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Frank H. Knight, Risk, Uncertainty, and Profit 
Risk, Uncertainty, and Profit (Boston MA: Hart, Schaffner and Marx; Houghton Mifflin, 1921).
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Table of Contents
There is little that is fundamentally new in this book. It represents an attempt to state the essential principles of the conventional economic doctrine more accurately, and to show their implications more clearly, than has previously been done. That is, its object is refinement, not reconstruction; it is a study in "pure theory." The motive back of its presentation is twofold. In the first place, the writer cherishes, in the face of the pragmatic, philistine tendencies of the present age, especially characteristic of the thought of our own country, the hope that careful, rigorous thinking in the field of social problems does after all have some significance for human weal and woe. In the second place, he has a feeling that the "practicalism" of the times is a passing phase, even to some extent a pose; that there is a strong undercurrent of discontent with loose and superficial thinking and a real desire, out of sheer intellectual self-respect, to reach a clearer understanding of the meaning of terms and dogmas which pass current as representing ideas. For the first of these assumptions a few words of elaboration or defense may be in place, in anticipation of the essay itself.
The "practical" justification for the study of general economics is a belief in the possibility of improving the quality of human life through changes in the form of organization of want-satisfying activity. More specifically, most projects of social betterment involve the substitution of some more consciously social or political form of control for private property and individual freedom of contract. The assumption underlying such studies as the present is that changes of this character will offer greater prospect of producing real improvement if they are carried out in the light of a clear understanding of the nature and tendencies of the system which it is proposed to modify or displace. The essay, therefore, endeavors to isolate and define the essential characteristics of free enterprise as a system or method of securing and directing coöoperative effort in a social group. As a necessary condition of success in this endeavor it is assumed that the description and explanation of phenomena must be radically separated from all questions of defense or criticism of the system under examination. By means of first showing what the system is, it is hoped that advance may be made toward discovering what such a system can, and what it cannot, accomplish. A closely related aim is that of formulating the data of the problem of economic organization, the unchangeable materials with which, and conditions under which, any machinery of organization has to work. A sharp and clear conception of these fundamentals is viewed as a necessary foundation for answering the question as to what is reasonably to be expected of a method of organization, and hence of whether the system as such is to be blamed for the failure to achieve ideal results, of where if at all it is at fault, and the sort of change or substitution which offers sufficient chance for improvement to justify experimentation.
The net result of the inquiry is by no means a defense of the existing order. On the contrary, it is probably to emphasize the inherent defects of free enterprise. But it must be admitted that careful analysis also emphasizes the fundamental difficulties of the problem and the fatuousness of over-sanguine expectations from mere changes in social machinery. Only this foundation-laying is within the scope of this study, or included within the province of economic theory. The final verdict on questions of social policy depends upon a similar study of other possible systems of organization and a comparison of these with free enterprise in relation to the tasks to be accomplished. This one "conclusion" may be hazarded, that no one mode of organization is adequate or tolerable for all purposes in all fields. In the ultimate society, no doubt, every conceivable type of organization machinery will find its place, and the problem takes the form of defining the tasks and spheres of social endeavor for which each type is best adapted.
The particular technical contribution to the theory of free enterprise which this essay purports to make is a fuller and more careful examination of the rôle of the entrepreneur or enterpriser, the recognized "central figure" of the system, and of the forces which fix the remuneration of his special function. The problem of profit was suggested to the writer as a suitable topic for a doctoral dissertation in the spring of 1914 by Dr. Alvin Johnson, then Professor of Economics in Cornell University. The study was chiefly worked out under the direction of Professor Allyn A. Young after Dr. Johnson left Cornell. My debt to these two teachers I can only gratefully acknowledge. Since the acceptance of the essay as a thesis at Cornell in June, 1916, and its submission in the Hart, Schaffner & Marx competition in 1917, it has been entirely rewritten under the editorial supervision of Professor J. M. Clark, of the University of Chicago. I have also profited much by discussions with Professor C. O. Hardy, my colleague at the same institution, and by access to his unpublished "Readings on Risk and Risk-Bearing." Professor Jacob Viner, of the University of Chicago, has kindly read the proof of the entire work. My obligations to various economists through their published work are very inadequately shown by text and footnote references, but are too comprehensive and indefinite to express in detail.
Iowa City, IowaJanuary, 1921[Back to Table of Contents]
INTRODUCTORY[Back to Table of Contents]
Part I, Chapter I
The Place of Profit and Uncertainty in Economic Theory
Economics, or more properly theoretical economics, is the only one of the social sciences which has aspired to the distinction of an exact science. To the extent that it is an exact science it must accept the limitations as well as share the dignity thereto pertaining, and it thus becomes like physics or mathematics in being necessarily somewhat abstract and unreal. In fact it is different from physics in degree, since, though it cannot well be made so exact, yet for special reasons it secures a moderate degree of exactness only at the cost of much greater unreality. The very conception of an exact science involves abstraction; its ideal is analytic treatment, and analysis and abstraction are virtually synonyms. We have given us the task of reducing to order a complex mass of interrelated changes, which is to say, of analyzing them into uniformities of sequence or behavior, called laws, and the isolation of the different elementary sequences for separate study.
Sometimes the various elementary constituents of our complex phenomenon are met with in nature in isolation complete or partial, and sometimes artificial experiments can be devised to present them either alone or with attendant conditions subject to control. The latter is, of course, the characteristic procedure of physical science. Its application to the study of industrial society is, however, generally impracticable. Here we must commonly search for manifestations of the various factors in our complex, under varying associations, or rely upon intuitive knowledge of general principles and follow through the workings of individual chains of sequence by logical processes.
The application of the analytic method in any class of problems is always very incomplete. It is never possible to deal in this way with a very large proportion, numerically speaking, of the vast complexity of factors entering into a normal real situation such as we must cope with in practical life. The value of the method depends on the fact that in large groups of problem situations certain elements are common and are not merely present in each single case, but in addition are both few in number and important enough largely to dominate the situations. The laws of these few elements, therefore, enable us to reach an approximation to the law of the situation as a whole. They give us statements of what "tends" to hold true or "would" hold true under "ideal" conditions, meaning merely in a situation where the numerous and variable but less important "other things" which our laws do not take into account were entirely absent.
Thus, in physics, the model and archetype of an exact science of nature, a relatively small and workable number of laws or principles tell us what would happen if simplified conditions be assumed and all disturbing factors eliminated. The simplified conditions include specifications as to dimensions, mass, shape, smoothness, rigidity, elasticity and properties generally of the objects worked with, specifications usually quite impossible to realize in fact, yet absolutely necessary to make, while the "disturbing factors" are simply anything not included in the specifications, and their actual elimination is probably equally impossible to realize, and, again, equally necessary to assume. Only thus could we ever obtain "laws," descriptions of the separate elements of phenomena and their separate behavior. And while such laws, of course, never accurately hold good in any particular case, because they are incomplete, not including all the elements in the case, yet they enable us to deal with practical problems intelligently because they are approximately true and we know how to discount their incompleteness. Only by such approximations, reached by dealing analytically with the more important and more universal aspects of phenomena, could we ever have attained any intelligent conception of the behavior of masses of matter in motion and secured our present marvelous mastery over the forces of nature.
In a similar way, but for various reasons not so completely and satisfactorily, we have developed a historic body of theoretical economics which deals with "tendencies"; i.e., with what "would" happen under simplified conditions never realized, but always more or less closely approached in practice. But theoretical economics has been much less successful than theoretical physics in making the procedure useful, largely because it has failed to make its nature and limitations explicit and clear. It studies what would happen under "perfect competition," noting betimes respects in which competition is not perfect; but much remains to be done to establish a systematic and coherent view of what is necessary to perfect competition, just how far and in what ways its conditions deviate from those of real life and what "corrections" have accordingly to be made in applying its conclusions to actual situations.1
The vague and unsettled state of ideas on this subject is manifest in the difference of opinion rife among economists as to the meaning and use of theoretical methods. At one extreme we have mathematical economists and pure theorists2 to whom little if anything outside of a closed system of deductions from a very small number of premises assumed as universal laws is to be regarded as scientific economics at all. At the other extreme there is certainly a strong and perhaps growing tendency to repudiate abstraction and deduction altogether, and insist upon a purely objective, descriptive science. And in between are all shades of opinion.
In the present writer's view the correct "middle way" between these extreme views, doing justice to both, is not hard to find. An abstract deductive system is only one small division of the great domain of economic science, but there is opportunity and the greatest necessity for cultivating that field. Indeed, in our analogy, theoretical mechanics is a very small section of the science of physical nature; but it is a very fundamental section, in a sense the "first" of all, the foundation and prerequisite of those that follow. And this also may very well hold good of a body of "pure theory" in economics; it may be that a small step, but the first step, toward a practical comprehension of the social system is to isolate and follow out to their logical conclusion a relatively small number of fundamental tendencies discoverable in it. There is abundant need for the use of both deduction and induction in economics as in other sciences, if indeed the two methods are theoretically separable. As Mill has well argued3 we must reason deductively as far as possible, always collating our conclusions with observed facts at every stage. Where the data are too complex to handle in this way induction must be applied and empirical laws formulated, to be connected deductively with the general principles of "ethology" (we should now say simply "human behavior"). Emphasis being laid on the provisos, in both cases, that in using deduction the conclusions must be constantly checked with facts by observation and premises revised accordingly, while the empirical laws resulting from induction must in turn be shown to follow from the general principles of the science before they can be credited with much significance or dependability, we see that there is little divergence left between the two methods.4
The method of economics is simply that of any field of inquiry where analysis is in any degree applicable and anything more than mere description possible. It is the scientific method, the method of successive approximations.5 The study will begin with a theoretical branch dealing with only the most general aspects of the subject matter, and proceed downward through a succession of principles applicable to more and more restricted classes of phenomena. How far the process is carried will be a matter of taste and of the practical requirements of any problem. In science generally it does not pay to elaborate laws of a very great degree of accuracy of detail. When the number of factors taken into account in deduction becomes large, the process rapidly becomes unmanageable and errors creep in, while the results lose in generality of application more significance than they gain by the closeness of approximation to fact in a given case. It is better to stop dealing with elements separately before they get too numerous and deal with the final stages of the approximation by applying corrections empirically determined.
The theoretical method in its pure form consists, then, in the complete and separate study of general principles, with the rigid exclusion of all fluctuations, modifications, and accidents of all sorts due to the influence of factors less general than those under investigation at any particular stage of the inquiry. Our question relates to the advisability of using this method in a tolerably rigid form in economics. The answer to this question depends on whether in the phenomena to be studied general principles can in fact be found of sufficient constancy and importance to justify their careful isolation and separate study. The writer is strongly of the opinion that the question must be answered affirmatively. Economics is the study of a particular form of organization of human want-satisfying activity which has become prevalent in Western nations and spread over the greater part of the field of conduct. It is called free enterprise or the competitive system. It is obviously not at all completely or perfectly competitive, but just as indisputably its general principles are those of free competition. Under these circumstances the study, as a first approximation, of a perfectly competitive system, in which the multitudinous degrees and kinds of divergences are eliminated by abstraction, is clearly indicated. The method is particularly indicated in a practical sense because our most important questions of social policy hinge directly upon the question of the character of the "natural" results of competition, and take the form of queries as to whether the tendencies of competition are to be furthered and supplemented or obstructed and replaced.
That such a theoretical first approximation is indicated in a theoretical sense, that it is the natural logical way of going at the problem, conforming to the workings of our thought processes, is sufficiently evidenced by the fact that this is what economists have always in fact done, ever since there has been such a science or such a social system to be studied. They have, to be sure, been criticized for doing it, and severely. But in the present writer's judgment theorists of the past and present are to be justly criticized not for following the theoretical method and studying a simplified and idealized form of competitive organization, but for not following it in a sufficiently self-conscious, critical, and explicit way. In their discussions of methodology the historic economists have, indeed, been as clear and explicit as could be desired,6 but in the use of the method as much cannot, unfortunately, be said.
It should go without saying that in the use of the scientific method of reasoning from simplified premises, it is imperative that it be clear to the reasoner and be made unmistakable to those who use his work what his procedure is and what presuppositions are involved. Two supreme difficulties have underlain controversies regarding method in the past. The first is the strong aversion of the masses of humanity, including even a large proportion of "scholars," to all thinking in general terms. The second difficulty, on the other side, is the fact referred to above, that the persons employing methods of approximation in economics have not themselves adequately and always recognized, and still less have they made clear to their readers, the approximate character of their conclusions, as descriptions of tendency only, but have frequently hastened to base principles of social and business policy upon very incomplete data. The evil results of the failure to emphasize the theoretical character of economic speculation are apparent in every field of practical economics. The theorist not having definite assumptions clearly in mind in working out the "principles," it is but natural that he, and still more the practical workers building upon his foundations, should forget that unreal assumptions were made, and should take the principles over bodily, apply them to concrete cases, and draw sweeping and wholly unwarranted conclusions from them. The clearly untenable and often vicious character of such deductions naturally works to discredit theory itself. This, of course, is wrong; we do not allow perpetual motion schemes to discredit theoretical mechanics, which is built upon the assumption of perpetual motion at every stage. But in economics a distrust of general principles, fatal as it is to clear thinking, will be inevitable as long as the postulates of theory are so nebulous and shifting. They can hardly be made sufficiently explicit; it is imperative that the contrast between these simplified assumptions and the complex facts of life be made as conspicuous and as familiar as has been done in mechanics.
The present essay is an attempt in the direction indicated above. We shall endeavor to search out and placard the unrealities of the postulates of theoretical economics, not for the purpose of discrediting the doctrine, but with a view to making clear its theoretical limitations. There are several reasons why the approximate character of theoretical economic laws and their inapplicability without empirical correction to real situations should be especially emphasized as compared, for instance, with those of mechanics. The first reason is historical and has already been indicated. The limitations of the results have not always been clear, and theorists themselves as well as writers in practical economics and statecraft have carelessly used them without regard for the corrections necessary to make them fit concrete facts. Policies must fail, and fail disastrously, which are based on perpetual motion reasoning without the recognition that it is such.
In the second place, the allowances and corrections necessary in the case of theoretical economics are vastly greater than in the case of mechanics, and the importance of not losing sight of them is correspondingly accentuated. The general principles do not bring us so close to reality; there is a larger proportion of factors in an economic situation which are of the variable and fluctuating sort.
Again, in spite of the greater contrast between theory and practice in the study of the mechanics of competition, as compared with the mechanics of matter and motion, the contrast is less familiar and more easily overlooked. Our race has been observing and handling in a rude way the latter type of phenomena ever since it has lived on the earth, while competitive relations among men were established only a few generations ago. In consequence the habit of clear thinking according to scientific method, the use of hypotheses and separation of fundamental principles from the accidents of particular instances, has become in some measure built up in the minds of at least a respectable body of the more cultivated division of the race. Perhaps it is even in some degree instinctive in certain strains.7
Finally, it makes vastly more difference practically whether we disseminate correct ideas among the people at large in the field of human relations than is the case with mechanical problems. For good or ill, we are committed to the policy of democratic control in the former case, and are not likely to resort to it in the latter. As far as material results are concerned, it is relatively unimportant whether people generally believe in their hearts that energy can be manufactured or that a cannon ball will sink part of the way to the bottom of the ocean and remain suspended, or any other fundamental misconception. We have here at least established the tradition that knowledge and training count and have persuaded the ignorant to defer to the judgment of the informed. In the field of natural science the masses can and will gladly take and use and construct appliances in regard to whose scientific basis they are as ignorant as they are indifferent. It is usually possible to demonstrate such things on a moderate scale, and literally to knock men down with "results." In the field of social science, however, fortunately or unfortunately, these things are not true. Our whole established tradition tends to the view that "Tom, Dick, and Harry" know as much about it as any "highbrow"; the ignorant will not in general defer to the opinion of the informed, and in the absence of voluntary deference it is usually impossible to give an objective demonstration. If our social science is to yield fruits in an improved quality of human life, it must for the most part be "sold" to the masses first. The necessity of making its literature not merely accurate and convincing, but as nearly "fool-proof " as possible, is therefore manifest.
Whether or not the use of the method of exact science is as necessary in the field of social phenonena as the present writer believes, it will doubtless be conceded; even by opponents of this view, that it has been employed in the great mass of the literature since the modern science of economics was founded. It may also be granted that the terminology, concepts, and modes of thinking in our economic instruction and in general discussion are and for a long time must be largely dominated by the established tradition. And it will certainly not be denied that if the method of reasoning from hypothetical or simplified premises is followed, its use must be thoroughly safeguarded by emphasizing the character of the premises and the consequent conditional or approximate validity of the conclusions reached. If, finally, it is admitted that this has not been adequately done hitherto, and that mischief and misunderstanding have followed from the loose use of assumptions and looser application of conclusions, then the call for such a study as the present will be established.
The tendency toward a sharper separation of the theoretical portion of economics from the empirical portion, and toward the clearer formulation of premises, can be traced in the literature of the subject, and notable progress in the right direction has recently been made. The work of the mathematical economists and non-mathematical pure theorists has already been mentioned. A considerable and fairly satisfactory body of consciously and rigidly "theoretical" (i.e., general and approximate) doctrine has been built up. The work of Pareto and Wicksteed seems to the writer especially worthy of note. Unfortunately it has not achieved the recognition and been accorded the fundamental place in the general program of the science which we think it should have; mathematical economics in particular seems likely to remain little more than a cult, a closed book to all except a few of the "initiated." In the great mass of economic literature there is certainly still wanting the evidence of a comprehensive grasp of general principles and even more of the meaning and importance of general principles in a scientific program. There is still a need for thoroughgoing and critical comparison and contrast of theoretical assumptions with the conditions of real life and of theoretical conclusions with concrete facts. The makers and users of economic analysis have in general still to be made to see that deductions from theory are necessary, not because literally true—that in the strict sense they are useful because not literally true—but only if they bear a certain relation to literal truth and if all who work with them constantly bear in mind what that relation is. It must be admitted that even the pure theorists have not generally been assiduous in emphasizing the practical significance of their work and its relation to the outside body of the science; they have been too exclusively interested in the construction of their a priori systems, and perhaps a little disposed to regard these as a disproportionate part of economic science. Such a bias is natural and even useful, but in a field where the relations between theory and practice do not come instinctively to the minds of the users of both, the supplementation of theory by works of interpretation becomes indispensable.
Indication of progress in this field is furnished especially by the discussion centering around the concept of normality in the work of Marshall in England and the related notion of the static state espoused in particular in this country by J. B. Clark.8 The meaning and bearings of the fundamental concepts are in the writer's opinion much better worked out by Marshall than by any other writer generally read. But Marshall himself has adopted a cautious, almost anti-theoretical attitude toward fundamentals; he refuses to lay down and follow rigidly defined hypotheses, but insists on sticking as closely as possible to concrete reality and discussing "representative" conditions as opposed to limiting tendencies. The gain in concreteness and realism is in our opinion much more than offset by the obscurity, vagueness, and unsystematic character of the discussion, the inevitable consequence of burying fundamentals in an overwhelming mass of qualification and detail. Professor Clark, on the other hand, is frankly theoretical and insistent upon the deliberate use of abstraction. But the writer at least is unable to agree with him on the question of what abstractions should be made and the manner of their use. While the specifications for his theoretical state are more definite and explicit than those of Marshall, they seem to us less correctly drawn up.9
The opposition to pure theory in general is based on a failure to understand it, and especially common is the misconception as to the meaning of static or normal hypotheses. It is not recognized that their use is inherent in the methodology of science, is in fact the very essence of scientific procedure; that it is not at all recondite or intellectual in its appeal, but is mere practical common sense. The aim of science is to predict the future for the purpose of making our conduct intelligent.10 Intelligence predicts, as shown above, through analysis, by isolating the different forces or tendencies in a situation and studying the character and effects of each separately. Static method and reasoning are therefore coextensive. We have no way of discussing a force or change except to describe its effects or results under given conditions.
The "static" method in economics does merely this. It inquires what conditions exist and studies the results which recognizable forces at work (or changes in progress—we know nothing about force; it is the assumed "cause" of change, which is the only fact) tend to produce under those conditions. It is "unreal" only in the simplification of its problem; i.e., in taking the more conspicuous forces and more important conditions and provisionally neglecting others. This the limitations of our minds compel us to do. We must first discuss one change at a time, assuming the others suspended while that one is working itself out to its final results, and then attempt to combine the tendencies at work, estimate their relative importance, and make actual predictions. This is the way our minds work; we must divide to conquer. Where a complex situation can be dealt with as a whole—if that ever happens—there is no occasion for "thought." Thought in the scientific sense, and analysis, are the same thing.
The reference to final results calls for a further word. The concept of equilibrium is closely related to that of static method. It is the nature of every change in the universe known to science to have "final" results under any given conditions, and the description of the change is incomplete if it stops short of the statement of these ultimate tendencies. Every movement in the world is and can be clearly seen to be a progress toward an equilibrium. Water seeks its level, air moves toward an equality of pressure, electricity toward a uniform potential, radiation toward a uniform temperature, etc. Every change is an equalization of the forces which produce that change, and tends to bring about a condition in which the change will no longer take place. The water continues to flow, the wind to blow, etc., only because the sun's heat—itself a similar but more long-drawn-out redistribution of energy—constantly restores the inequalities which these movements themselves constantly destroy.
So also in economic phenomena. Goods move from the point of lower to one of higher demand or price, and every such movement obliterates the price difference which causes it. The circulation of goods continues because the life activities of man (the production of wealth) keep new supplies forthcoming. The same applies to shifts in productive energy from one use to another. There are really as many static states as there are changes to be studied, sets of given conditions to be assumed. It is arbitrary but convenient to speak of the static state in relation to given conditions of the supply and demand (production and consumption) of consumption goods. We shall see that there are in fact two other fundamental static problems; the first assumes given supplies of consumption goods, and the second, given general conditions under which the creation of production goods and changes in wants take place; the first is the problem of the market or of market price, and the second that of social economic progress, often referred to as economic dynamics.
The argument of the present essay will center around the general idea of normality, viewed as an attempt to isolate for study the essentials or general principles of a competitive social economic organization. The aim will be to bring out the content of the assumptions or hypotheses of the historic body of economic thought, referred to by the classical writers as "natural price" theory. By this is meant, not the assumptions definitely in the minds of the classical economists, but the assumptions necessary to define the conditions of perfect competition, at which the classical thought was aimed, and which are significant as forming the limiting tendency of actual economic processes.11
As the title of the essay indicates, our task will be envisaged from the immediate standpoint of the problem of profit in distributive theory. The primary attribute of competition, universally recognized and evident at a glance, is the "tendency" to eliminate profit12 or loss, and bring the value of economic goods to equality with their cost. Or, since costs are in the large identical with the distributive shares other than profit, we may express the same principle by saying that the tendency is toward a remainderless distribution of products among the agencies contributing to their production. But in actual society, cost and value only "tend" to equality; it is only by an occasional accident that they are precisely equal in fact; they are usually separated by a margin of "profit," positive or negative. Hence the problem of profit is one way of looking at the problem of the contrast between perfect competition and actual competition.
Our preliminary examination of the problem of profit will show, however, that the difficulties in this field have arisen from a confusion of ideas which goes deep down into the foundations of our thinking. The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein. It is around this idea, therefore, that our main argument will finally center. A satisfactory explanation of profit will bring into relief the nature of the distinction between the perfect competition of theory and the remote approach which is made to it by the actual competition of, say, twentieth-century United States; and the answer to this twofold problem is to be found in a thorough examination and criticism of the concept of Uncertainty, and its bearings upon economic processes.
But Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term "risk," as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. The nature of this confusion will be dealt with at length in chapter VII, but the essence of it may be stated in a few words at this point. The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. There are other ambiguities in the term "risk" as well, which will be pointed out; but this is the most important. It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We shall accordingly restrict the term "uncertainty" to cases of the non-quantitive type. It is this "true" uncertainty, and not risk, as has been argued, which forms the basis of a valid theory of profit and accounts for the divergence between actual and theoretical competition.
As a background for the discussion of the meaning and causal relations of uncertainty, we shall first make a brief survey of previously proposed theories of profit. After a summary glance at the history of the treatment of the subject down to recent decades, it will be necessary to dwell at slightly greater length upon the controversy recently carried on in connection with the explanation of profit in terms of risk. The crucial character of the distinction between measurable risk and unmeasurable uncertainty will become apparent in this discussion.
Part Two (chapters III-VI) will be taken up with an outline study of a theoretical, perfectly competitive society. In the course of the argument it will become increasingly evident that the prime essential to that perfect competition which would secure in fact those results to which actual competition only "tends," is the absence of Uncertainty (in the true, unmeasurable sense). Other presuppositions are mostly included in or subordinate to this, that men must know what they are doing, and not merely guess more or less accurately. The "tendency" toward perfect competition is at once explained, since men are creatures endowed with the capacity to learn, and tend to find out the results of their acts, while the cause of the failure ever to reach the goal is equally evident so long as omniscience remains unattainable. Now since risk, in the ordinary sense, does not preclude perfect planning (for reasons which can easily be made clear), such risk cannot prevent the complete realization of the tendencies of competitive forces, or give rise to profit.
At the conclusion of this brief treatment of perfect competition we shall devote a short chapter to limitations of perfect competition other than the imperfection of knowledge, and then take up in Part Three a careful analysis of the concepts of Risk and Uncertainty (chapter VII), proceeding (in the remaining chapters) with a somewhat detailed study of the effects of both, but especially of true or unmeasurable uncertainty upon the economic organization and of its bearings upon economic theory. The economic relations of risk in the narrower sense of a measurable probability have been extensively dealt with in the literature of the subject and do not call for elaborate treatment here. Our main concern will be with the contrast between Risk as a known chance and true Uncertainty, and treatment of the former is incidental to this purpose.[Back to Table of Contents]
Part I, Chapter II
Theories of Profit;13 Change and Risk in Relation to Profit
In view of the facts set forth in the introductory chapter as to the relation of profit to theoretical economics, and the vagueness in the minds of economic writers as to fundamental postulates, it is not surprising that the theory of profit has remained one of the most unsatisfactory and controversial divisions of economic doctrine. Considering, however, the universal recognition of the "tendency" of competition to eliminate profit, it is perhaps somewhat remarkable that the problem of profit itself has not, with one important exception,14 been attacked from the direct point of view adopted in this essay, of an inquiry into the causes of the failure of ideal competition to be fully realized in fact. It is, indeed, only within comparatively recent years that the existence of profit as a really distinct share has become established and the problem of its explanation given definite status.
As in the case of most sciences whose subject matter is some field of human activity, economic theory has been much influenced by practice, and in particular the loose use of terms in everyday affairs has given rise to serious confusions in terminology. The concept of profit is bound up in a certain type of organization of industry, a type realized in various degrees in different places and times, and always undergoing modification and development.
At the time when the English classical school of economists were writing—i.e., in the later eighteenth and early nineteenth centuries—corporations were relatively unimportant, being practically restricted to a few banks and trading companies. There was, of course, some lending at interest, but in the dominant form of industry men used their own capital, hiring labor, and renting land from others. The managerial function centered in the capitalist. Moreover, English industries were new and rapidly expanding; competition was not highly developed; the possession of capital seemed to be and was the dominant factor in the situation. Only in more recent times has the accumulation of capital, the perfection of financial institutions, and the growth of competition transferred the center of interest to business ability, made it easy or at least generally possible for ability to secure capital when not in possession of it by direct ownership, and made common the carrying-on of business predominantly with borrowed resources.
Under these early conditions it was natural to connect the income of the business manager with the ownership of capital, and in all the classical writings we find the word "profit" used in this sense. A further source of confusion was the indefiniteness of the conception and use of the ideas of natural and market price in the minds of the early writers. It is natural and inevitable that a distinction which goes to the heart of the fundamental problems of the nature and methodology of economic science should be but imperfectly worked out in the initial stages of the speculation. Only recently, again, has the analysis of long-time normal price by Marshall and of the "static state" by Clark and Schumpeter begun to give to economists a clearer notion of what is really involved in "natural" or normal conditions. To the earlier classical writers this obscurity hid the fundamental difference between the total income of the capitalist manager and contract interest. The only separation considered necessary in the explanation of distribution was to restrict the theory of the business manager's income to the explanation of "normal profit," which was regarded as substantially equivalent to contract interest. Another barrier to the formulation of a clear statement of the relations between interest and profit was the lack of an adequate understanding of the productivity of capital, which also these authors did not possess and which has first been worked out in recent years.
The qualification of "near" or "substantial" identification of normal profit and interest is necessary, however, in referring to the classical treatments. Even Adam Smith and his immediate followers recognized that profits even normally contain an element which is not interest on capital. Remuneration for the work and care of supervising the business was always distinguished. Reference was also made to risk, but in the sense of risk of loss of capital, which does not clearly distinguish profit from interest.15 Adam Smith is explicit in regard to these elements, while Malthus and M'Culloch were more so. J. S. Mill pointed out in a somewhat groping way that the wages of management are determined in a different way from other wages, and noted also that profits, so called, include as a third element a payment for risk, as well as wages of management (and interest). The inclusion of interest in profit was opposed by Bagehot, and in the United States by Walker, but the use of the term is still somewhat loose in England, as is seen in Marshall. Even in this country the development of corporation accounting, while separating wages of management from profit, has tended to a new confusion of profit and interest.
The early French writers, beginning with J. B. Say, adopted a different view of profit, or at least a different use of the word, insisting on a separation of profit from interest and defining the former explicitly as a wage. The difference in procedure may have been due, as v. Mangoldt suggests,16 to the different character of typical French industry and the greater importance of the manager's personality in it relatively to the capital factor. It is worthy of note that in the fourth edition of his "Traité," Say included in profit the reward for risk-taking; he had in the earlier editions viewed this income as accruing to the capitalist as such, but now transferred it to the entrepreneur. Especial mention should be made of Courcelle-Seneuil, who insisted that profit is not a wage, but is due to the assumption of risk.17
The older German economists varied widely in their treatment of profits. Some, of whom Schäffle is perhaps the most notable example, follow the "English" view in classing profit as essentially a return to capital. Others, notably Roscher, adopt the "French"18 attitude and treat it as a form of wages. Roscher does not even use the term "profit," but substitutes Unternehmerlohn. Other writers, such as Hermann and Rau, took a more or less intermediate position.
Still another group, of more importance for our purposes, contended that profit should be recognized as a unique form of income, not susceptible of reduction to remuneration for either capital or labor. This position was taken in a somewhat timid way by Hufeland19 and more definitely by Riedel,20 but its most notable advocates were Thünen and v. Mangoldt. Thünen's great work, "Der Isolirte Staat,"21 defines profit as what is left after (a) interest, (b) insurance, and (c) wages of management, are met. This residuum consists of two parts: (1) payment for certain risks, especially changes in values and the chance of failure of the whole enterprise, which cannot be insured against, and (2) the extra productivity of the manager's labor due to the fact that he is working for himself, his "sleepless nights" when he is planning for the business. Thünen called these elements respectively Industriebelohnung and Unternehmergewinn, and their sum Gewerbsprofit.
A most careful and exhaustive analysis of profit is contained in the monograph of H. v. Mangoldt, already referred to. Proceeding on the basis of an elaborate classification of the forms of industrial organization and a discussion of the economic advantages of the entrepreneur form, this writer finds in the income of the business enterpriser a complex group of unique elements. He divides it first into three parts: (1) a premium on those risks which are of such a nature that he cannot shift them by insurance; (2) entrepreneur interest and wages, including only payments for special forms of capital or productive effort which do not admit of exploitation by any other than their owner; (3) entrepreneur rents. These last again fall into four subdivisions: (a) capital rents, (b) wage rents, (c) large enterprise rent, and (d) "entrepreneur rent in the narrower sense." They are all due to the limitation of special capacities or characteristics (the last to special combinations of such) and are called "premiums on scarcity" (Seltenheits prämeien). This is, of course, a question-begging term (though many writers have used it) since all incomes depend in the same way on the limitation of the agencies to which they are imputed. It would seem that every imaginable source of income is included in this minute and subtle classification.
A special place in the history of theories of profit should be given to the German socialist school, the so-called "scientific" socialists, Rodbertus, Marx, Engels, Lassalle, and their followers. These writers take the English classical treatment of profit in a narrowly literal (one must say wholly uncritical and superficial) sense as including all income accruing to capital, to which they add land. Combining this with an equally blind reading of the labor theory of value which was the starting-point of Smith and Ricardo, they derive a simple classification of income in which all that is not wages is a profit which represents exploitation of the working classes. Capital is equivalent to property, which is to be regarded as mere power over the economic activities of others due to the strategic position of ownership over the implements of labor. It is analogous to a robber baron's crag, a toll-gate on a natural highway, or a political franchise to exploit. Pierstorff, in the monograph referred to above, follows Rodbertus in the main, after criticizing alternative views.22
After the publication in 1871 of Menger's "Grundsätze" had given a new interest and new turn to value theory in Austria and Germany, a notable series of discussions of profit appeared in those countries. Those calling for especial mention are the monographs of Gross23 and Mataja24 and the treatments by Mithoff25 and Kleinwächter26 in Schönberg's "Handbuch," the last-named elaborated in the author's book already referred to. Gross takes as his starting-point the plain fact that profit is the difference between the cost of goods and their value, and studies the position of the entrepreneur in the two markets in which he buys productive services and raw materials and sells his finished product. He may be said to reduce profit to bargaining power, in which, of course, superior knowledge and foresight are recognized as playing a large part, but Gross does not work out a systematic treatment of the nature and significance of risk or uncertainty. He thinks an income which is a premium for taking risks is inherently impossible, as gains and losses would necessarily balance. Few other writers agree with this proposition. Socially, profit is for Gross the inducement to follow closely the economic law of cheapest possible production and most effective utilization of goods.
Mataja's analysis of profit is a more literal application of Menger's utility theory of value. He seeks to explain price differences by means of the differences between the various uses of "goods of higher order" in making different kinds of "goods of lower order" and ultimately different consumption goods. His discussion does not get beyond a statement of the problem.
Mithoff holds that the entrepreneur's income consists of rents, wages, etc., at market rates for the productive services which he furnishes to the business, plus a "profit" which may be regarded as remuneration for taking the risk of its failure. He contends, however, that this profit is at best a mere abstraction, a complex of a number of indeterminate surpluses, and that the entrepreneur income as a whole alone has definite meaning or practical significance.
Körner is another writer who explains the entrepreneur's income in terms of superior bargaining power. His position is figured as that of a watchman on a tower and is summed up in the expression that his is a wider market than that of the men he buys from and sells to, especially the laborer whom he hires. The essential mystery of why the competition of other watchmen on similar towers does not eliminate his peculiar gain is not touched upon. The nonsocialistic German writers are usually particularly concerned to combat the allegations of the socialists and furnish a social justification of profit.
Kleinwächter views profit from the social standpoint as pay for taking the twofold risk of production—technical and economic, a distinction made by Gross—and for the care of supervision. From the individual point of view it is a speculative gain arising from advantage taken of differences between the prices of economic goods and the prices of the agents necessary to their production. In his fuller treatment in his book on distribution, Kleinwächter devotes most of his energy to a sarcastic polemic against the English classical economic theory, according to which the prices of commodities should equal their costs of production or the sum of the wages, interest, and rent paid the agents employed to produce them. No serious criticism of this theory is attempted, however, nor any sign displayed of a comprehension of its real meaning as a statement of the limits of tendencies. The general conclusion that the existence of profit follows from a divergence between the conditions of theory and those of fact is the starting-point of the present study. It is, of course, a statement of the problem, and not a solution of it; Kleinwächter virtually explains profit by ridiculing the idea that it should be thought to call for explanation.
In other than the German-speaking countries the subject of profit has not been prolific of independent monographs and treatises, but has usually been dealt with as an integral part of the general theory of distribution (though there are some exceptions in France and Italy which would have to be noticed in a fuller historical treatment). It is, of course, impossible to take up even the important theorists in all countries and summarize their views, while any brief treatment by schools or groups would be misleading rather than helpful. The writers already mentioned pretty well cover the fundamental theories and standpoints, with exceptions yet to be noted.27 A very common procedure is to treat profit as a special case of monopoly gain, or to combine elements of monopoly position with other factors. This method is apt to degenerate into a mere confusion of the two income categories. The common use of the term "monopoly profit" to designate monopoly revenue directly incites to this confusion.
The first notable development in the field of profit theory in America was the work of General Francis A. Walker.28 Walker effectually emphasized the place and importance of the entrepreneur or "captain of industry," and helped to free economic treatises in English from the careless handling of profit as an element in interest. His own "rent theory," however, in spite of its vogue at the time of its promulgation, need not now detain us. Walker wrote before Marshall, Clark,29 and Hobson30 had shown that all incomes are like rent in the mode of their determination, and with that point once made clear the rent theory is reduced to a wage theory merely, and its special significance disappears.
More recently the center of interest in the discussion of profit has shifted from Walker's theory to two other opposed views, the "dynamic theory" and the "risk theory" respectively. The former is the view upheld by Professor J. B. Clark and his followers and the latter is sponsored in particular by Mr. F. B. Hawley.31 Neither the connection between profit and changes in conditions nor that between profit and risk is an entirely new idea, but hitherto neither had been erected into a definite and ostensibly sufficient principle of explanation of the peculiar income of the entrepreneur. These two theories call for somewhat fuller treatment.
The dynamic theory is a correlate of Professor J. B. Clark's theory of distribution in the profitless "static state."32 Professor Clark outlines a systematic structure of theoretical economics in three main divisions.
The first treats of universal phenomena, and the second of static social phenomena. Starting with those laws of economics which act whether humanity is organized or not, we next study the forces that depend on organization but do not depend on progress. Finally it is necessary to study the forces of progress. To influences that would act if society were in a stationary state, we must add those which act only as society is thrown into a condition of movement and disturbance. This will give us a science of Social Economic Dynamics.33
The static state is the state of "natural" adjustments of Ricardo and the early classical writers.
What are called "natural" standards of values and "natural" or normal rates of wages, interest, and profits are in reality, static rates. They are identical with those which would be realized, if a society were perfectly organized, but were free from the disturbances that progress causes.... Reduce society to a stationary state, let industry go on with entire freedom, make labor and capital absolutely mobile... and you will have a régime of natural values.34
To realize the static state, we should have to eliminate five kinds of change which are constantly in progress:
Five generic changes are going on, every one of which reacts on the structure of society, by changing the arrangements of that group system which it is the work of catallactics to study:
In the static state each factor secures what it produces, and since cost and selling price are always equal there can be no profits beyond wages for the routine work of supervision.
The prices of goods are in these older theories said to be "natural" when they equal the cost of producing them;... in reality their "natural prices" were static prices.36 The prices that conform to the cost of production are, of course, those which give no clear profit to the entrepreneur. A business man whose goods sell at such rates will get wages for whatever amount of labor he may perform, and interest for any capital that he may furnish; but he will have nothing more to show in the way of gain. He will sell his product for what the elements that compose it have really cost him, if his own labor and the use of his capital be counted among the costs. We shall see that this condition of no-profit prices exactly corresponds to the one that would result from the static adjustment of the producing groups.37
Profits are, then, the result exclusively of dynamic change. "Obviously, from all these changes two general results must follow: first, values, wages and interest will differ from the static standards; secondly, the static standards themselves will always be changing."38 The type of dynamic change is invention; "an invention makes it possible to produce something more cheaply. It first gives a profit to entrepreneurs and then... adds something to wages and interest.... Let another invention be made.... It also creates a profit; and this profit, like the first, is an elusive sum, which entrepreneurs grasp but cannot hold." It "slips through their fingers and bestows itself on all members of society."39 Thus the effect of any one dynamic change is to produce temporary profits. But in actual society such changes constantly occur, and the readjustments are always in process. "As a result, we... have the standard of wages moving continuously upward and actual wages steadily pursuing the standard rate in its upward movement, but always remaining by a certain interval behind it."40
In another sense profit is dependent on "friction": "The interval between actual wages and the static standard is the result of friction; for, if competition worked without let or hindrance, pure business profit would be annihilated as fast as it could be created...."41 "Were it not for that interval, entrepreneurs as such would get nothing, however much they might add to the world's productive power."42
The fatal criticism of this procedure of taking changes in conditions as the explanation and cause of profit is that it overlooks the fundamental question of the difference between a change that is foreseen a reasonable time in advance and one that is unforeseen. Now, if we merely assume that all the "dynamic changes" which Professor Clark enumerates, and any others which may be named, are foreknown for a sufficient time before they take place, or that they take place continuously in accordance with laws generally and accurately known, so that their course may be predicted as far into the future as occasion may require, then the whole argument based on the effects of change will fall completely to the ground. If the retort is made that this is a supposition contrary to fact and illicit, the answer is that it is only partly contrary to fact. Some changes are foreseen and some are not, the laws of some are tolerably accurately known, of others hardly at all;43 and the variation in foreknowledge makes it clearly indispensable to separate its effects from those of change as such if any real understanding of the elements of the situation is to be attained. It is evident that a society might be ever so dynamic, as Professor Clark defines the term, and yet have all its prices "natural" or constantly equal to production costs, excluding any chance for the entrepreneur to secure a net profit. It is fallacious to define "natural" conditions as "static" conditions.
No a priori argument is necessary to prove that with general foreknowledge of progressive changes no losses and no chance to make profits will arise out of them. This is the first principle of speculation, and is particularly familiar in the capitalization of the anticipated increase in the value of land. The effect of any change which can be foreseen will be adequately discounted in advance, any "costs" connected with it will be affected in exactly the same way as the corresponding "values" and no separation between the two will take place.
It will be interesting to follow this line of thought somewhat farther, as suggested above in connection with Professor Clark's characterization of profit as the lure that causes men to make the efforts and take the risks involved in progress. It is in fact but a short step from the foreknowledge of change to the fact that change in reality does not usually just happen, but is largely itself the result of human activity. It is evident that if the laws of economically significant changes are known, those human actions which give rise to such changes will be governed by the same motives as the operations productive of immediate utilities, and in the competition of resources for profitable employment returns will be adjusted to equality between the two fields of use. Industrial progress would certainly take place under these conditions quite as readily as where the operations giving rise to it gave highly unpredictable results, but the rewards of making inventions, discovering new natural resources, etc., with the speculative character of the operations once removed, would be in no wise different from wages, interest, and rent in any other line of productive activity. They would be equal in amount, determined in the same way, in the same competitive market, and in short would be wages, interest, and rent merely, and not profit. And this is what does come about to the extent that progress can be foreseen, which is to say in very large measure. Dynamic changes give rise to a peculiar form of income only in so far as the changes and their consequences are unpredictable in character.
It cannot, then, be change, which is the cause of profit, since if the law of the change is known, as in fact is largely the case, no profits can arise. The connection between change and profit is uncertain and always indirect. Change may cause a situation out of which profit will be made, if it brings about ignorance of the future. Without change of some sort there would, it is true, be no profits, for if everything moved along in an absolutely uniform way, the future would be completely foreknown in the present and competition would certainly adjust things to the ideal state where all prices would equal costs. It is this fact that change is a necessary condition of our being ignorant of the future (though ignorance need not follow from the fact of change and only to a limited extent does so) that has given rise to the error that change is the cause of profit.
Not only may change take place without occasioning profit, but profit may also arise in the entire absence of any "dynamic" or progressive changes of the kind enumerated by Professor Clark. If conditions are subject to unpredictable fluctuations,44 ignorance of the future will result in the same way and inaccuracies in the competitive adjustment and profits will be the inevitable consequence. And the failure of an anticipated change to occur is the same in effect as the occurrence of an unanticipated one. It is not dynamic change, nor any change, as such, which causes profit, but the divergence of actual conditions from those which have been expected and on the basis of which business arrangements have been made. For a satisfactory explanation of profit we seem to be thrown back from the "dynamic" theory to the Uncertainty of the Future, a condition of affairs loosely designated by the term "risk" in ordinary language and in business parlance.
Except for one or two passing references, Professor Clark does not take up the subject of risk in the treatise from which we have quoted. In a short article on "Insurance and Profits"45 (written in refutation of Mr. Hawley) he takes the position that risk-taking gives rise to a special category of income, but that it accrues to the capitalist, and cannot go to the entrepreneur, as such. How he would treat this income, what relation it would bear to interest, he does not tell us. But it is no part of profit, which is defined as "the excess of the price of goods over their cost."46 "It goes without saying that the hazard of business falls on the capitalist. The entrepreneur, as such, is empty-handed. No man can carry risk who has nothing to lose."47 In his later work, the "Essentials of Economic Theory," the subject of risk again receives scant attention.48 Risks are simply ruled out of the discussion, since "the greater part of them arise from dynamic causes," and the "unavoidable remainder" of static risk can be taken care of by setting aside "a small percentage of the annual gains [of each establishment, which]... will make good these losses as they occur and leave the businesses in a condition in which they can yield as a steady return to owners of stock, to lenders of... capital, and to laborers all of their real product."
It is clear that Professor Clark admits that his perfectly competitive state implies substantially perfect knowledge on the part of all members of society of present and future facts significant for the ordering of their business conduct. Dr. A. H. Willett49 has supplemented the theory of the static state in this field, and Dr. A. S. Johnson has some discussion of it in his study of rent.50 Willett recognizes that the disturbing effects of progress do not constitute the sole cause of divergence between actual society and the theoretical ideal; "the conception of the static state is reached by a process of abstraction," which "cannot stop" with the elimination of the five dynamic changes:
If all dynamic changes were to cease, the ideal static state would never be realized in human society. There are other assumptions which have to be made, such as a high degree of mobility of capital and labor, the universal prevalence of the economic motive, and the power of accurately foreseeing the future....
It is the influence of the last of these disturbing factors on static rates of wages and interest that we are to seek to determine. The ideal adjustment could be realized only on the condition that there were no discrepancies between the anticipated and the actual results of economic activity. Production and consumption must go on either with absolute uniformity or with a regular periodicity.51
From the above admission that the static state is not an adequate formulation of the conditions of ideal competition, it would be an easy inference in line with static theory as a whole that some modification in the treatment of profit would be called for. But this inference is not drawn by the author quoted. He is not looking for and does not find any connection between profit and risk. He agrees explicitly with Clark that the entrepreneur takes risk only as a capitalist, and that the income resulting is therefore not profit. In his discussion of the reward for risk-taking, Willett states even more emphatically than Clark had done the contention that only the capitalist as such can take risk or get the reward of risk-assumption. To him this "seems to be a self-evident proposition,"52 but he fails to take account of the familiar fact that men may secure their obligations in other ways than through pledging material resources already owned and invested, as for example by mortgaging their current income from all sources and their future earning power.
In his discussion of profits referred to above, Dr. Johnson makes some reference to risk, but he also makes no attempt to find in it an explanation of profit. He discovers four elements in "the income of a fortunate and capable entrepreneur."
(1) A gain due to chance, offset by a smaller loss (borne, however, by some other entrepreneur); (2) a gain due to his own power of combining labor and capital in ways more effective than those usually employed in the community; (3) a certain share in the first fruits of economic improvements; (4) a part of the gains which entrepreneurs as a class secure through the fact that their services are limited in proportion to the demand for them.
We need not stop to criticize this analysis in detail; it might be pointed out that shares (2) and (4) are identical, and that neither formulation would distinguish profit from wages (and (4) not from any other income, as we have remarked above); (3) is a reference to the "dynamic" explanation of profit and is unclear without further elaboration; (1) seems to point to a connection between profit and risk, but this is not worked out. It is clear that these discussions of risk, as emendations of the dynamic theory, make no pretense of explaining the connection between profit and uncertainty which our discussion of Professor Clark's treatment showed to be necessary. Both writers are, indeed, opposed to and attempt to refute the doctrine that profit is the result of assuming risk.
The doctrine that profit is to be explained exclusively in terms of risk has been vigorously upheld by Mr. F. B. Hawley,53 who finds in risk-taking the essential function of the entrepreneur and therefore the basis of his peculiar income. In Mr. Hawley's distributive theory the entrepreneur, or "enterpriser" as he is called, plays a rôle of unique importance. Enterprise is the only really productive factor, strictly speaking, land, labor, and capital being relegated to the position of "means" of production. In regard to profit, the reward of enterprise, Hawley says:54
...the profit of an undertaking, or the residue of the product after the claims of land, capital, and labor (furnished by others or by the undertaker himself) are satisfied, is not the reward of management or coördination, but of the risks and responsibilities that the undertaker... subjects himself to. And as no one, as a matter of business, subjects himself to risk for what he believes the actuarial value of the risk amounts to—in the calculation of which he is on the average correct—a net income accrues to Enterprise, as a whole, equal to the difference between the gains derived from undertakings and the actual losses incurred in them. This net income, being manifestly an unpredetermined residue, must be a profit, and as there cannot be two unpredetermined residues in the same undertaking, profit is identified with the reward for the assumption of responsibility, especially, though not exclusively, that involved in ownership.55
Mr. Hawley is in agreement with Professor Clark and his followers in defining profit as "residual income," and as to the nature and basis of the special income connected with the assumption of risk as an excess of payment above the actuarial value of the risk, demanded because exposure to risk is "irksome"; but Hawley insists that residual income and uncertain income are interchangeable concepts,56 while Clark is equally sure that the reward of risk-taking necessarily goes to the capitalist as such and that the pure profit of the entrepreneur is a species of monopoly gain arising in connection with dynamic disturbances, and that his only income under static conditions would be wages of management or coördination. Hawley contends that such income is wages merely, and not profit, and does not distinguish between "static" and "dynamic" conditions. Coördination, however, is in his view distinguished from labor by the fact of proprietorship, "which is the very essence of the matter in dispute."57 Profit cannot be the reward of management, for this can be performed by hired labor if the manager takes no risk, but this individual is no longer an entrepreneur.
It is admitted that the entrepreneur may get rid of risk in some cases for a fixed cost, by means of insurance. But by the act of insurance the business man abdicates so much of his entrepreneurship, "for it is manifest that an entrepreneur who should eliminate all his risks by means of insurance would have left no income at all which was not resolvable into wages of management and monopoly gains" (i.e., no profit).58 To the extent to which the business man insures, he restricts the exercise of his peculiar function, but the risk is merely transferred to the insurer, who by accepting it becomes himself an enterpriser and the recipient of an unpredetermined residue or profit." The reward of an insurer is not the premium he receives, but the difference between that premium and the loss he eventually suffers."59
The clue to the disagreement and to the straightening-out of the facts as well is to be found in a confusion fallen into by those on both sides of the controversy, in assuming that the "actuarial value" of the risks taken is known to the entrepreneur. There is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known. It is so fundamental, indeed, that, as we shall see, a known risk will not lead to any reward or special payment at all. Though Willett distinguishes between "uncertainty" and "risk" and the mathematical probability of loss,60 he still treats uncertainty throughout his study as a known quantity.61 The same applies to Johnson; he also implicitly recognizes at various points that the true chance or actuarial value of the risk may not be known, and devotes some space62 to Thünen's emphasis on the distinction between insurable and uninsurable risks; but he also fails entirely to take account in his discussion of profit of the fact that the risk involved in entrepreneurship is not and cannot be a known quantity.
In a similar way Hawley repeatedly refers to the fact of uninsurable risk as well as to "pure luck" and to "changes that no one could have foreseen," but he fails to inquire into its meaning or to recognize its theoretical import.63 Once he goes so far as to say that "the great source of monopoly profit is to be found in the fact that the actuarial risk of any given undertaking is not the same for different entrepreneurs, owing to differences among them in ability and environment";64 and again, that "profit is the result of risks wisely selected."65 Even here, however, he fails to develop the point and draw the consequences from the fact that the actuarial value of the risk undergone by any venturer is not known, either to himself or to his competitors.
In a sense Mr. Hawley comes still nearer to the crux of the matter in his insistence on the responsibility and risk of proprietorship as the essential attributes of entrepreneurship. The entrepreneur is the owner of all real wealth, and ownership involves risk; the coördinator "makes decisions," but it is the entrepreneur who "accepts the consequences of decisions."66 He admits that others than the recognized entrepreneur are subject to risk; the landlord is also a proprietor, and his land may change in value; the capitalist especially requires payment for the large risks he runs, and a part of both rent and interest is accordingly profit. A person who invests his own capital in any form of opportunity necessarily combines the two functions of capitalist and enterpriser. The same should apparently apply to the laborer, who is also admitted to run risks.
Mr. Hawley does not regard the term "risk" as calling for special definition, but it is clear that, like the other writers, he treats it as a known quantity; he says this much explicitly.67 He and his opponents alike have failed to appreciate the fundamental difference between a determinate uncertainty or risk and an indeterminate, unmeasurable one. The only practical bearing of the question as to whether the value of the risk is known which is recognized by Hawley is to determine whether it is likely to be insured, which is to say merely who will get the "profit" for assuming it; even this point is not very explicitly made. Now a little consideration will show that there can be no considerable "irksomeness" attached to exposure to an insurable risk, for if there is it will be insured; hence there can be no peculiar income arising out of this alleged indisposition. If risk were exclusively of the nature of a known chance or mathematical probability, there could be no reward of risk-taking; the fact of risk could exert no considerable influence on the distribution of income in any way. For if the actuarial chance of gain or loss in any transaction is ascertainable, either by calculation a priori or by the application of statistical methods to past experience, the burden of bearing the risk can be avoided by the payment of a small fixed cost limited to the administrative expense of providing insurance.
The fact is that while a single situation involving a known risk may be regarded as "uncertain," this uncertainty is easily converted into effective certainty; for in a considerable number of such cases the results become predictable in accordance with the laws of chance, and the error in such prediction approaches zero as the number of cases is increased. Hence it is simply a matter of an elementary development of business organization to combine a sufficient number of cases to reduce the uncertainty to any desired limits. This is, of course, what is accomplished by the institution of insurance.
It is true that the person subject to such a risk may voluntarily choose not to insure, but it is hard to distinguish such a course from deliberate gambling, and economists have not felt constrained to recognize gambling gains in general as a special income category in the theory of distribution. If it is objected that practical difficulties may prevent insurance even where the risk is determinate, the reply is that insurance, in the technical sense, is only one method of applying the same principle. We shall show at length in our general discussion of risk and uncertainty that if the risk is measurable, but the "moral factor" or some other consideration makes ordinary insurance inapplicable, some other method of securing the same result will be developed and employed. When the technique of business organization has reached a fairly high stage of development a known degree of uncertainty is practically no uncertainty at all, for such risks will be borne in groups large enough to reduce the uncertainty to substantially negligible proportions.
The result of the foregoing analysis should be to show the inadequacy of the two opposed theories of profit and to indicate the reasons for it and the direction in which a tenable solution of the problem of profit is to be sought. It has been seen, first, that change as such cannot upset the competitive adjustment if the law of the change is known; and now, secondly, that an unpredictable change will be similarly ineffective if the chance of its occurrence can be measured in any way. In a well-organized society, if business men know either (1) what actual changes are impending or (2) the "risks" they run—i.e., what is the probability of any particular occurrence,—the effect in the long run is the same; the only result of such changes will be a certain redistribution of productive energy which will take place continuously and without any disturbance of perfect competitive conditions.68 The fact that prediction may involve costs, and likewise the organization for grouping risks and eliminating their uncertainty, does not negate the truth of the proposition, so long as these costs are given elements in the competitive situation.
Yet it is equally evident that there is a principle of truth in both the "dynamic" and the "risk" theories, and the true theory must to a considerable degree reconcile the two views. On the one hand, profit is in fact bound up in economic change (but because change is the condition of uncertainty), and on the other, it is clearly the result of risk, or what good usage calls such, but only of a unique kind of risk, which is not susceptible of measurement. The Clark school has confused change with a common but not universal or necessary implication of change, and both schools have followed everyday speech into the fallacy of treating risk as a substantially homogeneous category, where a fundamental difference in kinds of risk is in fact the key to the whole mystery.
The meaning of "uncertainty," and of the different kinds of uncertainties, and their significance in competitive economic relations, will therefore constitute the principal subject which we have finally to investigate in the present study. The next step in the progress of the argument will be to lay a comparative basis for this investigation by attempting to gain a clear view of the mechanism of competitive valuation and distribution as they would be if uncertainty and its correlative profit were entirely absent. The next three chapters will therefore be taken up with an examination of the conditions and workings of a perfectly competitive society; of these conditions the crucial one will constantly appear as the possession of accurate and certain knowledge of the whole economic situation by all the competitors.[Back to Table of Contents]
PERFECT COMPETITION[Back to Table of Contents]
Part II, Chapter III
The Theory of Choice and of Exchange
We turn now from historical and critical considerations to the real work of construction. We have seen that the historic body of economic theory rests upon the assumption of perfect competition, but that the precise character of this assumption has been partially implicit and never adequately formulated. We do not criticize the older economists for making abstract assumptions in order to simplify and analyze their problem, but contend that the assumptions actually made and their implications need to be brought to the surface and emphasized. To display these implicit premises of theoretical reasoning is, we have argued, to explain the problem of profit, the absence of which is the essential distinction between theoretical and actual economic society. This explanation will immediately take the form of a general inquiry into "Uncertainty," the presence or absence of which will appear as the most important underlying difference1 between the conditions which theory is compelled to assume and those which exist in fact. The present chapter and the two next following will be taken up with the attempt to define and analyze perfect competition. The argument is to be regarded as a condensed summary of classical economic theory, with especial reference to and emphasis upon those premises and implications which have not been adequately emphasized in the theory itself and have been liable to escape the observation of its readers. Aside from this special emphasis the argument will differ not a great deal from that of J. S. Mill and very little from Marshall's "Principles."
Economics is a human science; its foundations are laid in the principles of human behavior, and consequently we must begin with some observations on the psychology of human conduct which controls economic life. Economic analysis may be truly said to deal with "conduct," in the Spencerian sense, of acts adapted to ends, or of the adaptation of acts to ends, in contrast with the broader category of "behavior" in general. It assumes that men's acts are ruled by conscious motives; that, as it is more ordinarily expressed, they are directed toward the "satisfaction of wants."2 At the very outset the science is thus subjected to notable restrictions, since it is only to a limited extent that our behavior, even our economic behavior, is of this character. Much of it is more or less impulsive and capricious. The conclusions of economic theory must in general be admitted subject to the qualification, in so far as men's economic activities are rational or planned.
This limitation is far more sweeping in its scope and import than is easily imagined. It raises the fundamental question of how far human behavior is inherently subject to scientific treatment. In his views on this point the writer is very much of an irrationalist. In this view the whole interpretation of life as activity directed toward securing anything considered as really wanted, is highly artificial and unreal. To be sure, this characterization seems to hold good for an individual at a given time and place, if the time is short enough. It is the way we think of ourselves as acting, not for the sake of the action or experience itself, but in order to some ulterior object. If, however, the object is merely accidental and temporary, such "wants" are of little service in interpreting an economic process which must look far forward. It is the writer's belief that this view of behavior, even though it is the view taken by the subject himself, is superficial at best. It appears that a relatively small fraction of the activities of civilized man are devoted to the gratification of needs or desires having any foundation beyond the mere fact that an impulse exists at the moment in the mind of the subject.
Most human motives tend on scrutiny to assimilate themselves to the game spirit. It is little matter, if any, what we set ourselves to do; it is imperative to have some objective in view, and we seize upon and set up for ourselves objectives more or less at random—getting an education, acquiring skill at some art, making money, or what-not. But once having set ourselves to achieve some goal it becomes an absolute value, weaving itself into and absorbing life itself. It is just as in a game where the concrete objective—capturing our opponents' pieces, carrying a ball across a mark, or whatever it may be—is a matter of accident, but to achieve it is for the moment the end and aim of being. And, as in a game again, so with life generally, the social situation furnishes much of the driving power, though again there are many who can become intensely interested in solitaire.
The basis of a science of conduct must be fixed principles of action, enduring and stable motives. It is doubtful, however, whether this is fundamentally the character of human life. What men want is not so much to get things that they want as it is to have interesting experiences. And the fact seems to be that an important condition of our interest in things is an element of the unanticipated, of novelty, of surprise. We must beware of the temptation to judge the nature of our conduct by the way in which we think about it. To think about it is, of course, to rationalize it, at least to "think" in the scientific sense, which has pretty well preëmpted the word. Logical thought is instrumental in character, a device for controlling and using the environment. It is, perhaps, a vice of Western civilization that the habits of thought which condition our wonderful material achievements tend to be carried over into the sphere of our personal lives. The writer ventures to surmise that this sort of thing is approaching, if it has not already reached, a climax. The fever of achievement in an external sense which now dominates our attitude toward life may be expected to give place to a saner, more epicurean view. Men will think more in terms of thought, beauty, and joy for their own sakes and less in terms of what things are good for, what can be done or gotten with them.3
Economics, as we have observed before, is the science of a certain form of organization of human activities. The fact of organization still further limits the scope of the discussion to the rationalistic view of activity as directed to the satisfaction of wants conceived as given and permanent entities. Conduct itself is necessarily forward-looking, but organized conduct is still more so. Any machinery of organization implies relatively much taking thought, since it requires time for its development and time for its operation. A most essential feature of economic organization as it exists is its anticipation of the wants of the consumer over a long and ever longer period of production; and this anticipation implies stability in the character of the wants themselves.
A clear view of what we are doing demands special emphasis on this character of economic theory as the science of a system of organization. Human activity might be relatively unorganized or it might be organized in many different ways. History, and especially modern history, is largely the story of progressive organization and its changes in form. Organization is nearly synonymous with division of labor. In organized activity individuals perform different tasks, and each enjoys the fruits of the labor of others. The two fundamental problems of organization are the assignment of tasks and the apportionment of rewards. In unorganized action each person performs all the tasks by whose performance he benefits, and his reward is the immediate, physical benefit of his own work. But when men work together some machinery must be provided to give each his special work and to determine the amount of the results of others' effort which he shall obtain and the amount of his own product which he shall give up to others.
Modern industrial society, the "existing economic order," performs this twofold task chiefly through free agreement and voluntary exchange between individuals themselves. Economic theory is the analysis of this mechanism, viewed for the scientific purpose of simplification as the only form of human relation. Going back to mediæval times or to the American frontier, we find relatively little joint activity, except for the division of labor between the sexes and in the family. Such organization as existed for war, religion, etc., was not along free exchange lines. But there was always some commerce with different regions, and this has always been worked out largely through exchange. As time passes we find that the greatest change is in the development of organization, and especially of the voluntary, free exchange type, though, to be sure, the functions of the political state develop also. We can imagine that industrial progress might have taken a very different form. The problems of the apportionment, of tasks and rewards might be solved for a complicated, technical civilization by an autocratic, theocratic, or militaristic giving of orders and rationing of produce in which the individual would have no voice in the least detail either of his work or his enjoyment.4 Or, again, we might have any one of numerous forms of democratic socialism. Some (the anarchists) have imagined that organization might be carried out without either exchange relations or a centralization of authority, simply by general consent. But it has been and is done principally through competitive free agreement, and our task is to study this mechanism and not any other.
The first essential of the existing system is that it solves its two fundamental problems together, as one. It is individualistic; it apportions tasks through the apportionment of rewards; it is an automatic system, in which the interrelations of individuals are determined by self-seeking on the part of each. The foundation of the process is the private ownership of productive resources—a synonym for individual freedom. There is (as we shall see more at length as we proceed) no difference in principle between the ownership of one's own powers and the ownership of other productive resources. The essence of ownership is the association or union of these two facts: (1) control of the agency, and (2) the right of disposition over its product. Modern society (on the economic side) is organized on the theory that the owners of productive resources will find their best use and place them in it, because in that way they can procure the largest returns for themselves. This system, therefore, involves the assumption that even in a complex organization the separate contribution of each separate productive agency can be identified, and that free competitive relations tend to impute to each agency its specific contribution as its reward for participation in productive activity. And to the extent that the system works at all, that we have an economic order and not chaos, this assumption must be justified.
From another point of view we may envisage the task of organization in three steps or stages:
1. Society as an organized entity must decide the relative importance of different lines of consumption as a basis for the guidance of production. Closely connected with this task, and worked out together with it, is the apportionment of existing stocks of goods, the product of past industry, in the satisfaction of existing wants. This twofold problem is worked out in the consumption goods market from day to day. The study of the process constitutes the first main division of economic science, the theory of market price.
2. Society must actually organize production. Every available productive agency is, so far as the system is successful, to be assigned to that task, and grouped with others in that way which will enable it to make the greatest possible contribution to the social dividend (of goods equated quantitatively according to the value scale established in the consumption goods market). The machinery for the direction of productive resources to their different uses is organized in the market for productive resources. The study of its workings is the second fundamental division of the science. It falls into two subdivisions, short-time distribution theory and long-time value theory.5 For the purpose of this study the supplies of productive resources must be taken as fixed, as well as the demand which they are to satisfy. Both the prices of consumption goods and the distributive shares are in fact much affected by the third general problem cutting across both the others.
3. At the same time that society is employing existing resources to satisfy existing wants it is also setting aside a portion of its existing resources to increase the supplies of those resources themselves, to improve the effectiveness of their use by working out better methods of production, and to increase its own membership in numbers and quality by providing for an excess of births over deaths and through education and refinement. There is thus another aspect to the problems of relative importances and of organization. Decision must be made as to how much of society's income is to be diverted from present consumption and to be used for the purpose of furthering social progress, and the diverted income must be applied to this purpose as effectively as may be. The first part of the problem is solved in the market by competition between present goods and the prospective fruits of their investment, giving rise to a rate of capitalization or of interest; and the second part is solved by competition for savings between different opportunities for their use.6
The fact that theoretical reasoning must take a large, long-run view of life leads to a difficulty in the treatment of wants which has been the source of much confusion. Our wants have the character of intermittence and recurrence; in any short period of time they are satisfied with a relatively small amount of what the want calls for, and we turn to the satisfaction of some other want. But if it is a true fundamental want it comes back again, and from a long-run point of view they all, with their satisfactions, take on the character of continuity. The periodicity, alternation between desire and satisfaction in the case of any one and dominance of different wants in succession, drops out if we look ahead a considerable distance so as to include a number of "complete cycles," so to speak. This long-run point of view is the one necessarily taken by a planned program of satisfying wants; it is evident that our activities at a moment are not predominantly affected by the thing we happen to be "hungry" for at that moment. When we go into a store to make our purchases we do not consult the momentary state of appetite or satiety in respect of any particular need, but its long-run importance in our existence viewed as a continuous process.
The problem of want-satisfaction is, therefore, a problem in proportions, or relative rates. The question is not how much absolutely of this or that, but how much—i.e., how large a share—of our time or income is to be devoted to each need or line of activity, how much per year or some other period long enough to get rid of the fluctuations. We can get the point of view by imagining that we had to plan our lives for a year on the first of January and live out the plan in detail. Economic discussion in terms of "quantities" of effort or satisfaction or choice between alternatives, under the influence of motives as immediate desires, is therefore elliptical, and more or less dangerous. The quantities of economics are properly rates, the motives not desires immediately present to consciousness, but detached judgments of need or value.
A fundamental fact about wants is their habit of conflicting among themselves. In fact, conflict seems to be essential to the very nature of conscious desire. It is questionable whether wants, as conscious motives to conduct, ever exist unless we are in a position of having to choose, to adopt one line of conduct and renounce another. Wants must be distinguished from needs which do not enter into our planful ordering of life. We "need" iodides and vitamines, and an infinite number of things of whose existence the race at large has been blissfully ignorant; but we do not "want" them, because they give rise to no conflicts and hence no "conduct." The common basis of conflict, and we may say of the existence of wants at all, is the limitation in the means of gratifying some impulse or need. When some means of satisfaction is limited in amount so that we have to plan its use and plan to increase its supply, then it enters into the field of conduct and we have a want. The most common and fundamental conflicts are between claims for our own time and energy, and after these upon some limited material agency or means employed as an aid in satisfying ourselves. Our personal powers are, of course, limited absolutely, and limited in fact still further, conditionally, by the tendency of exertion to become disagreeable, giving rise to a "want" to avoid it.7 The confusion to be avoided is that between a want, proper, as related to consciously planned action, the weighing of alternatives, and such things as supposed needs or metaphysical explanations of the immediate fact.
The power of things to satisfy conscious wants, or quality of being wanted, is utility in the economic sense, which is equivalent to "power over conduct." Utility, of course, must have the same fundamental properties or dimensions as want; it is not, therefore, a quantity in any simple sense, but a quality having intensity, or a rate. We speak of the utility of a given amount of a thing, but this again is elliptical; the psychological variable is in fact a degree of utility of a certain rate of consumption of the good. And as want is a correlate of conflict, utility is a correlate of limitation; intensity of want and rate of supply of means of satisfying it are strictly connected, each varying inversely as the other; that is to say, as a good is supplied for the satisfaction of any want at higher rates it loses degree or intensity of utility in that use and gains (degree of) utility in the conflicting employment.8 The confusion between a want and a need or hypothetical reason for having the want is manifest in the field of utility in ascribing economic utility to "free" goods, goods that exist in superabundance. This is a pernicious error. Such goods have no causal relation to conduct and no place in a science of conduct. The confusion has doubtless arisen from the fact that there are many things like air and water which under some circumstances do come to have power over conduct, or utility, though ordinarily they do not. This fact brings home to our consciousness their "potential" utility, the fact that they would have great utility if cut off or subject to limitation; but they have utility only when not free.
Diminishing utility is the scientific designation for the general fact that as any want is satisfied relatively to others9 it diminishes in intensity, or, from the point of view of the means of satisfaction, that the one loses in utility and the other gains. The essential relation of conflict and relativity of utilities is somewhat obscured by the existence of intermediate "means" of satisfaction, and even of series of such. But the further course of the analysis will show that without significant exception there is always in question a diversion of the ultimate means from one use to another; it is a matter of alternatives, and the ground of one want or satisfaction being alternative to another is the dependence on a common, limited means of satisfaction.
The intermittence of wants, with wave-like alternation of desire and satisfaction, tends to give a false conception of diminishing utility. It is beside the point to talk of boys eating successive oranges or other "dinner-table" illustrations as is so commonly done. The serious error resulting from this method is that it gives the impression that there is a difference between the utilities of different portions of supply. This also is fatal to clear thinking, as will be seen if the contrast between such a situation and that of laying in supplies for a long time in advance (or even an ordinary shopping trip) is considered for a moment. The utility of any one unit is, in its effect on conduct, which is the only relevant consideration, exactly like that of any other; the essential fact is that as there are more units relatively, the utility per unit or utility of any unit is relatively less.
The fact of relativity is important, because easily and commonly lost sight of. Every valuation is a comparison; we have no conception of an absolute utility or an absolute standard of utility. The notion of value is meaningless except in relation to alternatives of choice. Not only is utility measured by another utility,—all things are measured by things of their own kind as standards, but its existence is conditioned by that of the alternative; it is like a force in the physical world; action and reaction are equal, a force cannot be imagined separate from an equal and opposite force or resistance.
The case of conflict of utilities most crucial in economic analysis is the familiar alternative of enjoying utilities at the expense of effort vs. sacrificing the utility for the sake of freedom from the exertion. "Labor" is usually thought of in an inverted, positive sense as a disutility. It is important to see that there is sufficient practical reason for this usage, but also that there is really no exception to the general principle of alternatives without distinction of kind. The point is that "labor" is really the sacrifice of some desirable alternative use of one's time and strength. If there is no alternative there is no sacrifice, nor any motivation, valuation, or "problem" of any kind. In truth, there is no distinction for conduct between a pain and the absence of a pleasure; it is all a matter of choice between alternatives, of "preference." The pleasure-pain question belongs exclusively in the field of the inner consciousness, and has no bearing on problems such as those of economics.10 The valid reason for the distinction between kinds of alternatives, for fixing our attention on something chosen in one case and something avoided in another, is, as will be shown more at length later on, that we are interested in measuring the alternatives, and we can come nearer a satisfactory quantitative determination of time and effort than we can of the indeterminate uses that would have been made of them if the labor of producing the (measurable quantity of) goods had not been performed.
The whole theory of conduct may now be summed up, as far as it is relevant for our purposes, in a comprehensive "Law of Choice": When confronted with alternative, quantitatively variable lines of action or experience, we tend to combine them in such proportions that the physically correlated amounts or degrees of each are of equal utility to the person choosing.11
A somewhat different statement of the principle of choice may better emphasize the basis of the alternative character of the alternative lines of conduct, the fact that not only must one give up more of the one to get more of the other, but, that this is true in a quantitative sense, that a definite amount of one is given up in return for a definite amount of the other. The reason for this fact we have found in the circumstance that the two kinds of satisfaction are both dependent on some common "means" or "resource." Accordingly we may restate the fundamental law of conduct in this way: In the utilization of limited resources in competing fields of employment, which is the form of all rational activity in conduct, we tend to apportion our resources among the alternative uses that are open in such a way that equal amounts of resource yield equivalent returns in all the fields.
This formulation makes it possibly a little more obvious that the principle is a true statement of the goal of rational planning. For, clearly, if a given unit of a given resource is yielding in one use a want satisfaction preferable to that which a similar unit is yielding in another, the yield of that resource can be increased by transferring some of it from the second use to the first until the importance of the one is increased and of the other decreased to the point of equivalence.12
It will be apparent that utility curves, as commonly drawn, representing diminishing utility and increasing sacrifice as absolute and independent magnitudes, and ascribing varying utility to successive units of commodities (and of disutility of exertion), require considerable modification or reinterpretation if the foregoing reasoning is valid. If utility is relative and in its essence a comparison, such a curve can only represent one variable measured in terms of the other, or each curve presupposes the other already drawn. The rôle of money in the process tends to complicate and confuse the exposition still further.
The principles above stated in general terms can be brought into relation with current treatments of the subject and with concrete fact if we begin by taking up a simple case of choice between alternatives such as is constantly dealt with in economic analysis. Let us take Marshall's13 example of a boy gathering and eating berries, but with the stipulation that some re-wording would be necessary to make the exposition accurately fit the case of choice between (i.e., combination of) alternatives in a comprehensive, long-time, plan of conduct. We can hardly suppose that the boy goes through such mental operations as drawing curves or making estimates of utility and disutility scales. What he does, in so far as he deliberates between the alternatives at all,14 is to consider together, with reference to successive amounts of his "commodity," the utility of each increment against its "cost in effort," and evaluate the net result as either positive or negative, either of a character to prompt the combined action of production and consumption of that unit, or not of this character. The "cost in effort" is evidently in fact the sacrifice of some alternative use or uses of the effort. Even that nondescript conduct called merely idling is still conduct, an alternative motive, and subject to the law of diminishing utility or relative proportions like any other. However, while to the eye of critical scrutiny there is no "logical" distinction between an increasing disutility experienced and an increasing utility foregone, a "psychological" difference must be admitted; there is no difference for conduct, but there is one for consciousness, to our pecuniarily sophisticated consciousness at least.
If it is desired to represent the situation graphically without the misleading implications of a comparison of separate absolute variables, it can be done by omitting the commodity axis as in the accompanying figure. The line OY is merely directed in space to show that "preference" increases in a vertical direction. Quantities of commodity are measured by a scale as shown, but the "utilities" are not fitted to any scale at all. If we call the curve U which represents the desirability of the commodity, and the other E for exertion, the one will show a (relative) fall in value and the other a (relative) rise as the production and consumption of the commodity increases. It is a matter of indifference whether the ascending curve is thought of as a sacrifice or a positive pain, whether the growing motive to divert energy from the use in question is imaged as an attraction or a repulsion. The intersection shows that at a certain point (on the commodity scale) the diversion will take place.
Beyond this point the curves have still less meaning for the reason that the E curve really represents nothing definite, but merely any alternative whatever; as drawn they indicate a rapidly increasing pressure against this particular line of activity. The curves indicate no absolute values of any sort; the vertical distance between them alone has meaning, each being the "base" for the other; this distance shows what might be called the "net utility" of picking and eating the successive increments of berries, as compared with all possible alternatives of conduct.
A still simpler and less ambiguous way to represent the facts would be to draw on a Cartesian plane a single curve of "net utility," as in the accompanying sketch. This curve will cut the X or commodity axis at the point where some other alternative becomes preferable, and then fall away rapidly into the "negative utility" field. It will be seen that the Y values of the curve have only the vaguest quantitative character. The boy not only does not ask how much sacrifice is how many berries worth, but merely, are these berries worth the sacrifice; he does not even ask, "by how much" are these berries worth "the" sacrifice. There is no true psychic quantity involved; only the commodity is measured or measurable. Still, there is a certain feeling of quantitative variability in the degree of preference, and such a curve is not utterly false to the facts of consciousness. The only point of clearly determinate locus on the curve is the zero point, and it is questionable whether that is to be interpreted as a quantitative equality between opposite incentives to action or merely the absence of incentive altogether.15
It follows at once from the non-quantitative or indefinitely quantitative character of the psychic variables16 that the "surpluses" which have cut so much figure in economic discussion are very shadowy and elusive things, if not altogether unreal. If the ordinates of the curves discussed above mean nothing definite, of course the areas under the curves mean no more. The fallacious notion of the surplus follows naturally from the confusion between momentary satiety and the correct standpoint, the estimation of relative importance of things in planning ahead, commented on above. The illicit use of "dinner-table " illustrations in the exposition of diminishing utility shows the same error. We cannot insist too strongly upon the point that men do not determine the expenditure of their income, generally speaking, on the basis of a comparison of momentary cravings for things for instantaneous consumption. A child in a candy store would not do that. From such a viewpoint there is a psychic difference in different units of a commodity, and it might be possible to substantiate a surplus doctrine. But this is not the viewpoint of economic reasoning, because in so far as men plan at all, they do not expend their incomes and so fix the prices of things and determine the utilization of social resources and the whole structure of the competitive economic system, on the basis of that sort of calculation.17 If we take a rational attitude toward the problem of value—as, for example, by the device, previously suggested, of placing ourselves in the position of one who had to determine the apportionment of his resources for a year or five years in advance—we shall get a different view of it. Then the earlier units are no different from the later ones, on either side of the balance; up to a certain point the balance is positive, then it suddenly becomes negative, and when the balance is struck the debits and credits are equal. There is a sort of Emersonian principle of Compensation applicable to every item; each is worth what it costs, but also costs what it is worth.
It does not at all follow that we have proved the pleasures of life just equal to its pains. That question is irrelevant to our problems, and our analysis has nothing to say about it. It is not the province of economics to determine the value of life in "hedonic units" or any other units, but to work out, on the basis of the general principles of conduct and the fundamental facts of the social situation, the laws which determine the prices of commodities and the direction of the social economic process.18 It is therefore not quantities, nor even intensities, of satisfaction with which we are concerned (though the limitations of language compel the use of these terms at times), or any absolute magnitude whatever, but the purely relative judgment of comparative significance of alternatives open to choice. Now, for conduct, it is self-evident that the importance of anything is the effort or sacrifice necessary to get it. Two things, each of which can be obtained at will by the sacrifice of the other, cannot conceivably have any other than equal importance from this point of view, and it is meaningless to speak of a surplus. The situation is especially clear in an exchange system which fixed prices where things can be converted at will at known rates by purchase and sale. We submit that it is clearly impossible, in such a situation, to conceive of things serving as motives to action in any other than the established ratios of conversion or substitution.
For understanding the psychology of valuation, the two points are equally important: (1) that, logically, choice is a matter of comparing alternatives and combining them according, to the law of rational procedure above formulated,19 and (2) that there is none the less a practical difference between two kinds of alternatives in an ordinary situation. This difference is perhaps connected with the distinction between our feelings of painfulness and pleasantness, but in its essence it relates to the quantitative character of the alternatives (in their physical aspects, not the psychic states involved). In the case just considered, of the boy and berries, the difference is evident from the fact that we use the berry alternative to measure the leisure alternative. We speak of a certain quantity of berries and the sacrificed alternatives corresponding to them, not of a certain quantity of alternative independently determined. The "trouble," "exertion," or what-not is not quantitative on its own account, it is measured by the berries; it is "the" amount of exertion, etc., connected with a specified amount of the measurable commodity. This result is inevitable because, as remarked above, "the" alternative is not in fact some particular alternative, but any alternative; it is not merely not measurable, but is heterogeneous and wholly indeterminate. It is this fact which throws us back on the conception of "resources" for rationalizing the deliberative process, making of it a quantitative comparison; it is this fact which gives its great importance to the "time" measure of effort. Time does not in any true sense measure the alternative or sacrifice, and, as we have seen, its employment in any use is a sacrifice in the first place only because there are other uses for it, which are the real sacrifice; but it is measurable, and our intelligence, forced to have something quantitative to feed upon, like the proverbial drowning man catches at any straw.
In spite, therefore, of the purely relative character of pain and pleasure and of the essential parity as motives of all alternatives of conduct, it is pragmatically necessary to distinguish in productive activity between the incoming "economic" utility and the sacrificed (resources, representing) non-economic, unspecified alternatives in general, between utility and disutility, or commodity and cost. "Cost," in this sense, is "pain cost," or "opportunity cost," as one prefers; there is no real difference in meaning between the two.
From this long but apparently necessary discussion of the fundamentals of valuation of psychology, we may proceed to consider a somewhat more complicated situation, as an approach to the study of the principles as manifested in the field of exchange relations. We will suppose an individual choosing between the production and consumption of a large number of "commodities," in addition to the alternative of not producing any of them, but of putting his time, etc., to "noneconomic" uses. This is the situation of Crusoe on his island, of which many economists have made use. The same law of choice will hold as before; between any two alternatives or among all that are open, the man will choose such amounts, or divide his time and "resources" among them in such proportions, that the physically alternative or correlated quantities of all are to him equally desirable. The only difference is that the alternatives are more complicated than in the case of the boy and his berries, and of a somewhat different character; in particular, the presence of a number of economic alternatives, involving concrete, measurable sources of satisfaction, is important.
In Crusoe's mind there would undoubtedly be built up something of the nature of a price system or value scale, if he seriously attempted to get the maximum of satisfaction out of the conditions of his environment. For an "intelligent" use of his opportunities can be arrived at in no other way. He must ascertain the ratios in which different goods are to be obtained for subjectively equivalent sacrifices in "effort," and similarly form judgments of their relative subjective importance to him, and attempt to bring the two sets of ratios into coincidence. But a set of equivalence ratios or scale of equivalent amounts of things is the essence of a price system. Exchange is a means by which things may be conveniently converted into or sacrificed for each other in determinate amounts, and substantially the same result follows from choosing between different lines of production in a Crusoe economy. It is sufficiently evident that the quantities involved in such a calculation are quantities of things and not of satisfaction or any psychic magnitude.
The rôle of the "resource" idea and the concept of "cost" will also take on characteristic form in the Crusoe case. The mental labor of evaluating everything in terms of everything else must force recourse to a crude measurement of "effort" as the common standard of value or "medium of exchange" (it is almost like that) for mediating the comparisons. It is clear that this is an "instrumental" but none the less very important device. "Really," it is purely a question of combining alternatives, among which are those indefinite, "non-economic" occupations, exploring the island, chatting with the parrot, sport or recreation of any appealing kind, or "loafing and inviting the soul." But the indefinite, heterogeneous, and uncertain character of these last, and the convenience of "time" as a rough basis for an approximate evaluation of the stuff they are made of, make it a matter of economy to resort to its use as a common denominator of alternatives. It will not be true that all things produced in equal times will be equated, for there are elements of "irksomeness," etc., which have to be taken account of. Crusoe's value scale will probably be based on time as a "first approximation" with mental allowances for the other factors to be considered.
Measurement relations will be reciprocal, in this case as always. The use of effort to measure other things amounts to an evaluation of effort in terms of other things. Thus we get the concept of a quantitative outlay cost meaning something more than merely any sacrificed alternative. As pointed out before, in stating in terms of "resources" the general law of choice among alternatives, this concept of cost has no very substantial independent meaning; "when pressed" we reformulate our resource or effort (or money) costs in terms of positive alternatives we might have had; but as a mediating, instrumental idea, it is none the less a useful and universally used notion. There is, however, no occasion to speak of a possible divergence between outlay cost and value return, of anything like a "profit" from operations.
There are many intermediate stages in the successive complication of alternatives which might be discussed, and which would shed light on various phases of economic relations; but for present purposes it is best to pass at once to the case of a group of people producing goods for exchange in a free market. The relations among the want-satisfying activities of a plurality of persons are based upon another "conflict," the conflict between similar wants of different individuals, to a large extent dependent on common, immediate means of satisfaction, while these immediate goods are almost entirely dependent upon a common fund of ultimate productive resources. The effect of the possibility of exchange is vastly to multiply and complicate the alternatives open to any individual. He is now free, not merely to make any possible combination of commodities for production and consumption, but to combine the production of some with the consumption of any combination—on terms afforded by an established set of exchange ratios, the investigation of which is the principal problem before us. In order to study first the most essential features of exchange relations, it will be necessary to simplify the situation as far as possible by a process of "heroic" abstraction. We therefore explicitly make the following assumptions as to the characteristics of our imaginary society:
1. The members of the society are supposed to be normal human beings in essential respects as to inherited and acquired dispositions, differing among themselves in the ways and to the degrees familiar in a modern Western nation—a "random sample" of the population of the industrial nations of to-day.
2. We assume that the members of the society act with complete "rationality." By this we do not mean that they are to be "as angels, knowing good from evil"; we assume ordinary human motives (with the reservations noted in the following paragraphs); but they are supposed to "know what they want" and to seek it "intelligently." Their behavior, that is, is all "conduct," as we have previously defined the term; all their acts take place in response to real, conscious, and stable and consistent motives, dispositions, or desires; nothing is capricious or experimental, everything deliberate. They are supposed to know absolutely the consequences of their acts when they are performed, and to perform them in the light of the consequences.
3. The people are formally free to act as their motives prompt in the production, exchange, and consumption of goods. They "own themselves"; there is no exercise of constraint over any individual by another individual or by "society"; each controls his own activities with a view to results which accrue to him individually. Every person is the final and absolute judge of his own welfare and interests.20
4. We must also assume complete absence of physical obstacles to the making, execution, and changing of plans at will; that is, there must be "perfect mobility" in all economic adjustments, no cost involved in movements or changes. To realize this ideal all the elements entering into economic calculations—effort, commodities, etc.—must be continuously variable, divisible without limit. Productive operations must not form habits, preferences, or aversions, or develop or reduce the capacity to perform them. In addition, the production process must be constantly and continuously complete; there is no time cycle of operations to be broken into or left incomplete by sudden readjustments. Each person continuously produces a complete commodity which is consumed as fast as produced. The exchange of commodities mint be virtually instantaneous and costless.
5. It follows as a corollary from number 4 that there is perfect competition. There must be perfect, continuous, costless intercommunication between all individual members of the society.21 Every potential buyer of a good constantly knows and chooses among the offers of all potential sellers, and conversely. Every commodity, it will be recalled, is divisible into an indefinite number of units which must be separately owned and compete effectually with each other.
6. Every member of the society is to act as an individual only, in entire independence of all other persons. To complete his independence he must be free from social wants, prejudices, preferences, or repulsions, or any values which are not completely manifested in market dealing. Exchange of finished goods is the only form of relation between individuals, or at least there is no other form which influences economic conduct. And in exchanges between individuals, no interests of persons not parties to the exchange are to be concerned, either for good or for ill. Individual independence in action excludes all forms of collusion, all degrees of monopoly or tendency to monopoly.
7. We formally exclude all preying of individuals upon each other. There must be no way of acquiring goods except through production and free exchange in the open market. This specification is really a corollary from numbers 2 and 3, which exclude fraud or deceit and theft or brigandage respectively, but it deserves explicit mention.
8. The motives for division of labor and exchange must be present and operative. These have never been adequately treated in the literature of economics in spite of the fact that the subject has been discussed more or less by countless writers on social problems from Plato down. The principal condition is diversification of wants associated with specialization of productive capacities or dispositions, or with physical restrictions on the range of productive activity. An important fact in this connection in the real world is the space distribution of the different resources of the earth and the limitations on human mobility. In addition the physical nature of the production process frequently calls for the simultaneous prosecution of a number of operations. For simplicity we shall assume that the first two conditions alone are sufficient to restrict each individual to the production of one single commodity at any given time. (Cf. number 11.)
9. All given factors and conditions are for the purposes of this and the following chapter and until notice to the contrary is expressly given, to remain absolutely unchanged. They must be free from periodic or progressive modification as well as irregular fluctuation. The connection between this specification and number 2 (perfect knowledge) is clear. Under static conditions every person would soon find out, if he did not already know, everything in his situation and surroundings which affected his conduct.
The above assumptions, especially the first eight, are idealizations or purifications of tendencies which hold good more or less in reality. They are the conditions necessary to perfect competition. The ninth, as we shall see, is on a somewhat different footing. Only its corollary of perfect knowledge (specification number 2) which may be present even when change takes place, is necessary for perfect competition. In addition to these differences in degree only from actual life, we must lay down for the special purpose of the immediate analysis two further suppositions quite contrary to the facts.
10. The first is that for the present there is to be no productive property in the ordinary sense in the society. Every productive agency or capacity is an inseparable part of the personal endowment of some member of the society. Material implements of production may be used provided they are either superabundant, and consequently free goods, or else are absolutely joined to their owners (not subject to lease or sale) and not subject to increase or decrease. The last characteristic, if not that of inseparability, is, of course, really implied in the specification of static conditions. We must also observe explicitly that personal powers themselves are similarly fixed in amount and character. The social consequences of the transfer of productive goods between individuals, and especially of their increase by "investment," will call for extended discussion later, and must be isolated by a preliminary study of a society in which they are absent.
11. The second "analytic" assumption is also contained in the preceding "idealizing" group. Under number 8 we declared that division of labor was to be carried to the point where each individual produced a single commodity. In modern industrial life it is, of course, carried vastly farther. But it is important to study separately a society where production is organized through the exchange of finished products only.22 At a later stage we can then discuss the special problems of that further stage of organization called secondary division of labor.
This isolation is of especial importance in view of the fact that the distribution of products is very much complicated when the agencies of production coöperate in the production of a single commodity, the product of a single agent being then no longer immediately identifiable. The problem of isolating the product of a single agency, where a number work jointly, is, of course, the familiar problem of "imputation" or distribution in the technical sense, which has been the greatest single center of controversy in economic discussion.
The above list of assumptions and artificial abstractions is indeed rather a formidable array. The intention has been to make the list no longer than really necessary or useful, but in no way to minimize its degree of artificiality, the amount of divergence of the hypothetical conditions from those of actual economic life about us. For the most part these same assumptions, especially the first eight, and to a considerable extent the ninth, are really involved at one point or another in a large part of the discussion of economic literature. If they are present, and necessary, and when present whether necessary or not, there will be no disparaging the importance of having their abstract and unreal character brought conspicuously to the surface.
Our next task is to form a picture of such a society in action, and to discover the conditions of equilibrium or natural results of the operation of the forces and tendencies at work in it. We are therefore to imagine such a population, set down in such an environment as described, starting out de novo in the business of satisfying their wants. Each person, on taking in the situation in its essential outlines, will enter upon the production of some commodity, with a view, through exchange with others, of securing the means of satisfying his varied wants. After a brief interval of time has elapsed, each will have accumulated a small stock of his particular good, and we may think of them all as meeting in a central market to exchange their wares.
The situation now presented is the familiar one in economic discussion, of a group of individuals with given stocks of goods which have to be disposed of,23 and we need not dwell upon the process by which fixed rates of exchange among all commodities will be established.24 When the process is finished the whole mass of commodities will have been reduced to a single homogeneous fund of exchange equivalence or value. Nor do we need to concern ourselves with the mode of expressing and handling this fund; in practice it would be inevitable that some sort of standard exchange medium would be set apart; but it is immaterial for present purposes whether there is some one kind of money or as many kinds as there are different commodities.
If intercommunication is actually perfect, exchanges can take place at only one price.25 We may imagine it to be determined all around what the ratios are to be through the medium of inquiries. Every individual, knowing the worth of the thing he possesses in terms of everything else, is in substantially the same position as a person spending a given money income in a market where selling prices are fixed by the seller and placarded. The good in his hands represents exchange power, a "resource," and he will apportion it among the possible uses according to the law of choice, so that each unit of it purchases equivalent utilities, want satisfactions, or "importances."
To show just how the price scale itself results from the fact that individuals act according to the law of choice in apportioning their purchasing power in a situation where the prices are given, is the task of that branch of economics known as the theory of market price. At any given price (ratio of sacrificing one good for the other) the more purchasing good is expended for any one commodity the less becomes the amount of want satisfaction purchased with each unit (relatively to the want-satisfying capacity either of the good given up or of any other good for which it might have been exchanged). From this it follows that the higher the price of any good (relative to others, including the purchase good), the less of it will be purchased by any individual.26 It is therefore theoretically possible to construct a schedule, or curve, of the amounts of any good that will be taken by any individual at every price in terms of other goods, and by adding these amounts for all individuals, to construct a similar schedule for the society as a whole. But there is a fixed amount of each good available in any given short space of time to be disposed of, and it must all be sold at one price. Therefore, in a perfect market each commodity will command a definite price, which is the highest uniform price at which the entire existing stock can be disposed of (including taking out of the market by present owners).
The diagrammatic representation of the market-price equilibrium is simple and obvious. The utility relations involved in the figures and analysis for the boy-and-berries situation above27 are applicable. The exchange situation is shown in the accompanying sketch. The horizontal base line is a scale of prices. The "demand" curve D shows the potential purchases at each price, for any individual or for the society as a whole, according to the scale used. The amount for sale is independent of price, a fixed physical quantity, and is represented by a horizontal line cutting the vertical or commodity axis at the proper point. The horizontal value of the intersection point gives the market price under the conditions.28
It is especially to be observed that all the quantities involved in this whole analysis are physical and not psychic. If utility in the individual consciousness is not a true, measurable magnitude, as argued, it is still more evident that utility in any social sense, involving a sublimation of individual utilities into a "social" estimate is a wholly inadmissible supposition. The concept of social utility is in fact a mere substitute for analysis. The whole problem is precisely this of showing how an objective and uniform price results from palpably subjective and variable individual preferences. This must be done by exhibiting the interactions of individual offers and bids in the actual market.29 We in fact know nothing about any absolute utility to any individual or about absolute amounts purchased by any one. All that can be said about the adjustment which results from perfect competition is comprised in three statements: (1) Under the conditions (the price alternatives as they are fixed) each individual achieves the goal of rational action, maximizing the want satisfaction procurable with his given resources (whatever they are) in purchasing power, by distributing them among the alternatives according to the law of choice; (2) the conditions themselves, the prices or exchange ratios being the same for all individuals, and the relative utilities adjusted to equality with these, it follows that the relative utilities of all goods (which any individual purchases at all) are the same to every individual; (3) the exchange ratios will be so adjusted that at those ratios no individual will wish to exchange anything in his possession for anything in the possession of any one else.
The emphasized expressions are so treated because of current ambiguous or actually confused conclusions in regard to the beneficence of the results of ideal competition. To call this result socially ideal or the best possible, involves assuming in addition to all the theoretical conditions as to the workings of the process itself30 that the initial situation, the distribution of goods before the exchanges commenced, was the best possible (i.e., either absolutely ideal or absolutely beyond human power to modify). All that is true (and stated baldly it is little better than a truism) is that free exchange tends toward that redistribution of goods which is the most satisfactory all around of any that can be obtained by voluntary consent all around.
It is self-evident that in ideal exchange the quantities exchanged are equal in value terms, and there is no chance for anything like a "profit" to arise.
The main condition of perfect exchange not realized in real life is that of "perfect intercommunication," which is to say perfect knowledge of what they are doing on the part of all exchangers.31
In our actual system middlemen fix a price which in the absence of monopoly is their best estimate of the theoretical price—which would just enable the visible supply to be disposed of—and change it from time to time as the rate of sales indicates it to be too high or too low. It is a familiar fact that in consequence of imperfect intercommunication appreciably different prices for the same commodity may obtain at different points in the general market area. Certain factors aggravate the effect of uncertainty in disturbing the theoretical adjustment: (1) Inertia or inflexibility of prices, due to habit, indifference, rounding off of figures, etc.; (2) variations in the "commodity" (and fraudulent representations of variations which do not exist); and this both in the crude physical ware, and still more in by-perquisite utilities, convenience or fashionableness of place of sale, ornamental containers, trade names, personality of vendor, etc.; (3) consumers' speculation; consumers do not buy continuously for their current needs, but lay in supplies or hold off, according to their prognostications of the market.
When terms are properly defined and allowances made for real commodity differences (which include all the factors under number 2 above) the tendency toward a definite and uniform price for similar goods is strong and conspicuous, and a fair approximation to this result is generally reached. There is, of course, the greatest difference in commodities in respect of this standardization, from wheat and cotton at one extreme to artistic products at the other.
When in our imaginary perfectly competitive society the exchanges are finished and the goods consumed, everybody will again start out to engage in production. But occupations will not be chosen as before; there will now be an established scale of prices of every good in terms of every other, and in accordance with this price scale every one will direct his effort and gauge its intensity, conforming, of course, to the Law of Choice in making his decision. The commodities produced will be thought of simply as purchasing power over goods in general, and the immediate alternatives are simply producing "wealth" and not producing it, which means doing something, or nothing (which is also doing "something") entirely outside the scale of quantitative comparisons, and this now means outside the market sphere. Every man will, therefore, like Crusoe, or the boy in the berry patch, carry his exertions to the point where utility and disutility—"really" sacrificed utility, but of an unspecified and non-quantitative sort—are of equal importance in the amounts which are alternative to each other.
As production goes on and goods accumulate in the hands of our "homines œconomici," they will be exchanged as before, distributed among the exchange possibilities in accordance with the Law of Choice; and the exchange possibilities will continuously be modified by the same process so as to be kept constantly at that point where momentarily the utility ratios of every one can be brought to equality with the price ratios. But this process of adjustment and readjustment also tends toward an equilibrium; the investigation of this tendency toward a condition in which production and consumption of all commodities would go forward at unvarying rates falls in the province of the second grand division of economic theory, one branch of which is the theory of normal price.32
In a situation such as we have described, with the production, exchange, and consumption of commodities going on continuously, the value scale or system of quantitative equivalences of commodities, becomes much more objective and definite than it could ever be in the economy of an individual Crusoe. The constant presence of the published scale of exchange ratios and the working-out of the whole organization in terms of it must have a tremendous influence in "rationalizing" the economic activity, in impressing its quantitative features on men's minds, and enforcing precise calculations and comparisons. The result is that all goods are reduced to a homogeneous aggregate or fund of value units. This fund of value, as the medium of solving the problems of alternatives, naturally divides the economic process for each individual into two parts or stages fairly distinct in his thought. The goods he produces being thought of merely as so much value in exchange, the problems of combining alternatives in production is separated and simplified by the necessity of considering but two alternatives, as we have noted above. Similarly, the problem of consumption is considered independently, taking the form of the problem of expending value in exchange, which is worked out on its own account in accordance with the principle of rational choice or distribution of resources among competing uses. Thus value in exchange on the expenditure side, becomes like the concept of exertion to Crusoe; it is an instrumental idea, with no ontological content, but extremely useful in solving the problem of choice. The separation of the two halves of the economic problem is much heightened in real life by the storing-up of value in exchange, and the production of it for the purpose of storing it up, against unknown contingencies, with no thought of any particular use to be made of it. The separation is still further heightened by the tendency of the production of wealth to lose all connection with the notion of consuming utilities and take on the form of a competitive contest in which value in exchange becomes a mere measure of success, a counter in the game.
The further establishment and objectification of the value-system will also involve a more definite evaluation of productive sacrifices or "exertion," really the "non-economic" alternative occupations given up to perform productive labor. This evaluation being in terms of value in exchange, productive labor is in this sense brought into the general value fund, though under the conditions we are now discussing (independent individual production only) it would not actually come into the market and be exchanged. The evaluation of productive effort, i.e., its measurement in terms of an established scale of equivalences of economic alternatives, furnishes a correspondingly substantial content for the notion of "outlay cost" in a quantitative or value sense, and men's minds would undoubtedly work largely in terms of this concept.
Now it is especially important to note that at this point in the hypothetical construction we have first arrived at a set of conditions where the outlay cost of a particular good is not necessarily and axiomatically equal to the value of the good itself. For, while the readjustment toward normal price or equilibrium conditions is taking place, the "value" of the labor will be determined in the market price situation at one moment, while the value of the good which it yields will be determined at a slightly later time, and there will typically be some difference between the two. The value of the productive effort is that which the good it produces has previously had, while the value of the good it does actually produce will when it comes on the market be something else. The difference, positive or negative, between the value of a good and the (value of) its cost is analogous to "profit." Its occurrence is manifestly due to the fact that men must base their acts on past conditions, or on uncertain inferences as to the future based upon past conditions, and not on the actual future conditions to which they really relate. As soon as men find out accurately what goods are going to be worth after they are produced, they will employ their productive energy accordingly, and the profit differential will disappear. And since this is what they constantly strive to do, with some measure of success, the system will tend toward that equilibrium adjustment in which no profit exists.
The theory of the normal price adjustment is precisely analogous to that of market price, since there is no difference in principle (but only one in complication) between the purchase of a good by the sacrifice of another in exchange and its"purchase" by the sacrifice of the production of another good in its production. Both normal price and market price theories are little more than corollaries from the single fundamental Law of Choice.
On the production side of the twofold alternative, the utility or importance of any good is its purchasing power, and the higher the price the more of it will be produced, for the same reason that Crusoe would produce more of a more wanted good or an individual in a market purchase more of a similar one. But the higher the price of any good the less of it can be disposed of. Now since the amounts produced and disposed of are axiomatically the same, the price will move toward the point at which the natural amounts of production and sales at that price are the same. Diagrammatically, taking again a scale of prices as a horizontal basis, an ascending curve will represent the (rate of) production or supply at different prices (in terms of other goods), while a descending curve will represent the (rate of) sales or demand. The intersection of the curves gives the price point.
A slightly different way of viewing exactly the same facts will make clearer the individual motivation and show the bearings of the idea of value-cost. The demand curve, viewed from the other direction, or with the axes interchanged, is in fact a cost of production curve. The amount produced (in unit time, the rate of production) at any price is the amount that can be produced at that price without either profit or loss. For if any given price yields a profit, resources will be diverted to, and if a loss, from the production of that good; the real meaning of profit is simply that resources being used to produce other goods (and valued in the other uses) will yield more in the production of the good in question; while similarly, loss means that resources producing the good in question are worth more in other uses (their value being determined by that of the best use). From the present point of view the demand curve shows the possible selling prices of different sizes of supply, and the condition of equilibrium is that cost and selling price shall be equal. The intersection of the curves then shows on one axis the equilibrium rate of production and consumption, and on the other the equilibrium price. The character of the whole analysis as an easy deduction from the Law of Choice is clear enough without further elaboration.33
Space does not permit us to give more consideration to these first fundamentals, and we must allow the above brief and perhaps somewhat dogmatic treatment of controverted issues to stand. It is difficult in the light of such an analysis to see any real meaning in such questions as the causal relation between cost and value, and others about which controversy has raged. Under competitive conditions a value involves an equal cost and a cost an equal value, so directly and obviously (since it is all a purely relative matter of choosing between alternatives in such a way as to equate them) that the two are but little more than different words for the same phenomenon viewed from different standpoints. Cost is the value of the resources embodied in a thing, which is to say the value of some use for them; it may be an "economic" or a "non-economic" (measurable and marketable or the opposite) use, but if there is not a competing attraction of some sort the "resources" will not be "resources" at all, just as if the thing itself is not wanted somewhere else it will not have (exchange) value, and we should say not even utility if the word is properly defined.
The whole argument is merely an elaboration of the Law of Choice (the correct form of the principle of utility), that preference ratios between alternatives will by combining the alternatives in the requisite proportions be made equal to the externally given physical equivalence ratios, first in the market and then in production. That "goods" are largely alternative to each other in production (involving the use of the same ultimate resources) is the condition of our having an economic order, an organization of want-satisfying activities based on free production and exchange. We turn now to consider the further complications of the competitive situation arising from the organization of a plurality of productive agents in the making of a single commodity.[Back to Table of Contents]
Part II, Chapter IV
Joint Production and Capitalization
The present chapter will bring a greater semblance of reality into the imaginary, highly simplified economic system partially constructed above. Many of the features of everyday life abstracted for simplification can now be introduced in succession and their relations and bearings separately studied. In this way we shall ultimately determine what is necessary to perfect competition and what is not. It will be found that most of the simplifying assumptions hitherto made can be dropped without destroying the conditions necessary to a perfect equilibrium in which costs and values are identical throughout. So long as we adhere to the fundamental condition already emphasized, that men know exactly what they are doing, that no uncertainty is present, other elements of reality hitherto abstracted merely complicate the process of adjustment without changing the character of the result. Their elimination has served the necessary end of simplifying the study of the fundamentals of economic behavior and made possible the separate study of these complicating considerations themselves, which we shall now undertake.
The first step in this further development of the imaginary social structure is to examine the nature and bearings of organized production. Hitherto our society has been arbitrarily restricted to the unorganized or individual creation of goods; there has been only "primary" division of labor, through the exchange of products. We now turn to consider "secondary" division of labor, or division of occupations within the separate industries, the coöperation of a large number of persons in the making of a single product. This added element in the situation gives us two serious new problems, though closely related; first, the mechanism of the actual organization of productive groups through free contract alone, and, second, the division of a joint product among the individuals making different kinds of contributions to its production. The latter is the familiar problem of "imputation" (Zurechnung) or "distribution" in the technical sense.
Practically speaking, we are now turning to the second general problem of economics as it is met with in the real world. For methodological reasons we have, indeed, found it necessary to discuss a society in which specialized production takes place, but not joint production. In reality, of course, production is joint, practically without exception. The subject for discussion now is, therefore, the general principles of social organization under free exchange where given resources are used (in the production of goods) for the satisfaction of given wants (and under given conditions as to available methods of technical organization, etc.). It is the problem of the "static state." In order to keep the problems of the organization of production and the division of the product as simple as possible and to introduce complicating factors one at a time, no other changes are now to be made in the arbitrary specifications of the system we are studying. In regard to production particularly, we assume the absolutely continuous creation of the complete article and its immediate exchange and consumption when complete, and the absence of productive "property" in the ordinary sense.34 That is, there are to be no material productive agents which are not either superabundant, and therefore free, or else rigidly attached to the persons of their owners, and no way is to be open either to increase the productive efficiency of person or thing or to decrease it through use. The only change now introduced in the conditions of our problem is that at least a large part of the commodities produced and consumed in our society are to be made by groups of individuals, performing a number of different kinds of productive work. It is not necessary that every individual perform a unique function; rather let it be typically true that considerable numbers perform the same sort of work and that there are gradations of similarity in the different tasks.35
The possibility of an automatic organization of production through free agreements between individuals depends upon a technological principle governing joint production and not hitherto introduced. This new axiom is as fundamental to economic thought and process as the principle of choice or diminishing utility, and very similar to it in statement. It is the principle of the variation of proportions in the factors of production, already long famous under the name of "diminishing returns," though its clear and approximately accurate formulation in general terms is a relatively recent achievement. This new law is a generalization from the facts of physical nature as the former is a generalization from the facts of human nature. Like the other, and all other "laws," it is an approximation, and its approximateness must be kept in mind in making practical applications of conclusions resting on it as a premise. Like the other great axioms in economics, it is purely a principle of relativity, dealing with proportions only. In this respect the current statements of the principle are generally less misleading than in the case of diminishing utility, there being less temptation to give it an absolutistic interpretation. It does seem strange, however, that it took economists so long (nearly a century) to recognize the inherent reversibility of a change in proportions and to draw the obvious inferences from the fact. We may observe finally that the new principle is much "truer"; i.e., more universally and accurately in conformity with the facts, more dependable, than its psychological counterpart.
In many other respects, also, there is similarity between the two fundamental principles of proportionality, the psychological law of diminishing utility and the technological one of diminishing returns. A formal and accurate statement of either presupposes continuous divisibility of the variable element, which is not true to fact in a particular case, but which does hold good with practical accuracy in a large market. In both cases divisibility breaks down completely (in an individual case) for minimum amounts. As there is a definite minimum quantity of any consumption good required to give it any significance, so there are limits to the proportions of productivity agencies which will yield any effect at all. As to minima in the case of consumption goods in the different sense of minimum amounts necessary to life, this, though commonly assumed, is ordinarily not true. It is only under very special circumstances that any particular commodity, as the market defines and differentiates commodities (and this is the only sound or relevant method), is indispensable.
In the case of both the law of diminishing utility and that of diminishing returns, also, there are maxima to be taken into account beyond which the good or agency ceases to enter into problems of conduct at all, becoming a "free good"—better called a potential good, as we have seen. The correct procedure is of course to treat superabundant elements in production as we did those in consumption; i.e., to take them absolutely for granted and ignore them completely. Only the "possibility" of a situation arising in which a thing would not be superabundant can give it significance or lead to its being consciously considered in any way.
In discussing the principle of diminishing returns a special difficulty arises in the confusion of varying proportions in a combination with changes in the absolute size of the combination as a whole. These things must imperatively be kept separate; in the writer's opinion more error has arisen over this point than any other single matter in distributive theory. If the amounts of all elements in a combination were freely variable without limit and the product also continuously divisible, it is evident that one size of combination would be precisely similar in its workings to any other similarly composed. But under this condition the tendency to monopoly in the production of every good would be unimpeded. For the competitive system to work, it is necessary to postulate that the conditions as to divisibility of factors are such that the bargaining unit of any one factor is quite small in relation to the total stock of agencies which more or less effectively compete with that unit, and also that an establishment of relatively small size in proportion to the industry as a whole is more efficient than a larger one. Under these conditions the first effect of competition must be to bring all the plants within an industry to the most economical size, and leave a sufficient number in operation to compete effectively for the productive agencies which all use.36
The principle of diminishing returns in its now current form runs somewhat as follows: As successive increments of any one agency are added to fixed amounts of other agencies in a combination, the physical product of the combination will increase, but after a certain point the output will increase in less proportion than that of the agency in question and will ultimately decrease absolutely.37 A more general formulation, emphasizing the reference to proportionality in contrast with absolute size, and the reversibility of the law, might run as follows: When the proportion of agencies in a combination is continuously varied over a very wide range, there is generally a first stage in which the product per unit of either agency increases; then a stage in which the product per unit of the relatively increased agency decreases and the product per unit of the relatively decreased agency increases; and finally a third stage in which the product relative to either agency decreases. Since either agency may be the increasing and the other the decreasing one, the first and third stages are identical in meaning.38
It is requisite for an intelligent organization of production and a determinate division of the produce among the factors by competitive price forces that not merely the product increase in less ratio than the factor, but that equal arithmetic increments of factor yield decreasing increments of product. These two principles have entirely different meanings, of course, but they are badly confused in many statements of the theory of diminishing returns. The second can, however, be deduced from the first, which follows from the very nature of an economic situation, as shown below. The relations of the various elements in the problem can best be shown by reference to a graph. In the accompanying figure, the horizontal or X distances represent quantities of the single variable productive factor in a combination, and the vertical or Y distances, the corresponding total physical output of the group. In graphic terms the point where diminishing returns begin is the point (3) where this curve becomes tangent to a straight line through the origin. Less than this proportion of the variable agent cannot intelligently be employed even if it is free, for the output could be increased by discarding a portion of the other factors, if no more of the variable one could be obtained at a uniform price. It is true, necessarily and a priori, that there is such a point on the curve, that for less amounts the product increases in greater ratio than the factor. That is, for any point on the curve between this point (3) and the intersection of the curve with the X axis the tangent must cut the X axis positively. Now, if below this point (3) the tangent to the curve cuts the positive X axis, if at this point it passes through the origin and beyond this point it cuts the positive Y axis, then manifestly the curve is concave downward at the point in question. And this is the graphic condition representing decreasing increments of product. It seems reasonable to assume that the same condition (concavity downward) holds from point 3 to the maximum point (4), but this is not demonstrable a priori. If it is untrue for a certain stage in this interval between points 3 and 4 over the whole field of industry, as represented by the dotted line in the figure, there is indeterminateness in the competitive situation in that interval and to that extent, but this is a rather incredible supposition.
It is immaterial what shape the curve has below point 3 so long as its tangent always cuts the X axis. No doubt in any one industry the curve will show stages of increasing returns interspersed with stages of decreasing returns, and various proportions of combination of the factors are wise and stable.39
If men are supposed to know what they are doing there is no occasion for discussing the first and third stages at all. The boundaries of the second stage represent extreme limits where one agency or the other becomes a free good and passes out of consideration altogether. Beyond this point the product is absolutely diminished by increasing one agency or the other, as the case may be, which is an absurdity. The identity in meaning of the first and the third stages is evident; the first stage when passing in one direction is the third when reading the data in the opposite order. It is a mere matter of the arrangement of results, not of the results themselves. Beyond the limits of the stage of "decreasing returns," therefore, or under circumstances where the law did not hold, there could not exist an "economic" situation. Unless the return per unit of any agency does decrease it is not productive at all; its use adds nothing to the output of the combination. If we imagine increasing returns the agency is negatively productive. This fact has been recognized in the case of land in the common statement that additional land would never be taken up until diminishing returns set in on that40 already in use.
The facts of variability in the proportions of agencies in the productive organization, and of the variation of the yield relative to the different agencies in accordance with the principle of diminishing returns not merely make possible the economic organization of society through free contract, but in their absence the whole question of organization would be meaningless; there would be no such problem. Unless there were open for use various combinations of various productivities, with the possibility of comparing them, there would be no question of using any one arrangement rather than any other. Organization is called for, is possible, and is carried out only through the fact that the separate contributions of separate agencies to a joint product can be identified. The organization through free contract under competition is possible and real and effective in so far as such a system tends to give to the owner of each agency the separate contribution of that agency. Modern society is organized through the association of control over productive agencies with the right to their yield. Only because the income is greater where the product is larger is such organization possible at all. In the absence of a law connecting distributive share with effective contribution our social system would be no system, but chaos. It is, therefore, inappropriate for economists to argue as to whether the separation of contributions to a joint product can or cannot be made; it is made; it is our business to explain the mechanism by which it is accomplished.
The business man does find out how much different agencies or units of productive power are worth to the productive process or he could not carry on his business. It is obvious that the business man, in bidding for the use of separate agencies, must think in terms of the added contributions of added units,—in technical economic parlance the "marginal" product,—and it is demonstrable that when the units are sufficiently small the sum of the separate, specific contribution of all the agencies exhausts the total joint product.41
It is to be observed that when a new productive unit is added to a productive combination the technical law of diminishing returns does not fully describe the variation in the output. In consequence of this law alone, the added physical product of similar agencies will rise in the position from which the one in question is withdrawn and fall in that into which it moves.42 But in addition, since the transfer decreases the total output of the commodity from whose production the agency is withdrawn, and increases the output of the industry into which it is moved, the price of the former will rise and of the latter fall relatively. In an organized free exchange society, producers naturally estimate product in terms of its exchange value and not of its physical magnitude. The variations in physical contribution and in the value of that contribution when an addition of any kind of agency is made, work in the same direction and must be added to give the total decrease in the value product. We shall call the aggregate variation by the name of diminishing value productivity or simply diminishing productivity, which must always be distinguished from the diminishing physical returns.43
It is unnecessary to introduce into our society any factors or agencies other than labor in order to study the mechanism of imputation. Groups of individuals more or less specialized to and specializing in different productive functions in the making of the same commodity represent in principle all that is involved in the coöperation of agencies of whatever difference in nature. We may, therefore, refer to these different functionaries as types of agencies, or indeed as "factors" of production, though we shall presently find reasons for avoiding this term, on account of its misleading connotations. When the conditions of a "static" society—i.e., given conditions of the production and consumption of goods—are correctly laid down, there is, as we have seen, no room for property in any sense which differentiates it from productive capacities inherent in the person of the owner.44
This matter will be discussed at greater length as we proceed. Let it merely be understood at this point that any class or group of agencies, or "factor" of production to which we refer, is formed on the basis of the physical facts and includes those things which are actually interchangeable one with another in the production process. If we speak of "factors" at all, there will thus be not three, but a quite indefinitely large number of them.45
As a matter of fact, a great deal of unnecessary mystification has been thrown around the problem of imputation. It is merely a case of joint demand, and the same situation is common in the case of consumption goods. There is really no more mystery or special difficulty about separating the demand for labor or any particular kind of labor, due to the fact that it is not employed alone, than there is about constructing a separate demand curve for butter, which is always consumed along with other commodities. The principle of variable proportions is the key to the solution in both cases. Commodities always used together and always in the same proportions would not be separate commodities, as far as consumption is concerned, but parts of one commodity, though they might still be valued separately if the conditions of production were distinct.
Keeping in mind the above facts and the simplified conditions under which we are working, it is not difficult to picture the actual mechanism of the organization. Let us begin as in the last chapter with a random adjustment and follow through the successive readjustments to the equilibrium condition. Suppose that groups of producers are formed by guess in any chance way, the product of each group as a whole being determined in the manner already described and its division among the members of the group arranged on any basis whatever. It is evident that the desire of every individual to better himself will lead at once to three sorts of inquiries. First, each person will endeavor to ascertain his own value to the group of which he is a member and compare it with the share which he is receiving; and second, he will similarly inquire what he might be worth to other groups. Third, as a member of a group each individual will interest himself in the value to the group of other individuals in it and in the value which individuals outside it would have if they could be procured for his group. As a result, (1) remunerations will rapidly be readjusted toward the values which the individuals contribute to the output of the groups with which they work, and (2) all individuals will gravitate toward those groups in which they can make the largest contributions to output. Any individual receiving from his group more than he is worth will be released or have his remuneration reduced. Any individual receiving less than he is worth will be able to secure his full value,46 since we have specified conditions under which perfect competition will exist between the groups.
All productive groups would thus compete among themselves for the services of actual and potential members, and the individuals in the society would compete for positions in the group in a manner quite analogous to the existing order of things. The standard of what a group could afford to pay for a man is clearly the amount which he enables it to produce more than it would produce without him. In the final adjustment the individual's contribution to the income of the group is his contribution to the income of society as a whole, which he is under pressure to make as large as possible by placing himself in the position where he is really most effective.47 The tendency of a competitive organization is, therefore, toward that ideal adjustment familiar in the literature of laissez-faire. In the final adjustment the organization could not be changed without bringing uncompensated losses, and the total produce would be divided among all claimants by giving each his added product.48
The conditions precedent to this theoretical result are indeed abstract; but they are the conditions of perfect competition, and they are the conditions which actual society more or less closely approaches. It is important both to understand free competition because society does approach it more or less closely as an ideal, and to be fully aware of the artificiality of the conditions necessary to realize it perfectly.
Another way of formulating the condition of equlibrium is to view the adjustment as a continual repricing of productive services. This process would be more closely analogous to the process by which the prices of consumption goods are determined. We can think of each producer or group as being in the market with a certain amount of money to spend for productive power in the abstract. At the price level established at any moment those productive agencies will, of course, be purchased which make the largest price contribution to product for a given price outlay. But since the amounts of all agencies in existence are fixed, competition will quickly force a readjustment of prices to that point at which equal price amounts of all agencies make equal price contributions to product, just as in the former case equal price amounts of all goods must represent "equal utilities" to all consumers. The organization of the productive system as a whole is in fact quite analogous to that of the expenditure of income. Productive agencies are now the given resources of which the best use is to be made by distributing them so as to secure equality of remuneration for similar units in all employments. In the organization as a whole, the two principles combine. The money income may be omitted, as an instrumental intermediary, and the result stated by saying that the real resources of society tend to be so distributed among all employments that similar physical units everywhere make contributions psychically equivalent to all persons in the system in a position to choose between them.
It will now be in order to notice the more important objections which have been made to the productivity theory of distribution, though many or all of them have already been answered and probably would not be made against the form of the theory presented above. To begin with, let us insist on the complete separation of the theory of distribution proper from certain sweeping moral and social dogmas, which have been deduced from it. Professor J. B. Clark, the leading American exponent of the theory, is partly responsible for this confusion, through a few unguarded paragraphs in "The Distribution of Wealth."49 The illegitimacy of these ethical deductions has been well argued, however, by Professor Carver,50 another expositor of the theory, as well as by Professor J. M. Clark in defending the theory itself.51 We may, therefore, pass over the strictures of those writers who do not like social implications which the theory does not have, which include a considerable part of the criticism of Professors Davenport52 and Adriance;53 we shall take up briefly the question of the ethical aspects of the competitive system in chapter VI.
Against the productivity theory itself an old and common criticism is that well stated by Wieser,54 who attempts to refute Menger's presentation of it, and substantially the same line of attack has been followed more recently by Hobson,55 who refers especially to Wicksteed. The contention is that specific or marginal productivity cannot afford a theoretically adequate method of distribution, for the reason that the sum of the products of the separate agencies, as defined by the theory, will be not equal to the total joint product, but considerably larger. The amount subtracted from the total product when "one unit" is withdrawn will, it is argued, be much greater than can be imputed to that agent alone, since the loss of any agent will more or less dislocate the organization. It, therefore, becomes impossible by this method to divide the total accurately into parts ascribable to the separate "factors" individually as the specific contribution of each. Wieser proposes an alternative method, which is identical with Professor F. M. Taylor's exposition of the productivity theory itself.56 Hobson dogmatically declares the problem impossible.
The error in this line of reasoning lies in fixing the attention upon a comparatively small organization and comparatively large blocks or units of productive service. When account is taken of the actual size of industrial society and of the ordinary unit of most agencies, it will be seen that the "dislocation" is negligible; theoretically, to be sure, the units would have to be of infinitesimal size, separately owned and effectively competing; i.e., the proportions must be continuously variable, in the mathematical sense. But in the typical case the error resulting from this assumption is not large in comparison with other inaccuracies in the competitive adjustment. It is true that there are exceptional cases where agencies are not highly divisible, or even not divisible at all, and competition gives place to a greater or less degree of monopoly. These exceptions are relatively infrequent in the mass of industry as a whole, but are of considerable absolute importance, and we shall have something to say later on in regard to unique and indivisible agencies.57
Padan, in the article referred to, further attacks Professor Clark's exposition of the productivity theory on the express ground that the amount received by any factor would depend on the arbitrary size assigned to the marginal unit. This point also is hypothetically sound, but irrelevant. The size of the unit is not an arbitrary matter of methodology, but a question of fact, and Professor Clark may be open to criticism only for seeming to imply the contrary. The soundness of the theory, the possibility of competitive distribution at all, in fact, depends on the actual division of productive agencies into bargaining units of small size.58 We should hold that it is an error to say that "labor" or any "factor" gets or tends to get its product. This holds good only for the actual individual men or other agencies.
A third, somewhat philosophical, criticism is also advanced by Davenport and Adriance. It is contended that the "marginal" product of labor, for example, is as much a joint product as that of any other than the marginal unit. The laborer who uses no-rent land still has to use it, can produce nothing without it, and hence the product cannot be ascribed to the labor alone. Professor Taussig also, though like Davenport somewhat guardedly, asserts that all product is joint product and cannot be divided into parcels attributable to separate agencies, though at the same time he inclines to regard all income as the "product" of labor.59 An examination of this reasoning would carry us into the question of the meaning of production and causality, which will be taken up presently. For the present it must suffice to point out that it involves a confusion between mechanical and economic productivity. The land used by marginal labor may be necessary to the operations in the former sense, but is not in the latter, since by hypothesis if it is withheld from use it can at once be replaced by other land equally good; otherwise it would not be free land. The fallacy is parallel to the confusion between "utility" (as usually defined) and economic value. Free goods, like air, may be necessary to life, but no particular portion being necessary, the good cannot have economic value (nor, as we have argued above, should it be said to have utility if this term is to be used to connote any sort of economic significance).
We must notice, finally, another objection raised by Hobson to the general doctrine of "marginalism."60 With Hobson's fundamental position, that marginalism is the necessary form of a rational treatment of choice, and that the rational view of life is subject to drastic limitations, the writer is in hearty accord. It is not clear that Hobson intends his strictures to apply specifically to the productivity theory of distribution, but it may not be out of place to remark that such an application would be an error. In general we submit that there is much more deliberate, quantitative balancing of alternatives in economic conduct than the discussion under notice would have us believe, but this is a large issue which cannot be threshed out here. It does not seem to us that the composition of life is closely analogous to Hobson's painting or cake in which the proportion of the ingredients is rigidly determined by a recipe or a preconceived ideal of the whole. In any case, the production of goods by industry is very emphatically a rational process, an adjustment worked out by the producer in terms of these very separable effects of separate agencies. Nor is it true, as Hobson does argue elsewhere,61 that technical conditions prescribe the proportions in which agencies are to be used. The proportions of labor to land and of capital to either, and to a large extent of various sorts of each among themselves, are open to variation through a range almost without technical limit, in the fundamental industries at least. Again, the final appeal is to fact. It is the value to the producer as an addition to his organization as a whole which determines the amount which he will bid in the market for the use of any unit of labor, land, or capital, or the amount of any one which he will purchase at an established price. Hence it is this "specific product" which rules the apportionment of income at large among productive agencies at large.
As remarked above, most of the objections to the productivity theory relate to the meaning of production and of product, and come down in fine to the propriety of using the word, rather than to any fundamental disagreement as to how the distributive mechanism actually works. We wish now to point out that in calling the addition made by any agency to the total output of a large organization its specific or separate product, we are using the word "product" in the same meaning and the only meaning which the words "cause" and "effect" or equivalent terms ever have. It is never true in an absolute sense that one event is the cause of another. The whole state of the universe at one moment may perhaps be said to cause its whole state at the next moment, but when we say that "A" is the "cause" of "B" we always assume that other things are equal; we never mean that if the rest of the universe were removed "A" alone would produce "B." And the imputation of any single event to another as cause or effect is always largely arbitrary. Every event has an infinite number of causes, and it depends upon circumstances, the point of view, the problem in hand, which of these we single out for designation as "The" cause. "The" cause of a phenomenon is merely that one of its necessary conditions which is for some practical reason crucial, generally from the standpoint of control. It is the one about which we must concern ourselves, the circumstances enabling us to take the others for granted. It may be quite correct to name a dozen different antecedents as "the" cause of a particular occurrence, according to the point of view. The fact that other agencies, even the whole social system, may be concerned in the production of a certain good does not therefore argue against its being the (specific) product of the particular agency upon whose activity its creation actually hinges under the actual circumstances of the case.62
A general analytic statement of the principles of static organization, in price terms and on the basis of supply and demand, will consist of two main parts. We have to consider two valuation problems relating respectively to consumption goods and productive services. The problems are usually designated as "value" and "distribution." It will be convenient to take up the second of these problems first. We have already seen that the effective form of the law of variation of proportions of factors is the law of diminishing value productivity. It is obvious that all readjustments involve transfers of productive resources and that every such transfer implies a price change, raising the prices of goods produced by the organization from which resources are taken and lowering the prices of goods to whose production resources are diverted. And the effect of this price change coincides in direction with the effect of diminishing physical returns. We may content ourselves for the present with this superficial view of the price reactions on the side of consumption goods and proceed to work out the price conditions of equilibrium of the system in terms of the distributive shares. After which the viewpoint will be shifted to regard these shares, not as the remunerations of agencies, but as costs of the goods into which their services enter. When the adjustment and its equilibrium have been studied as a relation between prices and costs of consumption goods, we can bring the two analyses together and see the relations of the three sets of price facts—values of goods, costs of goods, and values of productive services. It is obvious that as aggregates the three concepts are identical, all being in fact the social income looked at from different points of view.
From the standpoint of the present problem of the "static state" the supplies of all productive agencies are rigidly fixed, and the theory of the valuation of their services is closely parallel to the market price theory as given in the last chapter for consumption goods. The facts of demand and supply for any particular kind of agency can be presented in the form of schedules or graphs showing the respective amounts that will be forthcoming and that can be sold at each price, and the equilibrium point would be manifest in such a presentation. The facts on both the supply and demand sides of the relation are more complicated than in the case of consumption goods. On the supply side we cannot take the amount in existence even at a moment as a given physical datum. For we are dealing with the services of a particular kind of agency, not the agency as such. The amount of the agency is fixed, but the amount of marketable service forthcoming from it may well vary with the price offered. Two courses are open. We may define and classify services on the basis of the physical characteristics of the agencies which render them or in terms of the physical result produced.63 Let us take first agencies as physically defined. In this case the effect of the substitution of more or less similar agencies is to be taken into account in plotting the demand curve; supply means the supply of the services of a particular kind of physical agent, things which are perfectly homogeneous and universally interchangeable alone being grouped together.
It is usual, because superficially "natural" to assume that a man will work more—i.e., work harder or more hours per day—for a higher wage than for a lower one. But a little examination will show that this assumption is for rational behavior incorrect. In so far as men act rationally—i.e., from fixed motives subject to the law of diminishing utility—they will at a higher rate divide their time between wage-earning and non-industrial uses in such a way as to earn more money, indeed, but to work fewer hours. Just where the balance will be struck depends upon the shape of the curve of comparison between money (representing the group of things purchasable with money) and leisure (representing all non-pecuniary, alternative uses of time). We therefore draw our momentary supply line in terms of price with some downward slope.64
The second alternative is to define agencies or factors in terms of the physical results which they produce. When this is done the shape of the supply curve at a moment will depend simply on the degree of specialization of the service under discussion. At one extreme we would have an unspecialized service, such as unskilled labor in a certain employment. For such a service there would be no supply at all below the established competitive price in all uses, and a virtually unlimited supply above that price. That is, the supply curve as a function of price would be a vertical line. At the other extreme would be absolutely specialized services, such as diamond cutters or aviators. For these there would be no supply below a certain minimum price, what such men can earn in other lines of work, and as the price rose the supply would rapidly increase until the men trained for the service were all employed in it, beyond which the curve would merge into the supply curve previously discussed of services from given agencies. (See accompanying graphs, which show supply as a function of price.)
In regard to demand, also, the case of productive services is less simple than that of consumptive goods; demand is (a) always indirect or derived, a reflection of the demand for the products of the agency, and (b) always joint in character. In connection with the first fact, the demand is also highly composite; identical productive agencies minister alternately to a vast range of wants and widely different agencies to the same wants. These complexities in the use of productive services make a really logical classification of them a difficult if not impossible problem. The fact of joint demand, as we have seen, differentiates producer's goods from consumer's goods in degree only, and to a relatively limited degree.
The shape of the demand curve showing possible sales of the services of any physically defined type of agency as a function of price is similar to that of the consumption goods demand curve. It is the curve of diminishing value productivity already described, descending in consequence both of decreasing physical productivity and decreasing price. That is, if the supply of any productive agency be increased the proportion of that agency in combinations in which it is employed will be raised all along the line, and at the same time there will be a relative increase in the production of those commodities in which its use is relatively important with a consequent decline in their relative price. The equilibrium price point under static conditions is practically the specific productivity of the given supply of the agency (though we must remember that there is some variation in supply of service as price varies even at a moment). In the equilibrium condition, that is to say, the value of each service is equal to the value of its contribution to the total product, and the contributions of physically similar agencies are of equal value throughout the system. It is evident that this adjustment fixes the prices of consumption goods at the same time with those of productive services, and we may apply the supply and demand analysis to consumption goods also, giving the theory of normal price in contrast with the theory of market price studied in the last chapter.
At a moment, the theoretical price of any good is the ("marginal") demand price of the existing supply, the highest uniform price that will take the supply out of the market. The supply is a given physical fact, not an economic variable, but a constant in the equation. The equilibrium price of a good over a long period is a different problem. Here it is not the amount of the good that is constant (together with the facts of demand), but (under "static" conditions) the conditions of production of goods in general (and of demand). The supply of any particular good may change freely and will do so as its price varies, other things being equal. The price must be adjusted not to dispose of a fixed supply, but to equate a rate65 of production with a rate of consumption, both variable with or "functions of " the price.
No particular reinterpretation of the demand curve is called for, however, the only new problem being on the supply side. Assuming for the moment that the rate of supply as well as the rate of demand is in fact a function of price, it is evident that the price must move toward an equilibrium point equating the two rates; for goods cannot be consumed more rapidly than they are produced and will not be produced more rapidly than they are consumed. Any difference either way will at once react on the price and the price will react on the production and consumption rates in accordance with the assumed functional relations, and so on until the demand and supply both correspond to the existing price.
To investigate the basis and character of the relation between supply and price, we must consider the motives which control production. The productive group or establishment, however organized, must pay its members (the owners of productive services) enough to retain them; i.e., it must meet competition. When any group can hire a new member at a profit it will do so, and clearly it can get any new member by raising ever so little the remuneration he is receiving elsewhere. Clearly, also, it will dispense with any member who must be employed at a loss; i.e., any to whom competing groups can afford to pay more than it can afford to pay. The amount of any commodity that will be produced at any price, therefore, tends quickly toward the amount that will yield neither profit nor loss, for when production yields ever so little profit it will increase, and vice versa. For the study of this adjustment it is convenient to interchange the axes of our previous graph and view cost and selling price as functions of the size of supply.
It is usually assumed that cost may either increase, remain constant or decrease as supply is increased.66 (Selling price, of course, practically always decreases.) The question is really one of the most difficult and perhaps one of the worst muddled in economic theory and cannot be adequately treated here. But examination seems to show that under the conditions necessary to perfect competition, costs must always increase as supply increases. If there is to be competition, conditions must be such that an establishment of relatively small size in comparison with the industry as a whole is more efficient than a large one; otherwise monopoly will result. New supply will then come through an increase in the number of similar establishments, not through an increase in the size of any of them, and no economies of large-scale production will be realized.
On the contrary, the increased supply must mean a diversion of productive resources from other uses, which will raise their price in those uses through the decreased output and consequent rise in price of the competing product. Of course, if competition exists the price will go up uniformly to all producers, and it goes without saying that the cost of all units of the supply is the same.67
The precise form of the cost function will depend on the importance of the particular good in the demand for the productive services which enter into it. If its production constitutes a negligible fraction of the demand for all these services, we shall have practically constant cost; if a considerable fraction, a more rapidly rising cost. It will also vary with the character of the function representing the law of decreasing returns in the given technological situation; for as production is increased the proportions of more abundant agencies will be increased relatively to those more limited in supply. The graph on p. 91 shows the character of the functions and the meaning of equilibrium, and is applicable also to conditions of joint production.
The equilibrium condition or long-run tendency for the static state has now been formulated in three ways from as many different standpoints. From the standpoint of distribution, every agency must be in the situation where it can make the greatest possible value contribution to the social income and be valued by the contribution which it makes. From the standpoint of consumption goods, prices must be such that rates of production and consumption are equal or that costs and selling prices per unit are everywhere the same. It is important to see clearly that these statements are logically equivalent, presenting different aspects of the same phenomena. It is self-evident that costs of goods are identical in the aggregate with distributive shares, and both with prices of goods; all three are in fact different names for the total income of the society. A formulation including all these statements would be that consumption goods and productive services must be so priced that equal price amounts of the second make equal price contributions of the first which have equal utilities to all persons in the system. It is really self-evident that this condition alone can be stable, that any other sets forces to work to bring it about.
Hitherto we have dealt only with different sorts of human services as giving rise to the phenomena of competitive imputation. The meaning and rôle of property in the problem of economic organization next call for notice. We have seen that material productive goods do not modify the principles of organization so long as they are not subject to increase or decrease and not separable from the persons of their owners, to whose personal capacities the same restrictions must apply.
The conventional classification of productive agencies under the three categories of land, labor, and capital has several times in the foregoing pages been referred to adversely, and it is appropriate at this point to take up for somewhat more detailed notice the difficult problem of correct definition and classification. It is evident that all these classes are anything but homogeneous, that different human beings, different machines, and different natural agents show the greatest diversity in characteristics and in the services which they perform. Cairnes's attempt to reduce labor to more approximately homogeneous bodies gave us the famous "non-competing groups." Still more obtrusive are the dissimilarities of different natural agents—wheat land vs. pineapple land, arable vs. grazing or timber, and all contrasted with mineral-bearing and the multitudinous kinds of the latter. Capital is somewhat peculiar in this respect, its "fluidity" depending on the length of time taken into view.
On the other hand, it is if possible a more important fact that agencies from different classes and of the most divergent physical properties may be equivalent and interchangeable with respect to the results which they achieve. As Carver has observed, a (human) ditch-digger is economically as closely akin to a steam shovel as he is to a bookkeeper.68 Indeed, the possibility of a competitive organization of society depends on the fact of varying proportions, that no particular agency is indispensable, but that within limits they may be substituted for each other and therefore each must compete with others of different kinds for its place. It is evident that otherwise producers would not be in the market for the agencies separately and they could not be separately evaluated through competitive bidding. The existence of a problem of distribution depends on the coöperation of different kinds of agencies performing physically different operations in the creation of product, and the possibility of solving the problem depends on the equivalence of determinate amounts of the several services in contributing to the value result. It follows at once that, as already observed, no classification or measurement of productive services on the basis of their contributions has any meaning for the distribution problem. According to such a standard they all form one vast homogeneous fund.69
The problem is really a difficult one, and cannot be passed over, since we cannot discuss the valuation of things without knowing what it is that is being evaluated. Much the same difficulty, however, was met with, as will be recalled, in the sphere of consumption goods, and the answer must come from the same source in the two cases—an appeal to the unsophisticated facts of the market. Things quoted under the same name and identically priced may be taken as identical, and vice versa. Some special features of the present case may be mentioned, however. In the first place, interchangeability of productive agents depends on the use; two things may be equivalent for one purpose, entirely dissimilar for another. This is not nearly so true of consumption goods, which, indeed, are not generally open to such a complex variety of uses. Interchangeability is also a matter of time. The problem of changing the form of productive agencies and adapting them to new uses carries us into long-time considerations, and especially the meaning of capital, which will come up in the next chapter. It will be seen that examination tends to widen the capital category greatly; most productive services ultimately represent a previous investment of resources of some sort.
The variation in interchangeability in different uses introduces a special complication which has caused confusion. The consideration which finally determines is not interchangeability in creating any particular physical product, but a certain amount of value. The former variety of interchangeability is not in fact a necessary condition for the operation of competitive distribution. If agencies are combined in different uses, effective substitution is secured through relative growth or decay of the different industries. We have previously remarked that Wieser, who repudiates the productivity theory of distribution as based on variation in proportions, puts forth the really equivalent theory, based on different proportions in different combinations. Taylor, however, takes the latter method for his explanation of the productivity theory, but points out that the two are equivalent. Both sorts of variations in proportion are, of course, concerned in the actual working of the market for productive services, and systematically occur together, as explained in our exposition of distribution theory just given.70
To conclude this brief discussion of the productive services, we may merely notice the invalidity of four commonly assumed grounds of distinction between labor and property services: (1) Activity vs. passivity. It is characteristic of the enterprise organization that labor is directed by its employer, not its owner, in a way analogous to material equipment. Certainly there is in this respect no sharp difference between a free laborer and a horse, not to mention a slave, who would, of course, be property. Closely related is (2) the question of preference in the agency itself as to (a) the kind and (b) the amount of service to be performed. But here also there is at most a vague difference in degree; the owner of property quite commonly does have moral or sentimental reasons for restricting the field of its employment. We must not confuse the agency actually performing work with the personality of its owner, and it appears that a tool or a building or a piece of land is in this regard similar to a man's hand or brain. Similarly as to (b) the amount of work done. It may be urged that material agents do not care whether they work or not. But the ground for restricting hours of labor or taking a vacation is a possible alternative use for one's personal resources or the desire to conserve them unimpaired, and the same considerations apply to property resources.71
(3) Another superficial difference which similarly dissolves under scrutiny relates to "sub-marginal" agencies—too poor in quality to be employed. It may be urged that there is no wageless labor analogous to free land. As a matter of fact, however, marginal and sub-marginal human beings are nearly as common and significant a phenomenon as in the case of land, and far surpass capital in this respect. Every man is a sub-marginal laborer for a considerable fraction of his life at each end of it, and institutions are full of sub-marginal men. And there are thousands and millions of other idle man-hours in a year which would be devoted to anything that brought in the least return above the competitive pay which would have to be given to the equipment necessary to employ them. On the other hand, the same fallacious reasoning noted in connection with overwork undoubtedly leads to the employment of large numbers who use equipment which would yield more product if employed in the "more intensive exploitation" of more competent workers.72
(4) The most important alleged difference between property and personal powers, the moral aspect, is not strictly within the scope of a purely descriptive discussion such as the present, but it may be in place to observe that it also is largely unreal. The contrast between personal-service income as "earned" and property income as "unearned," of which much is made by "reformers," is distinctly misleading; it is difficult if not impossible to find grounds for a moral distinction of any general validity between the two. "Some are born great, some achieve greatness, and some have greatness thrust upon them"; and the same applies quite as well to wealth. And the task of separating the portion of product or capacity to produce which is due to conscientious effort from that which goes back to inherited advantage or pure luck is about as impossible—and the evil results of making a false separation perhaps about as great—in one case as in the other. There is a difference of some significance in the practical possibility of effecting a redistribution in the two cases, which brings us back to the one specification which we found it necessary to lay down in regard to property in order to exclude it as a complicating fact; it is separable from the person of its owner, and labor generally is not, or is so to nothing like the same degree. The only conclusion as to social policy which we shall insert here is the insistence that "society" must get rid of the idea that because income is "earned" it is "deserved" and not otherwise. We are already far from this view in practice, as is shown by the indiscriminate taxation of large "service" incomes and assistance of the unfortunate and incapable. If we are to have organized society and maintain human standards of life, we must either radically eliminate weakness or impose upon strength the burdens which weakness cannot bear. (And even then there are limits to the possible toleration of weakness, and the luck element would still remain!)
Turning again now to consider the causal relations to economic organization of the one causally significant distinguishing attribute of property, let us first suppose that in our society some property is separable by lease, though not by sale, from the person of its owner. The only difference will be that the owner of such property may belong to more than one productive group and contribute more than one kind of service at the same time. The principles of organization of the system as a whole are in no wise affected by this change in the conditions of competitive arrangements.
The possibility of the permanent transfer of property by exchange, even though not subject to increase or decrease, does introduce some new factors into our problem. These results are closely related to the bearings of another abstraction hitherto made, the continuity and timelessness of the production-consumption process. Consequently, we must first get rid of this simplification and consider the effect of the abstracted element. What then will happen in a society such as we have studied when conditions are so modified in the direction of reality that, while perfect knowledge and static conditions in other respects are maintained, the production process is protracted over a considerable period of time and split up into complicated stages and subdivisions, and when, moreover, goods need no longer be consumed at once when finished, but may be stored for future use, or exchanged?
The division of the productive process into stages carried on in different groups or plants is a detail connected with the time length of the process, but which we can pass over with brief notice. It is in fact a relatively accidental matter of organization, and under the "frictionless" conditions here assumed it would make no practical difference whether successive processes in the making of an article were integrated through the internal organization of a single group or through the external mechanism of market dealings between groups. Under these conditions there will be in existence at any time a complex aggregate of partial products, goods in process, which of course will have value. We must separate that element in the value of the partial products which is due merely to the stored-up productive energy which they contain from any modification of this value due to the direct psychical influence of the time which must elapse before they are ready for consumption.
The relation of time to the production and consumption of goods is a complicated and controversial question; while only a very brief discussion can be attempted here, it is necessary to make a superficial survey. The assumption of a general preference in human nature for present over future goods is so commonly and confidently made that some courage is required to call in question the foundations of the entire body of doctrine on the subject; yet it must be done. Most discussion of the subject is, in the writer's view, vitiated by a false conception of the nature of the problem. The fact of the existence of interest in society is wrongly taken as proving that men discount the future. The relation between interest and time preference is, in fact, inverted in this view. In a free market where interest can be obtained it is natural that men should esteem a present dollar equally with its amount at the current interest rate at a future date, since one can be freely exchanged for the other. Nor does the fact that men do not postpone all consumption of goods indefinitely into the future argue an ingrained abstract preference of present to future consumption. Neither do they wish to compress all the satisfactions of a lifetime into the present moment and fast forever after,73 which act by the same reasoning would prove a disposition to discount the present in favor of the future.
The error in the current reasoning is a wrong choice of a zero point from which to measure time preference. The correct basis is not everything to-day and nothing in the future; a more sensible form of question would be this: If one had to choose between enjoyment to-day with abstinence to-morrow on the one hand, and abstinence to-day with enjoyment to-morrow, on the other, which would be more desirable, all other things being equal? Or better still, if a man were given his entire income for a year in a lump-sum payment on January first, how would he distribute its expenditure through the year? There would clearly be no question either of eating it all up the first day or saving it all till the last day; a zero time preference obviously means a uniform distribution in time. Any piling-up of consumption at an earlier date to be compensated by reduced consumption later on would be a real discount of the future, while to skimp now for the sake of plenty or luxury in the future would be to discount the present. Of course, we abstract from the element of uncertainty as to the future. We seem justified in pronouncing either tendency irrational if other things are really reduced to equality in the alternatives.74
As to the facts of human nature it is safe to assume that different individuals would give the most varied forms of distribution. Doubtless few, if any, of these would conform to straight lines or smooth curves of any sort, ascending, descending, or level. Most would go in waves of greater or less period and amplitude, intervals of moderation or even abstemiousness alternating with "blow-outs" of various sorts and degrees. Irregularity seems in fact to be a virtue on its own account, at least to the spirited individual.75 Whether there would be an upward or downward trend would depend also upon the individual. To many, a bird in the hand is worth two or more in the bush, while others take much thought for the morrow. Some children, as Marshall remarks, pick the plums out of the pudding to eat first, while others save them until the last, and many do not pick them out at all; and adults differ in the same way. The improvidence of savages is proverbial. Of course, the physical conditions of life set limits to the discounting process in both directions; we cannot enjoy to-morrow unless we live to-day, and many have learned at a cost that too high a rate of living in the present may have a similar effect upon the capacity for future enjoyment. No generalization in regard to the human race at large seems to be worth making, especially in view of the unreality of any simple assumptions as to the conditions surrounding the choice. The facts of mere prodigality on the one hand and mere miserliness on the other are indisputable and may be studied without attempting to strike any precise balance.
It is perhaps even more important at this point to insist that the mere question of time preference in consumption is relatively unimportant at best as an explanation of the phenomenon of saving. The disposition to spend or to save, to consume income in the present or to store up wealth, is much more influenced, in fact, by other motives.76 Like human conduct in other respects it is mostly a matter of social standards, of what is "good form," "the thing" or not the thing to do. The fact of possessing an accumulation of goods confers social prestige and in addition vast power over one's fellows. Even where, as we are now assuming, productive employment is not open to wealth, the rich man will be in a position to make his favor solicited, his ill-will feared, and may, of course, turn his situation to material profit if so disposed. Accumulations are necessary to lavish displays or magnificence of any kind. On the other hand, we must suppose that where accumulation is limited to consumption goods, it will be subject to considerable costs, for storage, preservation, protection, and doubtless inevitable deterioration.77
It will be evident that differences among the individual members of society in economic position and taste with reference to the time of use of goods create a situation in which exchange will be mutually advantageous. To one, a present or early allotment of goods in advance of his own production and against an obligation to repay later will be or seem a benefit, while to another, with an accumulated and growing idle stock, a dependable obligation78 for the future delivery of a certain amount of value, may be highly preferable to the possession of the goods themselves.
If the balance of the time preference in the population as a whole is in favor of the present, no appreciable net accumulation of goods will take place. Those disposed to accumulate will transfer their surplus production as fast as made to others disposed to draw on the future. The conditions of supply and demand will establish a market ratio of exchange between present and future goods which in this case will show a premium on the present, the magnitude of the premium depending on the strength of the excess desire to anticipate the future. Obviously the premium on the present goods will constitute an additional motive for surplus production and a deterrent to surplus present consumption. The rate established will be that at which the amount of surplus present production will equal the amount of surplus present consumption. The repayment of loans does not affect the principles involved, as it is a repetition of the original transaction with the rôles of the parties interchanged. In the aggregate an excess of present consumption over current production is, of course, impossible.
If, on the other hand, the balance of time preference is on the side of a disposition to postpone, the result will be an excess for the time being of production over consumption with net accumulation in the society as a whole. The exchanges between present and future goods will establish a premium on the latter. The ratio at which exchanges take place must constantly be such as to equate the amounts of each sort of service offered in the market to the amount that will be taken at the price. With a premium on future goods, accumulation will continue at a rate depending in part on the amount of the premium, until the premium disappears or becomes equal to the cost of keeping the accumulated stocks. Any greater premium on the future is impossible as a permanent thing. But the conditions of accumulation might well be such that an indefinitely long time would be required to reach the equilibrium result. In that case the actual condition at any time is a premium on the future with progressive accumulation taking place.
The "premium" or time preference rate under the conditions described, though similar to (positive or negative) interest, must be distinguished from that phenomenon as it is met with in modern industrial life; it is, indeed, an element, but a relatively insignificant one, affecting the interest rate on loans of productive capital.79
Time value, presentness or futureness, is perhaps best regarded as a special sort of utility in a good, like nutritive value or beauty or any other quality conferring or enhancing desirability. The rate of payment for it, where separated from other considerations, is evidently determined by "psychological" considerations on both the demand and supply sides, and the current interest theory of the psychological school is based on a confusion of this phenomenon with interest proper as a distributive share. The subject of interest proper will claim attention at a later stage of the discussion. We shall find that interest in the correct sense may not be met with at all in a society where uncertainty is absent, even if accumulated wealth is productively used and even if the society is progressive with respect to the accumulation of capital, if knowledge and foreknowledge are complete.
We may now return, and in view of the knowledge obtained of the rôle of time in economic conduct take up the relations of property in the simple sense of productive agencies separable from the persons of their owners and subject to lease and sale. It must be borne in mind that for the present we exclude any possibility of either increase or decrease in the property or any physical change of such a character as to modify its functioning. Such changes and their effects belong to our third division of economics, which deals with changes in the conditions of the production and consumption of wealth. To realize static conditions they must be abstracted. It will be convenient to refer to property of the sort we have in view as "land,"80 since land has been conventionally treated as if qualitatively and quantitatively given once for all by nature. This is not at all the view of land which will be presented in this study when the time comes to discuss the subject. But it is a convenient name at this point for a productive agency of a certain described character. We assume, as a matter of course, that such property is limited in amount (i.e., subject to "diminishing returns") and that there is no other sort of property present in the society. On the production side, then, the side of demand, and in relation to functional distribution it will be exactly like other agencies (human services), but its presence may affect the personal distribution of income very considerably.
Supposing the final adjustment to have been reached in the organization of production, any piece of property such as described may be regarded as a right or title to a commodity or money income in perpetuity. As such, its bearings on conduct are closely related to the time distribution of consumption. A piece of land represents future goods in the very special form of a value income distributed uniformly throughout all future time. We may assume without argument that such a piece of property will be desirable and that under conditions of free contract a definite market rate of exchange between land and consumption goods will be established. More accurately this price will be a ratio between the income from the land (of which there is no significant measure other than its income) and a quantity of present goods also measured in value terms. The price could, therefore, be stated as a certain number of years' purchase or a rate per cent per annum, and represents the familiar phenomenon of capitalization. Our present problem is to formulate the conditions determining this capitalization rate.
Land will be in demand especially by persons disposed to store up wealth for future use; i.e., to discount the present. It is in effect future goods, but the manner of their distribution in the future imposes a new special limitation on the conditions of their demand. We have seen that it is reasonable and common for human beings to prefer future goods to present, within limits, as compared with a uniform distribution in time. Most civilized persons, in fact, plan for a rising standard of living through life rather than a constant, much less a falling one. But when infinite time comes under consideration the case is different.
Any finite amount of consumption or enjoyment distributed uniformly through infinite time becomes a zero rate of real income. Hence there must be an apparent discount on the future in the demand for perpetual income goods. Indeed, it is self-evident that future incomes must be discounted at some rate greater than zero or they would have infinite present worth. The discount of the present in favor of the future can hold good only for finite periods of time in a society where present goods are limited at all; i.e., under economic conditions. We must note also, however, that when a capitalization rate and a market price for land have been established, the land will be convertible at will into a fund of present consumption goods The existence of a free market for permanent income goods makes the apparent rate of time preference uniform for all real (finite) intervals. The individual who may not wish to keep on postponing to the end of a long period knows that he does not need to do so unless he wishes; for at any time he can realize upon his accumulation in present consumption form as rapidly as he may wish. There must be a premium on present over future goods in the market for perpetual income property; but such a premium, even if high, is not incompatible with a premium on the future over the present for any finite interval, and might perfectly well exist in a society where every individual and the group as a whole distributed its consumption in time in a curve ascending at any finite slope.
Under these conditions a person could arrange, by the purchase and sale of income property, for any desired distribution of consumption over any specified period, or, through an appropriate life insurance organization, over the uncertain period of his life. Those wishing to postpone consumption, to secure a rising distribution of real income, would buy such property in the earlier years and gradually sell it off in the later ones. Those wishing to anticipate future production and secure a descending curve of consumption would progressively sell off their land. (Persons possessing no land could make the anticipation arrangement only in the manner described above in discussing a situation where such goods were absent.) The society as a whole cannot anticipate future production unless there is some other society from which it can borrow. It can postpone in the aggregate only as in the situation above described, through an actual accumulation of consumption goods. The process of net accumulation would again tend toward an equilibrium with current production and consumption equal, though the goal might be an indefinite distance in the future. There must at any time be an equilibration of the two sorts of motives through the discount rate established, together with, in the case just mentioned, a certain rate of net accumulation.
The rate at which perpetual income goods are capitalized in the market is not yet a rate of interest in the sense of a distributive share. Nor would there be any necessity under the conditions we have described for lending money in connection with the transfer or use of income-bearing property (though consumption loans might be effected in much the familiar form). The capital loan for productive purposes is, as we shall presently see, a device for separating the ownership of value equities in production goods from the direct ownership of the goods themselves. It is mainly the presence of the risk or uncertainty factor which makes such a separation desirable. In a progressive society some motives for specializing to individuals other than the savers the function of making the investment might exist even in the absence of uncertainty. In the society which we have described with both uncertainty and progress absent, there would be no motive for lending or borrowing value funds for the purchase of productive agencies.[Back to Table of Contents]
Part II, Chapter V
Change and Progress with Uncertainty Absent
We turn now to the third grand division of theoretical economics, the study of the use of resources in the increase of resources for the making of goods and in the refinement of wants alongside of and alternative to their direct use in making goods for consumption. The relations of these three theoretical problems are somewhat complex and confusions in regard to them have been a prolific source of error in economic thinking. The first problem is the use of given goods in the satisfaction of given wants (with a given distribution of the goods to begin with, and free exchange) and its analysis and solution constitute the theory of market price. Market prices, besides determining the apportionment of given stocks of goods, the product of past industry, at the same time show the social estimate of the relative importance of different goods according to which the apportionment of resources under the second problem is worked out. In this first division, production goods do not enter at all, since costs already incurred have no bearing on price; as Jevons puts it, "bygones are forever bygones."
The second problem deals with the use of given productive resources in the production of goods to be used (always in accordance with market price principles) in the satisfaction of given wants; it has become known as the problem of the static society or "static state," and has two aspects. The first phase relates to the value of productive services separately; the second, to the values of particular consumption goods, in relation to the values of the productive services which go into them, or their costs; this is the problem of the long-time or normal prices of consumption goods. In a sense it is, as Marshall suggests, a case of two classifications crossing each other. The first problem classifies on the basis of consumption goods, showing the equation of the value of a commodity to that of the bundle of productive services entering into it. The second takes the productive service as a basis and shows the equation of the value of each unit of productive service to the value of the portion of each kind of consumption goods in whose creation it is used, for which it is responsible. The first is the long-time "value" problem, the second is the short-time "distribution" problem. The changes in supply (and value) of consumption goods are studied in relation to fixed conditions of production, including especially fixed supplies and methods of organization of productive resources.
The third general problem also relates to both value and distribution phenomena. Changes in the "fundamental conditions of demand and supply" of goods give rise to what Marshall calls "secular changes in normal price." But the principal "fundamental conditions" subject to change are the supplies of the different productive services which evidently affect still more directly the prices of these services, the distributive shares. Our discussion, like Marshall's, will be practically limited to this more simple and direct effect, the modification of the distribution situation, and its tendency toward an equilibrium.81
First, let us try to formulate clearly and accurately what is involved in the problem of progress. What new variables come in for study? What is the exact content of the "general conditions of demand and supply," or the "given resources used in the satisfaction of given wants," which our previous analysis has assumed? And finally, what are the changes in these factors which call for consideration in order to bring our society into the closest possible approximation to reality? Marshall, whom the present study more closely follows than it does any other writer, seems to avoid, not to say evade, answering this question explicitly. He does at one point begin an enumeration of elements, but cuts it short at once with the blanket expression quoted above.82 A well-known explicit list of static state or dynamic factors to be excluded is that of Professor J. B. Clark, whose name is especially associated with the contrast between static and dynamic problems in this country. He gives these five elements of progress:83 (1) growth of population; (2) accumulation of new capital; (3) progress in technology; (4) improvement in methods of business organization; (5) development of new wants. Professor Seager modifies this list, and in the writer's view greatly improves it, by combining the third and fourth factors and adding a new one, the impairment of natural resources or discovery of new natural wealth.
It will aid in clarifying the issues if we first consider separately the conditions of demand and of the supply of goods. Conditions of demand seem to include the following fundamental facts:
Given conditions of supply include especially the supply of the factors of production, but there are other vital considerations. We may classify as follows:
Combining the two groups and removing duplication we find the following factors in regard to which change or the possibility of change must be studied:
Systematic completeness would call for a survey of possible changes in each of these elements and the relation of such changes to both value and distribution phenomena, the prices of consumption goods and of productive services (and in addition their relations to the capitalization rate, the sale prices of productive agencies). No such ambitious program can be entered upon, however. We shall merely point out some of the more important price bearings of changes and make such comments as seem especially significant in illuminating dark places in theory. The point for especial emphasis is that the really far-reaching effects of change are not the results of the fact of change itself, but of the uncertainty which is involved in a changing world. If any or all of these changes take place regularly, whether progressively or periodically or according to whatever known law, their consequences in the price system and the economic organization can be briefly disposed of. Through the machinery of the exchange of present and future values all of them will be fully " discounted " an indefinite time before they occur. They will not upset human calculations or destroy universal perfect equalization of alternatives. Hence, in particular, changes, if foreseeable, do not disturb the prerequisites of perfect competition for productive services, bringing about exact equivalence between costs and values, with absence of profit.
As a matter of fact the effects of changes in the general conditions of the production and consumption of goods upon the prices of consumption goods are either so obvious or so complicated and hopeless of practical prediction that it does not seem worth while to attempt systematic treatment of them. Our discussion will be confined almost entirely to the theory of distribution. In this field, also, let us note that progressive changes can usually be fairly well foreseen and discounted and their effects are not generally important over short periods of time. They produce relatively little real disturbance in the competitive adjustment and are not a significant cause of profit. The significant disturbances and sources of profit are rather the short-period and erratic fluctuations, and the irregularities of progressive change, not the change itself. The increase in population and accumulation of new capital are not disturbing facts to any appreciable extent, and the disturbances arising from invention and improvement are due to the local and spasmodic way in which they originate, not to the general tendency.
In discussing the short-time theory of distribution (distribution under conditions of fixed supplies of productive agencies) we have repeatedly emphasized the absence of any valid ground for a general classification of productive agencies, either along the lines of the traditional three factors or along any other lines. That is, on the demand side they are alike or differ by innumerable imperceptible gradations, and for short-time problems the conditions of supply—given quantities in existence—are also obviously identical for all. The long-time point of view, however, brings in the new question of changes in supply, in regard to which there are real differences. These differences in the conditions of supply afford a basis for legitimate classification, somewhat along the lines of the tripartite division. It is superficially reasonable to recognize three categorically different conditions of supply. First we should have agencies whose supply is given once for all even over long periods, things not subject to increase or decrease, improvement or deterioration. The traditional definition of land fits this description. (We do not here raise the question whether anything exists to which the definition applies.) In the second place, some productive goods may be, and obviously are, freely reproducible in the same manner as consumption goods, under conditions in which supply becomes a definite function of the price of their services. The traditional view of capital gives it this character. (Again we make no assertions as to the correctness of the view.) And finally, the supply of still other agencies may be variable, but not a function of price, or not connected with price in an immediate or direct way. The traditional treatment of the long-time supply of labor (the merits of which are also reserved for later examination) differentiate it in this respect from other productive powers. This traditional classification is not accepted as valid, even from the long-time point of view, and will be criticized at length as we proceed. But the superficial basis for it and the fact that it is well established in the thought and terminology of the science may justify taking it as a starting-point.
The ramifications and interconnections of effects of any particular change are ultimately rather complicated, and may be followed out until nearly every aspect of the adjustment is modified in some way. This is obviously true of the first of the static characteristics named. Historically the population question has been considered with distribution in connection with wage theory through its relation to the supply of labor. Of course, an increase of population is an increase in the demand for goods and hence in the demand for all the productive services including labor itself. But the demand for any productive service depends finally upon two elements, the total output of industry and the relative importance of that service in increasing the output. In accordance with the law of diminishing returns and the specific productivity theory based upon that law, a relative increase in the supply of labor will increase the product of industry less than proportionally and decrease the relative productivity of labor. Both effects tend to lower wages per man. The same reasoning applies to any other productive service as well as to labor.
Much confusion has arisen in economic discussion through different meanings given to a distributive share. We may speak of wages, for example, as above, as wages per man, and similarly of other incomes in relation to the concrete agency which produces them. The problem of distribution from this point of view Cannan calls "pseudo-distribution,"85 seemingly an unfortunate term, for this is surely the phase of the subject in which we have the greatest and most direct interest. The classical economists themselves, led by Ricardo, usually centered their discussion around the fraction of the total social produce received by the "factor" under discussion. Another clearly possible meaning is the aggregate share of a "factor" measured in absolute terms.
The effect of an increase in a factor (meaning a large group of physically interchangeable productive units) on the fraction of the social income it will receive, depends on the rate of diminishing returns realized from the application of that agency to others in the vicinity of the proportions already in existence. If the increase in total production is nearly proportional to the increase in the factor (remembering that it cannot be equal or greater), its fractional share will rise; if much less, it will fall. The aggregate absolute share of income falling to the agency will increase unless the falling-off in product is in equal or greater ratio with the increase in the agency. Both points, however, are rather remote from the problem of immediate interest. If the income per unit is known, the relative and absolute shares of the factor can more naturally be determined indirectly.
Obviously a shift in the amount of any productive agency will, through its effect on incomes, react on the demands for goods, and ultimately affect nearly every feature of the organization of industry and of the price system. The resulting changes in the prices of consumption goods are what Marshall calls secular changes in normal price. It does not seem profitable, if indeed it is possible, to discuss these in the abstract. About the only general observation which seems worth making is that those goods in whose production any particular agency predominates will tend to fall in value as the supply of that agency increases, other things being equal.
The really difficult problem in the theory of progress relates not so much to the effects of particular changes. These effects, though complicated, can be traced out by the application of the principles of the market, the "laws" of supply and demand. The difficulty comes in the prediction of the changes themselves. What are the conditions of supply of the productive services? What changes in the supplies of the different services may be reasonably anticipated, and to what goals or equilibria do they tend? The question is of especial interest because it was in terms of these ultimate equilibrium levels that the classical theory of distribution was almost exclusively worked out. In our opinion the meaning of these equilibrium conditions was misconceived in classical economics and their significance perhaps somewhat overestimated. The early writers regarded the equilibrium condition as constantly at hand in a sense analogous to the normal price equilibrium between the production and consumption, cost and value, of consumption goods. Their "static state" was, if not the actual condition of society, a condition on which it constantly verged.86 It makes a great deal of difference in the theory when we recognize, as the facts require, that the equilibrium is an indefinite and usually a very great distance in the future. The condition must then be viewed as the theoretical result of a particular tendency only, which may be modified to any extent or reversed by the effect of other tendencies, or the conditions may be entirely changed by unforeseen developments long before any considerable approach to the equilibrium has been made. The equilibrium, then, in a particular case, is not a result actually to be anticipated; a concrete prediction of the future course of events must take into account all the tendencies at work and estimate their relative importance, and in addition must always be made subject to wide reservations for unpredictable influences. In fact, as we shall see, the interrelations of the various factors of progress are so complicated, and the functions themselves are so inaccurately known and are affected by so many unknown variables, that definite predictions extending any considerable distance into the future seem to be quite out of the question.
Turning now to the question of the conditions influencing the progress variables and of the changes to be expected in regard to each, we may begin with the factor of population once more and go through the list. The plan, of course, is not to investigate hypotheses at random, but to inquire seriously about the facts of the world we live in. The only arbitrary or unreal element in the procedure is the selection of the outstanding dominant features and their isolation with a view to ascertaining if possible their own inherent tendencies. The products of such an inquiry are, like all theoretical deductions,—all general principles,—partial truths which cannot be applied uncritically, but must be combined according to circumstances and supplemented with empirical data. Historic population theory, or Malthusianism, pictured laborers as analogous to a good supplied under conditions of constant cost. Wages were accordingly held to tend toward an equilibrium level equal to this cost, the (real or commodity, not money) cost of maintaining a static population. The premise was not, of course, that the production of laborers takes place from motives of pecuniary profit,87 but that in consequence of the physiological-psychological law of population, the supply varied in a strictly analogous way. The tendency of wages to the minimum of subsistence is indeed a natural and correct deduction from the tendency of population to press constantly upon the supply of the necessaries of life.88
This early version of the theory of the cost of labor was immediately recognized as untenable and gave place to the standard of living theory which depends for its validity on the assumption that the standard of living will remain stationary when the wage level changes. The classical economists recognized that an increase in the supply of labor will increase the food supply, but insisted that the second increase would be at a smaller ratio (Malthus's crude hypothesis of arithmetic versus geometric progression being replaced in the later work, especially that of Mill, by the scientific principle of diminishing returns).
Mill also recognized that the standard of living might not remain stationary if the wage level were raised, but was very pessimistic (much more so than Malthus in fact) about a permanent elevation of wages unless a wide gap could be produced and maintained for a generation between actual wages and the psychological standard controlling the population. The facts seem to be that if wages are suddenly raised through a general improvement in industry or the opening-up of extensive new natural resources, the population will increase, but the psychological standard which limits its increase rises at the same time. The new equilibrium should therefore be established with a wage level higher than the old. The historic facts are of this character. The modern industrial era began with the opening-up of vast new regions to European civilization, and the movement has gone on ever since, though recently at a slackening pace. The improvement of technology has perhaps accelerated in velocity clear down to the present. The world population of European stock has increased four or five fold, and the average standard of living (if definite meaning can be given to this concept) is also vastly higher. The relative amounts of the two changes could not be measured; the writer's conjecture would favor a vindication of the Malthusian hypothesis on the whole. Certainly both changes are still in full swing.89
The most serious omission in the classical reasoning was that already referred to, the neglect to allow for the length of time required for the long-time adjustment to work itself out. Not merely may innumerable "other things" interfere with the logical course of events, but it is a serious error to view the condition of equilibrium as an approximate description at any given time. The fact of the rapid increase in the population of the industrial world, still going on, proves that the wage level has been and is far above the psychological minimum standard. It would be idle to speculate as to the length of time which would be required to bring about the equilibrium adjustment even if other things were to remain equal. It is theoretically impossible to formulate the condition of equilibrium unless the amount of disparity between present wage level and psychological minimum is accurately known, and in addition the relative rates of change of the two, corresponding to this and all lesser differences between them.
Changes in the physical composition of a population do not call for detailed discussion in this brief survey. The principal facts to be noted would be differences between an increasing and decreasing population and changes due to immigration, emigration, and internal migration. If we abstract from all human interests which do not effectively manifest themselves in the market, and assume perfect intercommunication and freedom of movement, the migration factors would quickly come to an equilibrium.
The second of our progress variables is the psychological element, the dispositions and tastes of the people. Like the number and composition of the population, it affects conditions on both the consumption and production sides of the problem. Changes and great changes do, of course, take place in wants for consumption goods and in attitudes toward different lines of productive activity.90 Most of these changes cannot profitably be treated as functions of price and no conditions of equilibrium can be formulated for them. They remain in the class of external disturbing causes little subject to prediction, especially on the production side. Tendencies can often be noted, such as the "lure of the city" which now operates to increase industrial production at the expense of agriculture. In America the irrational preference for white-collar jobs has raised the wages of mechanics above those of clerical tasks calling for much more ability and education. Other preferences and vogues for particular kinds of work must be passed over with the mere pointing-out that they are part of the given conditions of the economic process and that changes in them have widely ramified effects. These considerations apply to uses of property as well as to personal powers, though in a much less degree.
On the consumption side there is a very important problem more amenable to scientific treatment, though still very treacherous to deal with. We refer to the familiar fact of the use of economic resources by private business to develop, create, or direct consumptive wants; i.e., the phenomenon of advertising.91 The increase of value through advertising, whether informative or merely persuasive, is quite parallel to any other form of production, or "creation of utilities." Such values are largely transferred from other goods, but except in so far as they result from a positive disparagement of competing commodities they are to be regarded as merely an additional utility in the advertised commodity.92
The business of want creation is, of course, very uncertain and aleatory or "risky"; but it is evident that, as with other changes, in so far as the results of action can be foreseen, competition will equalize gains with those in other fields. Costs will then be equal to values throughout the system, the conditions of profitless adjustment being present. Whether the creation of wants is subject to diminishing returns, the process consequently tending toward an equilibrium, where it would no longer take place, or whether it is inherently a perpetual cause making for continued change, is a matter we cannot discuss on its merits. The writer's guess would favor the latter alternative.
In regard to the third progress factor, the amount of productive resources in existence, the first question relates to the classification of these resources from the standpoint of changes in supply. We have shown above that differences must be recognized somewhat along the lines of the conventional tripartite division, but we must emphasize that the differences have been much exaggerated and that definite classification along the traditional lines cannot be maintained.93
The long-time conditions of the supply of labor consist of two elements: The first, the population, has already been discussed. The second is the factor of education, taken in the broad sense. Now training, which results in increased productive efficiency, is evidently similar to a material productive agency or capital good created by the diversion of resources from present consumptive uses. Even the population itself, as observed above, depends to a large extent upon considerations of pecuniary profit in the case of the social classes which subsist mainly by labor. The distinction between labor and capital thus shows a tendency to fade away. A degree of distinction, indeed, persists. Technical training cannot be sold or leased for use separate from its owner, and cannot in any direct sense be perpetuated beyond the owner's working life. Capital is at least less attached to its owner's personality (it is important to note that it is never absolutely detached) and may function in perpetuity. In addition the investment in education is more affected by other than profit-seeking motives, and in consequence is not so closely adjusted by effective competition to equality of return with other forms of investment.94 Investment in the improvement of human powers is rather a long-time proposition, yet does not look so far ahead as many other forms of investment; in other ways, however, it is subject to a very high degree of uncertainty. After all there seems to be as much difference between different cases or types of labor production and between different varieties of material productive goods creation as there is between the two classes of investment of resources as types. In so far as uncertainty is absent and competition obtains, it is clear that investment will distribute itself between the two fields and over all parts of each in such a way as constantly to equalize their net advantages. Which is to say (remembering that costs merely register competing attractions) that with uncertainty absent costs and values would be equal throughout the system; that is, there would be a perfect, profitless organization of production and exchange.
There is a fundamental similarity in the conditions of supply of all the productive services involving the investment of resources. In every case there is a diversion of productive power from use in making present consumption goods to the creation of sources of new consumption goods income. A discussion of the conditions of equilibrium for any of them will therefore be postponed until all can be dealt with together. The general theory of equilibrium in this case is in fact the long-run theory of interest.
The classical economist treated land, or natural agents, as given in supply. This assumption was the basis for propounding a theory of rent different from the reasoning by which the other distributive shares were explained,95 and for positing a special relation between rent and cost. The definition given for land to make it fit the description of a fixed supply—the original and inexhaustible powers of the soil—is indeed drastic in its limitation. Later, this dogma of unconditional fixity of supply was made the basis for the single-tax propaganda. We cannot discuss this position at length, but must take space to remark quite briefly that it is utterly fallacious. It should be self-evident that when the discovery, appropriation, and development of new natural resources is an open, competitive game, there is unlikely to be any difference between the returns from resources put to this use and those put to any other. Moreover, any disparity which exists is either a result of chance and as likely to be in the favor of one field as the other, or else is due to some difference in psychological appeal between the fields; i.e., goes to offset some other difference in their net advantages. Viewing as a whole the historic process by which land is made available for productive employment, it must be said to be "produced"; i.e., to have its utility conferred upon it in a way quite on a par with that which holds for any other exchangeable good. This, of course, again abstracts from the factor of uncertainty. In real life a large speculative element is introduced; but this cannot be said to differentiate land generically from any other class of goods, though the results are met with on an especially large scale in the case of land.
A new form of productive resource has become of very great importance in modern society, consisting of special methods of production or exclusive technical processes, whether patented or kept secret, or merely not "yet" extended in use over the whole field of production. Such a process is a source of income like any other agent, and is produced in the first place in the same way, by the investment of present resources (in research and experiment). They are different from most capital goods, however, in that their cost of maintenance and multiple reproduction is so low96 that it is profitable to multiply them to the point of becoming free goods, except in so far as they inhere in the persons of their possessors. They thus tend to revert to the category of enhanced individual capacities, unless in some way "monopolized." New productive processes are like natural resources in being produced under conditions in which the gambling element is large, but in so far as the results of operations can be foreseen they also tend to equality of return on investment in comparison with other fields.
We turn, therefore, to the ordinary and simple case of the investment of resources in the creation of new productive capacities; i.e., to the case of capital goods. In this connection we can conveniently discuss the general case, subsequently returning briefly to the problems of human powers, natural agents, and productive methods just mentioned. The argument will be closely related to, in fact may be said to take up and continue, the discussion in the last chapter on the subject of time preference and the purchase and sale of productive goods. We now have the further complication that our productive goods are no longer fixed in supply, but that opportunity exists for the indefinite creation of such goods through the diversion of resources from the production of present consumption goods. For it will be seen that to the individual the investment of present goods (their use to pay productive agencies while the latter, being liberated by the "advance,"97 devote themselves to the making of the new equipment) is equivalent to their exchange for productive services already in existence in the possession of others; it is an alternative method for securing the same result. The previous discussion of the motivation involved, therefore, applies to the present case; i.e., it fits the assumptions usually made as to the motives for capital formation. We would emphasize the importance of a new motive not present in the former hypothetical case, the opportunity to create, which we hold to be a motive on its own account very distinct from, or at least very much more than, the mere desire to possess the thing created. However, in this brief survey, it seems necessary to abstract from the complicating factors in the motive for saving and to treat new productive equipment as a perpetual value-income merely (with the possibility of cashing in by sale at any time, as in the previous case).98
The demand for capital goods is, therefore, merely the demand for future income, already discussed. Assuming a static and universally known technology, all forms of such goods will necessarily be kept at a uniform level of productivity in relation to the investment necessary to create them, and they can be treated as a homogeneous class. The demand for capital goods in industry, like that for any other productive agency, is subject to the twofold law of diminishing productivity already familiar, and the more of such goods created the lower the value income they will yield, in terms of the goods themselves measured physically. But the base on which the investor figures is not the physical productive goods created. These are as non-existent to his calculation. He is interested exclusively in the relation between (a) the amount (i.e., value) of present goods he gives up and (b) the size of the value income which he receives. Hence, we have in this case a really fourfold law of diminishing effective demand: (1) The creation of producers' goods involves a diversion of resources from the making of consumption goods, and this transfer takes place subject to diminishing physical returns. The sacrifice of a given amount and kind of consumption goods makes possible the creation of a smaller amount of any given kind of capital goods the further the process is carried.99 (2) Those productive goods which are more readily multiplied by the investment of resources must increase relatively to the other agents with which they are combined in production, and become subject to diminishing physical returns in their use. (3) To the extent that the relatively increased agencies enter into the production of certain commodities more than of others these commodities will have their supply relatively increased and will fall in price relatively to other commodities. (4) Finally, as present goods are progressively sacrificed to the creation of future income, the relative preference of the latter to the former must fall off as more of it becomes available.
Other things being equal, the investment of resources should ultimately be carried to a point of equilibrium at which the amount of value income and the amount of present value which must be sacrificed to create it become equal to every person in the system. As long as the income which can be produced by sacrificing a given amount of present goods has a sufficient appeal to induce new savings, the new savings must continue to be made and to reduce the amount of value income obtainable from a given amount of investment. A point must ultimately be reached at which the product of investment is just attractive enough to hold in existence capital already saved, without calling forth new savings. Of course some individuals may at any time be consuming capital previously saved, while others are saving and investing, provided the two offset each other.100
The above is a brief statement of the "eclectic" theory of interest. The equilibrium ratio of the annual value income yielded by the capital goods created to the present value sacrificed in creating them—that ratio at which no further net conversion (saving and investment) takes place—is the theoretical long-time rate of interest. It is the magnitude toward which, as Marshall says,101 the interest rate constantly "tends." Of course, "other things" must be assumed to be "equal." But in the nature of the case other things are not and cannot be equal. As investment takes place, the new income derived from it makes the saving of any given amount constantly easier, thus progressively changing the conditions of supply of new capital. In addition it is inconceivable that wants and tastes, or even the state of the arts, should remain static while such an adjustment worked itself out. The theory is logically sound if correctly understood. It describes conditions under which the interest rate would not tend to change, and is of service in predicting the future movements of the rate: But it gives a very incomplete view of the facts which must be taken into account in an actual prediction. Changes in the other things—especially the psychology of spending and saving (partly a matter of the size of income)—in the given amounts of agencies not freely reproducible through investment, and the development of technology, not to mention wars and other catastrophes—do in fact commonly exert quite as much influence on the interest rate as does the tendency to equilibrium due to progressive saving and investment.102
But the most serious criticism to be made of the eclectic theory as it is currently presented (e.g., in Marshall) is its failure to recognize the true meaning of the equilibrium, and its assumption that actual conditions at a given time approach that state. The contrary is true; the case is similar to that of population already discussed, but more striking and important. At a given moment in a society where new investment is taking place the rate of capitalization is the technical ratio of conversion of present goods into future income. It is the "productivity" ratio of new investment, the ratio between the annual value yield of the capital goods to be created103 and the value of the present goods sacrificed to create them. Where the possibility of conversion—of saving and investment or of consuming capital already in existence through inadequate maintenance—exists, it cannot be otherwise. The psychology of saving and spending can have no appreciable influence on the interest rate at a moment. The supply of capital is not for short periods a function of the interest rate, but a fixed physical fact. Changes in psychical attitudes may cause people to save (or consume) a little more or a little less, but the effect will be insignificant in comparison with the total supply and demand of capital in the society. The rate of time preference fixes the rate at which new capital accumulates, and influences the rate of interest at future times, but not at the moment. The possibility of conversion impels every individual to equate his time preference rate to the existing productivity rate, which is causal, by saving more or less of his income or consuming more or less capital already saved.
There are no limits to the time which may be requisite at any moment to bring about the equilibrium adjustment, even assuming all other things static. Throughout the modern industrial period the rate of interest has been above the equilibrium level, social conditions being as they are (including human psychology, the mores, and especially the concentration of income in a few hands), as is proved by the fact that capital has constantly and rapidly accumulated. How long it would take to reach the equilibrium, if the demand for capital and other things remained constant, depends on the rate at which people save corresponding to any divergence between the actual interest rate and the equilibrium rate (allowance being made for the increase in income and reduction in the psychic cost of saving) and the rapidity of operation of the law of diminishing returns in the application of new capital to other productive agencies existing in society. Historically, of course, the other things have been so far from equal—especially the demand for capital has increased so rapidly through the increase of population and opening-up of new natural resources—that the interest rate shows an astonishing constancy. We should note, also, that improvements in technology generally tend to economize labor and land and relatively increase the demand for capital. The conditions of equilibrium we can formulate; the actual course of the events which are to bring about those conditions or the length of time they will occupy are probably matters of pure and unfruitful speculation. It is quite unnecessary to believe that there will really be any progress toward equilibrium, and it goes without saying that the failure of such progress to occur militates against neither the logical soundness nor the practical utility of the theory itself.
The above analysis does not refer to an interest rate in the ordinary sense of the term, but merely to a capitalization rate or ratio of exchange between present consumption goods and income property which is also the ratio of productivity of investment to the investment where the opportunity for investment is open. It is not clear whether the phenomenon of lending free capital at interest would be met with in a society where uncertainty was absent. The capital loan is an institution or device for separating the ownership of the value of a productive agent from the ownership of the concrete thing itself. The principal, if not the only significant motive for this separation, is the uncertainty as to future changes in the value of the agents. Where this value is not subject to change, or where it is variable, but the variations are predictable, the sale price of the agency will inevitably be such as to make it a matter of complete indifference to a prospective user whether he leases the agency or buys it with borrowed funds. The loan contract is an alternative to a rental contract. Producers borrow capital and invest it, converting it into productive goods by "advancing" it to laborers, landlords, and capitalists, who furnish the resources to make the new equipment. It is apparent that the original owner of the capital could just as well invest it himself and lease the agencies thus created as to lend the money. Investment would be a practically costless operation in a world where the future was perfectly foreknown. However, it may be reasonable to suppose that the inevitable minimum of care and trouble would be sufficient to specialize the investment function and separate it from the furnishing of the capital. If so, the capital loan and interest proper would appear, the rate of interest being, of course, the capitalization and productivity ratio just discussed (less pay for investment costs if these were appreciable).
After investment is once made we have already observed that the income is simply a matter of the value yield of the goods, and the value of the agency is determined by capitalization of this yield at the interest rate determined in the market for free capital. But with freely reproducible productive goods this value can never diverge appreciably from the cost of production. Capital goods in fact differ widely in the length of time required to adjust supply to changes in demand. If there are any agencies not subject to reproduction through investment at all, they conform to the classical description of land. It is the writer's view that such agents are practically negligible and that in the long run land is like any other capital good. Investment in exploration and development work competes with investment in other fields and is similar in all essential respects to other production costs. The distinction between goods relatively flexible and those relatively inflexible in supply and the recognition of a special category of income (Marshall's "quasi-rent ") for the latter is possibly expedient. With uncertainty absent such a distinction is, of course, irrelevant.
We must deal briefly with the remaining items in the list of factors assumed invariable in discussing the static state. The fourth was the distribution of ownership of productive services. The only points to be noted here are that the condition affects personal powers (labor) in precisely the same way as property, and that the facts depend entirely on social institutions. It is only because we have been accustomed to it that we think in terms of rights to income from either inherited property or inherited ability. Nor is it any more inevitable that out-and-out ownership (nearly unlimited right of control plus right to entire income) should be conferred even for his own lifetime upon an individual who by the investment of present income has developed productive powers, whether in his own person, or in produced capital goods, or by the discovery and development of natural resources.104 That we should separate the two categories in our thinking, taking property rights for granted in the case of inherited personal powers and stigmatizing the yield of inherited material goods as "unearned income" seems to be quite inexplicable. Society will always have to find some way to encourage the development and serious, interested use of productive capacities of all sorts (as it may always have to recognize family relationships in securing continuity of control from one generation to another). But many other ways are conceivable for doing these things, though their practical availability is not a subject for discussion here. It is to be noted that society is now progressing rapidly in the limitation of ownership, on both the control and income sides; more and more restrictions are being thrown around the use of property and the conditions under which an individual may agree to work, and more and more income is being taken through taxation for "social" purposes.
In regard to geographical distributions—much might be said on this neglected topic, but space and the plan of this work do not permit. The question of mere concentration of population, irrespective of where it is concentrated, i.e., of city versus country, is far-reaching and fascinating. Immigration and emigration and internal migration are obviously important and intricate problems. In this field also we can recognize the condition of an ultimate equilibrium wherein the advantages of all locations would be equalized; and here also progress toward the theoretical goal is slow in comparison with the interval which separates us from it at any particular time. Changes in wants, and activities directed to change wants from motives of private gain, are especially important in this connection. It is hardly too much to say that the political as well as economic history of America has been dominated by real estate speculation and by the cheap money controversy, largely an offshoot from the former. The actual distribution of population is, of course, largely determined by the distribution of natural productive resources and by the topography of the country in relation to transportation; partly also by mere desirability of locations for residential purposes. But it is interesting to observe that considerations of consumption and social motives alone would probably bring people together in groups of all sizes and degrees of compactness even in a world whose physical conditions were absolutely uniform.
Static conditions include finally static technology and knowledge in general, and this is one of the most treacherous concepts of all as a subject for scientific discourse. Activities directed to the increase of knowledge may be very productive, but it is too great a strain on the imagination to try to think of their results as being predictable in a particular case. We have, however, an approach to predictability in large groups; in many fields research can even now be carried on more or less "intelligently" where the scale of operations is sufficiently large. It seems almost fanciful also to speak seriously of a condition of equilibrium where the rewards or chances of reward from further effort would no longer be adequate to entice productive energy into this field. But it is clear that even here, in so far as results can be foreseen, resources will be distributed so as to secure equality of return over the whole field of investment and under competition every value realized will be just equal to the cost incurred in creating it. In this field uncertainty is indeed an inevitable concomitant of progress. Yet there is an approach to predictability, a variation in the amount of unpredictability independent of variation in the amount of progress and the two factors must be separated in the causal analysis, for their effects are very different.
This completes the list of progressive changes. In every case the necessary and sufficient condition of a perfect, remainderless distribution of the product of industry among the agencies causally concerned in creating it, in addition to perfect competition itself, is that the change can be anticipated over the period of time to which producers' calculations relate. Where the results of the employment of resources can be foreseen, competition will force every user of any productive resource to pay all that he can afford to pay, which is its net specific contribution to the total product of industry. No sort of change interferes with the no-profit adjustment if the law of the change is known.[Back to Table of Contents]
Part II, Chapter VI
Minor Prerequisites for Perfect Competition
In Part Two we have attempted an analytical construction of a perfectly competitive society, with a view to determining the precise meaning of the theoretical tendencies of a private property, free exchange organization of society, and especially the conditions necessary to the realization of those tendencies. The abstract conditions first enumerated in chapter III represented in part divergencies in degree only from real life, and were in part arbitrary abstractions from fundamental characteristics of the pecuniary organization made for the purpose of a separate study of the constituent elements. Those of the latter type have been dealt with in chapters IV and V, and the result, up to the present point, is an outline picture of the essentials of a perfect competitive system.105 The first, rather preliminary, objective of the study has thus been achieved, as far as the author is prepared or feels it advisable to go. The second and more fundamental purpose is to contrast this ideal, perfect competition with the facts of ordinary life, to examine the limitations of the general principles developed, and to inquire as to the directions in which they must be supplemented by detailed, empirical data before completely applicable conclusions can be drawn.
But it is not the intention to cover this field with any great degree of exhaustiveness. Only one of the theoretical simplifications is to be studied in detail, the assumption of perfect knowledge. Part Three of the essay will be devoted to a discussion of the meaning and consequences of uncertainty, the incompleteness and inaccuracy of the beliefs and opinions upon which economic conduct is based. But it is desirable to have as a background some brief notice of the other abstracted factors.106
It will readily be seen that many of the objections to the pure theory of distribution commented upon in chapter IV relate to these necessary scientific idealizations, and have real significance as limitations on the completeness and accuracy of the generalizations of theory. They are not, therefore, valid objections to the theory and have been advanced as such only because of the common failure to comprehend the nature of scientific reasoning, the meaning and use of general principles. This is especially applicable to the first point to be noticed, the assumption of continuous variability in the magnitude of all factors dealt with. The question of the size of the "marginal unit" is clearly relative to that of the flexibility of industrial organization, and the two must be considered together. When we give up the illicit procedure of funding productive agents into "factors" and deal with the actual competing units on their own account, this problem becomes of practical significance and constitutes an effective limitation on the application of the theory. In the case of labor especially, with which we are here particularly concerned, the human individual is a very effective unit; not only does he bargain as a unit, but he cannot practically be divided up between different establishments, and the range of occupations in which he can engage in any short interval of time is also very narrowly restricted. He may also be in a high and surprising degree unique; he does not always shade off by imperceptible gradations from one variety to another to the extent that perfect competitive imputation demands. His numbers (in proportion to the number of variants) are not nearly always so large as to make an individual a negligible fraction of a group of similars.107
As a consequence of the appreciable dimensions of the natural agent, the flexibility of the economic organization as a whole is restricted, and the criticism made by Mr. J. A. Hobson and Professor Wieser against the productivity theory is true to a considerable extent in many individual cases. There are many productive organizations consisting of small numbers of rather unique agents which very effectively supplement each other and are not so effectively demanded elsewhere. In such a case competition does not afford means of distributing the entire yield of the group among its members; an appreciable part of it resists automatic division and remains a joint product, dependent on the peculiar effectiveness of the particular organization. Many partnerships illustrate this point. Imputation goes as far as the group, giving that its proper income, but fails to distribute accurately within it. In case of a partnership this division between the members is usually made on ethical grounds or on the basis of "bargaining power," sheer personal force. In industry at large the special product of the organization above that competitively assigned to its components is likely to go, largely at least, to the entrepreneur, though bargaining power or the strategic situation always plays a large part in the proceedings.
The same factors give rise to a peculiar difficulty in dealing with the law of diminishing returns. When any agent is by its physical nature or any particular circumstances available only in relatively large blocks, so that only a few, perhaps only one, is used in a single competitive organization, the technological features of particular combinations may cause apparent exceptions to the "law" at some points; these may be apparent for certain sections of the curve for the simple reason that one element is not subject to decrease and the best proportions can be secured only by increasing the other elements. A conspicuous example is the case of railways, the principal crucial "agent" being the right of way. If the demand for transportation were large enough to require an indefinite number of tracks the curve would be smoothed out and would ultimately show increasing costs from the other elements in the equipment. So with gas or water mains, until a certain size has been reached, and many similar cases. The fact of limited divisibility is responsible for all differences in the economy of operation of establishments of different sizes. The amounts of certain agencies or elements in the operations not being continuously variable, other things have to be proportioned to them to get the best ratio, thus imposing restrictions on the size of the plant as a whole. Many, if not most, of these questions of size ultimately come back to the human being as a relatively indivisible unit.
Preliminary to a discussion of predatory activity, or acquisition which is not production, we must again refer to the question of the ethical implications of the productivity analysis. The purely causal meaning of productivity in a scientific explanation of economic phenomena is apt to be confused with social or moral issues which belong in an entirely different sphere. We have insisted that the word "produce" in the sense of the specific productivity theory of distribution, is used in precisely the same way as the word "cause" in scientific discourse in general. But the word "cause" itself is vague in ordinary speech, and it is natural that confusion should arise in regard to the economic synonym. For example, the socialists, with no lack of suggestion and justification from the loose usage of words by economists of non-socialistic schools, have insisted that all wealth is "produced" by labor. We need do no more than mention the names of Smith and Ricardo in this connection, while among contemporary writers Professor Taussig exemplifies the same practice, expressly stating that labor produces all wealth, but may not be entitled to all.108 We should say that the reverse is more correct, that labor does not "produce" all wealth, but may be entitled to all, on ideal grounds.
Inasmuch as any assertion of a cause and effect relation between particular events is always (as already pointed out) made on the ground of some special human interest or "bias," there is much justification for such usage, but this only makes the more imperative, a clear separation from the "scientific," use of causal terminology. Thus it is quite proper to say, in ordinary speech, that the cook "prepares" the meal, that the opening of the throttle of the locomotive by the engineer is the "cause" of the starting of the train, and that his failure to see the signal is the "cause" of the wreck and the deaths of the passengers. In an analogous way a small group of agents might for some purposes be credited with nearly the whole output of a large establishment; "other things equal," the product depends on their coöperation.
But it must be evident that scientific economics cannot use the word "produce" in this sense. The product of any productive service can for scientific purposes be only what we have defined it to be, that which is really dependent upon the service in question, that which can be produced by its aid and which cannot be produced without it, in the social situation as it is, allowing for the change in organization which would accompany its withdrawal from use. It follows that we cannot properly speak of the "product" of an economic "factor," even if we use the word "factor" in the possibly legitimate sense of a group of physically interchangeable things. The product of "labor," "land," or "capital," as aggregates, involves a still more illicit and meaningless use of terms. The only specific product which can be recognized is that of a single agent as such, an individual human being or machine, or such a parcel of land (or of liquid capital) as is actually bargained for and used in the production process (and for perfect competition to take place it must be negligible in size).
More important, however, is the error of attributing any sort of moral significance to economic productivity. It is a physical, mechanical attribute, attaching to inanimate objects quite as properly as to persons, and to non-moral or even immoral as well as virtuous activities of the latter. The confusion of causality with desert is an inexcusable blunder for which the bourgeois psychology of modern society is perhaps ultimately to blame, though productivity theorists are not guiltless.109 We must guard against thinking of the "natural" adjustment of the competitive system as having any moral import, though it is of course "ideal" in the scientific sense of being a condition of stability. To call it the "best possible" arrangement is merely to beg the question or to misuse words. The natural arrangement is only that under which, with the given conditions as to the demand and supply of goods, especially the existing distribution of productive power, no one is under any inducement to make any change. If we pass over the question of how far individual wants for specific things really dominate conduct, and neglect equally the whole category of wants for certain social relationships and interests in other individuals (not absolutely dependent), and assume in addition (we shall investigate the point presently) that no interests are involved in any exchange except those of the direct parties to it—then the result is a mere mechanical equilibrium of the pull and haul of interacting individual self-interests.
It is imperative that we bear in mind that the serpent's tail is always in the serpent's mouth, that what the competitive system tends to give back is just what is put into it in the way of human motives and human powers, natural, acquired, or conferred, and has in itself no moral attribute whatever. In real life the possession of property (or superior training) is supposed to represent saving or invention or some contribution to social progress. But it is clear that there is no technical (much less moral) equivalence between these services and the right to their entire fruits in perpetuity, and to confer it on one's heirs and assigns forever—particularly when we consider the enormous element of pure luck in all operations of this sort. The only sense and the only degree in which rewards for service are ethical is that of the necessity of paying the reward in order to get the service performed. From this point of view the only defense of most of the existing system is the difficulty of suggesting a workable alternative.
We must now turn again briefly to the point mentioned above, the extent to which outside interests not represented in agreements between individuals are affected by them (otherwise than through direct competition in the market). The mere mechanical effectiveness of competitive free contract in producing a reconciliation of individual interests under given conditions depends largely on the answer to this question. Obviously, outsiders may be affected either advantageously or disadvantageously. In the former case voluntary agreements will not be carried far enough to secure maximum social (total individual) advantage, while in the latter case they will be carried too far. These facts form the most important source of the need for social interference. Many services, such as communication and education, not to mention the administration of justice, confer a general benefit on the community in addition to the special benefit to the individual, and must be encouraged by bounties or actually taken over and performed by public agencies or they will not be developed to the point of maximum benefit. The most familiar illustrations of the opposite case in our society relate to the use of land for purposes which damage the neighborhood, or are thought to do so. It is perhaps of nearly equal importance that improvements on land and industrial developments generally may benefit neighboring property, and might be made much more readily and in ways involving less injustice if there were some practicable way of assessing these benefits. This is notably true of public and quasi-public works, which effect enormous uncompensated transfers of values. It may be doubted whether in fact any agreement between individuals is ever made which does not affect for good or ill many persons other than the immediate parties, and a large proportion have wide ramifications over "society."
In this brief sketch we can only mention and insist on the fundamental importance of the fact that a large part of what men want relates directly to other members of society. Man is, after all, zoön politikon and quite on a par with his personal needs are all sorts of interests in furthering the plans of people whom he likes and, always relatively and generally absolutely, obstructing those of others, in a wide scale of gradations down to Thackeray's " 'e's a furriner; 'eave a 'arf a brick at 'im!" or, "kill the nigger!" The relative importance of other-regarding motives and desires, directed not to material things, but to forms of social relationships, is sure to be underestimated by any one treating economic phenomena in a "scientific" way.
The extreme phase of the problem of the moral character of the economic system relates to positively predatory activity. Davenport, following Veblen, has stressed the contrast between (private) acquisition and (social) production, making much of the hiring of sluggers, assassins, and incendiaries as part of the demand for labor, the productivity of burglars and their implements, and the like. It is not really very difficult in most cases for one who is disposed to do so to distinguish between theft or brigandage and free contract, and perhaps all that is needful to say of them in treating the theory of contractual organization is that they are obviously outside of it. A large part of the critics' strictures on the existing system come down to protests against the individual wanting what he wants instead of what is good for him, of which the critic is to be the judge; and the critic does not feel himself called upon even to outline any standards other than his own preferences upon a basis of which judgment is to be passed. It would be well for the progress of science if we had less of this sort of thing and more serious effort to formulate standards and to determine the conditions under which free contract does or does not promote individual interests harmoniously and realize social ideals. In addition it is most desirable that some attempt be made to separate the evils for which the form of organization is more or less reasonably blamable from those which are inherent in nature and human nature, or in organization as such, irrespective of its form, and to keep the question in view, in criticizing the exchange system, of whether any other conceivable system would offer any possible chance for change or improvement.110
There is a close connection between the moral aspect of the economic order and the problem of monopoly. This subject is of especial importance in the theory of profit, since profit has often been ascribed wholly or in part to monopoly gain, as already noticed in the case of Macvane and the Clark School. "Monopoly" is a word used to cover things which for present purposes must be kept distinct, and its meaning must first be made clear. Monopoly is usually defined as the control of the supply of a commodity. A common but disastrous error is the confusion of control with natural limitation of supply. We need not pause longer than to characterize as a serious misuse of words the denomination of land rent, for example, as a monopoly income. Even J. S. Mill fell into the error of defining monopoly as limitation, and it is exemplified in its extreme form by Mr. F. B. Hawley, who virtually calls all income due to the "scarcity" of any productive resource a monopoly return. Now, as all income, from the distributive standpoint, is dependent on the scarcity of the agents which produce it, and all in exactly the same way, the meaninglessness of such a description is apparent. And of course the same applies to "scarcity income" in general, whether called monopoly gain or not. There is under free competition no other sort of income, qualitatively or quantitatively, and the designation neither distinguishes or in any significant way describes anything.
It is no part of our present purpose to go into an exhaustive discussion of monopoly, and we may pass over the ordinary type of the phenomenon very briefly. In its original meaning the word signified an exclusive right to produce or sell a certain commodity, and was essentially a legal concept. The "legitimate" representative of the type in modern industry is the patented article for consumption—not patented production process (including machines, etc.), which will be considered later. Monopoly may also be based on mere financial power, on the threat of local underselling, boycott, and other forms of "unfair competition"; this amounts in effect to a voice in the control of property owned by others or their persons as well; that is, to part ownership. Free competition, of course, involves the complete, separate ownership of every productive agent or natural unit, and the exploitation of every one in a way to secure its maximum value yield. Any sort of violent interference with competition manifestly contradicts this assumption and may be roughly designated monopoly.
In the same category of monopoly (control of a consumption good) we may place two other varieties significant in the modern economic world. The first is the "corner," in which only a temporary control is secured, amounting in reality to control over the time of marketing of an existing stock not subject to rapid increase at the moment by further production. The other is the use of trademarks, trade names, advertising slogans, etc., and we may include the services of professional men with established reputations (whatever their real foundation). The buyer being the judge of his own wants, if the name makes a difference to him it constitutes a peculiarity in the commodity, however similar it may be in physical properties to competing wares. And the difference from physically equivalent goods may be very real, in the way of confidence in what one is getting. Such goods are then commodities whose supply is controlled by the producer, and competition with other makes or brands is a case of substitution of more or less similar goods, such as a monopolist always has to take into account.
A monopoly, of the category described, is evidently "productive" in the economic or mechanical causality sense. It may be viewed either as a separate productive element, in which case it is property in perfectly good business standing, and may be exchanged for other property on an income basis. Allowance will be made for the security of the income, but this allowance is perhaps as likely to be in favor of the monopoly as against it. Or we may take the view that the monopoly of a consumption good confers superior productivity on the agencies producing it, above physically identical agencies in other uses. As long as these are debarred in any way from producing the monopolized good the effect is the same as that of a physical incapacity to do so, and they are, like the branded article, economically differentiated, however similar physically. If the monopoly is of the character of a patent, and freely salable separately from the plant producing the goods, it is better to treat it as a productive agency on its own account.
Again, monopoly may consist in the exclusive control of the supply of some productive agency, physically defined as a group of interchangeable units. The only incentive to obtain such a monopoly is the desire to secure one of the former type, the power to restrict the supply of some consumption good. The control of any type of productive agent, of course, gives control of the supply of commodities whose production is dependent on the use of that agent, through the power to withhold the agent from use altogether or restrict its use in the making of any particular commodity while leaving its employment in other uses free. Whether the monopolist produces these goods himself or leases his monopolized agency to others, he can secure the entire increase in the net revenue from the final commodity as a rent on the restricted and restricting agency. It is evident in this case also that the restriction on the use of the agency, whatever its basis, is equivalent in effect to a physical peculiarity, and that the causal productivity of the agency is increased by its limitation in the same way as if part of it had gone out of existence or undergone some incapacitating change. Nor should it be necessary to insist again on the separation of the causality aspect of the case from the question of social policy.
A somewhat different case is the exclusive control of a peculiarly effective method or system of organization of production. The question of the productivity of a special process protected by patent or kept secret is a difficult one. Treatment of it in economic literature varies from that of Lavergne,111 who insists that the idée productrice is an independent factor, always present along with land, labor, and capital, to that of A. S. Johnson, who contends that an idea or method cannot be regarded as productive because it is the nature of an idea to multiply itself indefinitely.112 Here, again, the crucial test can only be the facts in the case. Does the method or idea get product imputed to it? This is largely a question of whether it is salable and so takes on capital value. If so; it is productive in the sense of economic causality. If it is not salable it will represent an element in the productivity of its possessor and its yield will accrue to him in the form of a wage. The moral question, whether it "ought" to be a source of income, is of course another matter. It seems evident113 on the one hand that the highest social advantage would require the most rapid and general extension of the use of the best methods, and it is of significance that this can theoretically be done nearly without cost. On the other hand, it is equally evident that both justice and expediency demand a fair reward for the origination of better ways of doing things. It would seem to be a matter of political development to provide a better way of rewarding these services than even a temporary monopoly of their use; but this inquiry belongs in the theory of progress, and as a question of social policy is outside the scope of the present study.
We must again insist, however, that the method must be recognized as being productive, or as conferring superior productivity on the agencies employed in connection with it.114 An arbitrary restriction is again causally equivalent to physical limitation. The method or idea is merely less productive of goods (and more productive of exchange value) than it would be if its use were unrestricted. The same paradox holds for any productive good; if multiplied indefinitely it would yield more goods in physical units, but have no value at all. The only difference in the case of a method of production is that it can be multiplied indefinitely without much cost (after once worked out), an important distinction from the standpoint of social policy (perhaps), but not significant from the standpoint of a cause and effect explanation of things. And we must again insist that the danger of reasoning about social totals of exchange value, and still more the extreme treachery of all reasoning about human welfare in terms of any such concept as economic utility, be borne in mind in attempting to reach conclusions as to social policy.115
The position taken above, that monopoly is productive, is in opposition to the doctrine of Professor J. B. Clark and his followers that the monopolist merely appropriates product created by other agents. But when monopoly income is said to be "diverted from its real producers,"116 or is called "exploitative," in the sense that it "is not secured by the agent that creates it,"117 the words "create" and "produce" are not used in their correct (causal) meaning. Monopoly is impossible except on the basis of some control over an element essential in the production of a commodity, and the extra product is rightly imputed to this essential element, or to the condition which makes control possible, if separable from the rest of the situation.
Monopoly of productive agencies has hitherto been of restricted importance in actual affairs, for several reasons. Most productive resources are specialized only to a limited extent, and are subject to effective competition from a wide range of substitutes. And in the hitherto undeveloped and rapidly changing condition of the world, most agencies, even of the most specialized types, have been rapidly and irregularly increasing in supply through new discoveries, and open to deliberate increase through moderate expenditures in exploration and development work. Finally, the technique of the large-scale organization requisite to secure unified control has been crude and imperfect, while the opposition of public opinion has been increasing in force. It is of some interest to inquire into the implications of absolutely free competition in this regard.
With perfect intercommunication it would seem that the assumed absence of collusion is very improbable, as organization costs would naturally tend to a low level. Under static conditions (with the existing stocks of all agencies fixed and known), a great development of monopoly would apparently be inevitable. It is not unreasonable to suppose even that in the absence of organized social interference conditions would approach the result contended for by the Marxian socialists, monopoly universal, or at least prevalent to an extent involving the complete breakdown of the competitive system of organization.
A further consideration, which goes back to the requirement of negligible size in the marginal unit as a condition of effective competition, tends to reinforce this view. In the ordinary sense of monopoly, concentration of control is not profitable unless it is nearly complete. But with organization costs absent or small, there might be a continuous incentive to increase the size of the bargaining unit. It is true, as some objectors to the productivity theory of distribution contend, that as the bargaining unit is larger the product theoretically dependent upon it is larger in greater ratio, and this fact affords a small incentive to combine even on a very small scale, and to increase the size of the unit without limit. The extra remuneration of the block over what it could obtain if its constituent units bargained separately would come out of the shares of the other agents used in connection with the one affected, not out of increased payments extorted from consumers as in case of monopoly.
The argument may be shown graphically by recourse to the "dosing method" of explaining specific productivity, made familiar by Professor J. B. Clark. There is no fallacy in this analysis if by a "factor" of production we mean merely a group of physically interchangeable things, and not a sort of labor or capital pulp obtained by putting things of all degrees of heterogeneity through the mill of the competitive process itself and reducing them to value productivity units. We must also remember that the method is a logical device purely, and in no sense represents the process by which productive services actually get evaluated. If, then, we imagine a static society, and fix our attention upon such a group of competing agents, it will be seen that the different units or members composing it may be regarded as placed along the descending curve of diminishing productivity of the familiar diagram. The curve, like that of diminishing utility and diminishing demand price,118 is purely hypothetical; the ordinate of each point merely shows what would be the productivity of each unit in the series if the total number were reduced to that indicated by the corresponding abscissa and production reorganized along "natural" lines. It does not indicate differences in productivity, or anything else, at the moment. We also pass over the fact that it is impossible to construct such a curve except for a very limited range in the region of known conditions and that any considerable extension of it (for an important productive service) soon carries us into the realm of pure fantasy.
But ignoring the difficulties and imagining the curve drawn, it is obvious that under theoretical imputation each member of any such group of competing agents will get what is directly dependent upon that which occupies the least important position, which is all that is ultimately "dependent" upon any one. But if two or more such agents combine so as to compete as a unit instead of separately, they can get the total product of that number of units at the lower end of the series, which is more than their separate "marginal" products. Therefore, under perfect competition, they will combine and bargain as a unit; and the same incentive will urge them to keep on combining until a monopoly results.
The situation is easily understood from the conventional diagram. If the curve CD represents the relative importance of successive agents of a series, or units of some really fundable agent, then under perfect competition every unit will get the product DE, and a certain group E'E will get FDE'E. If now these EE' units combine so as to become marginal as a group, they can get instead D'DE'E, gaining D'DF over the former arrangement. The owner of the group can prevent the substitution of a (marginal) unit outside the group for any unit in it, and so cause a larger product to be dependent on the employment of the group than the aggregate marginal products of its members. Similar agencies outside the combination will only get the wage DE, and the surplus income received by our consolidated block will come out of the shares of the agencies with which it is combined, not out of an increase in the price of the product to consumers. The employers of the "block" use no more nor less of the agency than before and make no more nor less product; hence they must sell the same supply at the same price. But the other agencies are forced to take less for their services because the block cannot be replaced a unit at a time from the margin, but only by an equal number of marginal units at once, a transfer which will raise their price all along the line. Only "friction" (human limitations) prevents this in actual society, the "diminishing returns of entrepreneurship."
It need not be remarked that this process would not go far in fact until something would have to be done to stop it. There does seem to be a certain Hegelian self-contradiction in the idea of theoretically perfect competition after all. As to what the end would be, it is fruitless to speculate, but it would have to be some arbitrary system of distribution under some sort of social control, doubtless based on ethics or political power or brute force, according to the circumstances—providing that society or somebody in it had sufficient intelligence and power to prevent a reversion to the bellum omnium contra omnes. Competitive industry is or hitherto has been saved by the fact that the human individual has been found normally incapable of wielding to his own advantage much more industrial power than, aided by legal and moral restraints, society as a whole can safely permit him to possess. How long this beneficent limitation can be counted upon to play its saving rôle may in the light of current business development occasion some doubt. With this subject we are not here particularly concerned, but it has seemed worth while to point out, in connection with the discussion of an ideal system of perfect competition, that such a system is inherently self-defeating and could not exist in the real world. Perfect competition implies conditions, especially as to the presence of human limitations, which would at the same time facilitate monopoly, make organization through free contract impossible, and force an authoritarian system upon society.119
In connection with the meaning of productivity it is of interest to raise the question of the economic value of the State. What would be the effect upon our economic life if society as such, acting through the political organization, should assert itself as an economic individual and charge "what the traffic will bear" for its own service? Obviously the Government has a monopoly on an absolutely indispensable commodity. Business could not be carried on at all without the protection of property and enforcement of contract. Into this interesting, but intricate, question it is impossible to enter at length here, but it appears that what the Government could take, its economic product, is hardly limited.120 The writer is much more optimistic as to the possibilities of a drastic program of taxation for securing a greater degree of economic equality than over most proposals for social interference in contractual relations.[Back to Table of Contents]
IMPERFECT COMPETITION THROUGH
[Back to Table of Contents]
|Value (i.e., consumption goods)||Distribution (productive services)|
|Problem I. Given supplies of goods and given wants to be satisfied. (The situation at a moment.)||Market price.||No problem of distribution involved.|
|Problem II. Given productive resources and given wants to be satisfied.||Normal price. (Marshall's long-time normal price.) Supply of each good a function of price.||Short-time or market price distribution theory. (Fixed supply of thing being priced.)|
|Problem III. Use of resources to increase resources and change wants as well as satisfy wants.||Secular changes in normal price.||Long-time distribution theory. Supply a function of price.|
[82.]Cf. Principles of Economics, 6th ed., p. 379.
[83.]The Distribution of Wealth, chap. V.
[84.]This distinction follows conventional usage; it will be examined presently and shown to be untenable. (See below, pp. 159 ff. [nn95—Ed.])
[84.]This distinction follows conventional usage; it will be examined presently and shown to be untenable. (See below, pp. 159 ff. [nn95—Ed.])
[85.]Theories of Production and Distribution, chap. VII.
[86.]Mills, Principles of Political Economy, book IV, chap. IV, sec. 4.
[87.]It is a neglected fact that in the "lower" strata of society the production of children is by no means so unrelated to the ordinary economic calculation as generally assumed. The age of marriage and the size of families probably depend much more in fact on the amount of economic gain or loss between the prospective earning of children and the cost of their keep while under their parents' control than they do upon calculations as to the possibility of maintaining standards of living from one generation to another. (Of course, the two sets of considerations are interrelated.) A comparison of birth-rates with living conditions in the city and country and in different social environments, also a study of the effects of child labor and compulsory education laws on birth-rates, are very suggestive in this connection.
[88.]It is hardly necessary to point out that the famous "iron law" of wages of Lassalle and the Marxian socialists is this classical theory of the equilibrium wage taken over bodily, but with the logical foundation on which it rested repudiated indignantly. If the tendency of wages to a minimum is based on a principle of population, all schemes of social reorganization (except in so far as they affect that principle) are helpless to produce any result save possibly a temporary amelioration, with a later increase in misery. This, it will be recalled, is the very thesis which the essay on population was originally written to prove in answer to the millennial hopes held out by Godwin's Political Justice.
[89.]The above discussion of population problems is admittedly superficial, but other factors must be passed over here. Students will recall that the over-simple treatment of labor as homogeneous in its conditions of supply was brought somewhat nearer to reality by Cairnes's discussion of non-competing groups. To-day the social interest in the question has completely shifted. It is not Malthusianism as a general proposition which is worrying us—perhaps rather its contrary, race suicide; but much more than either, the differential aspects of the case, the over-multiplication of the incompetent and the failure of the upper classes to reproduce themselves. It seems plausible that below a certain standard an increase in wages means an increase in population, while beyond a critical point not far above physical comfort, the reverse relation begins to hold. The effect of popular education, industrialization and city life, and inscrutable factors in the Zeitgeist complicate the problem beyond measure. The great World War, in particular, has wrought changes in human attitudes about which it would be rash to say anything except that they are certain to be far-reaching.
[90.]Strong social disapproval of any line of business or occupation undoubtedly tends to aggravate any real evil connected with it, by throwing it into the hands of persons (of whom there is never any dearth) to whom social approval and disapproval are a matter of indifference. Conspicuous examples are money-lending in the Middle Ages (and the same type of money-lending now) and the liquor business in modern times.
[91.]Efforts on the part of society, the public, organized and unorganized, to direct consumption along approved lines, fall outside the scope of a study of private competitive organization.
[92.]Disparagement of competing commodities must be eliminated from consideration for the same reasons as burglary and such crude fraud as the dispensing of gold bricks, liquozone, etc. It will be recalled that we have expressly eliminated effects of interest not represented in market transactions.
The suggestion may seem fanciful, but I find it impossible to differentiate between elements in the physical form and appearance of a commodity which make no difference in its efficiency for the purpose intended (an agreeable color, decorative ornament often actually interfering with its uses, fancy containers, etc.), on the one hand, and on the other an element of appeal due to a high-sounding name or any other form of "puffing." These things do make a difference in the commodity to the consumer and in an exchange system the consumer is the last court of appeal. If they are different to him, they are different; if he is willing to buy one sort in preference to the other, then the first is superior to the second; it contains "utilities" which the other does not have. I do not see that it makes any real difference whether these utilities are in the thing itself or in some associated fact.
[93.]It will be kept in mind that from the standpoint of short-time problems, where changes in supply are not at issue, and demand alone determines distributive relations, no classification at all is valid.
[94.]The fact that so many opportunities for the profitable investment of resources in the development of human potentialities are neglected, and so many wasteful investments of the same kind made, is perhaps one of the most serious criticisms of existing society. The fault, however, is in the family system rather than in the private enterprise organization of industry in any sense in which the two may be dissociated.
[95.]The differential theory of rent has long since been recognized as applying equally well to the other shares. See J. B. Clark, "Distribution as Determined by a Law of Rent," and J. A. Hobson, "The Law of the Three Rents," Quarterly Journal of Economics, vol. V. It is not so generally recognized that in consequence it explains none of them. It is especially remarkable that the theory of distribution propounded by General Francis A. Walker, whose book was long a standard text in American colleges, amounted to nothing more than an elaboration of the proposition that each factor gets what is left after the others are paid. It is easy to show that the differential theory when stated in its significant form is identical with the specific productivity theory. Cf. A. A. Young, Ely's Outlines of Economics, 3d ed., pp. 415-16.
[96.]Ideas are not, however, free from these costs, as sometimes assumed. Thus A. S. Johnson (Rent in Modern Economic Theory, p. 120) contends that an idea cannot be regarded as productive, because it is "its nature" to multiply itself indefinitely. It would simplify the problem of education if it were so! But perhaps we should wish some discrimination to be exercised in the extension of the quality to ideas generally! Even so, if the "natural" tendency is obstructed, the idea limited in application seems to be productive in the sense in which anything else is productive. (See below, chapter VI.)
[97.]The classical writers' view of capital as "advances to laborers" was correct except for the failure—natural from their labor theory point of view—to include the other productive factors as well as labor.
[98.]Beyond the dogma that the desire to secure the income from capital is the sole motive for saving, it is a still further and questionable assumption that the strength of the motive varies in proportion to the size of the income expected or is connected with it by some simple law. Again we make, for convenience, the conventional simple supposition, merely taking this opportunity to record grave doubts as to the validity of any of this procedure. The saving of capital seems to us to be in fact the result mainly of two or three motives of which the desire for increased consumption of goods in the future is only one and probably one of the less important. Like other acts of man in society, it is largely a mere matter of established social custom, good form, the thing to do, the mores. Then we must emphasize the impulse to create. Probably the greatest single source of saving is the putting of income back into a business, because of sheer interest in the business and the desire to make it grow. That the desire for the increased income is not the dominant motive in much of this is proved by the fact that men invest as desperately in an enterprise never likely to be profitable as they do in the most prosperous concern, and by the further fact that much of the reinvestment in society is made by directors of corporations who will not get the fruits of the work for themselves at all. The truth is, we believe, that the real motives of human life, at least of those people who do big things, are idealistic in character. The business man has the same fundamental psychology as the artist, inventor, or statesman. He has set himself at a certain work and the work absorbs and becomes himself. It is the expression of his personality; he lives in its growth and perfection according to his plans.
[99.]The statement is applicable to the other methods of investing resources—the development of new natural agents, training of labor and improvement of technology—as well as to the creation of capital goods in the narrow sense. The use of resources to increase population in numbers appears to be exceptional as population subsists upon consumption goods themselves, and no change in the forms of production is involved. This action, however, is only to a very limited extent a matter of the calculated exchange of present for future goods.
[100.]A caution is in place against taking this equilibrium as strictly analogous to the normal price of a consumption good. A consumption good is destroyed in use. The equilibrium condition in regard to it is equality in the rates of its consumption and production with a negligible amount of the good actually in existence. (Durable consumers' goods are, of course, capital in fact.) Capital, on the other hand, accumulates, new production being constantly added to the whole net product of the past. The equilibrium in its case is a constant amount in existence, current production and consumption amounting in the equilibrium condition only to replacement of wear and tear. In this respect capital is like gold in the theory of its valuation. It is like gold, again, in the respect which we proceed to discuss, that the equilibrium condition is actually an indefinite distance in the future, that new production is constant and sure, but still small in amount in comparison with the existing supply, and that, therefore, conditions of production have a negligible effect on value over moderate periods of time.
[101.]Principles, 6th ed., p. 536.
[102.]Mention should also be made of banking, speculation, and the vicissitudes of foreign trade, which may completely dominate the rate for very short periods. Passing over such phenomena as the call-loan rate and the relation of international transactions to the interest rate, a word should be said on the subject of the bank rate. An issue of new currency by banks through an expansion of loans creates a momentary new supply of capital and, other things equal, tends to lower the interest rate. The effect is chiefly limited to those short-time loans in which banks mainly deal, but perhaps not entirely so. It is imperative to recognize, however, that inflation produces its effect through an actual saving, a diversion of income from present consumption to capital goods creation. The new currency which the bank lends to the investor is not new purchasing power from the standpoint of society as a whole. It is axiomatic in theory that the aggregate real value of the circulating medium is independent of the number of units of which it is composed. When inflation occurs, therefore, purchasing power is not created, but merely transferred from the previous owners of circulating medium to the persons into whose hands the new currency is placed for its first expenditure. The enormous rôle played in history by inflationism and the persistence of the heresy rest upon the fact that the effects of the expenditure of the new money are more conspicuous than the diminished effects of that which already existed. It is another case of the familiar type, "ce qu'on voit et ce qu'on ne voit pas."
However, it is to be emphasized also, that the psychology of business is fundamental in the economic process and that it is a very complex, sensitive, even treacherous thing. It will not do to draw conclusions as to policy from mere cause-and-effect reasoning based on any simple or reasonable assumptions about human behavior. Bank loans may, after all, create more demand for capital than they supply. But it is outside our plan to enter into the intricate problem of changes in business conditions or the business cycle. Some interesting suggestions in this field may be found in a series of articles on "Commercial Banking and Capital Formation," by H. G. Moulton and Myron W. Watkins, Journal of Political Economy, 1918 and 1919.
[103.]In real life, where uncertainty is present, it is the product generally anticipated in the market, which may not be the same as that subsequently realized in any particular case.
The correct statement of the productivity theory as given in the text manifestly sidetracks the objection of Professor Fetter and the time discount school that the product of capital is not homogeneous with the capital, and that consequently no such ratio can exist until the capitalization process has been applied to the capital itself. Before the investment is made the capital and its anticipated product are quite homogeneous, and it is in the market for capital not yet invested that the interest rate is determined. Capital goods once created are, of course, valued by capitalization; this operation presupposes an interest rate, which is therefore in no wise affected by the relation between capital goods and their income.
[104.]It is noteworthy that in the fourth great field for the investment of resources, the improvement of productive methods through research and experiment (we are not including the numerical increase of population) perpetual rights to the earnings of the improvement are not conferred upon the person who makes the advance. The individual may retain a monopoly on his idea as long as he can keep it secret or otherwise prevent its being copied, but this is usually quite impracticable for any length of time. In the case of specified sorts of technical inventions, society confers and protects a temporary monopoly in the form of a patent. (In the United States we find a growing tendency to limit the method of exploitation of even this temporary monopoly. Witness the prohibition of tying contracts.)
[105.]There is one important exception to this statement. As observed in chapters I and II, the presence of uncertainty in regard to individual events does not necessarily obstruct the workings of competition or prevent the realization of its theoretical result in a remainderless distribution of the product of industry among the productive agents. If the uncertainty in a particular case is measurable, it may in effect be eliminated by the grouping or clubbing of a sufficient number of cases to secure certainty in regard to the group. This point cannot be dealt with until after the general theory of risk and uncertainty has been presented. (See chapter VIII.)
[106.]Specifications numbered (2) and (5) in chapter III—that people are perfectly rational and that there is perfect intercommunication among them—are clearly phases of the problem of perfect knowledge to be taken up in Part Three. In the present chapter we are concerned especially with numbers (3) and (4)—formal freedom of action and perfect mobility, implying perfect divisibility; (6) and (7) the absence of monopoly and predation. Numbers (8), (9), (10), and (11) have already been considered, but some further remarks will be in place in regard to the first point mentioned under number (8), the relations of social as contrasted with individual wants. We may note here that the timelessness of the production process necessary to secure perfect mobility has been dealt with in one aspect in chapter IV. In addition it retards the speed of readjustments by holding productive forces committed to certain uses for an interval after it would otherwise be profitable for them to change. But it does not affect the final results, the character of adjustment when achieved. Some discussion of the intermediate effects is necessary in connection with the study of profits, and the whole subject of "friction" will be gone into after the treatment of uncertainty has cleared the way for a discussion of profit.
[107.]It is not necessary that he be an infinitesimal fraction of the productive power of a particular establishment. The imputation process works itself out through the competition of establishments for the different agents. If a number of establishments exist in which a certain type of agencies is on an indifference margin, the income of all similar agencies will be accurately determined.
[108.]Paper entitled "Outlines of a Theory of Wages," read at the twenty-second annual meeting of the American Economic Association. See Proceedings, pp. 143-44, note.
[109.]Notably Professor J. B. Clark. Cf. above, p.109 [II.IV.22—Ed.]. The concessions of Professor J. M. Clark (loc. cit.) seem to me to cover only a portion of the ground. I see nothing morally ideal in a distribution according to innate personal ability—certainly not ability measured by pecuniary demand for its products, unless the rest of the human race are idealized—and suggest that such a distribution would yield vastly more inequality, misery, and despair than does the present order. Nor, in the abstract, can I see any connection between innate ability and moral desert. Is inherited ability on any better footing morally than inherited property?
[110.]See Davenport, Economics of Enterprise, chap. IX, especially p. 127; and cf. L. H. Haney, "The Social Point of View," Quarterly Journal of Economics, vol. XXVIII, pp. 319-21.
Though the case of the pickpocket offers no real difficulty and is not likely to be taken seriously, there are many cases where standards of productivity are very hard to define. Gambling, for example, is definitely ambiguous. If the men who gamble know what they are about, play for fun, at a game which is "fair," and do not risk more than they can afford to pay for the excitement, I should say that the gains of the banker represent product. If all are interested in winning only, and play because they expect to win, I suppose the operation is unproductive and produces a transfer, not a production of wealth. It will doubtless be conceded that there is such a thing as a transfer of wealth, distinguishable from production, or else receiving gifts must also be classed as productive work!
Other cases are more difficult still, since no clear line can be drawn between being tricked and gratifying a perverted taste. The difficulty is the ultimate impossibility of saying what one "really" wants. In cases where each knows what he is getting and what he is giving—no "compulsion" (artificial manipulation of alternatives) being present—and actually gets the means of satisfying his actual want, we must hold that the operation is a production of utility in the economic sense. But what we may call "crude" fraud must be classed outside of exchange relations along with forced transfers. The man who sells whiskey, patent medicine, corrupt literature or art, etc., to people who want them and are willing to pay for them is productive; but one who sells gilded chunks of lead to unsuspecting rustics for gold bricks clearly is not. If the buyer be in a position where it never can make any difference whether the metal is lead or gold and never could find out which it is, the action is hard to classify, but we must consider that he could have had what he got for vastly less money, if he had known. Is the buyer of an imitation jewel or antique for a genuine, and who never knows the difference, really cheated? And suppose the purchaser of Liquozone or Peruna is really cured of his (real or imaginary) ailment! And suppose he is not! Was it the medicine, or a cure, that he really bought?
We are carried back to the already oft-reiterated observation that any scientific thinking about conduct presupposes that wants are given entities, and that exchange organization of the satisfaction of wants presupposes that their character is known. Capricious and experimental conduct are not amenable to scientific treatment (unless subject to prediction in large groups, a case which we have postponed for later consideration). In the language of abstract logic, a must remain a throughout the discussion. This it can do either by remaining sensibly unchanged or by changing in accordance with a known law. The last alternative reverts to the first, since such a change can be thought of only as an expression of an inner, unchanging attribute of the thing changing.
[111.]Bertrand Lavergne, Théorie des marchés Économiques. Paris, 1910.
[112.]Rent in Modern Economic Theory, p. 120, note.
[113.]Supposing the desideratum to be the greatest possible consumption of commodities. Supposing it to be maximum happiness, the case is not so clear, while the question of maximum "welfare" involves us in still greater uncertainty.
[114.]There is a danger in over-emphasizing the difference between these two views of productivity. Remembering that all production is joint, it is clear that any separate productivity of a particular agency means ultimately superior productivity conferred upon others used in connection with it.
[115.]It seems in place to remark that a confusion is involved in laying down "appropriability" or what might be called competitive self-assertion, as a condition of economic productivity. Productivity is a matter of limitation. If an agency is limited relatively to the need for its use, it must be appropriated by some one, to be administered, to decide who is to have the use of it and who is to do without. And any productivity conferred on an object by appropriation must come through and in connection with restriction on its use. Thus Professor Young (Outlines of Economics, by R. T. Ely and others, ed. of 1908, pp. 555-56) contends that the Strait of Gibraltar would be productive wealth if the British Government were to charge for its use. But they could not charge for its use without reducing its volume; it would be a case of monopoly merely. This and several other confusions are involved in Veblen's contention (on the "Nature of Capital," Quarterly Journal of Economics, vol. XXII, pp. 917 ff., ., and vol. XXIII, pp. 104 ff.) that the world's stock of knowledge is its most important "capital," which is without value merely because not privately exploited. It could be exploited only by having its use restricted; i.e., by monopoly. The notion that capital is significant as limiting access to the world fund of technical knowledge is absurd, for the reason, already noted, that production is joint, and the productivity of anything may be viewed as a productivity conferred on other things.
[117.]Johnson, pp. 106, 107.
[118.]Cf. chapter III.
[119.]In addition to the incentives to combination afforded by the gains through increase in the size of the bargaining unit, another tendency might work in the same direction. In many cases it might be profitable for the owner of a considerable block, though not the whole supply of an important productive service, to restrict its use and so increase the value of the product. Whether the owner of a part of a supply can gain by withholding some of that part from use will depend upon the fraction of the supply which he holds and on the flexibility of the supply obtainable from competing sources and the elasticity of the demand for the product. In view of the fact that practically every business is a partial monopoly, it is remarkable that the theoretical treatment of economics has related so exclusively to complete monopoly and perfect competition.
Attention may be directed to another tendency fatal to free competition under theoretical conditions. This is the matter of the inflation of credit. With all forms of friction eliminated there would seem to be hardly a limit to the substitution of credit for any sort of commodity as a medium of exchange and a stable value-standard would apparently be impossible to establish.
[120.]Concerning the "economic surplus" of which much has been made by some writers, notably Hobson, the remark made above (page 188 n. [nn115—Ed.]) is applicable. The payment necessary to secure the performance of any service depends on how much of that service is desired. The question is much complicated by human mortality and the fact of inheritance, but in general there are no surpluses available without reducing the volume of the service. This will not be true of monopolized or highly specialized agencies, and there are, no doubt, many remunerations which are too high absolutely and which if reduced would positively increase the volume of the services for which they are paid.
Part III, Chapter VII
[1.]The problem of uncertainty and risk in economics is, of course, not new. Some reference has already been made to the literature. It has been recognized and discussed in three connections: (1) insurance; (2) speculation; and (3) entrepreneurship. For a full treatment of the last-named it is necessary to go to the German works cited in the historical portion of this study. English economics has been too exclusively occupied with long-time tendencies or with "static" economics to give adequate attention to this problem. For a very general discussion of uncertainty see, in addition to works already cited, Ross, Uncertainty as a Factor in Production, Annals, American Academy, vol. VIII, pp. 304 ff. See also Leslie, T. E. Cliffe, "The Known and the Unknown in the Economic World," Essays in Political Economy, pp. 221-42; Lavington, F., "Uncertainty in its Relation to the Rate of Interest," in Economic Journal, vol. XXII, pp. 398-409; and "The Social Interest in Speculation," ibid., vol. XXIII, pp. 36-52; Pigou, A. C., Wealth and Welfare, part V; Haynes, John, "Risk as an Economic Factor," Quarterly Journal of Economics, July, 1895.
In this superficial sketch of the theory of knowledge it has not seemed important to give extended reference to philosophic literature. It will be evident that the doctrine expounded is a functional or pragmatic view, with some reservations. By way of further "reservation" we should point out that the tone of the discussion merely results from the fact that it is the function of consciousness and knowledge in relation to conduct that we are interested in, for present purposes, and the text must not be taken as expressing any view whatever as to the ultimate nature of reality or any other philosophic position. The writer is in fact a radical empiricist in logic, which is to say, as far as theoretical reasoning is concerned, an agnostic on all questions beyond the fairly immediate facts of experience.
[2.]See the brilliant lectures of E. DuBois-Raymond, "Uber die Grenzen des Naturerkennens" and "Die sieben Welträtsel."
[3.]Cf. Comte's Classification of the Sciences.
[4.]Professor Cooley's descriptive phrase. See Social Organization, chap. I.
[5.]See James, Psychology, chap. XXII, on "Association by Similarity."
[6.]Marshall remarks that the business manager's decisions are guided by "trained instinct" rather than knowledge. (Principles, 6th ed., p. 406.)
[7.]When variations in degree in the attributes X and Y are taken into account, the problem must be dealt with by applying the statistical theory of correlation, which is a further development of probability theory. See especially the works of K. Pearson and F. Y. Edgeworth. An elementary discussion will be found in any treatise on statistics. A. L. Bowley's Measurement of Groups and Series is particularly serviceable for the general reader. A rough idea may be obtained from Elderton's Primer of Statistics. Pearson's Grammar of Science, chaps. IV and V, may be consulted on the whole ground of the present chapter.
[8.]The calling of bonds by lot is an illustration. In Germany bondholders often insure against this chance.
[9.]Professor Irving Fisher is particularly insistent upon the interpretation of probability as due to ignorance alone. See The Nature of Capital and Income, chap. XVI, sec. 1.
[10.]Cf. E. Borel, Le Hasard, pp. 196-97.
[11.]See Karl Pearson's essay on "The Scientific Aspects of Monte Carlo Roulette," in The Chances of Death and Other Studies in Evolution. The necessity of constant appeal to a dogmatic preference of simple to complicated hypotheses is brilliantly treated in Poincaré's chapter on "Probabilities," in The Foundations of Science, Science and Hypothesis, chap. XI. See also Poincaré's fascinating treatment of the relations between small causes and large effects in the same volume, Science and Method, chap. IV. Poincaré bases the doctrine of equal probability on the mathematical principle that for small changes any continuous analytical function changes in the same ratio as the variable. The same unsatisfactory, if not absurd, doctrine of "intrinsic reasonableness" (for how can one thing be "intrinsically" more probable than another?) is developed from a different point of view in Balfour's Theism and Humanism, lecture VII, on "Probability, Calculable and Intuitive."
[12.]For an excellent brief discussion of the issue, with references to the literature, the reader is referred to Arne Fisher, The Mathematical Theory of Probability, chap. I: "General Principles and Philosophic Aspects." The writer's position is that taken by Fisher and designated the principle of "cogent reason" in opposition to the older view common among mathematicians, of "insufficient reason." Compare also La Place, Essay on the Philosophical Theory of Probability.
[13.]"The Philosophy of Chance," Mind, vol. 9, 1884.
[14.]See The Nature of Capital and Income, p. 266.
[15.]The chief limitation in fact relates less to the proposition as stated than to the dogma of "conduct" or activity exclusively in order to a future reward. Means and end seem to be the form in which we think about our behavior rather than the actual form of the behavior itself. The literature of ethics is one long record of failure to find any absolute end; in life every end becomes a means to some new and farther goal. The attempt to rationalize human behavior seems to be a perpetual chase after one's own shadow, and the conclusion forces itself upon us that the "summum bonum" or any other objective "bonum" is an ignis fatuus. We are compelled to believe that in a great proportion of cases we take more interest in action whose fruition is only probable than we would if it were certain.
[16.]Professor Irving Fisher's term (The Nature of Capital and Income, p. 288). I should prefer simply "grouping" as both shorter and more descriptive.
[17.]It would be out of place here to go into the social aspects of life insurance, but one observation may be worth making. From the social point of view it is arguable that all classification of risks is a bad thing, except in so far as the special hazard is purely occupational and the cost of carrying it can be transferred to the consumer of the product. It is hard to discover any good reason why the unfortunate should be especially burdened because of their handicaps. It would, therefore, be better if all were insured at a uniform rate. Indeed, we may go farther and contend that the rate should be graduated inversely with the risk (occupational risks excepted, as noted). It goes without saying that only a state compulsory insurance scheme could operate on any such principles; under private profit incentives, competition will compel any insurance agency to classify its risks as accurately and minutely as practicable.
[18.]Cf. Huebner, Property Insurance, chaps. XVI, XVII.
[19.]Haney (Business Organization and Combination, chap. XXIII) uses the terms "The Corporation Problem" and "The Trust Problem" to designate what I have called the "internal" and "external" problems respectively. He properly emphasizes the importance of the former in view of the tendency of the evils of monopoly, etc., to overshadow it in the popular mind and in much of the literature of the subject.
[20.]On the production and sale of "guidance" see J. M. Clark, Journal of Political Economy, vol. 26, Nos. 1 and 2.
[21.]Cf. Willett, Economic Theory of Risk and Insurance, chap. III.
[22.]Cf. chapter XII.
[23.]The situation which we here endeavor to delineate is what Dr. A. H. Willett appears to have in mind under the designation of the "approximate static state." See The Economic Theory of Risk and Insurance, pp. 15, 16.
In this connection, again, we cannot be rigorously logical and definite without getting off into mere subtleties. We do not know whether there is ultimately real uncertainty and caprice in either physical nature or human nature. It may be that all changes are self-compensating some time, and that if progress were eliminated we should finally achieve prophetic powers in regard to phenomena in the aggregate (through application of the principle of consolidation) if not in individual instances. But in view of the tragically limited success of science in predicting the weather, for example, it is clear that there is no strain on credulity in assuming a large amount of real uncertainty. We must not forget that the periodicity of change or the interval required for canceling out of fluctuations is in practice relative to the length of human life. If such a cancellation would occur ultimately (as some writers, notably Nietzsche, have ventured to suppose) the period is so long in relation to human life that no advantage of it could be taken.
[24.]Chapter V, the reader will recall, dealt with the effects of progress with uncertainty absent. We here retrace our steps somewhat in order to consider uncertainty with progress absent, thus completing the design of studying the two factors separately. After completing the present task we shall (in chapter XI) study them in combination. A confusion between the effects of uncertainty and those of progress, which are largely, though never quite completely, separable facts, has been seen to underlie the reasoning of the "dynamic" theory of profit.
[25.]See above, chapter IV, p. 106, note [nn46—Ed.].
[26.]The statement implies that a man's judgment has in an effective sense a true or objective value. This assumption will be justified by the further course of the argument.
[27.]As already observed, the theoretical features of contractual income are those associated with rent in the conventional distributive analysis. From the point of view of our present assumptions, all productive goods being fixed in amount and in their distribution among the members of society, such incomes might naturally be called wages. As we have insisted that there is no significant causal or ethical difference in the sources of income it does not particularly matter what they are called.
[28.]In actual society freedom of choice between employer and employee status depends normally on the possession of a minimum amount of capital. The degree of abstraction involved in assuming such freedom is not serious, however, since demonstrated ability can always get funds for business operations. A propertyless employer can make the contractual payments secure by insurance even when they may involve loss, and complete separation of the risk-taking and control function from that of furnishing productive services is possible if there is a high development of organization and a high code of business honor. But the conditions generally necessary in real life for the giving of effective guarantees must also be taken into account as we proceed.
[29.]As has been well observed in connection with games of skill. It is not necessarily a proof of high skill to make a twenty-foot putt in golf or pierce a two-inch bull's-eye at a hundred yards with a rifle; nor a lack of skill to miss a three-foot putt or strike outside the eight-inch circle. Either would happen sometimes with good shots or poor; only the proportion of successes and failures in a fair number of trials gives any indication of real ability to do the trick.
[30.]The diminishing returns of management is a subject often referred to in economic literature, but in regard to which there is a dearth of scientific discussion. For an interesting, but in the present writer's view fundamentally unsound, treatment, see H. C. Taylor, Agricultural Economics, chap. VI. Our own discussion of the theory of enterprise is admitted to be vague and unsatisfactory. A complete and logically rigorous discussion would be a large undertaking. In view of the extreme complexity of the elements involved in uncertainty, most of which may be independent variables, the number of possible suppositions which might be followed out is prohibitive. At least it would require so much space and be so difficult to follow, and of so little practical significance, that the probability of its being read does not justify the attempt. It is hoped that the above discussion covers the principal points of interest. The essential factors are men's ability in the entrepreneur field, which includes foresight and executive capacity, and their knowledge of their own powers and disposition to trust them in action. The factors likely to be neglected are the last two, self-knowledge and self-confidence or initiative, which are closely related, but not identical. In addition, knowledge of, and willingness to trust, other men's powers and judgment is a still more important consideration, not yet discussed.
[31.]It does not follow that he would have to own property, though in the real world this is the practical consequence. It is easily conceivable, however, that one might secure the payment of his obligations by pledging his own earning power. Such an arrangement need not call for more difficult feats of organization or involve greater strain on human nature than is true of indemnity insurance at present.
[32.]That is, the most important characteristic from the standpoint of organization. Of perhaps equal importance is the legal nature of the corporation as an entity separate from its member owners. The term "limited liability" is not descriptive. The members of a corporation have, strictly speaking, no responsibility at all; only the property of the corporation, which property does not directly belong to the owners, is liable for the corporation's obligations.
[33.]It need hardly be pointed out that the principle of consolidation of risks is operative here to a certain extent. The employer of men passes judgment on their "average" competency to do the things that they are expected to do, an average in the case of each individual and an average involving a further canceling-out of errors if he selects a number of employees. A still higher order of responsible judgment is involved in laying-out and subdividing the work of the establishment so that the task of each single employee is adapted to a certain fairly uniform grade of ability.
[34.]Cf. Hawley's contention (Quarterly Journal of Economics, vol. XV, p. 88) that the hired manager makes decisions, but the enterpriser takes the consequences of decisions, and that the former is therefore not an enterpriser.
[35.]Of course, the machinery by which control is exercised becomes more indirect and the control itself more remote. Stocks approximate to the real position of bonds as well as bonds to that of stocks. One form of the change is a tendency to cover a larger proportion of investment by stock issues (as compared with bonds) than formerly. The increased recourse to borrowing from banks shows the same tendency, for banks in particular keep in touch with the management of businesses in which they invest.
[36.]The case of the ultimate entrepreneur, dealing with and knowing men rather than things, suggests again the analogous political problem. The progress of democracy toward intelligent efficiency seems to depend on a tendency for the ultimate sovereign, the electorate, to center its attention on the selection of competent agents, leaving to them the actual formulation of policies and conduct of affairs. Commission government, and still more the manager plan of municipal government, is a case in point. In the political sphere there is a real problem of ultimate ends, which must, of course, be dealt with by the electorate if the system remains democratic. And perhaps more than in the case of business the voter's judgment of the candidate must be connected with passing an opinion upon the issues, partly because major issues to some extent involve a question of ultimate social ideals. Professor Cooley (Social Organization, p. 129 and chap. XIII) bases an optimistic view of democracy on a belief in the capacity of the populace, admittedly ignorant in regard to political issues and the technique of government, to select men wisely on the basis of a sort of intuitive recognition of personal superiority.
[37.]By "interest" is here meant property income merely. The relation between interest and rent is essentially a "dynamic" problem, and will be taken up for discussion in the following chapter. It is questionable whether interest would be met with at all in an unprogressive society, and certain that the distinction between interest and rent would be of small importance. Cf. also above, chapter V.
[38.]We must again refer to the use of the term "interest" as meaning property income merely, though superficially this is not quite consistent with treatment of it as a "rate." Pure interest is much more easily defined than a pure competitive return on actual property, but even the latter offers less difficulty than an appraisal of the competitive value of the services of an independent entrepreneur.
[39.]To the extent that he does not give adequate security the owners of the productive services exposed to loss are the true entrepreneurs.
[40.]Including, of course, monopoly elements in the situation. Cf. above, chapter VI.
[41.]The hiring of men to meet uncertainty can be illustrated by many examples from different fields. Corporations employ at set, fixed wages inventors, experimenters, prospectors for minerals, weather and crop forecasters, market predictors, speculators, etc. Gambling-houses pay men weekly salaries to play poker with their clients. It is clear that such employees, like the hired manager, make decisions as a matter of routine, without taking responsibility. The responsible decision is made by the employer, who selects them for their tasks, and the operation of the principle of consolidation of uncertainties is also apparent. The latter point is not so clear in other cases; the doctor makes decisions, but his patients take the responsibility for their correctness!
[42.]See chapter V.
[43.]In many instances, of course, this situation is inverted; the selling price is known in advance by contracting and it is the cost outlays which are uncertain.
[44.]A small amount of capital wealth would, of course, result from the temporary investment of savings later withdrawn and consumed. An adequate discussion of the motives involved in the production of such surplus wealth would be beyond the scope of this work. The writer would say, however, that the theory of an "instinct" of acquisition or accumulation seems to him to be even below the plane of scientific thinking of the famous "dormitive virtue" of opiates. The latter at least is a real property or mode of behavior of something, while the human activity of accumulation is not a distinctive reaction, but a manifestation of the same tendencies found in human conduct generally. The "creative" or "constructive" impulse is open to the same objection; the "pleasure of being a cause" used by Gross, Preyer, Cooley, and others seems to be the best description of action not directed to gratifying an immediate and conscious need of the organism as a vital machine. It is merely a confusing misuse of terms to call an undifferentiated and undirected tendency to action-in-general an "instinct."
[45.]See above, chapter V, where it is shown that the "capitalization rate" which would determine or rather arise out of the sale-value of property on the second of the above assumptions is not interest in the proper sense of the term, and that its rate is determined by "psychological" considerations of "time-preference," very different from the forces which determine the rate of interest in the present world. These forces we now proceed to analyze more in detail.
[46.]Substantially followed by Taussig, and rightly so. See Wages and Capital; also Principles of Economics, chaps. 38-40.
[47.]Borrowing for the purchase of productive equipment already in existence (land or other goods) manifestly makes no difference in either the demand or supply of capital and hence has no effect on the interest rate.
[48.]From the standpoint of an ultimate long-time treatment of interest theory it is important that this conversion is not usually utterly irrevocable. The process can generally be reversed, the capital withdrawn, and the wealth recovered in the form of consumption goods—more or less quickly and effectively—by under-maintenance of the capital goods.
[49.]See chapter IV for a discussion of the possibility that interest might appear in connection with the use of property in a static state, and chapter V for a similar discussion with regard to a progressive society with uncertainty absent.
[50.]Whether entrepreneurs as a class or on the average do secure remuneration for their services as entrepreneurs in the strict sense—i.e., exclusive of payment for their work and for the use of their property—a point about which question will be raised in the next chapter.
[51.]Time preference or discount of the future, as more fully explained elsewhere, has nothing to do with the interest rate except in determining the supply of new capital (rate of saving). This indirect effect becomes appreciable only over long periods of time, since the saving made in any short period is negligible at best in comparison with the total investment previously made, or more strictly that part of this total which retains some degree of fluidity, and is also negligible in relation to the total demand for capital in the market.
[52.]Allowance must be made for the uncertainty of the permanence of the income.
[53.]The correct line for a scientific interpretation of human behavior is in the writer's view well indicated in the "Methodological Introduction (by Professor Thomas) to The Polish Peasant in Europe and America, by Thomas and Czaniecki. Professor Thomas's analysis runs in terms of "values" (social customs, conventions, or mores) and "attitudes," the result of individual criticism of the established values and tending constantly to modify and reconstruct the latter. This view is also harmonious with that of Professor Tufts, formulated in more general terms in the essay on "The Moral Life" in the volume entitled Creative Intelligence.
[54.]Veblen (The Theory of Business Enterprise) has made much of this form of business activity. Perhaps it had been neglected unduly by economists, but Veblen's allegation that such stealing through the production of disturbances in business arrangements is the usual or characteristic activity of modern economic life is of course merely humorous. Davenport also, following Veblen, shows a propensity for the view that the members of modern economic society enrich themselves by mutual predations.
[55.]Davenport (Economics of Enterprise) has emphasized the fact that the short-period changes in the interest rate are due to changes in the supply of bank funds. He is to be criticized for failing to make it clear that the long-time questions must be handled along wholly different lines. Cf. also Moulton, "Commercial Banking and Capital Formation," Journal of Political Economy, 1918, pp. 484 ff., 638 ff., 705 ff., 849 ff.
[56.]Cf. above, p. 34 f [n41—Ed.].
[57.]Limited progress has been made in some countries in the development of organizations of laborers which engage in enterprise independently, borrowing any necessary capital and hiring supervision at fixed rates. Coöperative production in the ordinary sense may also be referred to, but neither of these cases affords a notable exception to the above generalization as the laborers borrow very little capital. It is one of the defects of our civilization that mechanism has not been involved to enable human ability to hypothecate its productive power in procuring resources to make it effective under its own direction and responsibility.
A notable tendency in modern business development is to specialize and subdivide uncertainty and control in all possible degrees. Corporations multiply securities representing every conceivable gradation from the position of a pure creditor with absolute safety and complete indifference to the conduct of the business at one extreme to risk and control so highly concentrated that slight fluctuations in earnings make the difference between high dividends and assessments at the other. In mercantile business and even in industrial concerns credit instruments pass through the hands of a lengthening series of middlemen who add their guarantees of soundness and pass them on at a little higher price or lower return. Bond houses, bill brokers, and acceptance banks are an interesting development in this field. In the labor field the same tendency is manifest. Intermediate employers may hire labor for re-hiring to actual exploiters, as in the familiar case of the padrone, and in some lines of professional work. Every development of profit-sharing is similarly a redistribution of risk and control.
[58.]Sir H. S. Maine and Herbert Spencer are especially responsible for this vicious and question-begging perversion of thought.
[59.]It is obvious that pure freedom of contract is impossible in a continuous society, as children and the aged and many others can control nothing. In order to deal with the concept in a pure form we are compelled (see chapter IV) to assume that all dependent persons were absolutely dependent, which is to say virtually "owned" by the freely contracting members of the society.
[60.]We make no distinction between natural agents and produced equipment goods, as we have shown that under competition no final distinction can be drawn between preëmption and production. (See the discussion of land and capital in chapters IV, V, and XI.) In this connection we may remark here that we are not necessarily in disagreement with a separation of land from capital from the point of view taken by Marshall (Principles of Economics, book IV, chap. I). From the standpoint of a single political unit occupying a limited area of the earth whose natural resources are thoroughly explored, they stand in a different relation as to new supply from that which they occupy in a world economy or a vast and relatively new country like the United States.
[61.]It is interesting to observe the concern of the management for the personal security of the workers brought about by compensation laws, and especially the remarkable results of the "safety first" movement in reducing accidents.
[62.]See Merril, J. C. F., article on "Speculation," Price Current Grain Reporter, September 29, 1915, pp. 26-27: "It is a universal axiom of business that the greater the risk involved in any line of business the greater must be the profits to those engaged in it, or . . . profits are in proportion to risks!"
[63.]Economic Theory of Risk and Insurance, pp. 55-56.
[64.]Op. cit. (Annals, Am. Acad., 1896), p. 119.
[65.]Quarterly Journal of Economics, vol. IX, no. 4, p. 414.
[66.]Institutes of Economics, p. 54.
[67.]Unternehmergewinn, p. 85.
[68.]Principles of Economics (1913), pp. 366-67, 383-84.
[69.]J. S. Mill stated that chances of profit tend to equality, but in the fifth edition changed the word "chances" to "expectations." See Principles, Ashly edition, p. 412.
[70.]See above, chapter II, p. 42 [I.II.35-36—Ed.].
[71.]Hawley sometimes holds that profit is negative (Quarterly Journal of Economics, vol. XV, p. 609) and at other times that it is positive. (Ibid., p. 79.)
[72.]M. Porte, Entrepreneurs et profits industriels (Paris, 1905), argues to this conclusion from certain figures on business failures in Massachusetts. The results of studies of farm accounts by the New York State College of Agriculture indicate that farmers commonly make less than fair wages and a fair return on the investment, and investigations of public utility ventures have yielded similar results. The best study of the distribution of income in the United States, by Dr. W. I. King, reaches the conclusion that the average profit per entrepreneur in this country is about one and four tenths times the average wage per laborer. (See Wealth and Income of the People of the United States, p. 165.) It seems safe to assume that entrepreneurs have greater ability than laborers in a larger ratio than this, especially since a large proportion of the wage-earners reported by the Census are women and young persons and children. But Dr. King's division of income into shares and his estimates of the numbers of recipients of each type are both replete with long-range deductions and assumptions leaving so much room for error that little if any confidence can be placed in the result.
[73.]Cited by Cannan, History of Theories of Production and Distribution, p. 369.
[74.]Article on "Profit" in Palgrave's Dictionary of Political Economy.
[75.]Distribution of Wealth, p. 283.
[76.]An accurate and exhaustive discussion of this point would have to distinguish between the motives of the entrepreneur and those of the owner who transfers the use of his property to an entrepreneur for a fixed return.