Risk, Uncertainty, and Profit

Frank H. Knight
Knight, Frank H.
(1885-1972)
CEE
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1921
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Boston, MA: Hart, Schaffner & Marx; Houghton Mifflin Co.
Pub. Date
1921
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1st edition. Based on award-winning dissertation essay.
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Part III, Chapter XI

Uncertainty and Social Progress

III.XI.1

The general character of the connection between progress and uncertainty has been dealt with at various points in the course of our inquiry. Change of some kind is prerequisite to the existence of uncertainty; in an absolutely unchanging world the future would be accurately foreknown, since it would be exactly like the past. Change in some sense is a condition of the existence of any problem whatever in connection with life or conduct, and is the actual condition of most of the problems of pure thought, since these are after all more or less related to practical requirements. We live in a world full of contradiction and paradox, a fact of which perhaps the most fundamental illustration is this: that the existence of a problem of knowledge depends on the future being different from the past, while the possibility of the solution of the problem depends on the future being like the past. The key to the paradox, as we have argued above (chapter VII), is to be found in two facts. In the first place, we analyze our world into objects which behave more or less consistently. That is, we recognize in things the unchanging property of changing in certain ways. If this process could be carried out to completeness, we should have a completely knowable world. It would also, however, be in the practical sense an unchanging world. It is a fact familiar to students of our thought processes that we thus explain change by explaining it away. The historic problem of thought is this of real change. The point for us here is that change according to known law (whether or not we call it change) does not give rise to uncertainty. What we practically mean by a static world is one in which all change is of this character.

III.XI.2

But the process of formulating change in terms of unchanging "laws" (properties or modes of behavior of "things") cannot be carried to completeness, and here our minds invent a second refuge to which to flee from an unknowable world, in the form of the law of permutations and combinations. A law of change means given behavior under given conditions. But the "given conditions" of the behavior of any object are the momentary states and changes of other objects. Hence the dogma of science, that the world is "really" made up of units which not only do not change (atoms, corpuscles, ether, or what-not), but whose laws of behavior are simple and comprehensible. But it is contended that there are so many of these units that the simple changes which they undergo (ideally movements in space alone) give rise to a variety of combinations which our minds are unable to grasp in detail. We have examined this dogma and been forced to the conclusion that whatever we find it pleasant to assume for philosophic purposes, the logic of our conduct assumes real indeterminateness, real change, discontinuity.

III.XI.3

Even the assumption of real indeterminateness, however, gives mind a new means of prediction, through grouping phenomena into classes and applying probability reasoning. This device enables us to predict what will happen in groups of instances where we find it impossible to derive laws fitting individual cases. The second fundamental fact of uncertainty is that this method also has its limits. Both methods in fact, prediction by law in individual cases and by probability reasoning in groups of cases, have rather narrow limitations in everyday life in consequence of the organic costs of applying them and the time required to get the necessary data; both outlay and time are commonly much greater than circumstances will allow us to consume in deciding upon a course of action. The actual procedure of making decisions in practical life is a rather inscrutable or "intuitive" formation of "estimates," subject to a wide margin of error or uncertainty.

III.XI.4

The significance of change is that it gives rise to the problem of the control of action, and in this respect the difference between predictable and unpredictable change is conspicuous. The succession of day and night or the alternation of the seasons, the vital processes and changes of our own lives, waking and sleeping, work-time and meal-time and play-time, infancy, maturity, and age—such events call for action, but give rise to no problem of action; they are predictable. Problems of action arise out of departures from routine in changes of all sorts. It is a common observation that irregularities would be of much less magnitude and consequence in the absence of social progress, and a common practice to distinguish between "static" and "dynamic" risks. The fundamental difference, as we have seen, is one of degree only, and consists in the greater unpredictability of some actual progressive changes. In the first place, it is impossible to draw a sharp and significant distinction between progressive change and fluctuations. Everything depends on the periodicity of the change. If it is self-compensating in an interval short as compared with the length of human life, it does not involve uncertainty, and the increasing perfection of organization devices designed to secure consolidation constantly extends the period over which effective self-compensation may come about. On the other hand, all our progressive changes may be ultimately periodic for all we know.

III.XI.5

Again, progressive change does not necessarily carry unpredictability with it; indeed, a merely progressive change does not. If the change takes place uniformly, or in accordance with any known mathematical function of time, the future may be foreknown as accurately as if there were no change. It is fluctuation after all which is the true cause of the uncertainty, fluctuation in progress. In fact some changes are fairly "constant" in their operation and do not give rise to uncertainties of the sort which disturb the operation of competition. Of this sort are the increase of population and the accumulation of capital. Others are highly capricious in their action and continually upset the calculations upon the basis of which entrepreneurs' bids for productive service are made.

III.XI.6

Scrutiny of the character of the progressive changes which we have recognized (chapter V) as significant in the study of economics reveals some interesting similarities and differences among them. If we begin by distinguishing between natural changes and changes due to human action, we note that we do not have to consider any progressive changes under the former head. Natural changes are either of the nature of fluctuations from a constant condition or else, like the supposed cooling-off of the solar system, so slow as to make no difference for human calculations. The changes due to acts of man are, however, of two different kinds. Some are produced by deliberate intent and others come about more or less incidentally as a result of actions directed toward other ends. A study of the "real" motives of action would lead far afield, and probably yield no very clear and satisfactory results at last, but we can make a rough distinction. The improvement of technology and in large part the discovery of natural resources are directly willed, though the latter is to a more considerable extent accidental. The accumulation of capital may be treated as deliberately effected, though with some reservations, and the various redistributions of things among persons may be similarly treated, but with more reservations. The improvement of wants is partly a deliberate matter, partly incidental to other endeavors, and partly it "just happens." The increase in population is hardly willed at all; the matter of its innate quality is even less affected by volitional interference (and in fact unquestionably shows rapid retrogression under modern industrial conditions); while the education and training of the individual are controlled by a baffling mixture of planned action and accident.

III.XI.7

Another dichotomy of fundamental importance for the study of uncertainty relates to the production as contrasted with the consumption of wealth. This distinction is also well recognized in discussions of uncertainty, the technological "risks" being separated from those connected with market changes. It is interesting to observe in the evolution of the modern industrial organization how the marketing function has consistently dominated that of production proper. We have already pointed out that the most fundamental determining fact in connection with organization is the meeting of uncertainty. The responsible decisions in organized economic life are price decisions; others can be reduced to routine and men can be hired to make them. The uncertainties of the market resist elimination or reduction by grouping more doggedly than do those connected with technological processes. Even in the transition period between the mediæval and modern eras it was the marketing guilds which gravitated into positions of control, became the "Liveried Companies" and employed the producers and set them at their tasks, owning the materials they worked upon and the product when completed.

III.XI.8

It will be observed that the main uncertainty which affects the entrepreneur is that connected with the sale price of his product. His position in the price system is typically*43 that of a purchaser of productive services at present prices to convert into finished goods for sale at the prices prevailing when the operation is finished. There is no uncertainty as to the prices of the things he buys. He bears the technological uncertainty as to the amount of physical product he will secure, but the probable error in calculations of this sort is generally not large; the gamble is in the price factor in relation to the product. But changes in the prices of producers' goods affect him indirectly, because they are likely to be connected with changes in product prices; they form one of the factors to be taken into account in forecasting the sales market. This is probably a secondary consideration, however, except in so far as capital values are involved, a fundamental exception, to be sure, which will have to be discussed at length presently. The main immediate sources of uncertainty are the amount of supply to be expected from other producers and the consumers' wants and purchasing power.

III.XI.9

The most fundamentally and irretrievably uncertain phases or factors of progress are those which amount essentially to the increase of knowledge as such. This description evidently holds for the improvement of technological processes and the forms of business organization and for the discovery of new natural resources. Here it is a contradiction in terms to speak of anticipation, in an accurate and detailed sense, for to anticipate the advance would be to make it at once. Yet even here, as we have seen, change and the uncertainty of change are in some degree separable factors. Though we cannot describe a new invention in advance without making it, nor say what quantity and quality of new natural productive capacity will be developed and where, yet it is possible in a large degree to offset ignorance with knowledge and behave intelligently with regard to the future. These changes are in large part the result of deliberate application of resources to bring them about, and in the large if not in a particular instance, the results of such activity can be so far foreseen that it is even possible to hire men and borrow capital at fixed remunerations for the purpose of carrying it on.

III.XI.10

Two further general observations are called for before we can take up in detail the effects of the uncertainties involved in progress upon the form and workings of the competitive economic organization. It is common to think of the economic process as the production of goods for the satisfaction of wants. This view is deficient in two vital respects. In the first place, the economic process produces wants as well as goods to satisfy existing wants, and the amount of social energy devoted to the former and neglected phase of activity is very large and constantly growing. The second point is that the production of the indirect means of want-satisfaction is by no means altogether directed to the ultimate satisfaction of wants in any direct sense of the terms. The increase in wealth is to a large extent an end in itself as well as a means to the increase of income, and this also again to a rapidly increasing degree as the standards of life are advanced. Men work "to get rich" in a large proportion of cases, not merely in addition to, but in place of, consuming larger amounts of goods. It is a grave error to assume that in a modern industrial nation production takes place only in order to consumption. It is true to a great and ever-increasing degree that consumption is sacrificed to increased production. Whatever our philosophy of human motives, we must face the fact that men do "raise more corn to feed more hogs, to buy more land to raise more corn to feed more hogs to buy more land," and, in business generally, produce wealth to be used in producing more wealth with no view to any use beyond the increase of wealth itself.

III.XI.11

From the standpoint of effects upon organization we must distinguish between the various phases of progress already enumerated (in chapter V), the increase of population, education and training, accumulation of capital, improvement in technology and business organization, discovery of new natural resources, and changes in the character of human wants. The most important of these from our point of view and at the same time the one easiest to discuss intelligently is the accumulation of capital.

III.XI.12

Let us begin with the relation of capital in the sense of material goods to the fundamental structure of society. The facts of progress will be seen to have an intimate connection with the very institution of private property. In an unprogressive society private property in the modern sense of the term need not exist. The social justification of private ownership is that the coupling of control of resources with enjoyment of the fruits of their use is supposed to give an incentive to use the goods effectively in production. The abolition of slavery or property in human beings rests on the fact that slaves do not work as effectively as free men, and it turns out to be cheaper to pay men for their services and leave their private lives under their own control than it is to maintain them and force them to labor.

III.XI.13

The same reasoning applies to property in material things, but in an unprogressive state the force of the argument is relatively weak. When production methods are a matter of routine, as in the Middle Ages, and there is no thought of progress, common ownership of land and tools is the rule. The problem of control becomes acute when methods are changing, and the incentive to change methods is mainly the desire to increase property values, to "get rich." We can hardly over-emphasize the fact that the dynamic urge back of modern economic life is the desire to increase wealth, rather than a desire to consume goods, though there is a psychological connection of an irrational sort between the two considerations. Even when improvement in standards of living does result from the increase of wealth, it cannot be assumed that this was the motive; for as we have previously emphasized, a permanent net increase of wealth must come from a surplus production on the part of individuals which they never plan to consume, but expect to die and leave behind them.*44

III.XI.14

The most direct connection of the uncertainties of progress with economic theory in the conventional use of the term is in relation to the explanation of interest. Interest is a phenomenon connected with the increase of the material equipment of society and dependent on the uncertainty involved in the process. It might or might not exist in a "static" society, depending largely on how rigidly the term "static" is interpreted. If productive goods were not changeable in either form or amount or distribution there would be no occasion for the lending of free capital, and interest would not exist; if all equipment were fixed in form and amount, but transferable from one individual to another, it might exist; with productive goods fixed in amount (no net saving or consumption of "capital" taking place), but changeable in form, interest would doubtless be found, but would make no appreciable difference in the distribution of income, as it would differ in very little but name from rent. *45

III.XI.15

To understand interest it is necessary to have clearly in view the mechanism of the creation of capital equipment through the process of saving and investment. The classical conception of capital as "advances to laborers"*46 is essentially sound at least as a starting-point, though it must be amended or qualified in two particulars. The description applies, first, only to new or "free" capital, capital in the process of formation; it is true in the sense that capital goods come into existence through an "advancement" of consumption goods. In the second place, the advances are not made to laborers only, but to owners of already existing capital goods (and natural resources if these are separated from capital goods) as well. The difficulties and confusions with which interest theory is beset arise largely from the use of terms, notably the ambiguity of the term "capital." In the discussion which follows we shall employ the expression "capital goods" to refer to "the produce of past industry used for further production," the concrete instruments and tools, and restrict the term "capital" to a much narrower meaning, relating to this antecedent stage in the creation of capital goods or to their value as distinct from the goods themselves.

III.XI.16

The nature of capital creation has been made clear by many writers. The primitive man constructs his own equipment to increase the efficiency of his own labor, and what he dies possessed of is likely to be buried with him. In organized civilized life the process is different in two respects. In consequence of specialization certain persons devote their energies altogether to the production of equipment goods, others not at all; and in the second place, a great permanent fund of goods is built up and maintained and increased from generation to generation. Yet what happens on the whole is fundamentally the same, though the division of labor makes it somewhat more difficult to see. Those who are engaged in the making of equipment goods are naturally not at the same time making their own living; they must live out of a surplus of consumption goods either stored up in advance or diverted from the use of those who produce it contemporaneously. In either case the first requisite to capital creation is the creation of a surplus, the production of more goods than are consumed, by somebody at some time prior to the coming into existence of the capital goods. This is the essential meaning of "saving."

III.XI.17

In civilized society the makers of capital goods include landlords and owners of capital goods as well as laborers. All who furnish productive services of any kind to the capital goods producing operations are manifestly paid out of prior production or excess contemporary creation of consumption goods by other persons and equipment. The essence of the process is that a surplus of consumption goods, set aside by being "saved," makes possible the diversion of productive resources from the creation of consumption goods to the creation of producers' goods. This is what is meant by "advances."

III.XI.18

The series of events is further complicated by the intervention of money, for a relatively small proportion of students of economics ever learn to think back of the exchange function of money to the transfers of real things mediated by it. Saving is erroneously thought of as the saving of money, and the income of the producers of capital goods as a money income. Of course the money is a mere medium of exchange. It represents to the saver the ownership of a certain amount of the wealth of society, which can be "drawn" or "cashed" in any form he pleases at existing prices. If the saving is "invested," used for capital creation, this wealth is transferred to those engaged in these operations and "cashed" by them in the form of the things they want, mainly consumption goods. The title to these things is what the saving is and what is transferred. The transferred goods maintain or support the producers of capital goods, including laborers, landowners, and owners of capital goods who would otherwise be engaged in making consumption goods for themselves or for exchange. Interest arises when saved wealth is not invested by the saver, but transferred by loan to another person, either direct from saver to investor or mediated by a bank or financial institution as middleman.

III.XI.19

The loan at interest is thus a means of securing specialization of function, enabling one set of persons to save surplus wealth and another set to convert savings into capital goods by advancing them to the owners of productive services who then use these services to create the capital goods instead of the consumption goods which they would have been used to produce had no saving taken place. The operations could be carried on without specialization; division of labor here as elsewhere involves economy merely, but is not the only way of getting things done. The savers could advance their own surpluses to owners of productive services and create capital goods on their own account, either themselves exploiting these new productive goods or transferring them by lease to other entrepreneurs. The gains from having them transfer this function to others who make investment their business are of the same character as the gains from specialization in any other connection.

III.XI.20

Notably the gains are the same as those which arise from the specialization of the entrepreneur or control-plus-responsibility function, for this is what is really involved in the loan. Let us suppose that the saver does his own advancing and comes out the owner of the capital equipment which results from his saving; what will he do with it then? He might also employ this new equipment himself in the production of the sort of goods to which it is adapted, continuing meanwhile the original business or profession out of which he made the first saved surplus. But we know that it is in general much better and much more likely to happen that he shall lease the equipment at a fixed rate to an entrepreneur for actual operation. Let us make it as clear as possible that exactly the same sort of gains are realized by his transferring the surplus of goods itself to an entrepreneur at a fixed remuneration and leaving to the latter the construction as well as operation of the new equipment (or leaving the construction and operation to two different outside entrepreneurs).

III.XI.21

The saving of surpluses is clearly one function or operation and their use to make possible the creation of new equipment another and quite different one, just as the furnishing of productive services is one function and their use in the production of goods is another. In fact a little reflection will show that the operation of converting surplus goods into capital goods partakes in an especial degree of the characteristics which lead to the specialization of the entrepreneur function in the field of ordinary productive operations: namely, it involves special knowledge and foresight of future conditions. A surplus of consumption goods is fluid capital; it may be used to create any kind of concrete productive instruments whatever, within the limits of physical possibility and arbitrary social control. In a society which permitted such use it could be made to produce or increase a supply of slave labor. It can as a matter of fact be used to increase the supply of natural agents or to invent and discover new ways of doing things, even to create new wants for goods, and many things not conventionally considered capital creation.

III.XI.22

The burning question in practice is, what form of new capital goods shall be created, where, by what methods, etc. The answer is an exercise of judgment of far the highest type called for in the business world. It is obviously inevitable that the function of answering this type of question will be specialized along the same lines and for the same reasons as the control of enterprise under static conditions. The individuals who control the conversion of saved surpluses into capital goods must take the responsibility for their decisions, though as in the former case the "control" may take the form of selecting some one else to exercise the immediate control as a routine task performed without responsibility for the results. The call for the exercise of judgment is greater as the uncertainties of progress are greater than those of routine operations, and the necessity that the responsibility be taken by the person who exercises the judgment—of the situation or of the human capacity to judge it—is correspondingly great.

III.XI.23

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.

III.XI.24

The buyers' decisions to enter the market represent a judgment of an investment opportunity that will yield a profit (together with ability to give the security demanded in consideration of the rate on the particular kind of loan). The entrepreneur in this case must make an estimate of the future, involving a very complicated series of factors. The borrower of funds (like the hirer of other agencies) for routine productive operations estimates the physical product to be turned out by their use and the sale price of this product. The borrower for the purpose of creating new capital equipment*47 must estimate in physical terms the results of his constructive operations, the physical output of his equipment after it is in use, and both the cost and the salability of that product, all of which are in the future by the interval required to construct the equipment in addition to the period of production in the industry. Besides all which it must be kept in mind that the construction of a new productive plant includes getting it into operation, building up business connections in the markets for all the things the business must purchase as well as the things which it sells; and this normally requires a much longer time than the mere mechanical construction of the plant.

III.XI.25

The specialization of entrepreneur activities may go farther than above indicated in various ways. In particular, the use of surplus goods, represented by money funds, in constructing new production goods may be separated from the operation of the new equipment when constructed. But for obvious reasons this is also likely not to be the case. Construction includes, as we have seen, an initial period of operation longer than the construction period itself in the narrow sense, and the overlapping in time makes them difficult to separate. It commonly happens, indeed, that the mechanical part of building a plant is turned over for a fixed consideration to another entrepreneur, a contractor. Of course the starting of new enterprises with a view to their sale or even lease to others for operation after they are established as going concerns is not at all unusual, but can hardly be said to be the typical procedure in most lines of business.

III.XI.26

The importance of the distinction between capital and capital goods should now be clear. The business world thinks of capital as money funds. Money, however, is only a medium of exchange, and in the investment function represents a title to a surplus of wealth, practically speaking a surplus of consumption goods. This is the real meaning of free capital, which is a stage in the development of capital goods. The crux of current confusion in interest theory lies in the failure to see the significance of the fact that we live in a progressive society, that new net surplus production is constantly flowing through the loan market into the investment field and being converted into material equipment.*48 That is, it is surplus production on the part of the individuals and classes who save it; from the standpoint of society as a whole there is no surplus production of consumption goods; the surplus appears in the form of additions to capital equipment. In an unprogressive society where new saving was not being used to create new resources, there could not be interest in the sense in which the term has significance to economic theorists,—i.e., as a distributive share,—though interest could be paid for consumption loans. At present consumption loans are negligible in comparison with loans for conversion into new productive goods; when they are made they, of course, take the same rate of interest, allowance being made for degree of security against loss of interest and principal.*49

III.XI.27

Interest is the payment for the use of free capital; for the use of capital goods when employed by another than their owner, the payment is a rent. Interest is manifestly paid out of the produce of the property created with the resources obtained by the loan; it is part of the produce of the capital goods which were in the mind of the borrower when the loan was made, which the capital represented to him. This yield of property must again be distinguished from rent; the former is the actual return realized from the exploitation of the material things, while rent is the competitive market value of their use. Rent is paid out of the property yield if the property is actually leased; if it is managed by the owner, income should still be imputed to it on the basis of its fair rental value. The yield should include rent plus a profit, if the entrepreneur is to get any remuneration for the performance of his special function.*50

III.XI.28

These three species of income thus form a sort of concatenated series, tied together by two forms of profit. The actual yield of the property includes the competitive rent, and the profit which pays the responsible entrepreneur who exploits it. The rent in turn includes competitive interest on the investment (the original value sacrificed to create it) plus a profit which is the remuneration for the entrepreneur function of converting the investment into the concrete goods.

III.XI.29

One striking difference between rent and interest has been especially fruitful as a source of confusion in the theory. Both are expressed as rates, per dollar per year, but the explanation is very different in the two cases. Interest is naturally a rate, a ratio between two values. The object transferred from saver to entrepreneur is expressed in value terms, a certain amount of money, representing surplus consumers' goods to a certain value, and the return to the capitalist is also stated in value terms. If rent is stated as a rate of return on the investment, however, the relation is inverse; the investment in this case means not an original value magnitude, but the sale value of the property, which is the result of capitalization at the current rate of interest. For obviously in a progressive society where men are constantly lending funds of value at interest, freedom of exchange between value funds and productive goods will fix a value on the latter equal to the investment necessary to produce an equivalent return. It is this phenomenon of capitalization which to certain writers of the "psychological school"*51 has obscured the fact that what is transferred in a loan at interest is a fund of value which is not the result of a capitalization process, but is valued as an immediate utility.

III.XI.30

Capitalization and property values are fundamental to an understanding of the phenomena which arise out of the uncertainties present in a progressive society, and call for some further discussion on their own account. When a new productive enterprise is once established and shows promise of yielding a profit above the competitive rates of return on the resources put into it and those necessary for its operation, this entire future yield, discounted to its present worth at the current rate of interest, can be drawn or cashed in at once by the sale of the property.*52 Taken in conjunction with the fact observed above, that the desire to own productive wealth is by no means merely an indirect desire to consume its revenue, this fact of the anticipation of future income by capitalization increases many fold the incentive to embark on new ventures. Even when the owner of the enterprise has no intention of selling the property, but considers only operating it to secure an income, the paper profit on the capital value must be considered a part of his remuneration more or less separable in his mind from the profit in the shape of an income above the competitive return on the investment.

III.XI.31

It would be hard to overestimate the error involved in the psychological interpretation of economic motive as desire to consume goods alone. Even the desire for an income is not simply a desire to consume. For societies, or social classes in any society, near the subsistence margin, this is more nearly true. Even the so-called "subsistence margin," however, in any advanced society like the United States includes probably several times as much as is really necessary to gratify the animal wants and maintain health and physical efficiency. This does not mean that an individual can really live on a fraction of what those with the lowest incomes actually consume, for in a civilized society, the conventional necessaries may be as indispensable in fact as the animal necessaries. The motives for the consumption of even the conventional necessaries are none the less different from the animal needs. The desire (or necessity) for conforming to conventions is not the same thing as the need for food and protection; the easy fallacy is confusion of the requirement for food, clothing, and shelter of the conventional kinds with the requirement for food, clothing, and shelter as physiological necessities. A large part of the consumption of persons, in the lower income strata even, does not yield satisfaction as consumption; the motives and cravings are social in their origin and nature. It is a commonplace that many of the necessities of to-day did not exist or were not available for our ancestors a few generations ago, irrespective of their wealth.

III.XI.32

In separating the desire to increase one's possessions from the desire to consume goods, we of course make no pretense of carrying our analysis back to "ultimate" motives, but an observation in this connection may not be out of place. Adverse reference has been made to the use of instinct psychology in economics. In the writer's view the lists of instincts given by Parker and others are superficial in the highest degree; yet it must be admitted that this literature represents progress, in comparison with the naïve psychologizing of conventional economics. The instincts are a step in the right direction, carrying back the immediate lines of endeavor to more generalized motives and impulses. The defect in the procedure is that it stops halfway on the road to a rather obvious goal. Man has no instincts in the sense of tendencies to act in a definite way under definite circumstances, at least above a plane so low that they are as properly interpreted as reflexes. He has a few needs, of course, but the knowledge of their mode of satisfaction is not innate. We should never know, if untaught, what to eat, if indeed we should connect the pangs of hunger with the act of eating at all in the absence of knowledge gained by teaching through stimulating certain reflexes. And similar statements probably hold for sex behavior. It seems clear that in our whole higher life above the plane of food and sex and primitive pleasure-pain reactions, our activities result from a single unspecified, undirected tendency to act purposefully, the specific direction of the desire and activity being determined by suggestion from the environment and critical reflection upon such outside suggestion. All the instincts not directly connected with self-preservation (and the specific content of even these as we have seen is largely taught) are easily analyzed into each other; any one of them—or better, any pair, for they run largely in pairs of opposites—if interpreted broadly will account for most of our conduct. The only differentiation that would have any meaning would be the separation of an instinct of repose from the instinct of action; and repose is a mere negative.

III.XI.33

Possibly thought is sometimes enough different from motor activity to justify a separation, but this would certainly be the case with exceptional individuals only, and the instinct theorists insist on universality as a criterion for a true instinct.*53

III.XI.34

The conclusion we are here interested in, however interpreted into human nature, is that social progress on the material side is largely motivated by a desire to possess wealth, and that the rôle of uncertainty in connection with capitalization is to make it possible for an individual through superior judgment or good luck to obtain a large increase in his wealth in a short time. In addition capitalization brings about a reduction of uncertainty through consolidation, in a way pointed out in an earlier chapter. Persons who are fitted for and enjoy making new ventures can specialize in this type of economic activity, selling the new enterprises when established. Thus by bringing many ventures within the scope of action of a single individual (or business unit) the errors tend more or less to cancel out; and an estimate can be formed of the objective value of the entrepreneur ability exemplified, still further reducing the margin of uncertainty in any particular venture.

III.XI.35

It goes without saying that the phenomena of capitalization hold good for established enterprises as well as new ones. Any change in the current yield of any property whatever at once accrues, in so far as it is viewed as permanent, in the form of a change in the capital value of that property. These changes in capital value often overshadow in importance the changes in income. Such changes in capital values, depending on the anticipated future income of the property, do not necessarily wait for or synchronize with changes in current yield itself. The phenomena of speculation thus result from the endeavor to foresee the yield of salable productive goods and to take advantage by purchase and sale of the resulting changes in present values magnified by capitalization. Of course the desire for the income itself continues to operate, but for important classes of business men these considerations are eclipsed by the hopes of profiting by changes in capital values. Many of the important and sinister phenomena of modern economic life result from these facts. Those in control of the policies of a business are almost inevitably in a better position to foresee its future earnings than are outsiders, and it is difficult to prevent their taking advantage of this position to the detriment of their efficiency as managers of productive operations. The "corporation problem" arises largely out of this situation.

III.XI.36

Matters become still worse when the managers of productive property begin to manipulate their industrial and financial policies with a view to producing changes in capital values, of which they inevitably know in advance of outsiders and of which they take advantage with corresponding ease. Instances of such action with enormous gains reaped by insiders are familiar to all who know anything of modern corporation history. It is hard to see how they can be prevented without a strengthening of the moral code of business and a strict application of criminal law.*54 The possibility of capitalizing the gains of all sorts of fraudulent activity, getting out from under and leaving the issues to be fought out between the victims and "innocent holders," is indeed a serious menace to the efficient working of a productive mechanism organized on the principle of private property and free contract. Perhaps as bad as manipulating policies for the sake of quick gains on the securities market is the corruption of sources of information for the same purpose. In a world where uncertainty plays so great a part as it does in our progressive private-property society, the virtue of truthfulness becomes the very pearl of character.

III.XI.37

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.

III.XI.38

An explanation of the variations in the interest rate would carry us into the general theory of business conditions and the business cycle, an excursion precluded by the limits of space. We must point out, however, that the theory of a uniformly progressive society is profoundly modified by the tendency hitherto manifested under modern industrial conditions for growth to take place in waves. It is like the oft-cited advance of the tide up a beach, advance and recession alternating and obscuring even the fact that a small gain of an occasional wave constitutes a net advance. Economic progress under real conditions shows similar advance and recession, proceeding in cycles of a character now fairly well understood, but of such uncertain length that the consequences at the turning-points are often catastrophic. A large part of the phenomenon is due to the fact that the creation of new capital is so closely bound up in the issue of circulating medium by commercial banks. Price levels and profit margins being even more dependent on this precarious exchange medium, the operations of business proper find themselves tied up to the tendencies of a credit currency under private control to expand to a point of instability and under the least shock to collapse. These phenomena enormously increase the uncertainty of business operations and create opportunities for making large gains through the exercise of superior foresight or by good luck.*55

III.XI.39

The above description of the uncertainty relations of one of the elements of social progress, brief and inadequate as it is, must suffice for the present sketch. Moreover, the other progress factors, though more complicated and difficult of treatment, will have to be disposed of very briefly by a mere indication of some of the similarities to and contrasts with the growth of capital. The increase of population may be briefly handled. In the aggregate, it is not subject to enough uncertainty to produce any noticeable effect on the organization of society. Over long periods the general increase, if it proceeds faster than new lands are opened, as it has since the industrial revolution, causes a rise in the value of "land." This change, however, as an aggregate is so far overshadowed by the differences in the changes at different locations that it may be passed over. There is little question that in fact speculators in land make on the whole less than the competitive return on their investment, though this is difficult to prove conclusively. The outstanding phenomenon is the large gains and losses, especially the large gains from a few fortunate investments in real estate held over a period of generations by the same families. We shall recur to this theme in the next chapter. It is clear that the main cause of the differential rates of value increase is another one of our progress factors, the redistribution of the population over the soil. The mixture of foresight and pure luck in the production of gains from such uncertainties is an interesting question, but one about which there seems to be little comment worth making. Another phenomenon in connection with the increase of population over long periods is the redistribution of wealth and probably of ability among individuals. We know that the wealthier families increase much more slowly than the less wealthy, and there is every reason to believe that the same applies to the more as compared with the less capable. As wealth and ability are both inherited in varying degrees the consequences are obtrusive, in their general character at least. These facts do not affect the form or theory of competitive organization, but as they modify the material upon which the mechanism works the results are none the less subject to change.

III.XI.40

Another progress factor, the increase in the available supply of natural resources, has been referred to incidentally above, and as the relations of "land" to "capital" were discussed in an earlier chapter, this topic need not detain us long. Discovery of new natural wealth may result from pure accident, in which case its value is all pure profit, which in consequence of the principle of capitalization may be cashed in at once by the finder. But this is not what usually happens. In the case of agricultural land the conditions and rewards of pioneering are fairly ascertainable. If any profit results from these operations it is an exceptional case or else it is remuneration for some special sacrifice undergone; i.e., is not a profit at all. With mineral resources things are different. Here there is an enormous amount of complete unpredictability. Under old-fashioned methods there is no question that prospecting for the precious metals involved in the aggregate enormous losses. In regard to other minerals, coal, oil, iron, copper, etc., the present writer has no ground for forming an opinion, but would "guess" that the search for these things being less feverish, the accidental gains are much less in arrear of the losses. Recently the search for precious metals has been placed on a much more scientific basis and there is doubtless in the aggregate less discrepancy than formerly between the returns realized and a normal competitive return on the resources invested.

III.XI.41

The point which calls for emphasis is that where the possibility of securing wealth by the discovery of natural resources is known, along with something of the operations and outlays required, resources will be attracted into the field of searching for them in accordance with men's estimates of the chances of success in relation to the outlays to be incurred. The quest of wealth by this process thus becomes to those engaged in it an ordinary business operation, differing from the routine production of goods for immediate consumption in no matter of principle, though perhaps affected by a larger degree of uncertainty. And the same organization devices will be called into existence to deal with the uncertainty present—large-scale operations, the use of insurance where possible still further to broaden the base of the calculations, scientific research into the conditions of prediction and control of results, etc. Entrepreneurs engaged in exploration and development work bid in the same market against entrepreneurs in the fields of static industry for the same fundamental productive resources, and competition must fix a uniform price for both uses and bring about the same tendency to equality of cost incurred with output secured over the whole field of investment.

III.XI.42

Another factor of progress having exceedingly complex uncertainty relations is the changes in human wants. These changes, again, may just happen, accidentally, or they may take place more or less in accordance with law and hence predictably, or they may be deliberately brought about by the expenditure of resources for the express purpose of effecting such a change. If they happen unexpectedly the disturbances in incomes and capital values which result must be classed as pure profit or loss. In so far as they can be foreseen, no profit will be realized. In so far as they result from a deliberate expenditure of resources, they become as all other economic operations. The amount of profit realized will then depend on the effectiveness of competition based on foreknowledge of the results of the activity. In this respect the "production" of wants is like the production of goods. In fact, as we have previously observed, the advertising, puffing, or salesmanship necessary to create a demand for a commodity is causally indistinguishable from a utility inherent in the commodity itself.

III.XI.43

The last progress factor calling for notice is that of knowledge, or what may be designated by the term "invention" taken in a broad sense. It is a commonplace fact that one of the chief sources of uncertainty in business life is the improvement of technological processes, methods of organization, and the like. It is difficult to draw a rigid distinction in principle between the discovery of new facts and the production of change in the facts themselves as objects of knowledge. It is plain that the finding of new natural resources is equivalent to their creation and the difference in the case of human wants is also rather hazy and metaphysical. The important practical difference between discovery and creation relates to the matter, referred to in a previous chapter, of the cost of reproduction of ideas as compared with things. The knowledge of a fact may be extensible almost without cost throughout the membership of competitive society. Of course—and this is an observation which students of the phenomena have neglected to make—it also may not be of this character; it may cost as much to get an idea into a head as it does to get matter from one form into another, and it always does cost some expenditure of energy somewhere. In general, however, a competitor can get the idea of a new method or process at less cost than he can get new material equipment, provided energy is not expended in preventing him from doing it. Moreover, the mere gratification of curiosity may be ample compensation for the effort required to get an idea, so that this cost can be entirely neglected or may even become negative.

III.XI.44

The essential facts about new knowledge for our purposes center around the qualities of the productive equipment, including laborers, requisite for carrying it into effect. A new process usually calls for changes in the forms and attributes of productive agencies and necessarily involves new combinations among these. In very simple cases, however, little may be involved beyond new manipulations of old things. Like all the other phases of progress this one may result from accident or from the planned expenditure of existing resources. Even in the case of accident we cannot say that anticipation of and allowance for the change is entirely eliminated. For it is not meaningless to assert that even of things beyond our knowledge or control some are more likely to happen than others. We do make such judgments and in the large they are probably more right than wrong, however mysterious may be the basis upon which their value rests. In so far as the probability of a discovery can be estimated it is evident, as in the case of progressive changes previously discussed, that entrepreneurs will make allowance for its effects and in so far it will in the aggregate cause no competitive maladjustment and produce no discrepancy between the prices paid by entrepreneurs for productive services and the prices received for their products. The value of such estimates is naturally very small, and we may assume that most of the offsetting of gains and losses from disturbances due to accidental discoveries is itself accidental and not the result of calculation.

III.XI.45

In the case of new knowledge which is the result of deliberate thought, investigation, and experiment, the element of predictability is of course greater. As inscrutable as with accidental discoveries, almost, are the operations by which we form an estimate of the chances of success in such operations, but the fact is inescapable that we do form such estimates and that they have considerable value. Much scientific and business research is now carried on under some approximation to competitive conditions by the employment of large-scale methods. That is, it is possible to foresee the average long-run results of the operations with suffcient accuracy to cause the employment of resources in the field up to a point where the return is approximately equated with the return from the same resources in the general competitive market. In any case it is clear that in so far as the results can be predicted the investment of resources in the acquisition of new knowledge will be so adjusted as to equate the return with the general competitive level, which is to say equate realized values to costs and eliminate profits.

III.XI.46

The matter is indeed frequently, if not usually, complicated by the very low cost of indefinitely multiplying an idea when it is once secured. As a consequence of this fact the inventor or discoverer usually has to make some special provision to limit the use of his results to his own business operations. In certain fields this can be done through legal protection granted by the State in recognition of the value to society of the service. In others artificial measures for secrecy must be taken. In many cases no direct safeguards are available and the economic profitableness of the idea is limited to the period of time required for competitors to copy the new method. Regular commercial research in these fields is doubtless rare. Even legal protection is valid only for a limited period of time and secrecy cannot often be permanently maintained. When the idea becomes common property it is like any other superabundant element in production, a free good and no longer a productive factor in the effective economic sense.

III.XI.47

It may often happen, however, that one of the results of a new departure is greatly to increase the value of some limited kind of material or human productive service. If this service be that of a non-reproducible natural agent the inventor may permanently secure that part of the value of his idea by purchasing such property. If the gain attaches to reproducible property he may prolong his differential gain by the period required to increase the supply, and even in case of a specialized human service a long-time contract may sometimes be utilized to retard diffusion of the results of superior methods. As observed in our discussion of monopoly it is immaterial whether we regard these cases as monopolization of the idea or method as such or as monopolization of the limited resources necessary for its exploitation. The losses which are equally likely to result from inventions fall upon the owners of the specialized human qualities or equipment goods.

III.XI.48

Discussion of the conditions of permanence of the gains from improved methods of production leads naturally to the consideration of the general subject of economic friction and its opposite, mobility. We have already observed that the advocates of the "dynamic" theory of profit, the theory that profit is the result of progressive change, give an exceedingly important place to the phenomenon of friction in their analysis.*56 In this view, indeed, friction is a necessary condition to the occurrence of profit, as it is expressly stated that in the absence of friction profit would disappear as fast as it appeared and that it does constantly slip through the fingers of the entrepreneur and spread over society at large as fast as the friction can be overcome.

III.XI.49

It will be apparent as soon as pointed out that this argument uses "friction" in an inadmissibly inclusive sense. To explain profit thus in terms of friction, the term must be made to cover every form of resistance to change and readjustment in productive operations. That is, to get rid of profit by eliminating friction, it would be necessary not merely to have a perfect market, perfect competition, and costless mobility, but in addition it would have to be possible without the consumption of time or effort to change the form of capital equipment and goods in process, not to speak of natural agencies and the existing labor force. In a world where this could be done, it is manifest that there would be no need for productive effort of any kind. Perhaps we may distinguish between the readjustments involving only the moving about and recombination of productive agencies of all kinds and those calling in addition for substantial alteration in the form of things. The latter it is clearly inadmissible to class under the head of overcoming "friction." But the same may be said even of mere movement of things. This also is a productive transformation, and undoubtedly the greater part of ordinary productive activity comes under the head of transportation, taken in a broad sense.

III.XI.50

It is necessary to take up the problem under the heads of the different types of production costs and investigate the forces which retard the readjustment of each type to correspondence with the value of the productive contribution of the agency to which the payment is made. The first and simplest readjustment is that of values of services which undergo no change in either form or position as a result of the introduction of new methods. A new discovery will, as already noted, increase the value contributions obtainable by the use of some agencies and decrease those of others. It will ordinarily be true that changes in the market prices of these services will lag appreciably behind the changes in their theoretical values to the entrepreneur. Many of them are hired under contracts covering a longer or shorter period of time which prevent sudden changes in their rate of remuneration. During any such interval the employing entrepreneur must, of course, make a gain or loss by their use.

III.XI.51

And even where the factor of a time contract does not enter, there will probably be a lag in the prices of productive services, i.e., in the costs of production, as compared with commodity prices. The former are, of course, in the aggregate caused by and reflected from the latter and the forces of competition which impute commodity values to the productive services upon which production depends do not operate instantaneously. The chief cause of this lag is again the difficulty and uncertainty of knowledge; it takes the owners of productive services and entrepreneurs some time to learn the facts. Most of this learning has to be done by crude and rather slow trial-and-error methods; there is generally no possibility of computing results in advance. In the interval necessary for every one to find out the exact relations of dependence between product values and the employment of each resource and of working out an ideal adjustment, it is clear that there will be many discrepancies between entrepreneurs' outlays and their returns, i.e., many occurrences of profit, positive or negative.

III.XI.52

A somewhat special case is presented by goods in process when new methods are introduced. The general tendency must be to decrease the values of most of these, though not necessarily of all. The loss will fall on the owner in whose hands they are when the price change takes place, which may not be the owner at the time the new process is invented, for these price changes will also lag more or less. The loss in value will depend on several factors, the amount of superiority of the new process over the old, the amount of difference between the old intermediate goods and the corresponding new ones, and the possibility, and the cost, of changing the old intermediate goods in a way to have the manufacture carried to completion by the new process.

III.XI.53

Material productive goods will fall more or less under the same head as goods in process according as they are or are not reproducible, short-lived, and amenable to change in form. We have seen that the difference between capital and land is one of degree, depending on these qualities in the agent. At one extreme, capital is typified by goods in process. At the other, "land" consists of these agencies whose supply is most rigidly fixed, the nearest approach to the theoretical limit being the element of site value. Taking this extreme first, a piece of pure land will gain or lose the capitalized value of the change in its income as soon as this is accurately adjusted. With ordinary capital equipment, allowance must be made for the life of the agency and also for the possibility and cost, including the time required, to adapt it to the new conditions. The adaptation may include both movement from one situation to another and change in form. Even a revolutionary invention, making buildings and machinery worthless for use in their present form, does not usually destroy all their value. At worst a scrap value of the material is recoverable of the original free capital invested in them.

III.XI.54

Laborers present a still different case. The only thing to be considered from the standpoint of economic organization is here the lag in the readjustment of wages to the new real value of labor. Changes in the value of specialized skill accrue to the laborer as an individual only and cannot be capitalized. The same facts as to possibility of readaptation hold good as in case of material equipment goods, but again this is a matter of the individual's own personal economy and does not affect entrepreneurs. The peculiarities of labor in relation to readjustments form one of the main sources of injustice and hardship in an individualist economy. The risk of loss in the value of acquired knowledge and training means a constantly impending threat of indigence. Laborers are attached to their homes and even to their work by sentimental ties to which market facts are ruthless. But these matters hardly call for detailed discussion in a study of the present sort.


Notes for this chapter


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.].

Part III, Chapter XII.

End of Notes


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