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Risk, Uncertainty, and Profit; Knight, Frank H.
35 paragraphs found.

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.


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 Graph III.4produce 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


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.


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 rate *65 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.


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.


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.


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.

Marshall correctly treats long-time demand and supply as time rates, but does not sharply contrast this form of the variable with the absolute amounts dealt with in market price.

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:

1. The population considered as consuming units; its numbers and physical composition as to age, sex, race, etc.
2. The psychic attributes of the population, its behavior attitudes toward the consumption of all sorts of goods, both inherited "instincts" (in whatever sense such things exist), and the "social inheritance" of habit, custom, tastes, standards, mores, and what-not, including, of course, actual knowledge or beliefs as to the real characteristics of commodities. We must also include here any institutional facts as to the control of the consumption of some persons by other persons, such as authority of parents, sumptuary laws, etc.
3. Immediately, the money income of the population both as to aggregate amount and distribution. Ultimately, in the equilibrium adjustment, the income and its distribution depend on the whole set of conditions of the supply of goods, especially the amount and distribution of productive resources in the society. It is imperative to remember that the end result of the competitive adjustment depends on the initial facts in all these respects.
4. For completeness it is important, also, to consider the given facts as to the geographic distribution of the population as consuming units; this is determined, of course, by the distribution of productive resources and of environmental conditions affecting desirability of sites for habitation. Differences here would also produce effects ramifying throughout the whole organization.

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.


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.


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.


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 created *103 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.


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.

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.
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.


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.

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.


Since in a free market there can be but one price on any commodity, a general wage rate must result from this competitive bidding. The rate established may be described as the socially or competitively anticipated value of the laborer's product, using the term "product" in the sense of specific contribution, as already explained. It is not the opinion of the future held by either party to an employment bargain which determines the rate; these opinions merely set maximum and minimum limits outside of which the agreement cannot take place. The mechanism of price adjustment is the same as in any other market. There is always an established uniform rate, which is kept constantly at the point which equates the supply and demand. If at any moment there are more bidders willing to employ at a higher rate than there are employees willing to accept the established rate, the rate will rise accordingly, and similarly if there is a balance of opinion in the opposite direction. The final decision by any individual as to what to do is based on a comparison of a momentarily existing price with a subjective judgment of significance of the commodity. The judgment in this case relates to the indirect significance derived from a twofold estimate of the future, involving both technological and price uncertainties. The employer in deciding whether to offer the current wage, and the employee in deciding whether to accept it, must estimate the technical or physically measured product (specific contribution) of the labor and the price to be expected for that product when it comes upon the market. The estimation may involve two sorts of calculation or estimate of probability. The venture itself may be of the nature of a gamble, involving a large proportion of inherently unpredictable factors. In such a case the decision depends upon an "estimate" of an "objective probability" of success, or of a series of such probabilities corresponding to various degrees of success or failure. And normally, in the case of intelligent men, account will be taken of the probable "true value" of the estimates in the case of all estimated factors.


The first step in attacking the problem is to inquire into the meaning of entrepreneur ability and its conditions of demand and supply. In regard to the first main division of the entrepreneur's income, the ordinary wage for the routine services of labor and property furnished to the business, no comment is necessary. This return is merely the competitive rate of pay for the grade of ability or kind of property in question. To be sure, it may not be possible in practice to say exactly what this rate is. Not merely is perfect standardization of things and services unattainable under the fluctuating conditions of real life, but in addition the conditions of the entrepreneur specialization may well bring it about that the same things are not done under closely comparable conditions by entrepreneurs and non-entrepreneurs. Hence the separation between the pure wage or rent element and the elements arising out of uncertainty cannot generally be made with complete accuracy. The serious difficulty comes with the attempt to deal with the relation between judgment and luck in determining that part of the entrepreneur's income which is associated with the performance of his peculiar twofold function of (a) exercising responsible control and (b) securing the owners of productive services against uncertainty and fluctuation in their incomes. Clearly this special income is also connected with a sort of effort and sacrifice and into the nature and conditions of supply and demand of the capacities and dispositions for these efforts and sacrifices it must be pertinent to inquire.


Still further, the venture itself may be a gamble, as we have repeatedly pointed out. Most decisions calling for the exercise of judgment in business or responsible life in any field involve factors not subject to estimate and which no one makes any pretense of estimating. The judgment itself is a judgment of the probability of a certain outcome, of the proportion of successes which would be achieved if the venture could be repeated a large number of times. The allowance for luck is therefore twofold. It requires a large number of trials to show the real probabilities in regard to which judgment is exercised in any given kind of case as well as to distinguish between intrinsic quality in the judgment and mere accident. And bearing in mind again the extreme crudeness of the classification of instances at best, the marvel grows that we are able to live as intelligently as we do. Let us now attempt to state the principles determining entrepreneur income more accurately and in the form of laws of demand and supply.


The demand for a productive service depends upon the steepness of the curve of diminishing returns from increasing amounts of other kinds of services applied to the first. In the familiar case of land, the more rapidly the returns from increased applications of labor and capital applied to a given plot of land fall off, the higher will be the rent on land. Now there is evidently a law of diminishing returns governing the combination of productive services with entrepreneurs. It is based on the fact already stated of limitation in the space range of foresight and executive capacity. The greater the magnitude of operations which any single individual attempts to direct the less effective in general he will be—"beyond a certain point," as in other cases of the law. The demand for entrepreneurs, again, like that for any productive agency, depends directly upon the supply of other agencies.


The supply of entrepreneur qualities in society is one of the chief factors in determining the number and size of its productive units. It is a common and perhaps justifiable opinion that most of the other factors tend toward greater economy with increasing size in the establishment, and that the chief limitation on size is the capacity of the leadership. If this is true the ability to handle large enterprises successfully, when it is met with, must tend to secure very large rewards. The income of any particular entrepreneur will in general tend to be larger: (1) as he himself has ability, and good luck; but (2), perhaps more important, as there is in the society a scarcity of self-confidence combined with the power to make effective guarantees to employees. The abundance or scarcity of mere ability to manage business successfully exerts relatively little influence on profit; the main thing is the rashness or timidity of entrepreneurs (actual and potential) as a class in bidding up the prices of productive services. Entrepreneur income, being residual, is determined by the demand for these other services, which demand is a matter of the self-confidence of entrepreneurs as a class, rather than upon a demand for entrepreneur services in a direct sense. We must see at once that it is perfectly possible for entrepreneurs as a class to sustain a net loss, which would merely have to be made up out of their earnings in some other capacity. This would be the natural result in a population combining low ability with high "courage." On the other hand, if men generally judge their own abilities well, the general rate of profit will probably be low, whether ability itself is low or high, but much more variable and fluctuating for a low level of real capacity. The condition for large profits is a narrowly limited supply of high-grade ability with a low general level of initiative as well as ability.


Under freedom of contract the machinery which naturally grows up for effecting this specialization is the machinery of the market, working in the same way as in the case of entrepreneurs' bargains with the owners of productive services. Surplus consumption goods, or titles to these in the form of money or bank deposits, form a perfectly standardized commodity of an ideal sort for trading. It is also extremely mobile, still further adapting it to the operations of a market of the widest scope. Banks and financial institutions have this market highly organized. The actual workings of the market are the same as those of any other market. At any time there is a price established, which in this case is unusually definite and uniform. It is not, indeed, a single homogeneous commodity that is dealt in, for funds for different sorts of investment admit of the specialization of the entrepreneur function in widely different degrees. But after all the loan market represents a narrower range of prices according to grade and kind of the goods than is true of nearly any other market to be named. Men who are willing to purchase at the established price meet men who are willing to sell at that price; others do not enter the market. If more of the commodity is offered than will be taken at the existing price the price falls, and vice versa, keeping the price constantly adjusted to the point which equates the supply and demand.


The uncertainty so far discussed in this chapter is solely that which arises from the conversion of free capital (surplus consumption goods represented by circulating medium) into new productive equipment of kinds already familiar. The creation of free capital itself is subject to uncertainty, which calls for some notice. We are not concerned with the effects of uncertainty on the saver (not also investor), since that is a matter of his inner consciousness and does not produce objective effects in modifying social organization. Of interest, however, is the fact that productive business counts on the interest rate as a datum in its calculations. It would seem that in a society made up of persons with a tolerably stable human nature and living in an environment as little subject as ours to progressive or capricious change, the supply and demand of new saving would be nearly constant, the market being as large as it is, and that the interest rate would be free from extreme fluctuations. We know that such is very far from being the case. It is manifest that changes in the interest rate are as effective as changes in the yield of the property in producing changes in capital values.

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.
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.

It is a fundamental fact that the possible objects of ownership fall into two main classes, personal powers inherent in the individual, and material things. If an individual does not have some form and degree of ownership in the former he is a slave, the property of some outside party, and outside the system altogether. The modern world is, of course, pretty well committed to private property in the individual's own personal powers in all adults not dangerously abnormal or incompetent, subject only to general limitations. It is difficult to secure effective utilization of these under any other system, and the live questions relate only to the ownership of material things. *60 We have seen in different connections that the importance of the difference between these two classes is at least much exaggerated, that generic natural differences are hard if not impossible to find in relation either to their cause-and-effect bearings on price theory and economic organization or to their moral standing. The conditions of demand, conditions of supply, and relation to the possessing individual turn out on examination to be much alike, and differences which exist at all are mostly artificial and conventional. But from the standpoint of our human interests outside the production and consumption of goods we must recognize that the ownership of one's self is in a somewhat higher position than the ownership of external objects. Yet in a civilization where man is highly and increasingly dependent on access to and use of material things for his very life this distinction tends to fade out, and recognition of this fact accounts for much of the current ferment and change in the social attitude toward "property" (used narrowly as property in things).