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Principles of Economics; Marshall, Alfred
33 paragraphs found.

When a man is engaged in business, his profits for the year are the excess of his receipts from his business during the year over his outlay for his business. The difference between the value of his stock of plant, material, etc. at the end and at the beginning of the year is taken as part of his receipts or as part of his outlay, according as there has been an increase or decrease of value. What remains of his profits after deducting interest on his capital at the current rate (allowing, where necessary, for insurance) is generally called his earnings of undertaking or management. The ratio in which his profits for the year stand to his capital is spoken of as his rate of profits. But this phrase, like the corresponding phrase with regard to interest, assumes that the money value of the things which constitute his capital has been estimated: and such an estimate is often found to involve great difficulties.

That is to say, if £30 represent necessaries, a person's satisfaction from his income will begin at that point; and when it has reached £40, an additional £1 will add a tenth to the £10 which represents its happiness-yielding power. But if his income were £100, that is £70 above the level of necessaries, an additional £7 would be required to add as much to his happiness as £1 if his income were £40: while if his income were £10,000, an additional £1000 would be needed to produce an equal effect (compare Note VIII. in the Appendix). Of course such estimates are very much at random, and unable to adapt themselves to the varying circumstances of individual life. As we shall see later, the systems of taxation which are now most widely prevalent follow generally on the lines of Bernoulli's suggestion. Earlier systems took from the poor very much more than would be in accordance with that plan; while the systems of graduated taxation, which are being foreshadowed in several countries, are in some measure based on the assumption that the addition of one per cent. to a very large income adds less to the wellbeing of its owner than an addition of one per cent. to smaller incomes would, even after Bernoulli's correction for necessaries has been made.

It may be mentioned in passing that from the general law that the utility to anyone of an additional £1 diminishes with the number of pounds he already has, there follow two important practical principles. The first is that gambling involves an economic loss, even when conducted on perfectly fair and even terms. For instance, a man who having £600 makes a fair even bet of £100, has now an expectation of happiness equal to half that derived from £700, and half that derived from £500; and this is less than the certain expectation of the happiness derived from £600, because by hypothesis the difference between the happiness got from £600 and £500 is greater than the difference between the happiness got from £700 and £600. (Compare Note IX. in the Appendix and Jevons, l. c. Ch. IV.) The second principle, the direct converse of the first, is that a theoretically fair insurance against risks is always an economic gain. But of course every insurance office, after calculating what is a theoretically fair premium, has to share in addition to it enough to pay profits on its own capital, and to cover its own expenses of working, among which are often to be reckoned very heavy items for advertising and for losses by fraud. The question whether it is advisable to pay the premium which insurance offices practically do charge, is one that must be decided for each case on its own merits.


§ 6. There are indeed some who find an intense pleasure in seeing their hoards of wealth grow up under their hands, with scarcely any thought for the happiness that may be got from its use by themselves or by others. They are prompted partly by the instincts of the chase, by the desire to outstrip their rivals; by the ambition to have shown ability in getting the wealth, and to acquire power and social position by its possession. And sometimes the force of habit, started when they were really in need of money, has given them, by a sort of reflex action, an artificial and unreasoning pleasure in amassing wealth for its own sake. But were it not for the family affections, many who now work hard and save carefully would not exert themselves to do more than secure a comfortable annuity for their own lives; either by purchase from an insurance company, or by arranging to spend every year, after they had retired from work, part of their capital as well as all their income. In the one case they would leave nothing behind them: in the other only provision for that part of their hoped-for old age, from which they had been cut off by death. That men labour and save chiefly for the sake of their families and not for themselves, is shown by the fact that they seldom spend, after they have retired from work, more than the income that comes in from their savings, preferring to leave their stored-up wealth intact for their families; while in this country alone twenty millions a year are saved in the form of insurance policies and are available only after the death of those who save them.


§ 5. To give definiteness to our ideas let us take an illustration from the woollen trade. Let us suppose that a person well acquainted with the woollen trade sets himself to inquire what would be the normal supply price of a certain number of millions of yards annually of a particular kind of cloth. He would have to reckon (i) the price of the wool, coal, and other materials which would be used up in making it, (ii) wear-and-tear and depreciation of the buildings, machinery and other fixed capital, (iii) interest and insurance on all the capital, (iv) the wages of those who work in the factories, and (v) the gross earnings of management (including insurance against loss), of those who undertake the risks, who engineer and superintend the working. He would of course estimate the supply prices of all these different factors of production of the cloth with reference to the amounts of each of them that would be wanted, and on the supposition that the conditions of supply would be normal; and he would add them all together to find the supply price of the cloth.

Figure 18. Click to enlarge in new window.Measuring, as in the case of the demand curve, amounts of the commodity along Ox and prices parallel to Oy, we get for each point M along Ox a line MP drawn at right angles to it measuring the supply price for the amount OM, the extremity of which, P, may be called a supply point; this price MP being made up of the supply prices of the several factors of production for the amount OM. The locus of P may be called the supply curve.

Suppose, for instance, that we classify the expenses of production of our representative firm, when an amount OM of cloth is being produced under the heads of (i) Mp1, the supply price of the wool and other circulating capital which would be consumed in making it, (ii) p1p2 the corresponding wear-and-tear and depreciation on buildings, machinery and other fixed capital; (iii) p2p3 the interest and insurance on all the capital, (iv) p3p4 the wages of those who work in the factory, and (v) p4P the gross earnings of management, etc. of those who undertake the risks and direct the work. Thus as M moves from O towards the right p1, p2, p3, p4 will each trace out a curve, and the ultimate supply curve traced out by P will be thus shown as obtained by superimposing the supply curves for the several factors of production of the cloth.

It must be remembered that these supply prices are the prices not of units of the several factors but of those amounts of the several factors which are required for producing a yard of the cloth. Thus, for instance, p3p4 is the supply price not of any fixed amount of labour but of that amount of labour which is employed in making a yard where there is an aggregate production of OM yards. (See above, § 3.) We need not trouble ourselves to consider just here whether the ground-rent of the factory must be put into a class by itself: this belongs to a group of questions which will be discussed later. We are taking no notice of rates and taxes, for which he would of course have to make his account.




§ 1. We may now return to the consideration of prime and supplementary costs, with special reference to the proper distribution of the latter between the joint products of a business.


§ 2. There are two elements of the general expenses of a business, the sharing of which between the different branches requires some special attention. They are the expense of marketing and that of insurance against risk.


It remains to make a closer study of the relation in which insurance against the risks of a business stands to the supply price of any particular commodity produced in it.


§ 3. The manufacturer and the trader commonly insure against injury by fire and loss at sea; and the premiums which they pay are among the general expenses, a share of which has to be added to the prime cost in order to determine the total cost of their goods. But no insurance can be effected against the great majority of business risks.


Even as regards losses by fire and sea, insurance companies have to allow for possible carelessness and fraud; and must therefore, independently of all allowances for their own expenses and profits, charge premiums considerably higher than the true equivalent of the risks run by the buildings or the ships of those who manage their affairs well. The injury done by fire or sea however is likely, if it occurs at all, to be so very great that it is generally worth while to pay this extra charge; partly for special trade reasons, but chiefly because the total utility of increasing wealth increases less than in proportion to its amount. But the greater part of business risks are so inseparably connected with the general management of the business that an insurance company which undertook them would really make itself responsible for the business: and in consequence every firm has to act as its own insurance office with regard to them. The charges to which it is put under this head are part of its general expenses, and a share of them has to be added to the prime cost of each of its products.


But here there are two difficulties. In some cases insurance against risk is apt to be left out of account altogether, in others it is apt to be counted twice over. Thus a large shipowner sometimes declines to insure his ships with the underwriters: and sets aside part at least of the premiums that he might have paid to them, to build up an insurance fund of his own. But he must still, when calculating the total cost of working a ship, add to its prime cost a charge on account of insurance. And he must do the same thing, in some form or other, with regard to those risks against which he could not buy an insurance policy on reasonable terms even if he wanted to. At times, for instance, some of his ships will be idle in port, or will earn only nominal freights: and to make his business remunerative in the long run he must, in some form or other, charge his successful voyages with an insurance premium to make up for his losses on those which are unsuccessful.


In general, however, he does this, not by making a formal entry in his accounts under a separate head, but by the simple plan of taking the average of successful and unsuccessful voyages together; and when that has once been done, insurance against these risks cannot be entered as a separate item in cost of production, without counting the same thing twice over. Having decided to run these risks himself, he is likely to spend a little more than the average of his competitors, in providing against their occurrence; and this extra expense enters in the ordinary way into his balance-sheet. It is really an insurance premium in another form; and therefore he must not count insurance against this part of the risk separately, for then he would be counting it twice over *69.


When a manufacturer has taken the average of his sales of dress materials over a long time, and bases his future action on the results of his past experience, he has already allowed for the risk that the machinery will be depreciated by new inventions rendering it nearly obsolete, and for the risk that his goods will be depreciated by changes in fashion. If he were to allow separately for insurance against these risks, he would be counting the same thing twice over *70.


§ 4. Thus, though when we have counted up the average receipts of a risky trade, we must not make a separate full allowance for insurance against risk; though there may be something to be allowed as a charge on account of uncertainty. It is true that an adventurous occupation, such as gold mining, has special attractions for some people: the deterrent force of risks of loss in it is less than the attractive force of changes of great gain, even when the value of the latter estimated on the actuarial principle is much less than that of the former; and as Adam Smith pointed out, a risky trade, in which there is an element of romance, often becomes so overcrowded that the average earnings in it are lower than if there were no risks to be run *71. But in the large majority of cases the influence of risk is in the opposite direction; a railway stock that is certain to pay four per cent. will sell for a higher price than one which is equally likely to pay one or seven per cent. or any intermediate amount.


Every trade then has its own peculiarities, but in most cases the evils of uncertainty count for something, though not very much: in some cases a slightly higher average price is required to induce a given outlay, if that average is the mean of widely divergent and uncertain results, than if the adventurer may reckon confidently on a return that differs but little from that average. To the average price therefore we must add a recompense for uncertainty, if that is unusually great; though if we added insurance against risk we should be counting the greater part of that twice over *72.

Again, certain insurance companies in America take risks against fire in factories at very much less than the ordinary rates, on condition that some prescribed precautions are taken, such as providing automatic sprinklers and making the walls and floor solid. The expense incurred in these arrangements is really an insurance premium; and care must be taken not to count it twice over. A factory which undertakes its own risks against fire will have to add to the prime cost of its goods an allowance for insurance at a lower rate, if it is arranged on this plan, than if built in the ordinary way.
Again, when a farmer has calculated the expenses of raising any particular crop with reference to an average year, he must not count in addition insurance against the risk that the season may be bad, and the crop a failure: for in taking an average year, he has already set off the chances of exceptionally good and bad seasons against one another. When the earnings of a ferryman have been calculated on the average of a year, allowance has already been made for the risk that he may sometimes have to cross the stream with an empty boat.

But here we meet with a difficulty as to the meaning of the term Net revenue. For the supply price of a freely-produced commodity includes normal profits; the whole of which, or at all events what remains of them after deducting interest on the capital employed and insurance against loss, is often classed indiscriminately as net revenue. And when a man manages his own business, he often does not distinguish carefully that portion of his profits, which really is his own earnings of management, from any exceptional gains arising from the fact that the business is to some extent of the nature of a monopoly.


The net income divided among the shareholders includes interest on the capital invested and insurance against risk of failure, but little or no earnings of management; so that the amount by which the dividends are in excess of what may fairly be allowed as interest and insurance, is the Monopoly Revenue which we are seeking.


Next we made some study of the division of the supplementary costs of a business,—and especially those connected with building up a trade connection, with marketing, and with insurance—among the various products of that business.


But in long periods both the internal and the external economies of production on a large scale have time to develop themselves. The marginal supply price is not the expenses of production of any particular bale of goods: but it is the whole expenses (including insurance, and gross earnings of management) of a marginal increment in the aggregate process of production and marketing.


Again one sometimes hears it said that a certain farmer starves his land for labour. Perhaps he has enough horses and plant; but "if he took on another man, he would get his money back, and a good deal more": that is, the net product of an additional man would more than cover his wages. Let us suppose that a farmer is raising such a question as to the number of his shepherds. For simplicity, we may suppose that an additional man would not require any further expenditure on plant or stock: that he would save the farmer himself just as much trouble in some ways as he gives in others; so that nothing has to be allowed for earnings of management (even when these are interpreted broadly so as to include insurance against risk, etc.): and lastly that the farmer reckons that he would do just so much in preventing the wastage of lambs, and in other ways as will increase by twenty his annual output of sheep in good condition. That is to say, he reckons that the net product of an additional man will be twenty sheep. If he can be got for much less than the equivalent of their price, the alert farmer will certainly hire him; but, if only for about that price, the farmer will be on the margin of doubt; and the man may then be called a marginal shepherd, because his employment is marginal.


And again, though, by taking this average, we obviate the necessity of making any separate allowance for insurance against risk, account generally remains to be taken of the evil of uncertainty. For there are many people of a sober steady-going temper, who like to know what is before them, and who would far rather have an appointment which offered a certain income of say £400 a year than one which was not unlikely to yield £600, but had an equal chance of affording only £200. Uncertainty, therefore, which does not appeal to great ambitions and lofty aspirations, has special attractions for very few; while it acts as a deterrent to many of those who are making their choice of a career. And as a rule the certainty of moderate success attracts more than an expectation of an uncertain success that has an equal actuarial value.


The necessity for making this allowance for insurance against risk is so obvious, that it is not often overlooked. But it is less obvious that every loan causes some trouble to the lender; that when, from the nature of the case, the loan involves considerable risk, a great deal of trouble has often to be taken to keep these risks as small as possible; and that then a great part of what appears to the borrower as interest, is, from the point of view of the lender, earnings of management of a troublesome business.


There is one set of risks which is common to both; which may be described as the trade risks of the particular business in which they are engaged. They arise from fluctuations in the markets for their raw materials and finished goods, from unforeseen changes of fashion, from new inventions, from the incursion of new and powerful rivals into their respective neighbourhoods, and so on. But there is another set of risks, the burden of which has to be borne by the man working with borrowed capital, and not by the other; and we may call them personal risks. For he who lends capital to be used by another for trade purposes, has to charge a high interest as insurance against the chances of some flaw or deficiency in the borrower's personal character or ability *68.


The price then that the borrower has to pay for the loan of capital, and which he regards as interest, is from the point of view of the lender more properly to be regarded as profits: for it includes insurance against risks which are often very heavy, and earnings of management for the task, which is often very arduous, of keeping those risks as small as possible. Variations in the nature of these risks and of the task of management will of course occasion corresponding variations in the gross interest, so called, that is paid for the use of money. The tendency of competition is therefore not towards equalizing this gross interest: on the contrary, the more thoroughly lenders and borrowers understand their business, the more certainly will some classes of borrowers obtain loans at a lower rate than others.


When we come to discuss the Money Market we shall have to study the causes which render the supply of capital for immediate use much larger at some times than at others; and which at certain times make bankers and others contented with an extremely low rate of interest, provided the security be good and they can get their money back into their own hands quickly in case of need. At such times they are willing to lend for short periods even to borrowers, whose security is not of the first order, at a rate of interest that is not very high. For their risks of loss are much reduced by their power of refusing to renew the loan, if they notice any indication of weakness on the part of the borrower; and since short loans on good security are fetching only a nominal price, nearly the whole of what interest they get from him is insurance against risk, and remuneration of their own trouble. But on the other hand such loans are not really very cheap to the borrower: they surround him by risks, to avoid which he would often be willing to pay a much higher rate of interest. For if any misfortune should injure his credit, or if a disturbance of the money market should cause a temporary scarcity of loanable capital, he may be quickly brought into great straits. Loans to traders at nominally low rates of interest, if for short periods only, do not therefore really form exceptions to the general rule just discussed.


As has already been observed *77, joint-stock companies are hampered by internal frictions, and conflicts of interest between shareholders and debenture holders, between ordinary and preferred shareholders, and between all these and the directors; and by the need for an elaborate system of checks and counterchecks. They seldom have the enterprise, the energy, the unity of purpose and the quickness of action of a private business. But these disadvantages are of relatively small importance in some trades. That publicity, which is one of the chief drawbacks of public companies in many branches of manufacture and of speculative commerce, is a positive advantage in ordinary banking and insurance and kindred businesses; while in these, as well as in most of the transport industries (railways, tramways, canals, and the supply of gas, water, and electricity), their unbounded command over capital gives them almost undisputed sway.


In trades that handle costly materials, success depends very much upon good fortune and ability in buying and selling; and the order of mind required for interpreting rightly and reducing to their proper proportions the causes that are likely to affect price is rare, and can command high earnings. The allowance to be made for this is so important in certain trades as to have induced some American writers to regard profits as remuneration of risk simply; and as consisting of what remains after deducting interest and earnings of management from gross profits. But this use of the term seems on the whole not advantageous, because it tends to class the work of management with mere routine superintendence. It is of course true that as a rule a person will not enter on a risky business, unless, other things being equal, he expects to gain from it more than he would in other trades open to him, after his probable losses had been deducted from his probable gains on a fair actuarial estimate. If there were not a positive evil in such risk, people would not pay premia to insurance companies; which they know are calculated on a scale sufficiently above the true actuarial value of the risk to pay the companies' great expenses of advertising and working, and yet to yield a surplus of net profits. And where the risks are not insured for, they must be compensated in the long run on a scale about as high as would be required for the premia of an insurance company, if the practical difficulties of insurance against business risks could be overcome. But further many of those who would be most competent to manage difficult businesses with wisdom and enterprise, are repelled from great risks, because their own capital is not large enough to bear great losses. Thus a risky trade is apt to get into the hands of rather reckless people; or perhaps into the hands of a few powerful capitalists, who work it ably, but arrange among themselves that the market shall not be forced so as to prevent them from having a high rate of profit on the average *84.

The fishmongers and greengrocers in working-class quarters especially lay themselves out to do a small business at a high rate of profits; because each individual purchase is so small that the customer would rather buy from a dear shop near at hand than go some way to a cheaper one. The retailer therefore may not be getting a very good living though he charges a penny for what he bought for less than a halfpenny. The same thing was however perhaps sold by the fisherman or the farmer for a farthing or even less: and the direct lost of carriage and insurance against loss will not account for any great part of this last difference. Thus there seems to be some justification for the popular opinion that the middlemen in these trades have special facilities for obtaining abnormally high profits by combination among themselves.
The expert evidence that is given in such cases is full of instruction to the economist in many ways, and in particular because of the use of mediæval phrases as to the customs of the trade, with a more or less conscious recognition of the causes which have produced those customs, and to which appeal must be made in support of their continued maintenance. And it almost always comes out finally that if the "customary" rate of profit on the turnover is higher for one class of job than another, the reason is that the former does (or did a little while ago) require a longer locking-up of capital; or a greater use of expensive appliances (especially such as are liable to rapid depreciation, or cannot be kept always employed, and therefore must pay their way on a comparatively small number of jobs); or that it requires more difficult or disagreeable work, or a greater amount of attention on the part of the undertaker; or that it has some special element of risk for which insurance has to be made. And the unreadiness of experts to bring to light these justifications of custom, which are lying almost hidden from themselves in the recesses of their own minds, gives ground for the belief that if we could call to life and cross-examine mediæval business men, we should find much more half-conscious adjustment of the rate of profit to the exigencies of particular cases than has been suggested by historians. Many of them fail sometimes to make it clear whether the customary rate of profits of which they are speaking is a certain rate on the turnover, or such a rate on the turnover as will afford in the long run a certain rate of profits per annum on the capital. Of course the greater uniformity of the methods of business in mediæval times, would enable a tolerably uniform rate of profits on the capital per annum to exist without causing so great variations in the rate on the turnover as are inevitable in modern business. But still it is clear that if one kind of rate of profits were nearly uniform, the other would not be; and the value of much that has been written on mediæval economic history seems to be somewhat impaired by the absence of a distinct recognition of the differences between the two kinds, and between the ultimate sanctions on which customs relating severally to them must depend.

§ 9. We may next consider how far landlords will in their own interest adjust the size of holdings to the real needs of the people. Small holdings often require more expensive buildings, roads and fences, and involve greater trouble and incidental expenses of management to the landlord in proportion to their acreage than do large holdings; and while a large farmer who has some rich land can turn poor soils to good account, small holdings will not flourish generally except on good soil *125. Their gross rental per acre must therefore always be at a higher rate than that of large farms. But it is contended that, especially when land is heavily burdened by settlements, landlords are unwilling to incur the expense of subdividing farms, unless they see their way to rents for small holdings that will give them, in addition to high profits on their outlay, a heavy insurance fund against the chance of having to throw the holdings together again; and that the rental for small holdings, and especially for those of only a few acres, is extravagantly high in many parts of the country. Sometimes the prejudices of the landlord and his desire for undisputed authority make him positively refuse to sell or let land to persons who are not in harmony with him on social, political or religious questions. It seems certain that evils of this kind have always been confined to a few districts, and that they are rapidly diminishing, but they rightly attract much attention; for there is a public need in every district for small holdings, as well as large; for allotments and large gardens; and generally for holdings so small that they can be worked by people who have some other occupation *126.

Appendix G

He contrives to the best of his ability that the site and the house (or other building), which he puts upon it, shall be permanently appropriate the one to the other. In so far as he succeeds, the rent of the property at any future time is the sum of its annual site value and the annual value of the building: and this he expects to yield him full profits on his outlay, allowing for insurance against the risks of a rather hazardous industry. This second part of the rent is commonly, though perhaps not with strict propriety, called the (annual) building value, or the building rent of the house.