable half of the capital alone. Of course this half could not be removed without rendering the remainder worthless.
The association of profit with income on property is valid, within the limits discussed, for the greater part of business enterprises, but there are important exceptions. The independent entrepreneur is not yet by any means an extinct species. Such a person typically furnishes both property and labor services to a business, meaning by labor services personal activities which might be hired and paid for with a fixed wage. The entrepreneur income in a case of this sort contains an element of wages as well as an element of interest. The contention of some accountants that a salary should be allowed for the owner's work and the residue considered as a return on his investment does not seem to be well founded. It is based on a bias derived from the habitual (and proper) procedure in corporations, where the responsible owner furnishes property services only. It would be just as logical to deduct from the owner's income a competitive rate of interest and call the residue wages or wages of management. The only significant distinction is that between the total income and a "pure profit" secured by deducting both competitive wages for the work and competitive interest on the investment furnished by the owner. The determination of the proper wage rate will be fraught with the same sort of difficulties that have been referred to in the case of pure interest, but in a much more aggravated form; it is far more difficult to appraise labor and find similar services in the competitive field as a basis of comparison than in the case of property.
In some instances, though perhaps a relatively small proportion of real enterprises and those probably of small average size, the independent entrepreneur may have no property investment in his business, furnishing labor services only. It is in reference to such a situation that the conventional (American) treatment of profit and wages of management has most significance. It must be very unusual, for reasons already pointed out, for a man to hire the use of the labor and property of others without putting up some property as well as labor of his own. It would be possible, within limits, for such a man to give adequate security for payment of the fixed remuneration of outside agencies, if his own earning capacity were high.
But in reality this probably does not happen on any considerable scale, or with enterprises of large magnitude. However, allowance must be made for the ownership of property used in other enterprises, and also for the "moral backing" of wealthy relatives or friends. And such "moral backing" may or may not constitute a division of the entrepreneur's responsibility. The only ultimate security may still be the potential earning power of the entrepreneur himself, which, however, might not be marketable on account of a moral hazard without being underwritten by property-owning connections.
On the whole we must say that the discussion of profit in relation to wages of management has been greatly overworked. The connection with property income is enormously more common, direct, and close. The residual share of income falls of necessity to the person in responsible control of a business; hence, in most cases to a person who also receives a property income. He may or may not also receive a labor income as well. The important distinction for the purposes of theoretical analysis is that between pure residual income or pure profit and property income. The relation to labor income is incidental in importance comparatively, and being of the same character, at any rate, does not call for much space in a discussion of profit. If a distinction is made between land and capital, it must be recognized that the profit receiver may be also a recipient of rent, in addition to interest or wages or both. And in exceptional cases he may receive rent only, as, for instance, a farmer who owns his land, but borrows all his working capital and hires all his work done. In such a case the practical problem would be to distinguish pure profit from rent. But such a situation is somewhat artificial, and the distinction between land and other property is from this point of view even more so.
The importance of property-ownership in connection with profit will be even greater and more apparent if "good-will," business connection, and established reputation, etc., be regarded as property. If these categories are capitalized and included in investment the cases are rare indeed where an employer of others' labor and capital has no investment of his own in the undertaking. As to the proper procedure in dealing with these items, whether they should or should not be regarded as property, the answer depends on whether they are salable. If good-will is separable from the other elements in a business, the test of which is that it can be sold away from them without affecting their value, then it is property on its own account, and the competitive rate of return on its sale value must be deducted from the owner's income before a pure profit is arrived at. If good-will is inseparable from some other property element, such as a site, it is a factor in the value of that piece of property, and income on the total value must similarly be considered a property income, not a pure profit. If the good-will inheres in the person of the owner, however, it is not property, but an element in the personal service of the owner, and its proper income is a wage; again not a profit. In so far as its value (in the capital or revenue sense) can be appraised, it must be considered as entitled to a contractual return and does not give rise to profit in the narrow sense.
Our discussion of the meaning of profit may now be summed up in a few brief statements. Organization involves the concentration of responsibility, placing resources belonging to a large number of individuals under centralized control. Examination shows that the human functions in production involve making decisions, exercising control, but that this control is not final unless combined with assumption of the results of the decisions. The responsible decision relates to men rather than things; the ultimate manager is he who plans the organization, lays out functions, selects men for functions and appraises their value to the organization as a whole, in competition with all other bidders in the market. For this ultimate management there is but one possible remuneration, the residuum of product remaining after payment is made at rates established in competition with all comers for all services of men or things for which competition exists. This residuum is profit; it is the remainder out of the value realized from the sale of product after deduction of the values of all factors in production which can be valued, or after all the product has been imputed to productive elements which can be imputed by the competitive mechanism. Profit is unimputable income, as distinguished from the total income of the owner of the business. Normally there are other elements in this total income, which, since they are not paid out by the business, may be said not to be imputed, or they may be described as "residually imputed."
Pure profit is theoretically unimputable, in the sense in which the competitive system of industrial organization imputes product value to agencies concerned in production. In this competitive process, all the product value which can be associated with any agency will accrue to that agency. The essence of the process is the bidding of entrepreneurs or would-be entrepreneurs for the use of productive services in the future, the rates of remuneration being determined by a present general competitive estimate of the values of the services in the market, while the return finally received from their use may diverge from this estimate in view of the fact of uncertainty or liability to error in all human prognostications. As far and as fast as any portion of income can be known in advance to be connected with the exercise of superior judgment, it will be imputed to the person possessing the unusual powers, and will become a wage (of management), no longer a profit. Wages of management are not different in principle from wages for routine work; management is routine work when the term is properly understood in the present connection. The true uncertainty in organized life is the uncertainty in an estimate of human capacity, which is always a capacity to meet uncertainty.
In general practice the ownership of property is necessary to the assumption of genuine responsibility, and in the typical modern business organization the responsible owner furnishes no labor services to the business, but property services only. In such a case profit in our sense of the term appears as a difference between the rate of return on the owner's investment and a competitive rate of return on investment generally. The scientific use of the term "profit" must therefore be distinguished from the various loose uses of the term in business, and particularly from the net revenue of the owner; it is well to use a special expression, such as "pure profit," to distinguish the share which is accurately residual, theoretically different from the returns from routine functions, imputed by competition to the agents which earn them. We must bear in mind, however, that the imputed or competitive element in the owner's income does not bear quite the same relation to the price of the product as outlays actually incurred. The expectation of such a return at the general competitive rate is a condition of the production of that business's contribution to the total supply of a commodity, but its realization cannot be said to be necessary.
If it is necessary to distinguish between profit and wages, it is just as vital to contrast profit with payment for risk-taking in any ordinary use of the terms. An insurer, in so far as his business is reduced to a science, takes no risk; the risk in the individual case of the insured is obliterated on being thrown in with the multitude of cases of the insurer. And it is immaterial whether the "cases" are a homogeneous group of similars or whether each is objectively in a class by itself, if the true probability can be ascertained. The "risk" which gives rise to profit is an uncertainty which cannot be evaluated, connected with a situation such that there is no possibility of grouping on any objective basis whatever. For while it is true that decisions made by an individual tend to approximate an objective value when considered as a group, decisions of this character reduce to routine and do not involve ultimate responsibility; in so far as the powers of the entrepreneur become evaluated, a definite return is imputed to his activity, and this return is no longer a profit, but a wage.
The only "risk" which leads to a profit is a unique uncertainty resulting from an exercise of ultimate responsibility which in its very nature cannot be insured nor capitalized nor salaried. Profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless. The receipt of profit in a particular case may be argued to be the result of superior judgment. But it is judgment of judgment, especially one's own judgment, and in an individual case there is no way of telling good judgment from good luck, and a succession of cases sufficient to evaluate the judgment or determine its probable value transforms the profit into a wage.
The fundamental fact of organized activity is the tendency to transform the uncertainties of human opinion and action into measurable probabilities by forming an approximate evaluation of the judgment and capacity of the man. The ability to judge men in relation to the problems they are to deal with, and the power to "inspire" them to efficiency in judging other men and things, are the essential characteristics of the executive.
If these capacities are known, the compensation for exercising them can be competitively imputed and is a wage; only, in so far as they are unknown or known only to the possessor himself, do they give rise to a profit. The powers and attributes of leadership form the most mysterious as well as the most vital endowment which fits the human species for civilized or organized life, transcending even that power of perceiving and associating qualities and relations which is the true nature of what we call reasoning. It is the margin of error in this most ultimate faculty of judging faculties whose exercise is the essence of responsible control, which constitutes the only true uncertainty in the workings of the competitive organization (as of any other organization). And it is uncertainty in this sense which explains profit in the proper use of the term, the sense toward which economic usage has been groping, that of a pure residual income, unimputable by the mechanism of competition to any agent concerned in its creation.
It remains to follow out this line of reasoning in detail, to show how a large part of the phenomena of current economic life, on the organization side, are the natural results of the fact of uncertainty and this fundamental method of meeting it. But it seems best to postpone this further discussion until we have examined the bearings of progressive change on the amount and kind of uncertainty involved in economic life. These two chapters have dealt only with the more fundamental features of free enterprise which would be met with even in a society as nearly static as material possibility admits, and in which a minimum degree of uncertainty would be present. We have abstracted from many important features of entrepreneurship which are connected with the fact of progress or the presence of the conditions of progress, for progress involves uncertainty in a high degree and in very special forms. We turn now to consider the bearings upon economic organization of the various dynamic factors or elements of progress and the uncertainty connected with them.
Part III, Chapter XI
Uncertainty and Social Progress
The general character of the connection between progress and uncertainty has been dealt with at various points in the course of our inquiry. Change of some kind is prerequisite to the existence of uncertainty; in an absolutely unchanging world the future would be accurately foreknown, since it would be exactly like the past. Change in some sense is a condition of the existence of any problem whatever in connection with life or conduct, and is the actual condition of most of the problems of pure thought, since these are after all more or less related to practical requirements. We live in a world full of contradiction and paradox, a fact of which perhaps the most fundamental illustration is this: that the existence of a problem of knowledge depends on the future being different from the past, while the possibility of the solution of the problem depends on the future being like the past. The key to the paradox, as we have argued above (chapter VII), is to be found in two facts. In the first place, we analyze our world into objects which behave more or less consistently. That is, we recognize in things the unchanging property of changing in certain ways. If this process could be carried out to completeness, we should have a completely knowable world. It would also, however, be in the practical sense an unchanging world. It is a fact familiar to students of our thought processes that we thus explain change by explaining it away. The historic problem of thought is this of real change. The point for us here is that change according to known law (whether or not we call it change) does not give rise to uncertainty. What we practically mean by a static world is one in which all change is of this character.
But the process of formulating change in terms of unchanging "laws" (properties or modes of behavior of "things") cannot be carried to completeness, and here our minds invent a second refuge to which to flee from an unknowable world, in the form of the law of permutations and combinations. A law of change means given behavior under given conditions. But the "given conditions" of the behavior of any object are the momentary states and changes of other objects. Hence the dogma of science, that the world is "really" made up of units which not only do not change (atoms, corpuscles, ether, or what-not), but whose laws of behavior are simple and comprehensible. But it is contended that there are so many of these units that the simple changes which they undergo (ideally movements in space alone) give rise to a variety of combinations which our minds are unable to grasp in detail. We have examined this dogma and been forced to the conclusion that whatever we find it pleasant to assume for philosophic purposes, the logic of our conduct assumes real indeterminateness, real change, discontinuity.
Even the assumption of real indeterminateness, however, gives mind a new means of prediction, through grouping phenomena into classes and applying probability reasoning. This device enables us to predict what will happen in groups of instances where we find it impossible to derive laws fitting individual cases. The second fundamental fact of uncertainty is that this method also has its limits. Both methods in fact, prediction by law in individual cases and by probability reasoning in groups of cases, have rather narrow limitations in everyday life in consequence of the organic costs of applying them and the time required to get the necessary data; both outlay and time are commonly much greater than circumstances will allow us to consume in deciding upon a course of action. The actual procedure of making decisions in practical life is a rather inscrutable or "intuitive" formation of "estimates," subject to a wide margin of error or uncertainty.
The significance of change is that it gives rise to the problem of the control of action, and in this respect the difference between predictable and unpredictable change is conspicuous. The succession of day and night or the alternation of the seasons, the vital processes and changes of our own lives, waking and sleeping, work-time and meal-time and play-time, infancy, maturity, and age—such events call for action, but give rise to no problem of action; they are predictable. Problems of action arise out of departures from routine in changes of all sorts. It is a common observation that irregularities would be of much less magnitude and consequence in the absence of social progress, and a common practice to distinguish between "static" and "dynamic" risks. The fundamental difference, as we have seen, is one of degree only, and consists in the greater unpredictability of some actual progressive changes. In the first place, it is impossible to draw a sharp and significant distinction between progressive change and fluctuations. Everything depends on the periodicity of the change. If it is self-compensating in an interval short as compared with the length of human life, it does not involve uncertainty, and the increasing perfection of organization devices designed to secure consolidation constantly extends the period over which effective self-compensation may come about. On the other hand, all our progressive changes may be ultimately periodic for all we know.
Again, progressive change does not necessarily carry unpredictability with it; indeed, a merely progressive change does not. If the change takes place uniformly, or in accordance with any known mathematical function of time, the future may be foreknown as accurately as if there were no change. It is fluctuation after all which is the true cause of the uncertainty, fluctuation in progress. In fact some changes are fairly "constant" in their operation and do not give rise to uncertainties of the sort which disturb the operation of competition. Of this sort are the increase of population and the accumulation of capital. Others are highly capricious in their action and continually upset the calculations upon the basis of which entrepreneurs' bids for productive service are made.
Scrutiny of the character of the progressive changes which we have recognized (chapter V) as significant in the study of economics reveals some interesting similarities and differences among them. If we begin by distinguishing between natural changes and changes due to human action, we note that we do not have to consider any progressive changes under the former head. Natural changes are either of the nature of fluctuations from a constant condition or else, like the supposed cooling-off of the solar system, so slow as to make no difference for human calculations. The changes due to acts of man are, however, of two different kinds. Some are produced by deliberate intent and others come about more or less incidentally as a result of actions directed toward other ends. A study of the "real" motives of action would lead far afield, and probably yield no very clear and satisfactory results at last, but we can make a rough distinction. The improvement of technology and in large part the discovery of natural resources are directly willed, though the latter is to a more considerable extent accidental. The accumulation of capital may be treated as deliberately effected, though with some reservations, and the various redistributions of things among persons may be similarly treated, but with more reservations. The improvement of wants is partly a deliberate matter, partly incidental to other endeavors, and partly it "just happens." The increase in population is hardly willed at all; the matter of its innate quality is even less affected by volitional interference (and in fact unquestionably shows rapid retrogression under modern industrial conditions); while the education and training of the individual are controlled by a baffling mixture of planned action and accident.
Another dichotomy of fundamental importance for the study of uncertainty relates to the production as contrasted with the consumption of wealth. This distinction is also well recognized in discussions of uncertainty, the technological "risks" being separated from those connected with market changes. It is interesting to observe in the evolution of the modern industrial organization how the marketing function has consistently dominated that of production proper. We have already pointed out that the most fundamental determining fact in connection with organization is the meeting of uncertainty. The responsible decisions in organized economic life are price decisions; others can be reduced to routine and men can be hired to make them. The uncertainties of the market resist elimination or reduction by grouping more doggedly than do those connected with technological processes. Even in the transition period between the mediæval and modern eras it was the marketing guilds which gravitated into positions of control, became the "Liveried Companies" and employed the producers and set them at their tasks, owning the materials they worked upon and the product when completed.
It will be observed that the main uncertainty which affects the entrepreneur is that connected with the sale price of his product. His position in the price system is typically that of a purchaser of productive services at present prices to convert into finished goods for sale at the prices prevailing when the operation is finished. There is no uncertainty as to the prices of the things he buys. He bears the technological uncertainty as to the amount of physical product he will secure, but the probable error in calculations of this sort is generally not large; the gamble is in the price factor in relation to the product. But changes in the prices of producers' goods affect him indirectly, because they are likely to be connected with changes in product prices; they form one of the factors to be taken into account in forecasting the sales market. This is probably a secondary consideration, however, except in so far as capital values are involved, a fundamental exception, to be sure, which will have to be discussed at length presently. The main immediate sources of uncertainty are the amount of supply to be expected from other producers and the consumers' wants and purchasing power.
The most fundamentally and irretrievably uncertain phases or factors of progress are those which amount essentially to the increase of knowledge as such. This description evidently holds for the improvement of technological processes and the forms of business organization and for the discovery of new natural resources. Here it is a contradiction in terms to speak of anticipation, in an accurate and detailed sense, for to anticipate the advance would be to make it at once. Yet even here, as we have seen, change and the uncertainty of change are in some degree separable factors. Though we cannot describe a new invention in advance without making it, nor say what quantity and quality of new natural productive capacity will be developed and where, yet it is possible in a large degree to offset ignorance with knowledge and behave intelligently with regard to the future. These changes are in large part the result of deliberate application of resources to bring them about, and in the large if not in a particular instance, the results of such activity can be so far foreseen that it is even possible to hire men and borrow capital at fixed remunerations for the purpose of carrying it on.
Two further general observations are called for before we can take up in detail the effects of the uncertainties involved in progress upon the form and workings of the competitive economic organization. It is common to think of the economic process as the production of goods for the satisfaction of wants. This view is deficient in two vital respects. In the first place, the economic process produces wants as well as goods to satisfy existing wants, and the amount of social energy devoted to the former and neglected phase of activity is very large and constantly growing. The second point is that the production of the indirect means of want-satisfaction is by no means altogether directed to the ultimate satisfaction of wants in any direct sense of the terms. The increase in wealth is to a large extent an end in itself as well as a means to the increase of income, and this also again to a rapidly increasing degree as the standards of life are advanced. Men work "to get rich" in a large proportion of cases, not merely in addition to, but in place of, consuming larger amounts of goods. It is a grave error to assume that in a modern industrial nation production takes place only in order to consumption. It is true to a great and ever-increasing degree that consumption is sacrificed to increased production. Whatever our philosophy of human motives, we must face the fact that men do "raise more corn to feed more hogs, to buy more land to raise more corn to feed more hogs to buy more land," and, in business generally, produce wealth to be used in producing more wealth with no view to any use beyond the increase of wealth itself.
From the standpoint of effects upon organization we must distinguish between the various phases of progress already enumerated (in chapter V), the increase of population, education and training, accumulation of capital, improvement in technology and business organization, discovery of new natural resources, and changes in the character of human wants. The most important of these from our point of view and at the same time the one easiest to discuss intelligently is the accumulation of capital.
Let us begin with the relation of capital in the sense of material goods to the fundamental structure of society. The facts of progress will be seen to have an intimate connection with the very institution of private property. In an unprogressive society private property in the modern sense of the term need not exist. The social justification of private ownership is that the coupling of control of resources with enjoyment of the fruits of their use is supposed to give an incentive to use the goods effectively in production. The abolition of slavery or property in human beings rests on the fact that slaves do not work as effectively as free men, and it turns out to be cheaper to pay men for their services and leave their private lives under their own control than it is to maintain them and force them to labor.
The same reasoning applies to property in material things, but in an unprogressive state the force of the argument is relatively weak. When production methods are a matter of routine, as in the Middle Ages, and there is no thought of progress, common ownership of land and tools is the rule. The problem of control becomes acute when methods are changing, and the incentive to change methods is mainly the desire to increase property values, to "get rich." We can hardly over-emphasize the fact that the dynamic urge back of modern economic life is the desire to increase wealth, rather than a desire to consume goods, though there is a psychological connection of an irrational sort between the two considerations. Even when improvement in standards of living does result from the increase of wealth, it cannot be assumed that this was the motive; for as we have previously emphasized, a permanent net increase of wealth must come from a surplus production on the part of individuals which they never plan to consume, but expect to die and leave behind them.
The most direct connection of the uncertainties of progress with economic theory in the conventional use of the term is in relation to the explanation of interest. Interest is a phenomenon connected with the increase of the material equipment of society and dependent on the uncertainty involved in the process. It might or might not exist in a "static" society, depending largely on how rigidly the term "static" is interpreted. If productive goods were not changeable in either form or amount or distribution there would be no occasion for the lending of free capital, and interest would not exist; if all equipment were fixed in form and amount, but transferable from one individual to another, it might exist; with productive goods fixed in amount (no net saving or consumption of "capital" taking place), but changeable in form, interest would doubtless be found, but would make no appreciable difference in the distribution of income, as it would differ in very little but name from rent.
To understand interest it is necessary to have clearly in view the mechanism of the creation of capital equipment through the process of saving and investment. The classical conception of capital as "advances to laborers" is essentially sound at least as a starting-point, though it must be amended or qualified in two particulars. The description applies, first, only to new or "free" capital, capital in the process of formation; it is true in the sense that capital goods come into existence through an "advancement" of consumption goods. In the second place, the advances are not made to laborers only, but to owners of already existing capital goods (and natural resources if these are separated from capital goods) as well. The difficulties and confusions with which interest theory is beset arise largely from the use of terms, notably the ambiguity of the term "capital." In the discussion which follows we shall employ the expression "capital goods" to refer to "the produce of past industry used for further production," the concrete instruments and tools, and restrict the term "capital" to a much narrower meaning, relating to this antecedent stage in the creation of capital goods or to their value as distinct from the goods themselves.
The nature of capital creation has been made clear by many writers. The primitive man constructs his own equipment to increase the efficiency of his own labor, and what he dies possessed of is likely to be buried with him. In organized civilized life the process is different in two respects. In consequence of specialization certain persons devote their energies altogether to the production of equipment goods, others not at all; and in the second place, a great permanent fund of goods is built up and maintained and increased from generation to generation. Yet what happens on the whole is fundamentally the same, though the division of labor makes it somewhat more difficult to see. Those who are engaged in the making of equipment goods are naturally not at the same time making their own living; they must live out of a surplus of consumption goods either stored up in advance or diverted from the use of those who produce it contemporaneously. In either case the first requisite to capital creation is the creation of a surplus, the production of more goods than are consumed, by somebody at some time prior to the coming into existence of the capital goods. This is the essential meaning of "saving."
In civilized society the makers of capital goods include landlords and owners of capital goods as well as laborers. All who furnish productive services of any kind to the capital goods producing operations are manifestly paid out of prior production or excess contemporary creation of consumption goods by other persons and equipment. The essence of the process is that a surplus of consumption goods, set aside by being "saved," makes possible the diversion of productive resources from the creation of consumption goods to the creation of producers' goods. This is what is meant by "advances."
The series of events is further complicated by the intervention of money, for a relatively small proportion of students of economics ever learn to think back of the exchange function of money to the transfers of real things mediated by it. Saving is erroneously thought of as the saving of money, and the income of the producers of capital goods as a money income. Of course the money is a mere medium of exchange. It represents to the saver the ownership of a certain amount of the wealth of society, which can be "drawn" or "cashed" in any form he pleases at existing prices. If the saving is "invested," used for capital creation, this wealth is transferred to those engaged in these operations and "cashed" by them in the form of the things they want, mainly consumption goods. The title to these things is what the saving is and what is transferred. The transferred goods maintain or support the producers of capital goods, including laborers, landowners, and owners of capital goods who would otherwise be engaged in making consumption goods for themselves or for exchange. Interest arises when saved wealth is not invested by the saver, but transferred by loan to another person, either direct from saver to investor or mediated by a bank or financial institution as middleman.
The loan at interest is thus a means of securing specialization of function, enabling one set of persons to save surplus wealth and another set to convert savings into capital goods by advancing them to the owners of productive services who then use these services to create the capital goods instead of the consumption goods which they would have been used to produce had no saving taken place. The operations could be carried on without specialization; division of labor here as elsewhere involves economy merely, but is not the only way of getting things done. The savers could advance their own surpluses to owners of productive services and create capital goods on their own account, either themselves exploiting these new productive goods or transferring them by lease to other entrepreneurs. The gains from having them transfer this function to others who make investment their business are of the same character as the gains from specialization in any other connection.
Notably the gains are the same as those which arise from the specialization of the entrepreneur or control-plus-responsibility function, for this is what is really involved in the loan. Let us suppose that the saver does his own advancing and comes out the owner of the capital equipment which results from his saving; what will he do with it then? He might also employ this new equipment himself in the production of the sort of goods to which it is adapted, continuing meanwhile the original business or profession out of which he made the first saved surplus. But we know that it is in general much better and much more likely to happen that he shall lease the equipment at a fixed rate to an entrepreneur for actual operation. Let us make it as clear as possible that exactly the same sort of gains are realized by his transferring the surplus of goods itself to an entrepreneur at a fixed remuneration and leaving to the latter the construction as well as operation of the new equipment (or leaving the construction and operation to two different outside entrepreneurs).
The saving of surpluses is clearly one function or operation and their use to make possible the creation of new equipment another and quite different one, just as the furnishing of productive services is one function and their use in the production of goods is another. In fact a little reflection will show that the operation of converting surplus goods into capital goods partakes in an especial degree of the characteristics which lead to the specialization of the entrepreneur function in the field of ordinary productive operations: namely, it involves special knowledge and foresight of future conditions. A surplus of consumption goods is fluid capital; it may be used to create any kind of concrete productive instruments whatever, within the limits of physical possibility and arbitrary social control. In a society which permitted such use it could be made to produce or increase a supply of slave labor. It can as a matter of fact be used to increase the supply of natural agents or to invent and discover new ways of doing things, even to create new wants for goods, and many things not conventionally considered capital creation.
The burning question in practice is, what form of new capital goods shall be created, where, by what methods, etc. The answer is an exercise of judgment of far the highest type called for in the business world. It is obviously inevitable that the function of answering this type of question will be specialized along the same lines and for the same reasons as the control of enterprise under static conditions. The individuals who control the conversion of saved surpluses into capital goods must take the responsibility for their decisions, though as in the former case the "control" may take the form of selecting some one else to exercise the immediate control as a routine task performed without responsibility for the results. The call for the exercise of judgment is greater as the uncertainties of progress are greater than those of routine operations, and the necessity that the responsibility be taken by the person who exercises the judgment—of the situation or of the human capacity to judge it—is correspondingly great.
Under freedom of contract the machinery which naturally grows up for effecting this specialization is the machinery of the market, working in the same way as in the case of entrepreneurs' bargains with the owners of productive services. Surplus consumption goods, or titles to these in the form of money or bank deposits, form a perfectly standardized commodity of an ideal sort for trading. It is also extremely mobile, still further adapting it to the operations of a market of the widest scope. Banks and financial institutions have this market highly organized. The actual workings of the market are the same as those of any other market. At any time there is a price established, which in this case is unusually definite and uniform. It is not, indeed, a single homogeneous commodity that is dealt in, for funds for different sorts of investment admit of the specialization of the entrepreneur function in widely different degrees. But after all the loan market represents a narrower range of prices according to grade and kind of the goods than is true of nearly any other market to be named. Men who are willing to purchase at the established price meet men who are willing to sell at that price; others do not enter the market. If more of the commodity is offered than will be taken at the existing price the price falls, and vice versa, keeping the price constantly adjusted to the point which equates the supply and demand.
The buyers' decisions to enter the market represent a judgment of an investment opportunity that will yield a profit (together with ability to give the security demanded in consideration of the rate on the particular kind of loan). The entrepreneur in this case must make an estimate of the future, involving a very complicated series of factors. The borrower of funds (like the hirer of other agencies) for routine productive operations estimates the physical product to be turned out by their use and the sale price of this product. The borrower for the purpose of creating new capital equipment must estimate in physical terms the results of his constructive operations, the physical output of his equipment after it is in use, and both the cost and the salability of that product, all of which are in the future by the interval required to construct the equipment in addition to the period of production in the industry. Besides all which it must be kept in mind that the construction of a new productive plant includes getting it into operation, building up business connections in the markets for all the things the business must purchase as well as the things which it sells; and this normally requires a much longer time than the mere mechanical construction of the plant.
The specialization of entrepreneur activities may go farther than above indicated in various ways. In particular, the use of surplus goods, represented by money funds, in constructing new production goods may be separated from the operation of the new equipment when constructed. But for obvious reasons this is also likely not to be the case. Construction includes, as we have seen, an initial period of operation longer than the construction period itself in the narrow sense, and the overlapping in time makes them difficult to separate. It commonly happens, indeed, that the mechanical part of building a plant is turned over for a fixed consideration to another entrepreneur, a contractor. Of course the starting of new enterprises with a view to their sale or even lease to others for operation after they are established as going concerns is not at all unusual, but can hardly be said to be the typical procedure in most lines of business.
The importance of the distinction between capital and capital goods should now be clear. The business world thinks of capital as money funds. Money, however, is only a medium of exchange, and in the investment function represents a title to a surplus of wealth, practically speaking a surplus of consumption goods. This is the real meaning of free capital, which is a stage in the development of capital goods. The crux of current confusion in interest theory lies in the failure to see the significance of the fact that we live in a progressive society, that new net surplus production is constantly flowing through the loan market into the investment field and being converted into material equipment. That is, it is surplus production on the part of the individuals and classes who save it; from the standpoint of society as a whole there is no surplus production of consumption goods; the surplus appears in the form of additions to capital equipment. In an unprogressive society where new saving was not being used to create new resources, there could not be interest in the sense in which the term has significance to economic theorists,—i.e., as a distributive share,—though interest could be paid for consumption loans. At present consumption loans are negligible in comparison with loans for conversion into new productive goods; when they are made they, of course, take the same rate of interest, allowance being made for degree of security against loss of interest and principal.
Interest is the payment for the use of free capital; for the use of capital goods when employed by another than their owner, the payment is a rent. Interest is manifestly paid out of the produce of the property created with the resources obtained by the loan; it is part of the produce of the capital goods which were in the mind of the borrower when the loan was made, which the capital represented to him. This yield of property must again be distinguished from rent; the former is the actual return realized from the exploitation of the material things, while rent is the competitive market value of their use. Rent is paid out of the property yield if the property is actually leased; if it is managed by the owner, income should still be imputed to it on the basis of its fair rental value. The yield should include rent plus a profit, if the entrepreneur is to get any remuneration for the performance of his special function.
These three species of income thus form a sort of concatenated series, tied together by two forms of profit. The actual yield of the property includes the competitive rent, and the profit which pays the responsible entrepreneur who exploits it. The rent in turn includes competitive interest on the investment (the original value sacrificed to create it) plus a profit which is the remuneration for the entrepreneur function of converting the investment into the concrete goods.
One striking difference between rent and interest has been especially fruitful as a source of confusion in the theory. Both are expressed as rates, per dollar per year, but the explanation is very different in the two cases. Interest is naturally a rate, a ratio between two values. The object transferred from saver to entrepreneur is expressed in value terms, a certain amount of money, representing surplus consumers' goods to a certain value, and the return to the capitalist is also stated in value terms. If rent is stated as a rate of return on the investment, however, the relation is inverse; the investment in this case means not an original value magnitude, but the sale value of the property, which is the result of capitalization at the current rate of interest. For obviously in a progressive society where men are constantly lending funds of value at interest, freedom of exchange between value funds and productive goods will fix a value on the latter equal to the investment necessary to produce an equivalent return. It is this phenomenon of capitalization which to certain writers of the "psychological school" has obscured the fact that what is transferred in a loan at interest is a fund of value which is not the result of a capitalization process, but is valued as an immediate utility.
Capitalization and property values are fundamental to an understanding of the phenomena which arise out of the uncertainties present in a progressive society, and call for some further discussion on their own account. When a new productive enterprise is once established and shows promise of yielding a profit above the competitive rates of return on the resources put into it and those necessary for its operation, this entire future yield, discounted to its present worth at the current rate of interest, can be drawn or cashed in at once by the sale of the property. Taken in conjunction with the fact observed above, that the desire to own productive wealth is by no means merely an indirect desire to consume its revenue, this fact of the anticipation of future income by capitalization increases many fold the incentive to embark on new ventures. Even when the owner of the enterprise has no intention of selling the property, but considers only operating it to secure an income, the paper profit on the capital value must be considered a part of his remuneration more or less separable in his mind from the profit in the shape of an income above the competitive return on the investment.
It would be hard to overestimate the error involved in the psychological interpretation of economic motive as desire to consume goods alone. Even the desire for an income is not simply a desire to consume. For societies, or social classes in any society, near the subsistence margin, this is more nearly true. Even the so-called "subsistence margin," however, in any advanced society like the United States includes probably several times as much as is really necessary to gratify the animal wants and maintain health and physical efficiency. This does not mean that an individual can really live on a fraction of what those with the lowest incomes actually consume, for in a civilized society, the conventional necessaries may be as indispensable in fact as the animal necessaries. The motives for the consumption of even the conventional necessaries are none the less different from the animal needs. The desire (or necessity) for conforming to conventions is not the same thing as the need for food and protection; the easy fallacy is confusion of the requirement for food, clothing, and shelter of the conventional kinds with the requirement for food, clothing, and shelter as physiological necessities. A large part of the consumption of persons, in the lower income strata even, does not yield satisfaction as consumption; the motives and cravings are social in their origin and nature. It is a commonplace that many of the necessities of to-day did not exist or were not available for our ancestors a few generations ago, irrespective of their wealth.
In separating the desire to increase one's possessions from the desire to consume goods, we of course make no pretense of carrying our analysis back to "ultimate" motives, but an observation in this connection may not be out of place. Adverse reference has been made to the use of instinct psychology in economics. In the writer's view the lists of instincts given by Parker and others are superficial in the highest degree; yet it must be admitted that this literature represents progress, in comparison with the naïve psychologizing of conventional economics. The instincts are a step in the right direction, carrying back the immediate lines of endeavor to more generalized motives and impulses. The defect in the procedure is that it stops halfway on the road to a rather obvious goal. Man has no instincts in the sense of tendencies to act in a definite way under definite circumstances, at least above a plane so low that they are as properly interpreted as reflexes. He has a few needs, of course, but the knowledge of their mode of satisfaction is not innate. We should never know, if untaught, what to eat, if indeed we should connect the pangs of hunger with the act of eating at all in the absence of knowledge gained by teaching through stimulating certain reflexes. And similar statements probably hold for sex behavior. It seems clear that in our whole higher life above the plane of food and sex and primitive pleasure-pain reactions, our activities result from a single unspecified, undirected tendency to act purposefully, the specific direction of the desire and activity being determined by suggestion from the environment and critical reflection upon such outside suggestion. All the instincts not directly connected with self-preservation (and the specific content of even these as we have seen is largely taught) are easily analyzed into each other; any one of them—or better, any pair, for they run largely in pairs of opposites—if interpreted broadly will account for most of our conduct. The only differentiation that would have any meaning would be the separation of an instinct of repose from the instinct of action; and repose is a mere negative.
Possibly thought is sometimes enough different from motor activity to justify a separation, but this would certainly be the case with exceptional individuals only, and the instinct theorists insist on universality as a criterion for a true instinct.
The conclusion we are here interested in, however interpreted into human nature, is that social progress on the material side is largely motivated by a desire to possess wealth, and that the rôle of uncertainty in connection with capitalization is to make it possible for an individual through superior judgment or good luck to obtain a large increase in his wealth in a short time. In addition capitalization brings about a reduction of uncertainty through consolidation, in a way pointed out in an earlier chapter. Persons who are fitted for and enjoy making new ventures can specialize in this type of economic activity, selling the new enterprises when established. Thus by bringing many ventures within the scope of action of a single individual (or business unit) the errors tend more or less to cancel out; and an estimate can be formed of the objective value of the entrepreneur ability exemplified, still further reducing the margin of uncertainty in any particular venture.
It goes without saying that the phenomena of capitalization hold good for established enterprises as well as new ones. Any change in the current yield of any property whatever at once accrues, in so far as it is viewed as permanent, in the form of a change in the capital value of that property. These changes in capital value often overshadow in importance the changes in income. Such changes in capital values, depending on the anticipated future income of the property, do not necessarily wait for or synchronize with changes in current yield itself. The phenomena of speculation thus result from the endeavor to foresee the yield of salable productive goods and to take advantage by purchase and sale of the resulting changes in present values magnified by capitalization. Of course the desire for the income itself continues to operate, but for important classes of business men these considerations are eclipsed by the hopes of profiting by changes in capital values. Many of the important and sinister phenomena of modern economic life result from these facts. Those in control of the policies of a business are almost inevitably in a better position to foresee its future earnings than are outsiders, and it is difficult to prevent their taking advantage of this position to the detriment of their efficiency as managers of productive operations. The "corporation problem" arises largely out of this situation.
Matters become still worse when the managers of productive property begin to manipulate their industrial and financial policies with a view to producing changes in capital values, of which they inevitably know in advance of outsiders and of which they take advantage with corresponding ease. Instances of such action with enormous gains reaped by insiders are familiar to all who know anything of modern corporation history. It is hard to see how they can be prevented without a strengthening of the moral code of business and a strict application of criminal law. The possibility of capitalizing the gains of all sorts of fraudulent activity, getting out from under and leaving the issues to be fought out between the victims and "innocent holders," is indeed a serious menace to the efficient working of a productive mechanism organized on the principle of private property and free contract. Perhaps as bad as manipulating policies for the sake of quick gains on the securities market is the corruption of sources of information for the same purpose. In a world where uncertainty plays so great a part as it does in our progressive private-property society, the virtue of truthfulness becomes the very pearl of character.
The uncertainty so far discussed in this chapter is solely that which arises from the conversion of free capital (surplus consumption goods represented by circulating medium) into new productive equipment of kinds already familiar. The creation of free capital itself is subject to uncertainty, which calls for some notice. We are not concerned with the effects of uncertainty on the saver (not also investor), since that is a matter of his inner consciousness and does not produce objective effects in modifying social organization. Of interest, however, is the fact that productive business counts on the interest rate as a datum in its calculations. It would seem that in a society made up of persons with a tolerably stable human nature and living in an environment as little subject as ours to progressive or capricious change, the supply and demand of new saving would be nearly constant, the market being as large as it is, and that the interest rate would be free from extreme fluctuations. We know that such is very far from being the case. It is manifest that changes in the interest rate are as effective as changes in the yield of the property in producing changes in capital values.
An explanation of the variations in the interest rate would carry us into the general theory of business conditions and the business cycle, an excursion precluded by the limits of space. We must point out, however, that the theory of a uniformly progressive society is profoundly modified by the tendency hitherto manifested under modern industrial conditions for growth to take place in waves. It is like the oft-cited advance of the tide up a beach, advance and recession alternating and obscuring even the fact that a small gain of an occasional wave constitutes a net advance. Economic progress under real conditions shows similar advance and recession, proceeding in cycles of a character now fairly well understood, but of such uncertain length that the consequences at the turning-points are often catastrophic. A large part of the phenomenon is due to the fact that the creation of new capital is so closely bound up in the issue of circulating medium by commercial banks. Price levels and profit margins being even more dependent on this precarious exchange medium, the operations of business proper find themselves tied up to the tendencies of a credit currency under private control to expand to a point of instability and under the least shock to collapse. These phenomena enormously increase the uncertainty of business operations and create opportunities for making large gains through the exercise of superior foresight or by good luck.
The above description of the uncertainty relations of one of the elements of social progress, brief and inadequate as it is, must suffice for the present sketch. Moreover, the other progress factors, though more complicated and difficult of treatment, will have to be disposed of very briefly by a mere indication of some of the similarities to and contrasts with the growth of capital. The increase of population may be briefly handled. In the aggregate, it is not subject to enough uncertainty to produce any noticeable effect on the organization of society. Over long periods the general increase, if it proceeds faster than new lands are opened, as it has since the industrial revolution, causes a rise in the value of "land." This change, however, as an aggregate is so far overshadowed by the differences in the changes at different locations that it may be passed over. There is little question that in fact speculators in land make on the whole less than the competitive return on their investment, though this is difficult to prove conclusively. The outstanding phenomenon is the large gains and losses, especially the large gains from a few fortunate investments in real estate held over a period of generations by the same families. We shall recur to this theme in the next chapter. It is clear that the main cause of the differential rates of value increase is another one of our progress factors, the redistribution of the population over the soil. The mixture of foresight and pure luck in the production of gains from such uncertainties is an interesting question, but one about which there seems to be little comment worth making. Another phenomenon in connection with the increase of population over long periods is the redistribution of wealth and probably of ability among individuals. We know that the wealthier families increase much more slowly than the less wealthy, and there is every reason to believe that the same applies to the more as compared with the less capable. As wealth and ability are both inherited in varying degrees the consequences are obtrusive, in their general character at least. These facts do not affect the form or theory of competitive organization, but as they modify the material upon which the mechanism works the results are none the less subject to change.
Another progress factor, the increase in the available supply of natural resources, has been referred to incidentally above, and as the relations of "land" to "capital" were discussed in an earlier chapter, this topic need not detain us long. Discovery of new natural wealth may result from pure accident, in which case its value is all pure profit, which in consequence of the principle of capitalization may be cashed in at once by the finder. But this is not what usually happens. In the case of agricultural land the conditions and rewards of pioneering are fairly ascertainable. If any profit results from these operations it is an exceptional case or else it is remuneration for some special sacrifice undergone; i.e., is not a profit at all. With mineral resources things are different. Here there is an enormous amount of complete unpredictability. Under old-fashioned methods there is no question that prospecting for the precious metals involved in the aggregate enormous losses. In regard to other minerals, coal, oil, iron, copper, etc., the present writer has no ground for forming an opinion, but would "guess" that the search for these things being less feverish, the accidental gains are much less in arrear of the losses. Recently the search for precious metals has been placed on a much more scientific basis and there is doubtless in the aggregate less discrepancy than formerly between the returns realized and a normal competitive return on the resources invested.
The point which calls for emphasis is that where the possibility of securing wealth by the discovery of natural resources is known, along with something of the operations and outlays required, resources will be attracted into the field of searching for them in accordance with men's estimates of the chances of success in relation to the outlays to be incurred. The quest of wealth by this process thus becomes to those engaged in it an ordinary business operation, differing from the routine production of goods for immediate consumption in no matter of principle, though perhaps affected by a larger degree of uncertainty. And the same organization devices will be called into existence to deal with the uncertainty present—large-scale operations, the use of insurance where possible still further to broaden the base of the calculations, scientific research into the conditions of prediction and control of results, etc. Entrepreneurs engaged in exploration and development work bid in the same market against entrepreneurs in the fields of static industry for the same fundamental productive resources, and competition must fix a uniform price for both uses and bring about the same tendency to equality of cost incurred with output secured over the whole field of investment.
Another factor of progress having exceedingly complex uncertainty relations is the changes in human wants. These changes, again, may just happen, accidentally, or they may take place more or less in accordance with law and hence predictably, or they may be deliberately brought about by the expenditure of resources for the express purpose of effecting such a change. If they happen unexpectedly the disturbances in incomes and capital values which result must be classed as pure profit or loss. In so far as they can be foreseen, no profit will be realized. In so far as they result from a deliberate expenditure of resources, they become as all other economic operations. The amount of profit realized will then depend on the effectiveness of competition based on foreknowledge of the results of the activity. In this respect the "production" of wants is like the production of goods. In fact, as we have previously observed, the advertising, puffing, or salesmanship necessary to create a demand for a commodity is causally indistinguishable from a utility inherent in the commodity itself.
The last progress factor calling for notice is that of knowledge, or what may be designated by the term "invention" taken in a broad sense. It is a commonplace fact that one of the chief sources of uncertainty in business life is the improvement of technological processes, methods of organization, and the like. It is difficult to draw a rigid distinction in principle between the discovery of new facts and the production of change in the facts themselves as objects of knowledge. It is plain that the finding of new natural resources is equivalent to their creation and the difference in the case of human wants is also rather hazy and metaphysical. The important practical difference between discovery and creation relates to the matter, referred to in a previous chapter, of the cost of reproduction of ideas as compared with things. The knowledge of a fact may be extensible almost without cost throughout the membership of competitive society. Of course—and this is an observation which students of the phenomena have neglected to make—it also may not be of this character; it may cost as much to get an idea into a head as it does to get matter from one form into another, and it always does cost some expenditure of energy somewhere. In general, however, a competitor can get the idea of a new method or process at less cost than he can get new material equipment, provided energy is not expended in preventing him from doing it. Moreover, the mere gratification of curiosity may be ample compensation for the effort required to get an idea, so that this cost can be entirely neglected or may even become negative.
The essential facts about new knowledge for our purposes center around the qualities of the productive equipment, including laborers, requisite for carrying it into effect. A new process usually calls for changes in the forms and attributes of productive agencies and necessarily involves new combinations among these. In very simple cases, however, little may be involved beyond new manipulations of old things. Like all the other phases of progress this one may result from accident or from the planned expenditure of existing resources. Even in the case of accident we cannot say that anticipation of and allowance for the change is entirely eliminated. For it is not meaningless to assert that even of things beyond our knowledge or control some are more likely to happen than others. We do make such judgments and in the large they are probably more right than wrong, however mysterious may be the basis upon which their value rests. In so far as the probability of a discovery can be estimated it is evident, as in the case of progressive changes previously discussed, that entrepreneurs will make allowance for its effects and in so far it will in the aggregate cause no competitive maladjustment and produce no discrepancy between the prices paid by entrepreneurs for productive services and the prices received for their products. The value of such estimates is naturally very small, and we may assume that most of the offsetting of gains and losses from disturbances due to accidental discoveries is itself accidental and not the result of calculation.
In the case of new knowledge which is the result of deliberate thought, investigation, and experiment, the element of predictability is of course greater. As inscrutable as with accidental discoveries, almost, are the operations by which we form an estimate of the chances of success in such operations, but the fact is inescapable that we do form such estimates and that they have considerable value. Much scientific and business research is now carried on under some approximation to competitive conditions by the employment of large-scale methods. That is, it is possible to foresee the average long-run results of the operations with suffcient accuracy to cause the employment of resources in the field up to a point where the return is approximately equated with the return from the same resources in the general competitive market. In any case it is clear that in so far as the results can be predicted the investment of resources in the acquisition of new knowledge will be so adjusted as to equate the return with the general competitive level, which is to say equate realized values to costs and eliminate profits.
The matter is indeed frequently, if not usually, complicated by the very low cost of indefinitely multiplying an idea when it is once secured. As a consequence of this fact the inventor or discoverer usually has to make some special provision to limit the use of his results to his own business operations. In certain fields this can be done through legal protection granted by the State in recognition of the value to society of the service. In others artificial measures for secrecy must be taken. In many cases no direct safeguards are available and the economic profitableness of the idea is limited to the period of time required for competitors to copy the new method. Regular commercial research in these fields is doubtless rare. Even legal protection is valid only for a limited period of time and secrecy cannot often be permanently maintained. When the idea becomes common property it is like any other superabundant element in production, a free good and no longer a productive factor in the effective economic sense.
It may often happen, however, that one of the results of a new departure is greatly to increase the value of some limited kind of material or human productive service. If this service be that of a non-reproducible natural agent the inventor may permanently secure that part of the value of his idea by purchasing such property. If the gain attaches to reproducible property he may prolong his differential gain by the period required to increase the supply, and even in case of a specialized human service a long-time contract may sometimes be utilized to retard diffusion of the results of superior methods. As observed in our discussion of monopoly it is immaterial whether we regard these cases as monopolization of the idea or method as such or as monopolization of the limited resources necessary for its exploitation. The losses which are equally likely to result from inventions fall upon the owners of the specialized human qualities or equipment goods.
Discussion of the conditions of permanence of the gains from improved methods of production leads naturally to the consideration of the general subject of economic friction and its opposite, mobility. We have already observed that the advocates of the "dynamic" theory of profit, the theory that profit is the result of progressive change, give an exceedingly important place to the phenomenon of friction in their analysis. In this view, indeed, friction is a necessary condition to the occurrence of profit, as it is expressly stated that in the absence of friction profit would disappear as fast as it appeared and that it does constantly slip through the fingers of the entrepreneur and spread over society at large as fast as the friction can be overcome.
It will be apparent as soon as pointed out that this argument uses "friction" in an inadmissibly inclusive sense. To explain profit thus in terms of friction, the term must be made to cover every form of resistance to change and readjustment in productive operations. That is, to get rid of profit by eliminating friction, it would be necessary not merely to have a perfect market, perfect competition, and costless mobility, but in addition it would have to be possible without the consumption of time or effort to change the form of capital equipment and goods in process, not to speak of natural agencies and the existing labor force. In a world where this could be done, it is manifest that there would be no need for productive effort of any kind. Perhaps we may distinguish between the readjustments involving only the moving about and recombination of productive agencies of all kinds and those calling in addition for substantial alteration in the form of things. The latter it is clearly inadmissible to class under the head of overcoming "friction." But the same may be said even of mere movement of things. This also is a productive transformation, and undoubtedly the greater part of ordinary productive activity comes under the head of transportation, taken in a broad sense.
It is necessary to take up the problem under the heads of the different types of production costs and investigate the forces which retard the readjustment of each type to correspondence with the value of the productive contribution of the agency to which the payment is made. The first and simplest readjustment is that of values of services which undergo no change in either form or position as a result of the introduction of new methods. A new discovery will, as already noted, increase the value contributions obtainable by the use of some agencies and decrease those of others. It will ordinarily be true that changes in the market prices of these services will lag appreciably behind the changes in their theoretical values to the entrepreneur. Many of them are hired under contracts covering a longer or shorter period of time which prevent sudden changes in their rate of remuneration. During any such interval the employing entrepreneur must, of course, make a gain or loss by their use.
And even where the factor of a time contract does not enter, there will probably be a lag in the prices of productive services, i.e., in the costs of production, as compared with commodity prices. The former are, of course, in the aggregate caused by and reflected from the latter and the forces of competition which impute commodity values to the productive services upon which production depends do not operate instantaneously. The chief cause of this lag is again the difficulty and uncertainty of knowledge; it takes the owners of productive services and entrepreneurs some time to learn the facts. Most of this learning has to be done by crude and rather slow trial-and-error methods; there is generally no possibility of computing results in advance. In the interval necessary for every one to find out the exact relations of dependence between product values and the employment of each resource and of working out an ideal adjustment, it is clear that there will be many discrepancies between entrepreneurs' outlays and their returns, i.e., many occurrences of profit, positive or negative.
A somewhat special case is presented by goods in process when new methods are introduced. The general tendency must be to decrease the values of most of these, though not necessarily of all. The loss will fall on the owner in whose hands they are when the price change takes place, which may not be the owner at the time the new process is invented, for these price changes will also lag more or less. The loss in value will depend on several factors, the amount of superiority of the new process over the old, the amount of difference between the old intermediate goods and the corresponding new ones, and the possibility, and the cost, of changing the old intermediate goods in a way to have the manufacture carried to completion by the new process.
Material productive goods will fall more or less under the same head as goods in process according as they are or are not reproducible, short-lived, and amenable to change in form. We have seen that the difference between capital and land is one of degree, depending on these qualities in the agent. At one extreme, capital is typified by goods in process. At the other, "land" consists of these agencies whose supply is most rigidly fixed, the nearest approach to the theoretical limit being the element of site value. Taking this extreme first, a piece of pure land will gain or lose the capitalized value of the change in its income as soon as this is accurately adjusted. With ordinary capital equipment, allowance must be made for the life of the agency and also for the possibility and cost, including the time required, to adapt it to the new conditions. The adaptation may include both movement from one situation to another and change in form. Even a revolutionary invention, making buildings and machinery worthless for use in their present form, does not usually destroy all their value. At worst a scrap value of the material is recoverable of the original free capital invested in them.
Laborers present a still different case. The only thing to be considered from the standpoint of economic organization is here the lag in the readjustment of wages to the new real value of labor. Changes in the value of specialized skill accrue to the laborer as an individual only and cannot be capitalized. The same facts as to possibility of readaptation hold good as in case of material equipment goods, but again this is a matter of the individual's own personal economy and does not affect entrepreneurs. The peculiarities of labor in relation to readjustments form one of the main sources of injustice and hardship in an individualist economy. The risk of loss in the value of acquired knowledge and training means a constantly impending threat of indigence. Laborers are attached to their homes and even to their work by sentimental ties to which market facts are ruthless. But these matters hardly call for detailed discussion in a study of the present sort.
Part III, Chapter XII
Social Aspects of Uncertainty and Profit
Uncertainty is one of the fundamental facts of life. It is as ineradicable from business decisions as from those in any other field. The amount of uncertainty may, however, be reduced in several ways, as we have seen. In the first place, we can increase our knowledge of the future through scientific research and the accumulation and study of the necessary data. To do this involves cost, the expenditure of resources which must be drawn from other uses. Another way is by the clubbing of uncertainties through large-scale organization of various forms. This operation also involves costs, and not merely in the sense of expenditure of resources. There is also to be considered the loss of individual freedom involved in any possible plan of organization, a loss for the great mass of persons affected, though possibly a gain for a few who may secure wider powers and a larger range of action from the concentration of authority.
In the third place it is possible, also at a cost, to increase control over the future. And here again both sorts of costs must be faced, substantive outlays and human losses through organization. Finally, uncertainty might be further reduced almost indefinitely by slowing up the march of progress, which, of course, involves a direct sacrifice in addition to both the forms of cost already noticed.
All these proposals raise the fundamental issue as to the essential evil of uncertainty, how great it is and hence how much we can afford to sacrifice in other ways in order to reduce it. In this sort of calculation as in all economic problems we are dealing with a question of proportioning alternatives subject to a principle of diminishing relative importance. It would doubtless be possible to use all the resources of society with more or less effect in reducing uncertainty, leaving none for any other use. It is a question of how far to go. The question is complicated by the fact that the use of resources in reducing uncertainty is an operation attended with the greatest uncertainty of all. If we are uncertain as to the results of ordinary business operations we are doubly so as to the results of expenditures along any of the lines enumerated looking toward the increase of knowledge and control.
Quite as important as the question of reducing uncertainty is that of its distribution. This question raises again the same fundamental issue, this time from the individual point of view instead of the social, as to the intrinsic desirability of reducing uncertainty. How far the burden should be equalized, how far concentrated or specialized, depends on the individual attitude toward uncertainty, and especially on the tendency of the irksomeness to increase as the amount of uncertainty faced by an individual increases, and vice-versa. The steeper the curve of increasing disutility the more we must favor a relative dispersion of the burden. It is perhaps obvious that high degrees of "risk" are more irksome; most of us are reluctant to jeopardize our lives or the elemental requirements of life. But it is also evident that individuals differ widely in the extent to which they find this true. We have already noted the more or less paradoxical fact that the very idea of intelligent conduct implies an effort to reduce uncertainty, while none the less we recognize, on any calm, cool contemplation of the matter, that a life with uncertainty eliminated or perhaps even very greatly reduced would not appeal to us.
There is a close connection between the two notions, reducing the absolute amount of uncertainty on the whole and distributing it, for most methods of reducing it effect either a concentration or a distribution. On this head there seems to be no generalization which can be made with confidence and which is worth making.
It is not too much to say that the very essence of free enterprise is the concentration of responsibility in its two aspects of making decisions and taking the consequences of decisions when put into effect. It is therefore of the utmost importance to inquire critically and carefully into the facts as to the results of such a concentration in comparison with any possible alternatives. At the outset we shall raise no question as to large-scale industry; and it is evident that if we are to have large-scale organization with its advantages in efficiency we must assume a corresponding degree of concentration of control in the immediate sense of executive direction. This, however, as we have been especially concerned to emphasize, does not necessarily mean concentration of responsibility. We have seen that practically all human activity, even that of the purest routine character, is in some manner and degree forward-looking and involves meeting unexpected situations and making decisions. But these decisions do not necessarily involve responsibility. The outstanding feature of free enterprise organization is the transfer of the lower grades of responsibility to men whose decisions relate to the selection of men for the places under their control and to answering occasional questions in regard to exceptional contingencies. The two functions are, indeed, never quite separate. The ultimate responsibility consists chiefly in the selection of a man or a very few men to "organize" the establishment. But the ultimate authority usually if not always exercises some direct control over business policy. In most cases also the higher officials of an enterprise have a direct stake in the business beyond their fixed salaries. And down through the organization the subordinate functionaries may be said to have responsibility in the sense that the results which they secure must come up to the expectations of their superiors or they will lose their positions.
In the existing system of things the ultimate responsibility centers almost altogether in the ownership of the property "at risk" in the business. There are infinite variations and complications in the distribution of "risk" and control, but the general tendency is clear. The lower grades of labor take practically no risk and exercise correspondingly little control, and the same is only less true of the higher grades and of borrowed capital. We must remember that the two things, uncertainty-bearing and responsible control, are inseparable; in so far as the reward of any service is contingent upon the success of the undertaking, the owner of that service, in consenting to its employment for a contingent remuneration, exercises judgment and wields power over the enterprise. But the greater part of the uncertainty and power are centered in the ownership of certain property which is placed in the position of guaranteeing the contractual income of the other property and that of the labor used in the business.
We shall not attempt to take up all the possible or actual arrangements in regard to responsibility and control, but shall limit the discussion to the general problem of concentration of uncertainty. It will be kept in mind that the basis of effective assumption of responsibility is necessarily either the ownership of property or the creation of a lien on future human productive power and is in fact almost altogether the former. Another preliminary reservation is that in a sense ultimate control rests with the consumer. But in so far as economic organization takes the form of free enterprise this control is exercised only after the fact, and the responsibility we are concerned with is that of meeting the consumer's demands at the end of the production process. We assume, then, that the entrepreneur system of organization, with production for the market impersonally, and concentration of direction, arises because it is superior to, or more satisfactory all around than any other free contract system. And the first step in our inquiry will be a brief examination into the meaning of free contract.
With the possible exception of the word "cause" and its equivalents, it is doubtful if there is a more abused word than "freedom"; and surely there is no more egregious confusion in the whole muddled science of politics than the confusion between "freedom" and "freedom of contract." Freedom refers or should refer to the range of choices open to a person, and in its broad sense is nearly synonymous with "power." Freedom of contract, on the other hand, means simply absence of formal restraint in disposal of "one's own." It may mean in fact the perfect antithesis of freedom in the sense of power to order one's life in accordance with one's desires and ideals. The actual content of freedom of contract depends entirely on what one owns.
Ownership, as we have seen, consists essentially of the combination of the rights of control and of usufruct. The point to be emphasized here is that in a social system based on pure freedom of contract, ownership and control are interchangeable terms; there is no other form of control. To be sure, there would have to be a "state" of some sort, an authoritative organization, to maintain such a system, but its sole function would be the enforcement of contract and prevention of non-contractual relations. Its necessity arises from the fact that contracts are not often executed on both sides simultaneously and the further fact that men might prey upon each other. That is, the rôle of the State in such a system would be merely to restrict human relations to the mutually voluntary, or contractual. In such a system, to repeat, those who owned nothing could not exist unless by the sufferance and generosity of those who did own, and the amount of freedom possessed by any person would be equal to the amount of his ownership.
Now, what one owns is under ideally simple conditions a result of three factors. The first and by far the most important is the historical "brute fact" of what he has "to begin with," his inheritance from the past. This is purely a matter of status—hence the fundamental absurdity of Maine's contrast between status and contract as descriptions of the position and condition of the individual. All free contract can mean is that status can be changed by voluntary agreement with another party, and cannot be changed without one's consent. The second factor in ownership is thus the result of previous contracts. And the possibility of change in status by mutually voluntary agreement depends on one's status—i.e., what one owns—at the time of the agreement, and hence finally on what one owned to begin with. The third factor in ownership or present status is change resulting from the voluntary and independent employment or transformation by utilization of one's own in the past. This element is also clearly a matter of change only, going back to initial status or what one owned to begin with. In a pure free contract system there is no power (control) except ownership; only change in ownership (which is to say really in status) has any connection with the exercise of free choice, and the range of choice depends absolutely on previous status and hence ultimately on the initial status in which the individual finds himself on his first entry into the system of contracting persons.
All the above, however, assumes that contracts and the activity directed to increasing ownership by "productive" transformation of what one already owns are intelligently carried out. In the world as it is, where all human designs and acts are fraught with uncertainty, a fourth factor must be added, the result of luck. Furthermore, we are still assuming complete independence and non-interference among the contracts and activities of different individuals. In the world as it is the interests affected by contracts are never all represented in the agreements. This is really a limitation on the assumption of pure freedom of contract, a failure to restrict human relations to the mutually voluntary sphere, but it is a fact which has to be taken into account, like deliberate predation.
These facts are so obtrusive that no one has in practice ever advocated pure freedom of contract, the restriction of the action of society as a whole to the negative function of preventing non-contractual relations. No question is ever actually raised as to the State limiting freedom of contract in many directions and encouraging agreements of other sorts. It also necessarily appropriates through taxation a considerable part of the usufruct of things privately "owned," thus modifying ownership in both its phases. And this modifying influence on private property extends rapidly in scope as the laissez-faire theory of the State loses ground in the modern world.
It is a fundamental fact that the possible objects of ownership fall into two main classes, personal powers inherent in the individual, and material things. If an individual does not have some form and degree of ownership in the former he is a slave, the property of some outside party, and outside the system altogether. The modern world is, of course, pretty well committed to private property in the individual's own personal powers in all adults not dangerously abnormal or incompetent, subject only to general limitations. It is difficult to secure effective utilization of these under any other system, and the live questions relate only to the ownership of material things. We have seen in different connections that the importance of the difference between these two classes is at least much exaggerated, that generic natural differences are hard if not impossible to find in relation either to their cause-and-effect bearings on price theory and economic organization or to their moral standing. The conditions of demand, conditions of supply, and relation to the possessing individual turn out on examination to be much alike, and differences which exist at all are mostly artificial and conventional. But from the standpoint of our human interests outside the production and consumption of goods we must recognize that the ownership of one's self is in a somewhat higher position than the ownership of external objects. Yet in a civilization where man is highly and increasingly dependent on access to and use of material things for his very life this distinction tends to fade out, and recognition of this fact accounts for much of the current ferment and change in the social attitude toward "property" (used narrowly as property in things).
Another line of argument on the question of the relations between ownership of one's own powers and ownership of material things follows somewhat parallel lines to a somewhat similar uncertain or negative conclusion, beginning from an opposed point of view. The starting-point of our inquiry is the fact, clearly brought out by our study of enterprise, that the drift under non-interference is toward placing the control of industry, the ultimate entrepreneurship, in the hands of property-owners and not the owners of the human services, the workers. The ostensible reason for this is that a business venture offers opportunity for actual absolute loss, as well as merely a greater or less gain, and that only property can in the nature of the case make the guarantees against this net loss. This fact seems at first sight to afford the basis for another distinction between labor and property services, namely, that laborers are only used in industry, while material goods are used up, that only the services are consumed in the one case, while the thing itself may be destroyed in the other.
A little critical reflection will show that this also is not really the case. Perhaps it ought to be so, but it is not, and cannot be. In the first place, the risk of destruction and total loss is perhaps as great in fact in the case of the laborer as in the case of the property-owner, and where in the latter case the owner loses only productive power the former loses health or bodily members or his life, which mean vastly more. The real merits of this situation are also being recognized by society and we see the growth of legislation designed to transfer the hazard of loss of the economic value of the laborer as a productive agent (and this only, so far) to the business and through it to the consumer of the product. There is another side to the question in the hazard of loss of specialized skill and training. These are acquired in connection with and for use in the particular business. The cost of acquisition is borne chiefly by the worker and if the business proves unprofitable, the loss generally falls on him. Yet these "risks," seemingly so much greater than those incurred by the property-owner, do not carry with them the control of the business, nor do the bearers of the risks even secure under competitive free contract (as is perfectly well known) anything like fair compensation in the form of a higher contractual return. And it must be added that the actuarial value of the worker's risks depends quite as much on the quality of the management as is the case with those of the owner of material property.
The only visible explanation of this state of things is an appeal to a "fact of human psychology" that the owners of "things" are less willing to trust those "things" to the control of others without an adequate guarantee in kind than are men who own only themselves to hazard such outside control without even the poor safeguard of a guarantee against economic loss.
It is manifestly impossible to carry on production without incurring both sorts of uncertainties, uncertainty as to the results and as to the preservation intact of the means of production employed, both human and material. Since production must precede consumption and requires time, all those concerned in it must be maintained during the production period out of the fruits of previous production. And these products must be advanced by those who own them. It is not physically necessary that they be permanently hazarded by the owners, that the actual producers should get their entire wage in advance of the completion of the process, but this is the way it works out under free contract. Nor is it inevitable that these products be owned by any individuals at all, a point which we must next take up. At the same time the chance of loss of equipment must be borne, temporarily, by those who have equipment to lose, if equipment is privately owned. The permanence of the loss to an individual owner is not physically prescribed, in case of the owner of material things or of human powers in their purely economic aspect. But this again is the way it does work out under the "obvious and simple system of natural free contract." We must now glance briefly at the social bearings of free contract in a more fundamental sense.
There is naturally no intention of implying that freedom of contract is to any appreciable extent a result of the deliberate adoption by society of a reasoned policy of organization. However, the continuation of the system is a question which has been much discussed on its merits and which may ultimately be decided on the basis of discussion. To discuss the issue systematically we shall first eliminate and postpone for later notice the point as to personal self-ownership and limit ourselves provisionally to the ownership of material productive goods, the more or less live issue between individual and social property in these things. And we must further distinguish at the outset between two different and to a large extent opposed sets of interests involved in social organization. The conventional view in economics treats social organization as a mechanism for the satisfaction of "wants" which are assumed to be fixed conscious desires and tendencies to action, subject to the principle of diminishing relative utility. The limitations of this view have been emphasized throughout our study, but we have to consider this aspect of economic life in purity and isolation if we are to use the scientific method of analysis. Other interests are just as fundamental, notably the desire for freedom and power for their own sakes and the preference for certain qualities of human relations. It is largely this second set of interests which, directly and indirectly, have finally abolished slavery and established self-ownership.
Viewing society, then, as a want-satisfying machine and applying the single test of efficiency, free enterprise must be justified if at all on the ground that men make decisions, exercise control, more effectively if they are made responsible for the results of the correctness, or the opposite, of those decisions. If property were socialized we should still have to concentrate the function of the actual making of decisions, but it would be in a far greater degree than now a routine task, with the remuneration independent of the results. In the light of our previous discussion there is a difficulty here and we must be careful to make the meaning clear. Two things, specifically, would happen. Businesses in which men now work directly with their own resources would be transformed into public enterprises under the management of hired functionaries. In this case the nature of the change is clear enough. More obscure is the case of the corporation, now controlled by a hired manager. Here the change is the substitution of the public, organized in some political way, for the stockholders, and the position of the immediate decision-maker is superficially not much changed.
But only superficially. It is true that the growing similarity of large-scale business to the political democracy is one of the socialist's strongest arguments against a probable loss of efficiency in the exchange of private for public ownership. But we must emphasize the fact that the similarity is much exaggerated—in fact by both parties to the controversy, from different motives, of course. The insistence on the large number of stockholders in some of our great corporations is definitely misleading. Most of these do not regard themselves and are not regarded as owners of the business. In form they are such, but in substance they are merely creditors, and both they and the insiders count upon the fact. The great companies are really owned and managed by small groups of men who generally know each other's personalities, motives, and policies tolerably well. Hence in the first place the salaried manager under a socialist government, whether appointed by a political superior or chosen in some way by a democratic constituency, would really be in a very different position from the president or manager of a present-day corporation. He could not conceivably be so directly accountable to the ultimate entrepreneur, society, as he now is to the ultimate entrepreneur, the small group of "insiders" who are the real owners of the business.
But the greater change would consist in the substitution of the public at large for the small group of owners. The main difference is an inevitable concomitant of the mere size of a group. The insuperable difficulty of coöperative production has been to make the individual feel that the results depend upon his own activity. The individual feels lost in the mass, helpless and insignificant. Political democracy, of course, encounters the same difficulty. Perhaps we may believe that some progress is being made in solving the problem in the political sphere where decisions are really much less important in that the alternatives among which choice is made relate to less vital matters. If so, it may be possible that some generations of political democracy might train the individual in a sense of personal responsibility which would make industrial democracy more feasible.
But this is at best an exceedingly superficial view of the problem. At bottom it is a matter of feeling for the large property-owner as well as for the masses served by industry. He is really a social functionary now. Private property is a social institution; society has the unquestionable right to change or abolish it at will, and will maintain the institution only so long as property-owners serve the social interest better than some other form of social agency promises to do. Of course there is a lot of moral flub-dub about natural rights, sacred institutions of the past, etc., and it has some power to hold back social change. But in the end, and a not very distant end either, the question will be decided on the basis of what the majority of the people think, in a more or less cold-blooded way, about the issues. If we get more effective management through the system of concentrated private ownership than we would through some democratic machinery, it is because men plan better when they do not feel like government officials doing things for other people, when they feel their work as their own and identify their personalities with it.
And this even though the same men know "in their hearts," subconsciously if not consciously, that they are the agents of the democracy and ultimately responsible to it for their trust. For it is clear that the "personal" interests which our rich and powerful business men work so hard to promote are not personal interests at all in the conventional economic sense of a desire to consume commodities. They consume in order to produce rather than produce in order to consume, in so far as they do either. The real motive is the desire to excel, to win at a game, the biggest and most fascinating game yet invented, not excepting even statecraft and war.
The suggestion which inevitably comes to mind is that a democratic economic order might conceivably appeal as effectively to the same fundamental motives. What is necessary is a development of political machinery and of political intelligence in the democracy itself to a point where men in responsible positions would actually feel their tenure secure and dependent only on their success in filling the position well. It is not mainly a matter of salary, though undoubtedly such men would have to live conspicuously well in an economic sense also—just as the officials of our political democracy expect to do, even when patriotic and public-spirited. The essential problem is wisely to select such responsible officials and promote them strictly on a basis of what they accomplish, to give them a "free hand" to make or mar their own careers. This is the lesson that must be learned before the democratization of industry will become a practical possibility. If we substitute for business competition, bad as it is, the game of political demagoguery as conventionally played, with rotation in office and "to the victors belong the spoils" as its main principles, the consequences can only be disastrous.
Another interesting misconception in regard to the public official should be pointed out before we leave this topic. It is common and natural to assume that a hired manager, dealing with resources which belong to others will be less careful in their use than an owner. The view shows little insight into human nature and does not square with observed facts. The real trouble with bureaucracies is not that they are rash, but the opposite. When not actually rotten with dishonesty and corruption they universally show a tendency to "play safe" and become hopelessly conservative. The great danger to be feared from a political control of economic life under ordinary conditions is not a reckless dissipation of the social resources so much as the arrest of progress and the vegetation of life.
This point leads naturally to the question which has been much discussed in treatments of risk and profit: does the private business man really abhor risk and uncertainty, and tend also to "play safe"? Other phases of the same question, the close relations of which are not always recognized, but which turn out to involve the same issue, relate to the social cost of risk-taking and the tendency of profits to a minimum.
The conventional view is, of course, to regard risk-taking as repugnant and irksome and to treat profit as the "reward" of assuming the "burden." This is, of course, the business man's own idea of the matter, and students of the problem have often held the same opinion. Thus Willett argues that society pays for the sacrifice of assuming risk through higher prices for commodities in whose production it is a factor, for the reason that men are deterred from entering these occupations by their unwillingness to assume risk and that the supply of such commodities is consequently reduced. Ross also assumes that risk is repugnant and draws the same conclusion, and Haynes lays still greater emphasis on the influence of risk as a deterrent to production, quoting Andrews to the same effect. Other writers have been more hesitant in generalizing or have made distinctions, or positively disagreed with this view. Thus v. Mangoldt remarks that it is notorious that more money is lost than made in most forms of speculative activity and asserts the belief that this is true of business enterprise in communities which are in comfortable circumstances and have a reasonable surplus for embarking in venturesome undertakings. Professor F. M. Taylor also analyzes the problem with some care, insisting that the profits of entrepreneurs may be either larger or smaller than the amount necessary to make up an insurance fund to cover actual losses. He holds it probable that they are for small risks larger and for large risks much smaller than the necessary insurance fund, but concludes that society has to pay a higher price for a particular commodity or service than it would have to pay if risk were eliminated.
There are several confusions of thought to be avoided in arguing this question. In the first place it is inaccurate to speak of profit as the reward of risk-taking or as the inducement to take risk. It is of the essence of the situation that the profit is in the future and uncertain when the decision is made and hence it is the prospect or estimated probability of profit which "moves men's wills" (Taylor). Hence we cannot assert a connection between actual profit and the irksomeness of risk in the individual instance. And from the standpoint of aggregate profit in the society as a whole the question is whether there is any such share or not, whether entrepreneurs as a class make a profit or suffer a loss (speaking, of course, of net or "pure" profit, after remunerations for all productive services are counted out).
Let us recall for clearness the precise situation of the profit-seeking business man. He contracts for productive services in advance, on a basis of what he expects to be able to make by their use. Like the purchaser of any commodity, he as an individual finds a price fixed and buys more or less at the established price, while in the aggregate the competition of all purchasers adjusts the price to the point where an entire existing supply can just be taken out of the market. It will be seen that the prices of productive services at any time, the entrepreneurs' costs of production, represent under perfect competition what entrepreneurs expect their products to be worth when sold, while the entrepreneurs' incomes represent the facts at a later time as contrasted with the anticipations at an earlier. The condition, then, under which entrepreneurs as a group will realize a positive profit is that they underestimate the prospects of their business relatively to their dispositions to venture. If, on the contrary, they overestimate their prospects (considering the degree of conviction necessary to move their wills), they will in the aggregate suffer loss, and if they estimate correctly on the whole, neither will occur. If the estimates are a matter of pure chance it would seem that the variations in the two directions would be equal, the average correct, and the general level of pure profit zero. Many writers, notably Hawley, have assumed that such a distribution of errors necessarily obtains, though in the absence of a correct theory of profit the appropriate conclusion is not drawn.
It may be objected that it is impossible that enterprise on the whole should suffer a net loss, but a little consideration will show that this is not true. The entrepreneur, as society is organized, is almost always a property-owner and must necessarily be the owner of productive power in some form. It may then well be that entrepreneurs lose more than they make, the difference coming out of the returns due them in some capacity other than that of entrepreneur. The question of fact is thus whether entrepreneurs as a class receive on the average more or less than the normal competitive rate of return on the productive services of person or property which they furnish to business.
The question does not admit of any definitive answer on inductive grounds. Such evidence as is avaliable in the form of statistics points to the conclusion that the net result is a loss, but it is inconclusive. Perhaps the best that can be done is to argue the case on a priori grounds and attempt nothing beyond an opinion as to the probable facts. The writer is strongly of the opinion that business as a whole suffers a loss. The main facts in the psychology of the case are familiar, and some of them have been stated above. The behavior of men in lotteries and gambling games is the most striking fact. Adam Smith pointed out the tendency of human nature to exaggerate the value of a small chance of large winnings. Senior thought that the imagination exaggerates the large odds in favor of either gains or losses. Cannan holds that both unusually risky and unusually safe investments are especially attractive to large classes of men and yield too small a return while ordinary hazards are neglected and hence yield more. Professor Carver contributes the suggestion that business risks are predominantly of the character in which the odds are not great and the possible losses larger than the probable gains, that these have a negative appeal to the gambling instinct and that profit is a positive quantity. But in view of the possibility of capitalizing the entire future return of a venture into present wealth this view of the nature of business risks seems very questionable. The point we wish to emphasize is that these "risks" do not relate to objective external probabilities, but to the value of the judgment and executive powers of the person taking the chance. It is certainly true that as Smith and v. Mangoldt both observed, most men have an irrationally high confidence in their own good fortune, and that this is doubly true when their personal prowess comes into the reckoning, when they are betting on themselves. Moreover, there is little doubt that business men represent mainly the class of men of whom these things are most strikingly true; they are not the critical and hesitant individuals, but rather those with restless energy, buoyant optimism, and large faith in things generally and themselves in particular.
To these considerations must be added the stimulus of the competitive situation, constantly exerting pressure to outbid one's rivals, as in an auction sale, where things often bring more than any one thinks they are worth. Another large factor is the human trait of tenacity, also conspicuous in bourgeois psychology. Men may possibly be timid and critical on first embarking in new ventures, but once committed, it seems unquestionable that the general rule is to hold on to the last ditch, and the greater part of the bidders for productive services are owners of businesses already established. The prestige of entrepreneurship and the satisfaction of being one's own boss must also be considered. It therefore seems most reasonable to suppose that the prices of these are fixed at a level above rather than below that which the facts actually warrant, and as we have noticed, the statistics, such as they are, point to the same conclusion.
So much for the pure profit of entrepreneurs. We have already emphasized the fact that profit and imputed income are never accurately separated on either side of the dividing line. As there is no income which is pure profit so there is none which does not contain an element of profit. This is perhaps most conspicuous, or at least most familiar, in connection with interest. It is recognized that "pure interest" is impossible of identification, that ordinary interest includes an element of "risk premium." It is no less true that wages contain a variable element which is to be explained by the uncertainty of the return. The earnings of professional men form the notorious case. Men are attracted into these callings more by the lure of the small chance of conspicuous success than by the position achieved by the rank and file. Adam Smith was sure, and the opinion is still corroborated by common observation, that an occupation offering a small chance of attaining a high position and a large income will yield a lower average return to the same ability than one in which earnings are more uniform. That is, there is a negative premium on risk-taking in these cases also.
With most kinds of labor the chance element amounts to relatively little in all probability, and in any case it is perhaps best regarded as a return on the investment in special knowledge and skill rather than on effort directly. In any case, if Smith's reasoning is sound it appears that risk-taking is the opposite of irksome, that men work (or labor to acquire the capacity for work) more cheaply on the average for an uncertain than for a fixed compensation. To the landowner there is virtually no risk of actual loss involved in leasing it, and usually little or none of failure to receive the contract rental. In lending capital we find risk of loss of principal as well as interest and a great deal of attention is paid to the risk element in fixing the rate of return. A rate of pure interest is a concept to which it is so difficult to attach any definite meaning that it seems futile to speculate as to the adequacy of the excess of contract interest above this level to constitute an insurance fund to cover losses. The question, as before, is whether the actual receipts from contract interest and repayments of principal form on the average an amount equal to or less or more than the pure interest and the original principal. The writer sees no way of forming an opinion on this subject.
From the standpoint of social policy, two questions are to be raised. From one point of view, "society" is a husbandman or "wirtschaftender Mensch," interested in getting its work done as well and as cheaply as possible. The foregoing considerations seem to indicate that from this pure productive efficiency point of view and with all the factors measured in competitive pecuniary terms it is better to let the individual take the risk. It seems probable that with society and human nature as they are, the individual not only charges nothing for this service, but pays something for the privilege of rendering it—on the average. But we must remember that in the case of property he really does not take the risk, and it is a question of making him feel that he does, for property is and always has been "really" social and ownership a social function. It is not clear that the illusion of ownership, with the possibility and actuality of enormous waste and dissipation involved, is in fact a cheap way for society to remunerate the management of its material wealth. As with all questions involving human motives, however, only negative statements can be made on this subject until we begin to know something of what men as individuals and as society really want. The quality of management secured has, of course, to be taken into account along with the cost of securing it, but we have already said all that it seems worth while to say in the present connection on this head.
The second question raised is whether it is really good for the individual, and hence for society which is the individual in the aggregate, to have the risks of industry assumed by the former even if he is willing to do it at a loss, on the average, to himself. Some light on the proper answer is to be gained by considering the attitude which we actually take toward lotteries and gambling generally. Clearly there are limits to the terms on which the members of society are to be allowed to take chances, and notably when the independent members have dependent upon them other members in whom society is peculiarly interested. Rapid progress is at present being made toward prohibiting the laborer from unwisely contracting to assume hazards, and no theoretical objection can be made to extending the principle to property risks where the fundamentals of a decent and self-respecting existence are at stake.
The protection of a minimum standard of life is only one of many questions of the human interests involved in the distribution of risk and control, but we cannot here go into or even attempt to classify or enumerate a list. In concluding the discussion of the topic we shall only insist again on the limitations of the economic view of social organization as a mechanism for satisfying human wants in any static and hence scientifically describable sense of the term. Man's chief interest in life is after all to find life interesting, which is a very different thing from merely consuming a maximum amount of wealth. Change, novelty, and surprise must be given large consideration as values per se, and since at best most of us must doubtless spend more time in producing wealth than in consuming it, the dynamic and personal factors must be taken into account on the production side of economic conduct, and weighed against the element of efficiency. One of the things we surely want is the society of other people on a basis of mutual agreeability, respect, and affection, irrespective of the question, itself inescapable in any serious reflection on the issues of life, as to whether personality has some sort of cosmic value. Hence each individual must be given responsibility, freedom of choice, a wider sphere of self-expression than he can have in a system of organization where control is specialized and concentrated to the last degree. Whether this is practicable and how it is to be done is the great problem which confronts the advocates of industrial democracy.
To conclude our study notice must be taken of certain long-time aspects of the problem of uncertainty and control. The distinction between "static" and "dynamic" "risks" is a much-labored but a fundamental point in connection with our subject. We have emphasized in this study also that uncertainty is dependent upon change, and in fact largely upon progressive change. The problem of management or control, being a correlate or implication of uncertainty, is in correspondingly large measure the problem of progress. In an unprogressive society knowledge of the future could be perfected to a high degree through actual forecast and control or the effect of certainty secured through the grouping of cases and application of probability reasoning. Under such conditions the problem of management would be indefinitely simplified as activity would follow in the main an established routine and real decisions would rarely be required. The actual form of economic control, free contract, and especially private property in material goods, is closely connected with the acute form of the problem of management which arises from the highly "dynamic" character of the society we live in and the extreme degree of uncertainty connected with change. Before the modern industrial era began, as we know, the economic life of Europe was unprogressive, and its organization of control was collectivistic. The establishment of individualism was the result of the desire for improvement, even though it would be misleading to say that it came about directly through a social conviction of its superiority over collectivism in this respect.
The social theory of private property rests, then, not so much on the premise that productive resources will be more effectively used in the creation of goods for consumption, as on the belief that there will be a greater stimulus to progress through inducing men to take the risks of action increasing the supplies of productive resources themselves, including both material things and technical knowledge and skill. We have shown in our discussion of interest the fallacy in the view that accumulation and forward-looking sacrifice can be explained on the basis of time preference in consumption. A sacrifice of present to future consumption does not generally increase the total consumption by the individual making it, and in addition the mere postponement of consumption would give rise to no considerable net increase in social equipment. The "abstinence" must be permanent, and not a mere matter of waiting. It follows that the premise of the justification of private property must be that the mere desire of ownership is a more potent motive to bring about sacrifice and effective control in this field than the desire to consume a larger amount of goods. The social policy of private property is sound, if at all, because the craving to own wealth will lead men to sacrifice consumption and take risks of complete loss in order to increase their property. The truth or falsity of this premise is not our present concern, but it seems worth while to point out some facts in connection with its application.
Practically all forms of social economic progress represent, as has been pointed out, different modes of increasing the productive power of society through the sacrifice or "investment" of present consumption. These different ways are open, competing alternatives, quite comparable generally speaking in quantitative terms. One may invest his present goods in creating new equipment goods (the conventional way, and type of all), or in finding and developing new natural resources, or in developing his own personal powers (or even to some extent those of other men), or in inventing, or in improving business organization, or in creating new social tastes and wants. The first two modes of investment give rise to new property and this society, generally speaking, grants to the successful investor in fee simple and to his heirs and assigns forever.
Investment in one's own person likewise gives rise to undisputed possession of the new capacities, but these are not permanent, passing out of existence with the end of the individual's own active life. It would be interesting, if it were possible, to compare the attractiveness of these two forms of investment, for the effectiveness of control beyond one's own lifetime as an incentive to investment is one of the principal issues in the theory of enterprise. We shall recur to this topic presently.
The case of investment in invention is different again. Here, owing to the low cost of indefinitely multiplying an idea, it is usually difficult to capitalize an increase in productive power. Society generally permits an inventor or his assigns to keep his idea secret as long as possible or to safeguard it in any manner. But this is so commonly impracticable and the social value of new inventions so manifest that the patent system has come into general use establishing and protecting by law a temporary, and rather short-lived, property right in the improvement. It is manifest that this is an exceedingly crude way of rewarding invention. Not merely do the consumers of the product pay, which is doubtless fair, but large numbers of other persons suffer who are prevented from using the commodity by the artificially high price. And as the thing works out, it is undoubtedly a very rare and exceptional case where the really deserving inventor gets anything like a fair reward. If any one gains, it is some purchaser of the invention or at best an inventor who adds a detail or finishing touch that makes an idea practicable where the real work of pioneering and exploration has been done by others. It would seem to be a matter of political intelligence and administrative capacity to replace artificial monopoly with some direct method of stimulating and rewarding research.
The improvement of business organization and methods offers still less chance of securing any permanent gain, since the result is usually neither patentable nor capable of being kept secret. Yet this form of progress also represents an investment of present wealth which could have been placed in fields yielding perpetual property rights. Surely there is no evidence of any unwillingness to make expenditures in this form of improvement, and the fact raises interesting questions as to the motives which actually operate in inducing men to make the present sacrifices which promote economic progress. Expenditure in creating new wants can be made to yield a more permanent advantage through the use of distinctive brands and legal protection of trade marks and trade names. Some of these, of course, become pieces of property of great value and ready salability.
Remains, then, the final question of the relative importance as stimuli to save and invest, of property rights and the right to transfer such rights to other individuals or project control beyond one's own lifetime. We cannot enter here at length into the question of inheritance. Still more than ownership in the strict sense, of which it is no essential part, inheritance rests on no conscious theory, but has simply happened. The attribute of inheritance more or less naturally inheres in personal effects where the family system exists, and it becomes transferred to productive goods as these increase in importance, while property in productive goods also enormously strengthens and isolates the private family sentiment. Voluntary bequest outside the family represents a later development and in a sense the reverse tendency.
The "theory" of the rights of transmission and bequest is, of course, that they form an important element in the inducement to conserve and accumulate wealth. The writer is extremely skeptical as to the soundness of this view, but there are considerations which must give pause to any rash advocacy of fundamental change. The difficulty, again, is to suggest an alternative plan which seems workable. The public confiscation of wealth at the death of the owner raises the question of what would be done with it. For those who are dubious of the direct management of productive enterprise by public agency, a leasing system or sale at auction in exchange for income rights in the form of debentures or the like perhaps offer a possible way out. This is much like some of the suggestions of the Saint-Simonian school of socialists. Even then the practical problem of distributing the income among the people or of its public utilization gives rise to misgivings.
Somewhat similar problems again arise in connection with the personal powers of individuals, which, as we have seen, obstinately resist generic separation from material goods in their economic bearings. Innate ability, in the sense in which there is such a thing, is inevitably hereditary, and nothing can be done about it except to modify the conception of the individual's property rights in his own powers. But culture in all its subtle significance, as well as education and training in their cruder forms, are also more or less transmissible and more or less subject to voluntary bestowal, and the factor of personal influence or "pull" can by no means be left out of account. The significance of control over these things is very great and would probably be multiplied rather than diminished in a society which abolished property in material things. It seems that real equality of opportunity, a true merit system, is hardly conceivable, and that no very close approach to such a consummation can be expected in connection with the private family. Plato, of course, recognized this fact, which most of his modern successors have a tendency to blink.
The ultimate difficulties of any arbitrary, artificial, moral, or rational reconstruction of society center around the problem of social continuity in a world where individuals are born naked, destitute, helpless, ignorant, and untrained, and must spend a third of their lives in acquiring the prerequisites of a free contractual existence. The distribution of control, of personal power, position, and opportunity, of the burden of labor and of uncertainty, and of the material produce of social industry cannot easily be radically altered, whatever we may think ideally ought to be done. The fundamental fact about society as a going concern is that it is made up of individuals who are born and die and give place to others; and the fundamental fact about modern civilization is that it is dependent upon the utilization of three great accumulating funds of inheritance from the past, material goods and appliances, knowledge and skill, and morale. Besides the torch of life itself, the material wealth of the world, a technological system of vast and increasing intricacy and the habituations which fit men for social life must in some manner be carried forward to new individuals born devoid of all these things as older individuals pass out. The existing order, with the institutions of the private family and private property (in self as well as goods), inheritance and bequest and parental responsibility, affords one way for securing more or less tolerable results in grappling with this problem. They are not ideal, nor even good; but candid consideration of the difficulties of radical transformation, especially in view of our ignorance and disagreement as to what we want, suggests caution and humility in dealing with reconstruction proposals.