Risk, Uncertainty, and Profit

Frank H. Knight
Knight, Frank H.
(1885-1972)
CEE
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First Pub. Date
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 XII

Social Aspects of Uncertainty and Profit

III.XII.1

Uncertainty is one of the fundamental facts of life. It is as ineradicable from business decisions as from those in any other field. The amount of uncertainty may, however, be reduced in several ways, as we have seen. In the first place, we can increase our knowledge of the future through scientific research and the accumulation and study of the necessary data. To do this involves cost, the expenditure of resources which must be drawn from other uses. Another way is by the clubbing of uncertainties through large-scale organization of various forms. This operation also involves costs, and not merely in the sense of expenditure of resources. There is also to be considered the loss of individual freedom involved in any possible plan of organization, a loss for the great mass of persons affected, though possibly a gain for a few who may secure wider powers and a larger range of action from the concentration of authority.

III.XII.2

In the third place it is possible, also at a cost, to increase control over the future. And here again both sorts of costs must be faced, substantive outlays and human losses through organization. Finally, uncertainty might be further reduced almost indefinitely by slowing up the march of progress, which, of course, involves a direct sacrifice in addition to both the forms of cost already noticed.

III.XII.3

All these proposals raise the fundamental issue as to the essential evil of uncertainty, how great it is and hence how much we can afford to sacrifice in other ways in order to reduce it. In this sort of calculation as in all economic problems we are dealing with a question of proportioning alternatives subject to a principle of diminishing relative importance. It would doubtless be possible to use all the resources of society with more or less effect in reducing uncertainty, leaving none for any other use. It is a question of how far to go. The question is complicated by the fact that the use of resources in reducing uncertainty is an operation attended with the greatest uncertainty of all. If we are uncertain as to the results of ordinary business operations we are doubly so as to the results of expenditures along any of the lines enumerated looking toward the increase of knowledge and control.

III.XII.4

Quite as important as the question of reducing uncertainty is that of its distribution. This question raises again the same fundamental issue, this time from the individual point of view instead of the social, as to the intrinsic desirability of reducing uncertainty. How far the burden should be equalized, how far concentrated or specialized, depends on the individual attitude toward uncertainty, and especially on the tendency of the irksomeness to increase as the amount of uncertainty faced by an individual increases, and vice-versa. The steeper the curve of increasing disutility the more we must favor a relative dispersion of the burden. It is perhaps obvious that high degrees of "risk" are more irksome; most of us are reluctant to jeopardize our lives or the elemental requirements of life. But it is also evident that individuals differ widely in the extent to which they find this true. We have already noted the more or less paradoxical fact that the very idea of intelligent conduct implies an effort to reduce uncertainty, while none the less we recognize, on any calm, cool contemplation of the matter, that a life with uncertainty eliminated or perhaps even very greatly reduced would not appeal to us.

III.XII.5

There is a close connection between the two notions, reducing the absolute amount of uncertainty on the whole and distributing it, for most methods of reducing it effect either a concentration or a distribution. On this head there seems to be no generalization which can be made with confidence and which is worth making.

III.XII.6

It is not too much to say that the very essence of free enterprise is the concentration of responsibility in its two aspects of making decisions and taking the consequences of decisions when put into effect. It is therefore of the utmost importance to inquire critically and carefully into the facts as to the results of such a concentration in comparison with any possible alternatives. At the outset we shall raise no question as to large-scale industry; and it is evident that if we are to have large-scale organization with its advantages in efficiency we must assume a corresponding degree of concentration of control in the immediate sense of executive direction. This, however, as we have been especially concerned to emphasize, does not necessarily mean concentration of responsibility. We have seen that practically all human activity, even that of the purest routine character, is in some manner and degree forward-looking and involves meeting unexpected situations and making decisions. But these decisions do not necessarily involve responsibility. The outstanding feature of free enterprise organization is the transfer of the lower grades of responsibility to men whose decisions relate to the selection of men for the places under their control and to answering occasional questions in regard to exceptional contingencies. The two functions are, indeed, never quite separate. The ultimate responsibility consists chiefly in the selection of a man or a very few men to "organize" the establishment. But the ultimate authority usually if not always exercises some direct control over business policy. In most cases also the higher officials of an enterprise have a direct stake in the business beyond their fixed salaries. And down through the organization the subordinate functionaries may be said to have responsibility in the sense that the results which they secure must come up to the expectations of their superiors or they will lose their positions.

III.XII.7

In the existing system of things the ultimate responsibility centers almost altogether in the ownership of the property "at risk" in the business. There are infinite variations and complications in the distribution of "risk" and control, but the general tendency is clear. The lower grades of labor take practically no risk and exercise correspondingly little control, and the same is only less true of the higher grades and of borrowed capital. We must remember that the two things, uncertainty-bearing and responsible control, are inseparable; in so far as the reward of any service is contingent upon the success of the undertaking, the owner of that service, in consenting to its employment for a contingent remuneration, exercises judgment and wields power over the enterprise. But the greater part of the uncertainty and power are centered in the ownership of certain property which is placed in the position of guaranteeing the contractual income of the other property and that of the labor used in the business.*57

III.XII.8

We shall not attempt to take up all the possible or actual arrangements in regard to responsibility and control, but shall limit the discussion to the general problem of concentration of uncertainty. It will be kept in mind that the basis of effective assumption of responsibility is necessarily either the ownership of property or the creation of a lien on future human productive power and is in fact almost altogether the former. Another preliminary reservation is that in a sense ultimate control rests with the consumer. But in so far as economic organization takes the form of free enterprise this control is exercised only after the fact, and the responsibility we are concerned with is that of meeting the consumer's demands at the end of the production process. We assume, then, that the entrepreneur system of organization, with production for the market impersonally, and concentration of direction, arises because it is superior to, or more satisfactory all around than any other free contract system. And the first step in our inquiry will be a brief examination into the meaning of free contract.

III.XII.9

With the possible exception of the word "cause" and its equivalents, it is doubtful if there is a more abused word than "freedom"; and surely there is no more egregious confusion in the whole muddled science of politics than the confusion between "freedom" and "freedom of contract."*58 Freedom refers or should refer to the range of choices open to a person, and in its broad sense is nearly synonymous with "power." Freedom of contract, on the other hand, means simply absence of formal restraint in disposal of "one's own." It may mean in fact the perfect antithesis of freedom in the sense of power to order one's life in accordance with one's desires and ideals. The actual content of freedom of contract depends entirely on what one owns.

III.XII.10

Ownership, as we have seen, consists essentially of the combination of the rights of control and of usufruct. The point to be emphasized here is that in a social system based on pure freedom of contract, ownership and control are interchangeable terms;*59 there is no other form of control. To be sure, there would have to be a "state" of some sort, an authoritative organization, to maintain such a system, but its sole function would be the enforcement of contract and prevention of non-contractual relations. Its necessity arises from the fact that contracts are not often executed on both sides simultaneously and the further fact that men might prey upon each other. That is, the rôle of the State in such a system would be merely to restrict human relations to the mutually voluntary, or contractual. In such a system, to repeat, those who owned nothing could not exist unless by the sufferance and generosity of those who did own, and the amount of freedom possessed by any person would be equal to the amount of his ownership.

III.XII.110

Now, what one owns is under ideally simple conditions a result of three factors. The first and by far the most important is the historical "brute fact" of what he has "to begin with," his inheritance from the past. This is purely a matter of status—hence the fundamental absurdity of Maine's contrast between status and contract as descriptions of the position and condition of the individual. All free contract can mean is that status can be changed by voluntary agreement with another party, and cannot be changed without one's consent. The second factor in ownership is thus the result of previous contracts. And the possibility of change in status by mutually voluntary agreement depends on one's status—i.e., what one owns—at the time of the agreement, and hence finally on what one owned to begin with. The third factor in ownership or present status is change resulting from the voluntary and independent employment or transformation by utilization of one's own in the past. This element is also clearly a matter of change only, going back to initial status or what one owned to begin with. In a pure free contract system there is no power (control) except ownership; only change in ownership (which is to say really in status) has any connection with the exercise of free choice, and the range of choice depends absolutely on previous status and hence ultimately on the initial status in which the individual finds himself on his first entry into the system of contracting persons.

III.XII.12

All the above, however, assumes that contracts and the activity directed to increasing ownership by "productive" transformation of what one already owns are intelligently carried out. In the world as it is, where all human designs and acts are fraught with uncertainty, a fourth factor must be added, the result of luck. Furthermore, we are still assuming complete independence and non-interference among the contracts and activities of different individuals. In the world as it is the interests affected by contracts are never all represented in the agreements. This is really a limitation on the assumption of pure freedom of contract, a failure to restrict human relations to the mutually voluntary sphere, but it is a fact which has to be taken into account, like deliberate predation.

III.XII.13

These facts are so obtrusive that no one has in practice ever advocated pure freedom of contract, the restriction of the action of society as a whole to the negative function of preventing non-contractual relations. No question is ever actually raised as to the State limiting freedom of contract in many directions and encouraging agreements of other sorts. It also necessarily appropriates through taxation a considerable part of the usufruct of things privately "owned," thus modifying ownership in both its phases. And this modifying influence on private property extends rapidly in scope as the laissez-faire theory of the State loses ground in the modern world.

III.XII.14

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).

III.XII.15

Another line of argument on the question of the relations between ownership of one's own powers and ownership of material things follows somewhat parallel lines to a somewhat similar uncertain or negative conclusion, beginning from an opposed point of view. The starting-point of our inquiry is the fact, clearly brought out by our study of enterprise, that the drift under non-interference is toward placing the control of industry, the ultimate entrepreneurship, in the hands of property-owners and not the owners of the human services, the workers. The ostensible reason for this is that a business venture offers opportunity for actual absolute loss, as well as merely a greater or less gain, and that only property can in the nature of the case make the guarantees against this net loss. This fact seems at first sight to afford the basis for another distinction between labor and property services, namely, that laborers are only used in industry, while material goods are used up, that only the services are consumed in the one case, while the thing itself may be destroyed in the other.

III.XII.16

A little critical reflection will show that this also is not really the case. Perhaps it ought to be so, but it is not, and cannot be. In the first place, the risk of destruction and total loss is perhaps as great in fact in the case of the laborer as in the case of the property-owner, and where in the latter case the owner loses only productive power the former loses health or bodily members or his life, which mean vastly more. The real merits of this situation are also being recognized by society and we see the growth of legislation designed to transfer the hazard of loss of the economic value of the laborer as a productive agent (and this only, so far) to the business and through it to the consumer of the product. There is another side to the question in the hazard of loss of specialized skill and training. These are acquired in connection with and for use in the particular business. The cost of acquisition is borne chiefly by the worker and if the business proves unprofitable, the loss generally falls on him. Yet these "risks," seemingly so much greater than those incurred by the property-owner, do not carry with them the control of the business, nor do the bearers of the risks even secure under competitive free contract (as is perfectly well known) anything like fair compensation in the form of a higher contractual return. And it must be added that the actuarial value of the worker's risks depends quite as much on the quality of the management as is the case with those of the owner of material property.

III.XII.17

The only visible explanation of this state of things is an appeal to a "fact of human psychology" that the owners of "things" are less willing to trust those "things" to the control of others without an adequate guarantee in kind than are men who own only themselves to hazard such outside control without even the poor safeguard of a guarantee against economic loss.*61

III.XII.18

It is manifestly impossible to carry on production without incurring both sorts of uncertainties, uncertainty as to the results and as to the preservation intact of the means of production employed, both human and material. Since production must precede consumption and requires time, all those concerned in it must be maintained during the production period out of the fruits of previous production. And these products must be advanced by those who own them. It is not physically necessary that they be permanently hazarded by the owners, that the actual producers should get their entire wage in advance of the completion of the process, but this is the way it works out under free contract. Nor is it inevitable that these products be owned by any individuals at all, a point which we must next take up. At the same time the chance of loss of equipment must be borne, temporarily, by those who have equipment to lose, if equipment is privately owned. The permanence of the loss to an individual owner is not physically prescribed, in case of the owner of material things or of human powers in their purely economic aspect. But this again is the way it does work out under the "obvious and simple system of natural free contract." We must now glance briefly at the social bearings of free contract in a more fundamental sense.

III.XII.19

There is naturally no intention of implying that freedom of contract is to any appreciable extent a result of the deliberate adoption by society of a reasoned policy of organization. However, the continuation of the system is a question which has been much discussed on its merits and which may ultimately be decided on the basis of discussion. To discuss the issue systematically we shall first eliminate and postpone for later notice the point as to personal self-ownership and limit ourselves provisionally to the ownership of material productive goods, the more or less live issue between individual and social property in these things. And we must further distinguish at the outset between two different and to a large extent opposed sets of interests involved in social organization. The conventional view in economics treats social organization as a mechanism for the satisfaction of "wants" which are assumed to be fixed conscious desires and tendencies to action, subject to the principle of diminishing relative utility. The limitations of this view have been emphasized throughout our study, but we have to consider this aspect of economic life in purity and isolation if we are to use the scientific method of analysis. Other interests are just as fundamental, notably the desire for freedom and power for their own sakes and the preference for certain qualities of human relations. It is largely this second set of interests which, directly and indirectly, have finally abolished slavery and established self-ownership.

III.XII.20

Viewing society, then, as a want-satisfying machine and applying the single test of efficiency, free enterprise must be justified if at all on the ground that men make decisions, exercise control, more effectively if they are made responsible for the results of the correctness, or the opposite, of those decisions. If property were socialized we should still have to concentrate the function of the actual making of decisions, but it would be in a far greater degree than now a routine task, with the remuneration independent of the results. In the light of our previous discussion there is a difficulty here and we must be careful to make the meaning clear. Two things, specifically, would happen. Businesses in which men now work directly with their own resources would be transformed into public enterprises under the management of hired functionaries. In this case the nature of the change is clear enough. More obscure is the case of the corporation, now controlled by a hired manager. Here the change is the substitution of the public, organized in some political way, for the stockholders, and the position of the immediate decision-maker is superficially not much changed.

III.XII.21

But only superficially. It is true that the growing similarity of large-scale business to the political democracy is one of the socialist's strongest arguments against a probable loss of efficiency in the exchange of private for public ownership. But we must emphasize the fact that the similarity is much exaggerated—in fact by both parties to the controversy, from different motives, of course. The insistence on the large number of stockholders in some of our great corporations is definitely misleading. Most of these do not regard themselves and are not regarded as owners of the business. In form they are such, but in substance they are merely creditors, and both they and the insiders count upon the fact. The great companies are really owned and managed by small groups of men who generally know each other's personalities, motives, and policies tolerably well. Hence in the first place the salaried manager under a socialist government, whether appointed by a political superior or chosen in some way by a democratic constituency, would really be in a very different position from the president or manager of a present-day corporation. He could not conceivably be so directly accountable to the ultimate entrepreneur, society, as he now is to the ultimate entrepreneur, the small group of "insiders" who are the real owners of the business.

III.XII.22

But the greater change would consist in the substitution of the public at large for the small group of owners. The main difference is an inevitable concomitant of the mere size of a group. The insuperable difficulty of coöperative production has been to make the individual feel that the results depend upon his own activity. The individual feels lost in the mass, helpless and insignificant. Political democracy, of course, encounters the same difficulty. Perhaps we may believe that some progress is being made in solving the problem in the political sphere where decisions are really much less important in that the alternatives among which choice is made relate to less vital matters. If so, it may be possible that some generations of political democracy might train the individual in a sense of personal responsibility which would make industrial democracy more feasible.

III.XII.23

But this is at best an exceedingly superficial view of the problem. At bottom it is a matter of feeling for the large property-owner as well as for the masses served by industry. He is really a social functionary now. Private property is a social institution; society has the unquestionable right to change or abolish it at will, and will maintain the institution only so long as property-owners serve the social interest better than some other form of social agency promises to do. Of course there is a lot of moral flub-dub about natural rights, sacred institutions of the past, etc., and it has some power to hold back social change. But in the end, and a not very distant end either, the question will be decided on the basis of what the majority of the people think, in a more or less cold-blooded way, about the issues. If we get more effective management through the system of concentrated private ownership than we would through some democratic machinery, it is because men plan better when they do not feel like government officials doing things for other people, when they feel their work as their own and identify their personalities with it.

III.XII.24

And this even though the same men know "in their hearts," subconsciously if not consciously, that they are the agents of the democracy and ultimately responsible to it for their trust. For it is clear that the "personal" interests which our rich and powerful business men work so hard to promote are not personal interests at all in the conventional economic sense of a desire to consume commodities. They consume in order to produce rather than produce in order to consume, in so far as they do either. The real motive is the desire to excel, to win at a game, the biggest and most fascinating game yet invented, not excepting even statecraft and war.

III.XII.25

The suggestion which inevitably comes to mind is that a democratic economic order might conceivably appeal as effectively to the same fundamental motives. What is necessary is a development of political machinery and of political intelligence in the democracy itself to a point where men in responsible positions would actually feel their tenure secure and dependent only on their success in filling the position well. It is not mainly a matter of salary, though undoubtedly such men would have to live conspicuously well in an economic sense also—just as the officials of our political democracy expect to do, even when patriotic and public-spirited. The essential problem is wisely to select such responsible officials and promote them strictly on a basis of what they accomplish, to give them a "free hand" to make or mar their own careers. This is the lesson that must be learned before the democratization of industry will become a practical possibility. If we substitute for business competition, bad as it is, the game of political demagoguery as conventionally played, with rotation in office and "to the victors belong the spoils" as its main principles, the consequences can only be disastrous.

III.XII.26

Another interesting misconception in regard to the public official should be pointed out before we leave this topic. It is common and natural to assume that a hired manager, dealing with resources which belong to others will be less careful in their use than an owner. The view shows little insight into human nature and does not square with observed facts. The real trouble with bureaucracies is not that they are rash, but the opposite. When not actually rotten with dishonesty and corruption they universally show a tendency to "play safe" and become hopelessly conservative. The great danger to be feared from a political control of economic life under ordinary conditions is not a reckless dissipation of the social resources so much as the arrest of progress and the vegetation of life.

III.XII.27

This point leads naturally to the question which has been much discussed in treatments of risk and profit: does the private business man really abhor risk and uncertainty, and tend also to "play safe"? Other phases of the same question, the close relations of which are not always recognized, but which turn out to involve the same issue, relate to the social cost of risk-taking and the tendency of profits to a minimum.

III.XII.28

The conventional view is, of course, to regard risk-taking as repugnant and irksome and to treat profit as the "reward" of assuming the "burden." This is, of course, the business man's own idea of the matter,*62 and students of the problem have often held the same opinion. Thus Willett*63 argues that society pays for the sacrifice of assuming risk through higher prices for commodities in whose production it is a factor, for the reason that men are deterred from entering these occupations by their unwillingness to assume risk and that the supply of such commodities is consequently reduced. Ross also assumes*64 that risk is repugnant and draws the same conclusion, and Haynes*65 lays still greater emphasis on the influence of risk as a deterrent to production, quoting Andrews*66 to the same effect. Other writers have been more hesitant in generalizing or have made distinctions, or positively disagreed with this view. Thus v. Mangoldt*67 remarks that it is notorious that more money is lost than made in most forms of speculative activity and asserts the belief that this is true of business enterprise in communities which are in comfortable circumstances and have a reasonable surplus for embarking in venturesome undertakings. Professor F. M. Taylor also analyzes the problem with some care,*68 insisting that the profits of entrepreneurs may be either larger or smaller than the amount necessary to make up an insurance fund to cover actual losses. He holds it probable that they are for small risks larger and for large risks much smaller than the necessary insurance fund, but concludes that society has to pay a higher price for a particular commodity or service than it would have to pay if risk were eliminated.

III.XII.29

There are several confusions of thought to be avoided in arguing this question. In the first place it is inaccurate to speak of profit as the reward of risk-taking or as the inducement to take risk. It is of the essence of the situation that the profit is in the future and uncertain when the decision is made and hence it is the prospect or estimated probability*69 of profit which "moves men's wills" (Taylor). Hence we cannot assert a connection between actual profit and the irksomeness of risk in the individual instance. And from the standpoint of aggregate profit in the society as a whole the question is whether there is any such share or not, whether entrepreneurs as a class make a profit or suffer a loss (speaking, of course, of net or "pure" profit, after remunerations for all productive services are counted out).

III.XII.30

Let us recall for clearness the precise situation of the profit-seeking business man. He contracts for productive services in advance, on a basis of what he expects to be able to make by their use. Like the purchaser of any commodity, he as an individual finds a price fixed and buys more or less at the established price, while in the aggregate the competition of all purchasers adjusts the price to the point where an entire existing supply can just be taken out of the market. It will be seen that the prices of productive services at any time, the entrepreneurs' costs of production, represent under perfect competition what entrepreneurs expect their products to be worth when sold, while the entrepreneurs' incomes represent the facts at a later time as contrasted with the anticipations at an earlier. The condition, then, under which entrepreneurs as a group will realize a positive profit is that they underestimate the prospects of their business relatively to their dispositions to venture. If, on the contrary, they overestimate their prospects (considering the degree of conviction necessary to move their wills), they will in the aggregate suffer loss, and if they estimate correctly on the whole, neither will occur. If the estimates are a matter of pure chance it would seem that the variations in the two directions would be equal, the average correct, and the general level of pure profit zero. Many writers, notably Hawley,*70 have assumed that such a distribution of errors necessarily obtains, though in the absence of a correct theory of profit the appropriate conclusion is not drawn.*71

III.XII.31

It may be objected that it is impossible that enterprise on the whole should suffer a net loss, but a little consideration will show that this is not true. The entrepreneur, as society is organized, is almost always a property-owner and must necessarily be the owner of productive power in some form. It may then well be that entrepreneurs lose more than they make, the difference coming out of the returns due them in some capacity other than that of entrepreneur. The question of fact is thus whether entrepreneurs as a class receive on the average more or less than the normal competitive rate of return on the productive services of person or property which they furnish to business.

III.XII.32

The question does not admit of any definitive answer on inductive grounds. Such evidence as is avaliable in the form of statistics points to the conclusion that the net result is a loss, but it is inconclusive.*72 Perhaps the best that can be done is to argue the case on a priori grounds and attempt nothing beyond an opinion as to the probable facts. The writer is strongly of the opinion that business as a whole suffers a loss. The main facts in the psychology of the case are familiar, and some of them have been stated above. The behavior of men in lotteries and gambling games is the most striking fact. Adam Smith pointed out the tendency of human nature to exaggerate the value of a small chance of large winnings. Senior*73 thought that the imagination exaggerates the large odds in favor of either gains or losses. Cannan*74 holds that both unusually risky and unusually safe investments are especially attractive to large classes of men and yield too small a return while ordinary hazards are neglected and hence yield more. Professor Carver contributes the suggestion*75 that business risks are predominantly of the character in which the odds are not great and the possible losses larger than the probable gains, that these have a negative appeal to the gambling instinct and that profit is a positive quantity. But in view of the possibility of capitalizing the entire future return of a venture into present wealth this view of the nature of business risks seems very questionable. The point we wish to emphasize is that these "risks" do not relate to objective external probabilities, but to the value of the judgment and executive powers of the person taking the chance. It is certainly true that as Smith and v. Mangoldt both observed, most men have an irrationally high confidence in their own good fortune, and that this is doubly true when their personal prowess comes into the reckoning, when they are betting on themselves. Moreover, there is little doubt that business men represent mainly the class of men of whom these things are most strikingly true; they are not the critical and hesitant individuals, but rather those with restless energy, buoyant optimism, and large faith in things generally and themselves in particular.

III.XII.33

To these considerations must be added the stimulus of the competitive situation, constantly exerting pressure to outbid one's rivals, as in an auction sale, where things often bring more than any one thinks they are worth. Another large factor is the human trait of tenacity, also conspicuous in bourgeois psychology. Men may possibly be timid and critical on first embarking in new ventures, but once committed, it seems unquestionable that the general rule is to hold on to the last ditch, and the greater part of the bidders for productive services are owners of businesses already established. The prestige of entrepreneurship and the satisfaction of being one's own boss must also be considered. It therefore seems most reasonable to suppose that the prices of these are fixed at a level above rather than below that which the facts actually warrant, and as we have noticed, the statistics, such as they are, point to the same conclusion.

III.XII.34

So much for the pure profit of entrepreneurs. We have already emphasized the fact that profit and imputed income are never accurately separated on either side of the dividing line. As there is no income which is pure profit so there is none which does not contain an element of profit. This is perhaps most conspicuous, or at least most familiar, in connection with interest. It is recognized that "pure interest" is impossible of identification, that ordinary interest includes an element of "risk premium." It is no less true that wages contain a variable element which is to be explained by the uncertainty of the return. The earnings of professional men form the notorious case. Men are attracted into these callings more by the lure of the small chance of conspicuous success than by the position achieved by the rank and file. Adam Smith was sure, and the opinion is still corroborated by common observation, that an occupation offering a small chance of attaining a high position and a large income will yield a lower average return to the same ability than one in which earnings are more uniform. That is, there is a negative premium on risk-taking in these cases also.

III.XII.35

With most kinds of labor the chance element amounts to relatively little in all probability, and in any case it is perhaps best regarded as a return on the investment in special knowledge and skill rather than on effort directly. In any case, if Smith's reasoning is sound it appears that risk-taking is the opposite of irksome, that men work (or labor to acquire the capacity for work) more cheaply on the average for an uncertain than for a fixed compensation. To the landowner there is virtually no risk of actual loss involved in leasing it, and usually little or none of failure to receive the contract rental. In lending capital we find risk of loss of principal as well as interest and a great deal of attention is paid to the risk element in fixing the rate of return. A rate of pure interest is a concept to which it is so difficult to attach any definite meaning that it seems futile to speculate as to the adequacy of the excess of contract interest above this level to constitute an insurance fund to cover losses. The question, as before, is whether the actual receipts from contract interest and repayments of principal form on the average an amount equal to or less or more than the pure interest and the original principal. The writer sees no way of forming an opinion on this subject.

III.XII.36

From the standpoint of social policy, two questions are to be raised. From one point of view, "society" is a husbandman or "wirtschaftender Mensch," interested in getting its work done as well and as cheaply as possible. The foregoing considerations seem to indicate that from this pure productive efficiency point of view and with all the factors measured in competitive pecuniary terms it is better to let the individual take the risk. It seems probable that with society and human nature as they are, the individual not only charges nothing for this service, but pays something for the privilege of rendering it—on the average. But we must remember that in the case of property he really does not take the risk, and it is a question of making him feel that he does, for property is and always has been "really" social and ownership a social function. It is not clear that the illusion of ownership, with the possibility and actuality of enormous waste and dissipation involved, is in fact a cheap way for society to remunerate the management of its material wealth. As with all questions involving human motives, however, only negative statements can be made on this subject until we begin to know something of what men as individuals and as society really want. The quality of management secured has, of course, to be taken into account along with the cost of securing it, but we have already said all that it seems worth while to say in the present connection on this head.

III.XII.37

The second question raised is whether it is really good for the individual, and hence for society which is the individual in the aggregate, to have the risks of industry assumed by the former even if he is willing to do it at a loss, on the average, to himself. Some light on the proper answer is to be gained by considering the attitude which we actually take toward lotteries and gambling generally. Clearly there are limits to the terms on which the members of society are to be allowed to take chances, and notably when the independent members have dependent upon them other members in whom society is peculiarly interested. Rapid progress is at present being made toward prohibiting the laborer from unwisely contracting to assume hazards, and no theoretical objection can be made to extending the principle to property risks where the fundamentals of a decent and self-respecting existence are at stake.

III.XII.38

The protection of a minimum standard of life is only one of many questions of the human interests involved in the distribution of risk and control, but we cannot here go into or even attempt to classify or enumerate a list. In concluding the discussion of the topic we shall only insist again on the limitations of the economic view of social organization as a mechanism for satisfying human wants in any static and hence scientifically describable sense of the term. Man's chief interest in life is after all to find life interesting, which is a very different thing from merely consuming a maximum amount of wealth. Change, novelty, and surprise must be given large consideration as values per se, and since at best most of us must doubtless spend more time in producing wealth than in consuming it, the dynamic and personal factors must be taken into account on the production side of economic conduct, and weighed against the element of efficiency. One of the things we surely want is the society of other people on a basis of mutual agreeability, respect, and affection, irrespective of the question, itself inescapable in any serious reflection on the issues of life, as to whether personality has some sort of cosmic value. Hence each individual must be given responsibility, freedom of choice, a wider sphere of self-expression than he can have in a system of organization where control is specialized and concentrated to the last degree. Whether this is practicable and how it is to be done is the great problem which confronts the advocates of industrial democracy.

III.XII.39

To conclude our study notice must be taken of certain long-time aspects of the problem of uncertainty and control. The distinction between "static" and "dynamic" "risks" is a much-labored but a fundamental point in connection with our subject. We have emphasized in this study also that uncertainty is dependent upon change, and in fact largely upon progressive change. The problem of management or control, being a correlate or implication of uncertainty, is in correspondingly large measure the problem of progress. In an unprogressive society knowledge of the future could be perfected to a high degree through actual forecast and control or the effect of certainty secured through the grouping of cases and application of probability reasoning. Under such conditions the problem of management would be indefinitely simplified as activity would follow in the main an established routine and real decisions would rarely be required. The actual form of economic control, free contract, and especially private property in material goods, is closely connected with the acute form of the problem of management which arises from the highly "dynamic" character of the society we live in and the extreme degree of uncertainty connected with change. Before the modern industrial era began, as we know, the economic life of Europe was unprogressive, and its organization of control was collectivistic. The establishment of individualism was the result of the desire for improvement, even though it would be misleading to say that it came about directly through a social conviction of its superiority over collectivism in this respect.

III.XII.40

The social theory of private property rests, then, not so much on the premise that productive resources will be more effectively used in the creation of goods for consumption, as on the belief that there will be a greater stimulus to progress through inducing men to take the risks of action increasing the supplies of productive resources themselves, including both material things and technical knowledge and skill. We have shown in our discussion of interest the fallacy in the view that accumulation and forward-looking sacrifice can be explained on the basis of time preference in consumption. A sacrifice of present to future consumption does not generally increase the total consumption by the individual making it, and in addition the mere postponement of consumption would give rise to no considerable net increase in social equipment. The "abstinence" must be permanent, and not a mere matter of waiting. It follows that the premise of the justification of private property must be that the mere desire of ownership is a more potent motive to bring about sacrifice and effective control in this field than the desire to consume a larger amount of goods. The social policy of private property is sound, if at all, because the craving to own wealth will lead men to sacrifice consumption and take risks of complete loss in order to increase their property.*76 The truth or falsity of this premise is not our present concern, but it seems worth while to point out some facts in connection with its application.

III.XII.41

Practically all forms of social economic progress represent, as has been pointed out, different modes of increasing the productive power of society through the sacrifice or "investment" of present consumption. These different ways are open, competing alternatives, quite comparable generally speaking in quantitative terms. One may invest his present goods in creating new equipment goods (the conventional way, and type of all), or in finding and developing new natural resources, or in developing his own personal powers (or even to some extent those of other men), or in inventing, or in improving business organization, or in creating new social tastes and wants. The first two modes of investment give rise to new property and this society, generally speaking, grants to the successful investor in fee simple and to his heirs and assigns forever.

III.XII.42

Investment in one's own person likewise gives rise to undisputed possession of the new capacities, but these are not permanent, passing out of existence with the end of the individual's own active life. It would be interesting, if it were possible, to compare the attractiveness of these two forms of investment, for the effectiveness of control beyond one's own lifetime as an incentive to investment is one of the principal issues in the theory of enterprise. We shall recur to this topic presently.

III.XII.43

The case of investment in invention is different again. Here, owing to the low cost of indefinitely multiplying an idea, it is usually difficult to capitalize an increase in productive power. Society generally permits an inventor or his assigns to keep his idea secret as long as possible or to safeguard it in any manner. But this is so commonly impracticable and the social value of new inventions so manifest that the patent system has come into general use establishing and protecting by law a temporary, and rather short-lived, property right in the improvement. It is manifest that this is an exceedingly crude way of rewarding invention. Not merely do the consumers of the product pay, which is doubtless fair, but large numbers of other persons suffer who are prevented from using the commodity by the artificially high price. And as the thing works out, it is undoubtedly a very rare and exceptional case where the really deserving inventor gets anything like a fair reward. If any one gains, it is some purchaser of the invention or at best an inventor who adds a detail or finishing touch that makes an idea practicable where the real work of pioneering and exploration has been done by others. It would seem to be a matter of political intelligence and administrative capacity to replace artificial monopoly with some direct method of stimulating and rewarding research.

III.XII.44

The improvement of business organization and methods offers still less chance of securing any permanent gain, since the result is usually neither patentable nor capable of being kept secret. Yet this form of progress also represents an investment of present wealth which could have been placed in fields yielding perpetual property rights. Surely there is no evidence of any unwillingness to make expenditures in this form of improvement, and the fact raises interesting questions as to the motives which actually operate in inducing men to make the present sacrifices which promote economic progress. Expenditure in creating new wants can be made to yield a more permanent advantage through the use of distinctive brands and legal protection of trade marks and trade names. Some of these, of course, become pieces of property of great value and ready salability.

III.XII.45

Remains, then, the final question of the relative importance as stimuli to save and invest, of property rights and the right to transfer such rights to other individuals or project control beyond one's own lifetime. We cannot enter here at length into the question of inheritance. Still more than ownership in the strict sense, of which it is no essential part, inheritance rests on no conscious theory, but has simply happened. The attribute of inheritance more or less naturally inheres in personal effects where the family system exists, and it becomes transferred to productive goods as these increase in importance, while property in productive goods also enormously strengthens and isolates the private family sentiment. Voluntary bequest outside the family represents a later development and in a sense the reverse tendency.

III.XII.46

The "theory" of the rights of transmission and bequest is, of course, that they form an important element in the inducement to conserve and accumulate wealth. The writer is extremely skeptical as to the soundness of this view, but there are considerations which must give pause to any rash advocacy of fundamental change. The difficulty, again, is to suggest an alternative plan which seems workable. The public confiscation of wealth at the death of the owner raises the question of what would be done with it. For those who are dubious of the direct management of productive enterprise by public agency, a leasing system or sale at auction in exchange for income rights in the form of debentures or the like perhaps offer a possible way out. This is much like some of the suggestions of the Saint-Simonian school of socialists.*77 Even then the practical problem of distributing the income among the people or of its public utilization gives rise to misgivings.

III.XII.47

Somewhat similar problems again arise in connection with the personal powers of individuals, which, as we have seen, obstinately resist generic separation from material goods in their economic bearings. Innate ability, in the sense in which there is such a thing, is inevitably hereditary, and nothing can be done about it except to modify the conception of the individual's property rights in his own powers. But culture in all its subtle significance, as well as education and training in their cruder forms, are also more or less transmissible and more or less subject to voluntary bestowal, and the factor of personal influence or "pull" can by no means be left out of account. The significance of control over these things is very great and would probably be multiplied rather than diminished in a society which abolished property in material things. It seems that real equality of opportunity, a true merit system, is hardly conceivable, and that no very close approach to such a consummation can be expected in connection with the private family. Plato, of course, recognized this fact, which most of his modern successors have a tendency to blink.

III.XII.48

The ultimate difficulties of any arbitrary, artificial, moral, or rational reconstruction of society center around the problem of social continuity in a world where individuals are born naked, destitute, helpless, ignorant, and untrained, and must spend a third of their lives in acquiring the prerequisites of a free contractual existence. The distribution of control, of personal power, position, and opportunity, of the burden of labor and of uncertainty, and of the material produce of social industry cannot easily be radically altered, whatever we may think ideally ought to be done. The fundamental fact about society as a going concern is that it is made up of individuals who are born and die and give place to others; and the fundamental fact about modern civilization is that it is dependent upon the utilization of three great accumulating funds of inheritance from the past, material goods and appliances, knowledge and skill, and morale. Besides the torch of life itself, the material wealth of the world, a technological system of vast and increasing intricacy and the habituations which fit men for social life must in some manner be carried forward to new individuals born devoid of all these things as older individuals pass out. The existing order, with the institutions of the private family and private property (in self as well as goods), inheritance and bequest and parental responsibility, affords one way for securing more or less tolerable results in grappling with this problem. They are not ideal, nor even good; but candid consideration of the difficulties of radical transformation, especially in view of our ignorance and disagreement as to what we want, suggests caution and humility in dealing with reconstruction proposals.


Notes for this chapter


57.
Limited progress has been made in some countries in the development of organizations of laborers which engage in enterprise independently, borrowing any necessary capital and hiring supervision at fixed rates. Coöperative production in the ordinary sense may also be referred to, but neither of these cases affords a notable exception to the above generalization as the laborers borrow very little capital. It is one of the defects of our civilization that mechanism has not been involved to enable human ability to hypothecate its productive power in procuring resources to make it effective under its own direction and responsibility.

A notable tendency in modern business development is to specialize and subdivide uncertainty and control in all possible degrees. Corporations multiply securities representing every conceivable gradation from the position of a pure creditor with absolute safety and complete indifference to the conduct of the business at one extreme to risk and control so highly concentrated that slight fluctuations in earnings make the difference between high dividends and assessments at the other. In mercantile business and even in industrial concerns credit instruments pass through the hands of a lengthening series of middlemen who add their guarantees of soundness and pass them on at a little higher price or lower return. Bond houses, bill brokers, and acceptance banks are an interesting development in this field. In the labor field the same tendency is manifest. Intermediate employers may hire labor for re-hiring to actual exploiters, as in the familiar case of the padrone, and in some lines of professional work. Every development of profit-sharing is similarly a redistribution of risk and control.

58.
Sir H. S. Maine and Herbert Spencer are especially responsible for this vicious and question-begging perversion of thought.
59.
It is obvious that pure freedom of contract is impossible in a continuous society, as children and the aged and many others can control nothing. In order to deal with the concept in a pure form we are compelled (see chapter IV) to assume that all dependent persons were absolutely dependent, which is to say virtually "owned" by the freely contracting members of the society.
60.
We make no distinction between natural agents and produced equipment goods, as we have shown that under competition no final distinction can be drawn between preëmption and production. (See the discussion of land and capital in chapters IV, V, and XI.) In this connection we may remark here that we are not necessarily in disagreement with a separation of land from capital from the point of view taken by Marshall (Principles of Economics, book IV, chap. I). From the standpoint of a single political unit occupying a limited area of the earth whose natural resources are thoroughly explored, they stand in a different relation as to new supply from that which they occupy in a world economy or a vast and relatively new country like the United States.
61.
It is interesting to observe the concern of the management for the personal security of the workers brought about by compensation laws, and especially the remarkable results of the "safety first" movement in reducing accidents.
62.
See Merril, J. C. F., article on "Speculation," Price Current Grain Reporter, September 29, 1915, pp. 26-27: "It is a universal axiom of business that the greater the risk involved in any line of business the greater must be the profits to those engaged in it, or . . . profits are in proportion to risks!"
63.
Economic Theory of Risk and Insurance, pp. 55-56.
64.
Op. cit. (Annals, Am. Acad., 1896), p. 119.
65.
Quarterly Journal of Economics, vol. IX, no. 4, p. 414.
66.
Institutes of Economics, p. 54.
67.
Unternehmergewinn, p. 85.
68.
Principles of Economics (1913), pp. 366-67, 383-84.
69.
J. S. Mill stated that chances of profit tend to equality, but in the fifth edition changed the word "chances" to "expectations." See Principles, Ashly edition, p. 412.
70.
See above, chapter II, p. 42 [I.II.35-36—Ed.].
71.
Hawley sometimes holds that profit is negative (Quarterly Journal of Economics, vol. XV, p. 609) and at other times that it is positive. (Ibid., p. 79.)
72.
M. Porte, Entrepreneurs et profits industriels (Paris, 1905), argues to this conclusion from certain figures on business failures in Massachusetts. The results of studies of farm accounts by the New York State College of Agriculture indicate that farmers commonly make less than fair wages and a fair return on the investment, and investigations of public utility ventures have yielded similar results. The best study of the distribution of income in the United States, by Dr. W. I. King, reaches the conclusion that the average profit per entrepreneur in this country is about one and four tenths times the average wage per laborer. (See Wealth and Income of the People of the United States, p. 165.) It seems safe to assume that entrepreneurs have greater ability than laborers in a larger ratio than this, especially since a large proportion of the wage-earners reported by the Census are women and young persons and children. But Dr. King's division of income into shares and his estimates of the numbers of recipients of each type are both replete with long-range deductions and assumptions leaving so much room for error that little if any confidence can be placed in the result.
73.
Cited by Cannan, History of Theories of Production and Distribution, p. 369.
74.
Article on "Profit" in Palgrave's Dictionary of Political Economy.
75.
Distribution of Wealth, p. 283.
76.
An accurate and exhaustive discussion of this point would have to distinguish between the motives of the entrepreneur and those of the owner who transfers the use of his property to an entrepreneur for a fixed return.
77.
See also Alvin S. Johnson, "The Public Capitalization of the Inheritance Tax," Journal of Political Economy, February, 1914.

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