Risk, Uncertainty, and Profit

Frank H. Knight
Knight, Frank H.
(1885-1972)
CEE
Display paragraphs in this book containing:
Editor/Trans.
First Pub. Date
1921
Publisher/Edition
Boston, MA: Hart, Schaffner & Marx; Houghton Mifflin Co.
Pub. Date
1921
Comments
1st edition. Based on award-winning dissertation essay.

1. Cf. Mackenzie, Introduction to Social Philosophy, p. 58. Also Bagehot, Economic Studies, no. 1: "The Presuppositions of English Political Economy."

2. There are three types or schools of mathematical economic theory, connected with the names of Cournot, Jevons, and Walras respectively. Dr. Vilfredo Pareto, of the University of Lausanne (successor of Walras), is now the most prominent exponent of the mathematical method. Among "literary" pure theorists, Wicksteed, Schumpeter, and Pantaleoni stand out.

3. Logic, book VI, chaps. IX and X.

4. The relations between deduction and induction are intimate, and a rigid separation or contrast between the two methods is misleading. A more careful study of the fundamentals of scientific method will be undertaken hereafter (chapter VII). We shall see that there is ultimately no such fact as deduction as commonly understood, that inference is from particulars to particular, and that generalization is always tentative and a mere labor-saving device. The fact is, however, that we can study facts intelligently and fruitfully only in the light of hypotheses, while hypotheses have value more or less in proportion to the amount of antecedent concrete knowledge of fact on which they are based. The actual procedure of science thus consists of making and testing hypotheses. The first hypotheses in any field are usually the impressions of "common sense"; i.e., of that superficial knowledge forced upon intelligence by direct contact with the world. Study, in the light of any hypothesis, corrects or refutes the guiding generalization and suggests new points of view, to be criticized and tested in the same way, and so the organization of the material proceeds. The importance of generalization arises from the fact that as our minds are built, it is nearly fruitless to attempt to observe phenomena unless we approach them with questions to be answered. This is what a hypothesis really is, a question. Superficial observation suggests questions which study answers. If and so long as it answers a question affirmatively and the answer is not contradicted by the test of practical application or casual observation, we have a law of nature, a truth about our environment which enables us to react intelligently to it in our conduct.

There is, then, little if any use for induction in the Baconian sense of an exhaustive collection and collation of facts, though in some cases this may be necessary and fruitful. On the other hand, there is equally little use for deduction taken as doing more than suggesting hypotheses, subject to verification. It is to be noted, however, that our common-sense generalizations have a very high degree of certainty in some fields, giving us, in regard to the external world, for instance, the "axioms" of mathematics. Even more important in the present connection is the rôle of common sense or intuition in the study of human phenomena. Observation and intuition are, indeed, hardly distinguishable operations in much of the field of human behavior. Our knowledge of ourselves is based on introspective observation, but is so direct that it may be called intuitive. Its extension to our fellow human beings is also based upon the interpretation of the communicative signs of speech, gesture, facial expression, etc., far more than upon direct observation of behavior, and this process of interpretation is highly instinctive and subconscious in character. Many of the fundamental laws of economics are therefore properly "intuitive" to begin with, though of course always subject to correction by induction in the ordinary sense of observation and statistical treatment of data.

These brief statements must not be thought of as dealing with philosophical problems. The writer is, like Mill, an empiricist, holding that all general truths or axioms are ultimately inductions from experience. By induction as a method is meant deliberate, scientific induction, the planned study of instances for the purpose of ascertaining their "law." And deduction means reaching new truth by the application of general laws to particular cases. In the present view both of these processes are regarded as suggestive merely, exhaustive induction and conclusive deduction being alike impossible.

5. The reader will recall Comte's arrangement of the sciences in the order of generality of the principles they establish. Mathematics, the properties of space and of quantity in the abstract, is applicable to all phenomena—and tells us correspondingly little about any of them. The laws of matter, of living matter, etc., are less general and more concretely real. The same principles are applicable within any grand division of knowledge.

6. Cf. Mill's Essays on Unsettled Questions, no. 5, which really leaves little to be said on the subject. Also Cairnes, on the Character and Logical Method of Political Economy, and the discussions of methodology of the English economists generally. The conception of the "economic man" was one way of emphasizing the abstract and simplified character of the premises of the science. Keynes's Scope and Logical Method of Political Economy is as ably clear and conclusive discussion of this whole subject.

7. It is necessary to admit that in fact only a pitifully small fraction of the race have any particular theoretical sense in the mechanical field either. Certainly a vast majority of literate adults with elementary experience with machinery have no real comprehension of the most fundamental principles of the transformation and equivalence of forces. As far as their own insight is concerned, they could easily be taken in with crude perpetual motion schemes, and an astonishing proportion are willing to back their own judgment in such matters against what they know to be the unanimous verdict of the scientific world. The recurrent discussion of such projects in our National Congress are familiar. A certain mechanical "handiness" is probably all that is to be found in any but the rare scientific minds, and these handy men are precisely the ones who seem most likely to waste their lives and means over palpably absurd enterprises. A large proportion even of competent engineers have neither comprehension nor appreciation of physical theory.

8. The static state idea is further developed along rigidly theoretical lines by Professor Schumpeter in Austria.

9. We shall attempt to show that it does not represent, as Professor Clark contends, the assumptions implicit in the classical economic theory. (See chapter II.)

10. Cf. Dewey's definition of reason as the method of social diagnosis and prognosis.

11. We need not here more than mention the obvious fact that the theoretical method is applicable to monopoly as well as competition and has dealt with both. It has been, of course, a theoretically "ideal" monopoly also—the real assumption being an exceptional instance of perfect monopoly in a general system of perfect competition. The contrast between theory and reality and the significance of the former is of the same sort in both cases, and we shall also discuss the meaning of perfect monopoly in the proper connection. (Chapter VI.)

12. It will be perceived that the word "profit" is here used in the sense of "pure profit, a distributive share different from the returns to the productive services of land, labor, and capital.

Part I, Chapter II.

13. Excellent histories of profit theory are to be found in the introductory sections of several monographs on profit and make it superfluous to go into this phase of the subject in detail. See especially the following:

    Mangoldt, H. v., Die Lehre vom Unternehmergewinn. Leipsic, 1855.
    Pierstorff, J., Die Lehre vom Unternehmergewinn. Berlin, 1875.
    Mataja, V., Der Unternehmergewinn. Vienna, 1884.
    Gross, G., Die Lehre vom Unternehmergewinn. Leipsic, 1884.
    Porte, M., Entrepreneurs et profits industriels. Paris, 1901.

14. The exception is Professor Clark's theory of perfect competition as equivalent to the "static state" and the corresponding "dynamic theory" of profit as the result of progress. This view will presently be taken up and criticized.

15. For a fuller discussion of the views of the English writers, with citations, see Cannan, Theories of Production and Distribution, chap. VI, sec. 2; also the same author's article on "Profit" in Palgrave's Dictionary of Political Economy. In opposition to the German historians and critics, who take the classical economists very literally, Cannan is sure that they really held, like their French followers, a wage theory of profit. Between the two views this seems the fairer on the whole, but it could hardly be maintained that the difference in expression does not represent some difference in thought. However, much of the contrast is undoubtedly due to differences in the use of terms. Old words used to designate new things necessarily become ambiguous, and "profit" is still correctly used with several different meanings.

16. Op. cit., p. 19, note.

17. Article, "Profit," in Coquelin and Guillaumin's Dictionnaire de l'économie politique, Paris, 1852. It is true that in another work (Traité d'économie politique, 2d ed., 1867) Courcelle was not so explicit, and also that in the same article he says that profit depends on the intelligence of the entrepreneur and the favorable or unfavorable conditions under which he works. This hesitation may explain Kleinwächter's classifying him with the followers of Say and adherents of the wages theory. (See Das Einkommen and seine Verteilung, p. 278.) It seems more probable, however, that Courcelle glimpsed the fact (which Kleinwächter did not) that the assumption of a "risk" of error in one's own judgment, inherent in the making of a responsible decision, is a phenomenon of a different character from the assumption of "risk" in the insurance sense. We shall build largely upon this distinction later.

18. These national designations of the two schools hold closely. The only notable exceptions (aside from Courcelle) are on the one side, Rossi, a French (naturalized Italian) writer, who strongly espoused the capitalistic or English view, and on the other Samuel Read who, while agreeing with the current English treatment in terminology, broke with it in substance and agreed with Say and his followers. Read insisted on identifying "profit" with the return to capital, or interest, and treating the distinctive income of the entrepreneur as a wage. He also emphasized the "compensation for risk" element in his "profit" (really interest), but thought it due to no determinate causes and "outside the pale of science." This last phrase shows at least an insight into the unique character of this sort of risk, since the assertion would certainly not have been made of an insurance premium. See his Political Economy, Edinburgh, 1829, pp. 263 and 269, note.

19. Neue Grundlage der Staatswissenschaft, vol. I. Giessen, 1807.

20. National Ökonomie, 1839.

21. Appeared 1826. 3d ed., 1876. See 3d ed., vol. II, pp. 83 ff.

22. See also the article "Unternehmergewinn," by Pierstorff in Conrad's Handwörterbuch der Staatswissenschaften. Dr. Thorstein Veblen's conceptions of capital and profit show strong leanings toward the same views.

23. Referred to above, p. 22 n.

24. Ibid.

25. G. Schönberg, Handbuch der PolitischenÖkonomie, 2d ed. (Tübingen, 1885), pp. 670 ff.

26. Ibid., pp. 220 ff.

Other works in the same group with the above are:

    E. Aug. Schroeder, Dab Unternehmen and der Unternehmergewinn. Vienna, 1884. (The same date of publication as Gross and Mataja.)
    A. Wirminghaus, Das Unternehmergewinn and die Beteiligung der Arbeiter am Unternehmergewinn. Jena, 1886.
    E. Zuns, Swei Fragen des Unternehmer-Einkommens. Berlin, 1881.
    A. Körner, Unternehmen and Unternehmergewinn. Vienna, 1893.

27. A noteworthy innovation in the treatment of profit has been made by a recent French writer, M. B. Lavergne, in his Théorie des marchées économiques (Paris, 1910). In his view profit is the remuneration of the idée productrice, which is elevated to the position of an independent productive factor. His book outlines an ingenious and suggestive theory of distribution. See review by Professor A. A. Young, American Economic Review, vol. I, pp. 549 ff.

28. Political Economy, part IV, chap. IV. See also "The Source of Business Profits and Reply to Mr. Macvane," Quarterly Journal of Economics, vol. I, pp. 265 ff., and vol. II, pp. 263 ff. (Macvane held a monopoly theory; cf. Quarterly Journal of Economics, vol. II, pp. 1 ff. and 453 ff.) A view similar to that of Walker has been advocated in France by Leroy-Beaulieu (Sr.). See Mémories de l'Academie des sciences morales et politiques, vol. I, pp. 717 ff, and Traité d'économie politique, part IV, chap. IX.

29. "Distribution as Determined by a Law of Rent," Quarterly Journal of Economics, vol. V, pp. 289 ff.

30. "The Law of the Three Rents," ibid., vol. V, pp. 263 ff.

More exhaustive than either Clark or Hobson is Wicksteed, The Coördination of the Laws of Distribution, London, 1894.

31. It is not meant that these are the only noteworthy advocates of the views in question, nor that other American writers on distribution have not been in some degree original in their treatment of profit. The discussions by the various authors—Davenport, Ely, Fetter, Fisher, Johnson, Seager, Seligman, Taussig, and others—are accessible everywhere. Perhaps especial mention should be made of the chapter on profit in Carver's Distribution of Wealth. Carver's distinction between compensation for risk-taking and the results of successful risk-taking points to the direction in which a solution of the problem is to be sought. Other writers also have seen the importance of a critical dissection of the risk concept, but none have so far carried out the work. Unquestionably the best of these textbook discussions is that of Professor F. M. Taylor in his unpublished Principles of Economics, a work characterized throughout by correctly reasoned and accurately stated theoretical argument.

32. See The Distribution of Wealth, 1900; and Essentials of Economic Theory, 1907.

33. The Distribution of Wealth, pp. 30, 31.

34. The Distribution of Wealth, p. 29.

35. Ibid., p. 66.

36. Ibid., pp. 68-69.

37. Ibid. Professor Joseph Schumpeter, who has carried the static analysis farther in some respects than Professor Clark, points out that in the static state there is no entrepreneur, properly speaking. The consumer, he adds, is really the entrepreneur; but it would seem preferable to say that the function is absent and let it go at that. (Theorie der Wirtschaftliche Entwickelung.)

38. The Distribution of Wealth, p. 404.

39. Ibid., p. 405.

40. Ibid., p. 406.

41. Ibid., p. 410. This is fallacious even under the assumptions, since the profits of change come largely in the form of readjustments of capital values. The difficulty is, of course, avoided if "friction" be so broadly defined that "perfect mobility" means the absence of all resistance to the human will. But in a world where a breath could transform a brick factory building into a railway yard or an ocean greyhound there would be no need for economic activity or economic science.

42. The Distribution of Wealth, p. 411. At this point Professor Clark makes a statement which if followed out would lead to serious questionings in regard to his analysis: "Profit," he says (p. 411), "is the lure that insures improvement, and improvement is the source of permanent additions to wages. To secure progress, this lure must be sufficient to make men overcome obstructions and take risks." (My italics.) It would seem that effort and risk have some connection with the income of the "entrepreneur as such," as well as change and friction. Along the same line is the statement in his first chapter (p. 3) that "free competition tends to give to labor what labor creates, to capitalists what capital creates, and to entrepreneurs what the coördinating function creates." When we ask, as we presently shall, whether the "effort" and "risk" connected with making progress, or the income to which they give rise, are essentially different from any other effort and risk and their incomes, we shall find ourselves forced to answer in the negative, and to look outside the fact of change altogether for an explanation of the unique income of the entrepreneur.

43. It may be objected that in regard to some changes it is an absurdity to imagine their being foreseen, since this would cause them to take place at once. The statement doubtless holds in regard to some discoveries of fact which to anticipate would be to make them now. But not many of the dynamic economic changes are of this sort. The accumulation of capital and increase in population are in fact relatively predictable and the broader features in the development of wants are known and the knowledge has no effect on the changes themselves. It is possible even to predict discovery of natural resources without saying just where they will be found, and the making of an invention without actually writing the specifications. The probability that inventions will be made and processes improved is in fact very frequently taken into account in making valuations and determining business policies. The assumption that all change might be predictable is contrary to fact, but not self-contradictory, and we leave it to the argument as a whole to justify its usefulness as well as legitimacy.

44. It is necessary to stipulate that the fluctuations must be of sufficient extent and irregularity that they do not cancel out and reduce to uniformity or regular periodicity in a time-interval short in comparison with the length of human life.

45. Quarterly Journal of Economics, vol. VII, pp. 40-54.

46. Ibid., p. 41.

47. Ibid., p. 46.

48. Footnote, pp. 122-23.

49. The Economic Theory of Risk and Insurance, Columbia University Studies in Political Science, vol. XIV, no. 2.

50. Rent in Modern Economic Theory. Publications of the American Economic Association, 3d Series, vol. III, no. 4. See chapter VI: "Rent. Profit, and Monopoly Return." (Both these monographs are doctoral dissertations written under Professor Clark's supervision.)

51. Willett, op. cit., pp. 13-14. (My italics.)

52. Ibid., p. 72.

53. The most complete exposition of Hawley's theory is in his book. Enterprise and the Productive Process (1907). Articles of earlier date in the Quarterly Journal of Economics contain briefer statements.

54. An earlier attempt by Mr. Hawley to present the essentials of his theory in the most compact form is superior in some respects and is worth quoting:

"The final consumer is forced to include in the price he pays for any product not only enough to cover all the items of cost to the entrepreneur,—among which items is a sum sufficient to cover the actuarial or average losses incidental to the various risks of all kinds necessarily assumed by the entrepreneur and his insurers,—but a further sum, without which, as an inducement, the entrepreneur, or enterpriser, and his insurers will not undergo or suffer the irksomeness of being exposed to risk.

"This surplus of consumer's cost over entrepreneur's cost, universally regarded as profit, and, from the nature of the case, an unpredetermined residue, is the inducement for the assumption by the entrepreneur, or enterpriser, of all the risks, whatever their nature, necessitated by the process of production. As the inducement to any given action and the reward for that action are the same thing,—the difference being not in the thing itself, but only in the point of time from which it is looked upon,—the unpredetermined residue, which served as the inducement to risk at the commencement of any industrial transaction must necessarily, when determined and realized at its close, be regarded as the result, reward, of the risks undergone." (Quarterly Journal of Economics, vol. XV, pp. 603-20.) (In the original the portion quoted is all in italics.)

55. Op. cit., pp. 106-07.

56. Quarterly Journal of Economics, vol. VII, p. 465; vol. XV, p. 88.

57. "Enterprise and Profit," Quarterly Journal of Economics, vol. XV, p. 86.

58. Quarterly Journal of Economics, vol. VII, p. 464. It should be explained that "monopoly gain" for Mr. Hawley includes all income due to limitation, and he finds that it forms a considerable portion of wages and interest, all of rent, and a large part of profit. We have repeatedly observed examples of this fallacy and remarked that there is no income which is not due to the "scarcity" of the agent securing it.

59. Enterprise and the Productive Process, p. 111.

60. Op. cit., pp. 27 ff.

61. Risk is defined as "the objective correlative of the subjective uncertainty" (p. 29), which varies with the mathematical chance of loss in such a way as to be at a maximum when the chances for and against the event are exactly even. But it is still to be regarded as a known quantity, since the mathematical chance is assumed to be known. Willett nowhere makes an explicit statement on this point, as Hawley does (see quotation in text on p. 42 above), but his discussion clearly shows that it is viewed as a known quantity. He takes his illustrations from games of chance or from the field of insurance, speaks of the influence of "a given degree of risk" (p. 65) on investors, etc. He does recognize the fact that the degree of risk is not always known in fact, and discusses methods of estimating the degree of risk; but (pp. 66 and 76) he expressly eliminates from the discussion the consequences of error in estimating the true value of the risk.

62. Op. cit., p. 112.

63. The reader will recall that many of the early discussions of profit (discussed in the early pages of this chapter), notably those of v. Mangoldt and v. Thünen, recognized the fact that some risks are insurable and others are not. No explanation of the fact, however, has been given, beyond phrases such as "in the nature of the case," which imply that it does not call for explanation.

64. "The Risk Theory of Profit," Quarterly Journal of Economics, vol. VII, p. 468.

65. Enterprise and the Productive Process, p. 108. Cf. Carver, "Risk Theory of Profits," Quarterly Journal of Economics, vol. XV, pp. 456 ff., and The Distribution of Wealth, chap. VII. Also A. A. Young in Ely's Outlines of Economics, 3d ed., chap. XXV. The phrase "successful risk-taking," used by both Carver and Young, like Hawley's "risks wisely selected," is certainly descriptive of the origin of profits. What is wanted is an examination of the meaning of risk-taking which will elucidate the conditions under which it will be successful and show the significant differences between cases of success and cases of failure.

66. "Enterprise and Profit," Quarterly Journal of Economics, vol. XV, p. 88.

67. See above, p. 42.

68. It must be understood that by laws and chances being "known," we mean that they are generally known, known to all to whom they are of any concern.

End of Part I Notes.

Part II, Chapter III.

1. Outside of monopoly considerations. But see chapter VI.

2. This is intended as a statement of historic fact, not a dogma of necessity or desirability. To the extent that in behavior of any other sort principles may be discovered of a sufficiently general applicability to enable useful conclusions to be drawn from them, there is no reason why such principles should not be incorporated in the premises of pure theory. On the other hand, it is indisputably legitimate to begin, as an early approximation to reality, with the assumption that all the behavior of which we treat is of the character which certainly belongs to a great part of it. In any case we have to separate fundamental tendencies by such a process of analysis (i.e., abstraction) if we are to know anything about them individually. Here we are not concerned to inquire into the possibilities of an economics of instinct and reflex, much less to build up the science; we rest on the fact that the historic body of speculation has dealt with that section of behavior which we call "conduct," and, in line with our leading aim, point out the corresponding limitations of the conclusions from the reasoning. It would be futile to insist further (for those who have not grasped the point already) that limitations are no valid objection to a theory,—may even be a condition of its having any worth,—but the limitations must be recognized and appreciated.

3. It is impossible to follow out this line of thought to the length that its importance really justifies. Considerations somewhat along the line suggested are ably put forward in a lecture on John Ruskin as an Economist, by Patrick Geddes (The Round Table Series); also by Professor H. W. Stuart in his essay on "The Phases of the Economic Interest," in the volume by Dewey and others entitled Creative Intelligence. Cf. also Wesley C. Mitchell, "Human Behaviour and Economics," Quarterly Journal of Economics, vol. XXIX, pp. 1 ff.

At the opposite extreme a presentation of economics uncritically rationalized and devitalized to the point of approximate chemical purity may be found in the writings of Professor T. N. Carver. The old economists employed the concept of an economic man deliberately and intelligently; for Carver he is literally the man in the street.

4. The extinct civilizations of Mexico, and especially of Peru, are alleged to have been largely of this character.

5. For fuller statement see below, chapter V.

6. We must by no means be understood to assert or assume that these things are done ideally or even in the best practicable manner by the free exchange system of organization. In the first and third problems in particular, the formation of the social value scale and the use of resources in furthering progress, its methods and results, are open to severe criticism. But again we do not assert that there is any better method or solution practically available. It is our business simply to analyze and describe the workings of a purely voluntary, individualistic, competitive system in relation to the fundamental tasks of organization.

7. It is outside our purpose to attempt a detailed classification of wants. We may notice in passing the difficulty of distinguishing between really different wants and different means of satisfying the same want. For example, we may speak of the want for food, or wants for different foods; one can supply the place of another within limits, but only within limits, and finally the desire for variety itself becomes a want. In our view wants must be classified for the purposes of economic science in accordance with the actual market classification of goods. Nor shall we pretend to go into the psychological problem of the basis of desire. Our discussion deals with things in relation to conduct, and it is a matter of no concern whether we want the things or the conscious states we expect to derive from them, or what, so long as the relation between the acts themselves and the material changes toward which they are directed is clear.

8. There seem to be and perhaps are exceptional cases where this description does not fit the facts; there seem to be, that is, absolute wants, based on absolute limitation and not on limitation due to conflicting demand for the means of satisfaction. These are certainly of negligible importance in economics, however, and on scrutiny they have a tendency to lose the character of "wants" altogether. It is hard to see how a science can deal fruitfully in a constructive way with utterly capricious phenomena; of course it must deal with them in the sense of recognizing that they exist and form a limitation on the completeness of theory, but they can hardly be taken account of in the theory itself.

9. We carry some wants to complete satiety because it takes less effort than would be required to calculate accurately the most desirable place to stop when this point would be near the absolute satiety limit, as in the case of eating bread, for example. The fact may serve to illustrate the fundamental "irrationality" of a perfectly "rational" attitude to life. One of our most significant "wants" is freedom from the bother of calculating things or making close estimates. Cf. J. M. Clark, "Economics and Modern Psychology," Journal of Political Economy, vol. 26, nos. 1 and 2.

10. Even "for consciousness" the difference between pleasure and the absence of pain and conversely, though real, is of an "accidental" and very elusive character; we cannot formulate a difference between the two series or classify experiences between them. It is too obvious to call for discussion that the same event will be a pleasure to one person and a pain to another, and even pleasurable to the same person at one time and painful at another, according to circumstances, and, especially, expectations. The difference fades out on scrutiny. An inheritance of a hundred thousand, which is a pleasure to one to whom it is a surprise, may be an intense grief if he has expected and made his plans for ten million. A prison sentence is undoubtedly a source of joy to a man who counted on being hanged, and it is ridiculous to say that it is "really" only an escape from a worse pain, or the inheritance a deprivation of a greater pleasure. The comparison of alternatives and fact of preference is the real thing; pleasure and pain are accidental and arbitrary matters.

11. The phrase "equal utility," as we shall presently see, should be taken to refer merely to the fact of indifference in choice, and not a comparison between quantities in the true sense at all. We avoid the expression "marginal" utility, because of its implication that there is a difference in the significance of different portions of the same supply. In speaking of the utility of a supply, however, it is sometimes useful to have some word to distinguish between the utility per unit and the utility of the supply as a whole. When it seems advisable we shall use the expression "specific utility" to indicate utility per unit.

The general method of taking the principle of choice as the starting-point of economic reasoning and treating "diminishing utility" in a comparative sense has been used with especial clearness and force by Wicksteed (Common Sense of Political Economy), and is also adopted by Fetter in his recent work (Economic Principles). Economists generally have been coming to recognize that the psychology of the subject is properly behavioristic; that an economist need not be a hedonist (Jevons and Edgeworth notwithstanding), and that he does not need even to consider the issue between rival psychologies of choice. See Mitchell, "The Rôle of Money in Economic Theory," Proceedings, Twenty-Eighth Annual Meeting of the American Economic Association. The principle of relativity of utility and value holds in the same way under any theory of motivation. B. M. Anderson, Jr. (Social Value, and Value of Money, chap. I) advocates a theory of absolute social value, defining value, as we have done, as power to motivate conduct. It is hard to explain his failure to see that this notion is as relative as any other, is in fact the most obviously relative of all. Motivation of conduct means of "this" conduct rather than some other, and is obviously inconceivable apart from a situation presenting alternatives between which comparison and choice must be made. Davenport, also (Economics of Enterprise, chap. VII), while insisting on the importance of relative utility in economic reasoning, treats utility itself as an absolute magnitude. The present writer finds it impossible to conceive such an entity.

12. Close scrutiny makes it appear doubtful just how much real explanatory value the viewpoint of the utilization of resources adds to the bare principle of combining alternatives. It seems that what we call a "resource" is such, not on its own account, but solely because of the uses to which it can be put, and its quantitative aspect, how much resource there is, is still more evidently determinable only in terms of the use. But at least the resource idea helps us to mediate in thought the fact of the quantitatively alternative character of the opposed lines of utilization, as is shown by the fact that we habitually make use of it. The form of the unsophisticated psychosis in regard to sacrifices or "costs" is in fact a bit puzzling. If we ask what a thing has cost, we seem inclined to answer first in terms of money or effort, etc., i.e., of "resources"; but when pressed, we are likely to go back of the latter and evaluate the resource in turn in terms of some other utility which might have been had for it. The "ontologizing" of the notion of resources seems to be an illustration of an "instrumental concept," but one which it would be difficult to get along without.

13. Principles of Economics, book V, chap. II, sec. 1.

14. Which, to be sure, is not very far. Nor is this any criticism of the boy. Quite the contrary! It is evident that the rational thing to do is to be irrational, where deliberation and estimation cost more than they are worth. That this is very often true, and that men still oftener (perhaps) behave as if it were, does not vitiate economic reasoning to the extent that might be supposed. For these irrationalities (whether rational or irrational!) tend to offset each other. The applicability of the general "theory" of conduct to a particular individual in a particular case is likely to give results bordering on the grotesque, but en masse and in the long run it is not so. The market behaves as if men were wont to calculate with the utmost precision in making their choices. We live largely, of necessity, by rule and blindly; but the results approximate rationality fairly well on an average.

15. The discussion assumes that the quantitative relation between the alternatives themselves remains unchanged, that one is sacrificed for the other in the same ratio throughout, or "resources" converted into both at the same rate, In practice this is only exceptionally possible; in general not only the relative importance of given quantities of alternative goods will change as the supply changes, but in addition the amount of one which must be sacrificed to obtain a given amount of the other will increase as the supply of the first increases; i.e., a "law of diminishing productivity" (likewise a law of proportions merely) becomes operative in addition to the law of diminishing utility (and works in the same direction).

Professor Patten has raised the objection to the utility analysis that consumption also requires time, which must be saved out of the productive operations. (See Annals, Amer. Acad. 1892-93, pp. 726-28. Cf. also Edgeworth, Mathematical Psychics, p. 68, where the energy as well as time required for consumption is considered.) It seems logically more accurate, however, to include in production everything except the actual experience of satisfaction, and if this is done the objection loses its force. In our method of approach to the problem, viewing it as a matter of choice between (i.e., combination of) alternatives, and taking the alternatives simply for whatever they may be in the facts of the case, the whole issue loses its relevance.

16. This may be expressed in technical phrase by saying that they are "ordinal" rather than "quantitative"; they are variable, but not measurable, can be ranked, but not added. The nature of this attribute will lose its mystery if any simple sensation, as a sensation, is considered for a moment. It is easy to tell when one light is brighter than another, impossible to tell how much brighter. The intensity of light is indeed "measured" by science, but it is done by a method analogous in principle to the discussion of utility above. One light is removed to such a distance that it becomes equal in intensity to the standard, and the distance is measured. Obviously this does not involve the measurement of sensation at all. Similarly, a thermometer does not measure the sensation of heat, or a balance that of weight. A better illustration of "ordinal" variables is furnished by the field of æsthetics (another form of "value," of course). We can tell that one poem or picture is better than another, but no one would seriously propose measuring the superiority. To be sure, in school and in contests we may go through the motion of "grading" such things (even deportment!) on a percentage scale, but no one whose opinion is entitled to respect attaches any particular weight to the results of this make-believe.

17. That to a considerable extent purchases are based on momentary impulse and not on an estimation of relative long-time significance, is, of course, true, and perhaps increasingly so with the development of the "anti-social" arts of window-dressing, display advertising, and salesmanship. This is one of the important "allowances" that has to be made in applying economic theory to actual fact, until the progress of the science reduces the phenomena to general laws and incorporates them into the deductive system. (Cf. above, p. 52 [II.III.2-3—Ed.], and note; also p. 61, note. [II.III.17, nn8—Ed.]) Effects balance out to approximate rationality under the law of large numbers.

18. The doctrine of the surplus is one of the few points where the writer is compelled to disagree with Marshall on a fundamental matter of doctrine. (See Principles, 6th ed., pp. 125-33, esp. p. 129, note.) The question relates to "scope and method," however, rather than to fact or logic. I simply cannot see any use for the notion in understanding human conduct or explaining economic phenomena, and am convinced that the confusion of viewpoint which underlies putting it to the fore has led to serious error and the drawing of wholly irrelevant conclusions from economic reasoning. Moreover, an appeal to "unsophisticated common sense" seems to fail utterly to substantiate the existence of the phenomenon. A man might pay, say, a thousand dollars for the "first" loaf of bread (whichever one that is) rather than do without it, but it does not follow and is not true that when he gets it for a dime he gets $999.90 worth of free satisfaction. Various thinkers have perceived the mythical character of these alleged surpluses; it is hoped that the argument above will suggest the source of the error and so render it more easily identified and avoided.

19. Pages 64, 65 [II.III.22-24—Ed.].

20. Dependent members of the society must be completely dependent on some particular individual in it. The wants of any dependent person will then operate only through wants on his behalf felt by his sponsor, and we need not consider them at all. We need simply regard the independent members of the society as having normal solicitudes in regard to families, etc., but each person enters into economic life on an absolute equality with others or not at all.

The meaning of the above assumptions is not necessarily that they form a complete description of the people and their relations. This is but an emphatic way of saying that we here consider only their market behavior, which is assumed to conform to these specifications.

21. It goes without saying that our imaginary society is "isolated." Every individual who has anything at all to do with it is in it and of it on a par with all the rest.

22. We might characterize such a society as a "handicraft" system in contrast with "enterprise," in which the operative has lost his responsible status and lives, not by the production and sale of a commodity, but by the sale of productive services to an entrepreneur.

23. We treat the entire stock as for sale without reserve. The demands of present owners for their own goods, which underlie any possible reservation prices, are in fact no different from the demand of other persons, and the situation as a whole is most truthfully and significantly represented as given quantities of goods over against given dispositions to own them, since the question of whose disposition it is has nothing to do with the price that will be established. We must, of course, include the demand of present owners in the demand for every good; that it is "backed up" by the good itself instead of some other good in hand has nothing to do with the result. (Cf. Davenport, Economics of Enterprise, chap. V, pp. 48 ff.)

24. The problem of a perfect market is best treated mathematically (i.e., symbolically) and has been well handled by mathematical economists. See Edgeworth, Mathematical Psychics, pp. 40 ff., and Marshall, Principles, Appendix F, and Mathematical Appendix, note XII bis.

25. Easily proved by disproving the contrary. If exchanges be thought of as taking place at different prices the buyer at the higher price and seller at the lower will get together at an intermediate figure.

26. These two propositions are often treated as equivalent in economic discussion, but the relation between them is not so simple as that. To prove the second from the first, suppose that at any given price the individual has determined upon the proper amount to purchase. (For the sake of similarity with the pecuniary situation let us leave the purchase good out of account and think of a comparison between two commodities being bought with money which has no commodity value.) Now let the price of one commodity rise, relatively to that of another. If the commodity which has risen in value is a very important one, it is probable that the individual will spend as much of his resources for it as before, quite possibly even more. But he will not buy as much of the commodity, measured in physical units. For to do so he would have to spend correspondingly less resources for the alternative good, and buy less of it. But if he buys the same amount of one good as before, and less of the other, the utility ratio between the two is upset (since it was in equilibrium), and a given amount of resources is buying less utility in the good of which relatively more is purchased; resources will therefore be diverted from this good to the other. That is, he will buy less of the good which has risen (relatively) in price. Q. E. D.

27. Pages 66 ff [II.III.26 and nn13—Ed.].

28. It is also possible, but complicates matters needlessly, to plot the demand of others than present owners of the good, only, in the demand curve, and draw an ascending curve to represent the sales at different prices taking account of the present holders' reservation prices. The same data will give the same price point whichever method is used, and the one described in the text is the more significant description of the situation, since there is no practical difference in the causes or motives back of reservation prices and demand prices.

29. Seligman's treatment (Principles of Economics, pp. 179 ff. and 198 ff.) is a particularly glaring instance of the organism fallacy. B. M. Anderson, Jr.'s Social Value involves the same error. Anderson palpably confuses social influences back of individual judgments and preferences with social judgments and preferences in any proper sense. Of course the individual is a social product, but consciousness is still an individual phenomenon, and the conduct with which economists are concerned no less so. It is individual purchases and sales which fix prices, not social, unless in a socialistic state or one organized in some other way than through free exchange between individuals, the kind economics deals with.

30. See above, pp. 76-80 [II.III.39-50—Ed.].

31. The use of money does not affect the theory at all, and the use of circulating credit not in any way that vitiates the argument, if it does not change in value.

In one respect the actual situation is very much simplified as compared with the theoretical, and the disparities which would otherwise arise mitigated. The continuity of the process and the constant existence of published prices means in general that sellers will not come into the market at all unless they are willing to take the quoted price (or more) and buyers not unless they are willing to pay that or anything less. It is then easy to see how an excess of goods offered or an excess of purchase offers will move the price downward or upward to the equilibrium point. The real, practical problem, that is, relates to price changes, not to the establishment of price, and is vastly less complicated than the latter.

32. The other branch is the theory of distribution under static conditions, but under our present assumptions there is no such problem since joint production is absent.

33. It will be noticed that our cost curve is one of increasing costs. This is the only case to be considered from the present point of view. The question of decreasing costs comes in at a later stage of the analysis under more complicated conditions. It is obvious that to increase the production of any good involves the diversion of resources from producing other goods, which will raise their value while lowering that of the good first considered, and since resources are valued according to the best available use, this means increasing cost with increased output. At the present stage of the argument there is no problem as to the cost of any unit of commodity or yield of any unit of productive agency, since only one kind of agency is used in making any one good.

Part II, Chapter IV.

34. See above, chapter III, pp. 76-80 [II.III.39-50—Ed.], for the assumptions under which we are working.

35. See note above, p. 86 n. [nn31—Ed.], on indifference as to the presence and use of money.

36. Competitive relations between similar establishments are much complicated in real life by the fact that practically every business enjoys a certain degree of partial monopoly. It does not turn out exactly the same product (bundle of utilities) as its competitors. An extreme example is the case of railroads where a part of the output, the through traffic, is competitive while the other part, the local traffic, is monopolistic. This whole question of the relation between the size of an industry and the size of an establishment seems to the writer badly mixed up in the literature. Professor Bullock has distinguished between the three principles of diminishing returns with varying proportions between the factors, diminishing costs in an industry as a whole and decreasing costs in the single establishment, or economy of large-scale production. (Cf. Quarterly Journal of Economics, vol. XVI, pp. 473 ff.) But no one, so far as I know, has worked out these cost laws adequately. (Cf. also Davenport, Economics of Enterprise, chap. XXIV). Davenport does not go as far as Bullock in the analysis of the problem.

37. See F. M. Taylor, Principles of Economics, chap. IV, for a very thorough and sound non-mathematical discussion of the whole question of variable proportions and diminishing returns. I must remark, however, that Taylor's treatment of the economy of large-scale production seems to me to be based on fallacy.

38. The second statement of the law is deducible from the first. All that is involved in the law of diminishing returns is properly to be regarded as a deduction from the following self-evident premises:

    1. The proportions of agencies in a combination may be varied without destroying its productivity.
    2. If to a certain amount of one agency (say, labor) another agency (say, land) is added in amounts varying continuously from zero to infinity, a definite amount or range of amounts of this second agency (neither zero nor infinity) will yield a larger total product than will larger or smaller amounts. In other words, if the proportion of one agency to another is increased without limit, the product per unit of the decreasing agency will first increase and then decrease; i.e., there is a maximum point, or range, beyond which in either direction the product (per unit of the increasing agency) will decrease.
    3. It is demonstrably true, and is necessary to the theory of distribution that extreme variation (short of infinity) in either direction will yield a zero product.

It is most essential in regard to this law that it relate to any variation in proportions irrespective of the absolute amount of any factor present and of the direction of the change. But the conventional case of the application of labor to land, or rather of land to labor, is easy to visualize and suitable for illustration. Let us imagine a group of new settlers on a virgin continent faced with the problem of how much of the unlimited supply of land to use with their limited supply of labor. It is surely evident: (1) that they can use different amounts and still get some product (Ax. 1); (2) that they can use too little or too much to get the largest amount of product (Ax. 2); (3) that they might conceivably try to use so little or so much land that no product at all would be secured (Ax. 3).

39. It is to be noted that we must assume the size of individual establishments to be nearly a matter of indifference.

The above reasoning proves also that the curve itself cuts the X axis positively as drawn in our figure, and does not pass through the origin. It follows further from the symmetry of the relation between factors that the curve will cut the X axis again beyond the maximum point and not become asymptotic, as it should do if it passed through the origin. Professor Taylor's curve was incorrectly drawn in this detail as it should either become asymptotic or else not pass through the origin.

40. Really on the other agencies applied to the land, but we follow the usual formulation. The assumption must be borne in mind that men know what they are doing and are motivated by the desire to maximize production. In fact, the results are much distorted by ignorance, the effect of tradition carried over from a place where land is scarce to new countries where it is abundant, ingrained land hunger, etc., and in the United States by the conditions of land settlement and preëmption.

41. Cf. below, p. 108 and note [II.IV.19-21 and nn48—Ed.].

42. The fall in specific or marginal contribution is an easy inference from the law of the variation of product per unit. For a detailed demonstration see Taylor, loc cit., especially pp. 101, 102. The "added product" of a unit in the text above is what Taylor and most writers call "the marginal product" of the "factor." For reasons which will presently appear I prefer to avoid the misleading terminology of factors and margins altogether.

43. This terminology is more or less arbitrary, but is one way of straightening out the current confusion and giving different names to different things. Taylor (loc. cit.) uses both expressions "diminishing returns" and "diminishing productivity," in connection with the instrumental law; in fact in virtually the same sense, and does not bring out the contrast between the variation of physical product and that of value product. Strange to say, he does not use the principle of diminishing returns which he so well formulates in his discussion of distribution, but adopts a different line of reasoning through different proportions of factors in different industries without variability of proportions in single industries. That this same principle is involved is recognized by Taylor, who thus shows a considerable advance over Wieser. This author, it will be recalled, uses the same theory of imputation which Taylor uses, but advances it in place of the specific productivity theory, applied to industries independently, which he repudiates. (See below, p. 110 [II.IV.23—Ed.].)

44. Cf. above, chapter III.

45. As Davenport has remarked. (Cf. Economics of Enterprise, chap. XXII.) But Davenport's position will come up for criticism later on. (Below, p. 124. [II.IV.44—Ed.])

46. The mode of internal organization of the groups need not trouble us here. It might take any form which would produce effective common action and responsibility. In life, it is, of course, generally worked out through a responsible entrepreneur as intermediary, but it is necessary to exclude such a functionary at this point in the argument, and in fact his services would be superfluous, except, perhaps, temporarily while the adjustment was being worked out. Greater violence is done to reality by the specification of perfect competition among organizations for members. This assumption involves, in the first place, perfect knowledge and intercommunication throughout the society. In addition it calls for a large number of groups exploiting every sort of service, and entire absence of collusive action among them. The number of establishments in any line of production depends upon the size of each, which in turn depends on the divisibility of the factors being combined. Hence the principle laid down above (p. 98 [II.IV.7-8—Ed.]) that competition depends on a degree of divisibility in productive factors. That division of labor is limited by the scope of the market is true; but commodities sold in different markets do not represent the same aggregations of utilities, and are different commodities.

47. There is a difficulty in regard to the meaning of the value contribution to a social total. Exchange values being essentially ratios, an aggregate of exchange value has very little meaning. We cannot be sure that the value income of society as measured by the market, in terms, say, of a particular commodity, would be larger when the final adjustment was reached than under any other arrangement, and, of course, it will not do to say that the individual gets the physical commodities which he enables the society to produce. The answer is that he will get the value of the physical contribution which he makes, enough value income to buy it. The actual physical contribution should theoretically consist of infinitesimal increments of practically all the commodities produced in the society, perhaps including an increment of "leisure."

48. For a full discussion and demonstration of the theoretical exhaustiveness of the distributive process as described above (though in a somewhat different setting), see Wicksteed, Common Sense of Political Economy, book II, chap. VI, and The Coördination of the Laws of Distribution, passim. The reader will notice that the lines along which the adjustment is supposed to be worked out above are very different from the "dosing method" familiar in American economic literature. (Cf. especially J. B. Clark, The Distribution of Wealth, chap. XII.) This latter procedure seems to the writer unnecessarily abstract and unreal and more difficult to follow than the realistic method of tracing out the effect of competition among establishments.

49. See especially pp. 8, 9.

50. Quarterly Journal of Economics, August, 1901.

51. Political Science Quarterly, June, 1915.

52. The Economics of Enterprise, chap. X.

53. "Specific Productivity," Quarterly Journal of Economics, vol. XXIX, pp. 149 ff., esp. pp. 159 and 160.

54. Der Natürliche Werth, 3. Abschnitt, "Die Natürliche Zurenchnung des Productiven Ertrages," § 22.

55. The Industrial System, chap. V, appendix, pp. 112-20. A somewhat different (quasi-mathematical) line of argument to the same end is put forth by R. S. Padan, Journal of Political Economy, March, 1901 (vol. IX, pp. 161 ff.).

56. Cf. above, p. 104, note [nn43—Ed.]. Taylor is right in the contention that specific productivity can be imputed through differences in the proportions of agencies in different industries alone without variability of proportions in the industries individually. In fact, both elements come into play. We have mentioned and shall presently discuss further the fallacy involved in the concept of the "factor" of production.

57. See chapter VI.

58. We may notice here another point raised by Padan, the bearing of increasing returns upon the theory. It is generally recognized that in the earlier stages of a hypothetical dosing process, increasing returns will be secured, up to a certain point. By "supposing" this stage of increasing returns to last throughout the process, Padan easily makes the application of the method appear absurd. This line of reasoning is still more arbitrary than his earlier point, however, and need not detain us. We have shown at sufficient length that increasing returns is an absurdity; that an agency worked under such conditions is negatively productive and had better not be used at all. Professor A. Landry, in criticizing Professor Carver, has also overworked this supposition. (See Quarterly Journal of Economics, vol. XXIII, pp. 557 ff.)

59. Proceedings, Twenty-Second Annual Meeting of the American Economic Association, p. 143. Taussig's statement that labor produces all wealth, but is not entitled to all of it, would better, it seems to me, be reversed. Labor cannot claim to be the only causal source of goods, but may put forth a superficial claim to a right to consume them all.

60. Work and Wealth, chap. XXII.

61. The Industrial System, cited above.

62. In the writer's opinion, the hostility to the productivity theory is due mainly to the notion that the productivity of labor and capital represents their moral desert in distribution, joined to the conviction that the existing order is not morally ideal. The theorists who treat a productivity remuneration as synonymous with ideal justice are merely uncritically voicing the popular view. It is this popular dogma which is the seat of the difficulty, and which represents a confusion of the most egregious sort and leads to equally muddled reasoning on the question of causality in order to avoid a repugnant conclusion as to the justice of things as they are. The question cannot be gone into here, but a little consideration will show that there is almost no case at all for an identification or close assimilation of causal contribution to production with moral desert in distribution. The inequalities in inherited property and opportunity in several senses are obvious, but it must also be recognized that natural differences in personal capacity are equally powerless to create a valid moral claim to favored treatment.

63. It seems to me a manifest absurdity to define them in price terms as does Professor J. B. Clark. (The Distribution of Wealth, chap. VI.) There would be only one factor if measured in price terms, and the theory of distribution would be a pure petitio principii.

64. If this conclusion is not evident after a little reflection it may be demonstrated by reasoning as follows. Suppose that at a higher rate per hour or per piece, a man previously at the perfect equilibrium adjustment works as before and earns a proportionally larger income. When, now, he goes to spend the extra money, he will naturally want to increase his expenditures for many commodities consumed and to take on some new ones. To divide his resources in such a way as to preserve equal importance of equal expenditures in all fields he must evidently lay out part of his new funds for increased leisure; i.e., buy back some of his working time or spend some of his money by the process of not earning it. The conclusion is enforced by the important practical consideration that the expenditure of money also requires time and energy which must be saved from the work period if the best results are to be secured.

The facts as to the shape of the supply curve of labor from given laborers are well known to employers of native workmen in backward countries, especially the tropics. White men in the advanced industrial nations have not always behaved so rationally; their traditions give them a higher preference for the kinds of satisfactions purchasable with money in comparison with the more inward and spiritual enjoyments. But the effect which was to be anticipated was very conspicuous after the outbreak of the World War, when the wages for certain kinds of work rose to unprecedented heights and produced increased loafing and dissipation instead of increased production. (It is important to bear in mind that we are speaking of a permanent change; it would be in keeping with rationality to work harder at a temporarily higher rate in order to purchase more leisure later on.)

While on the subject we may observe that it is also an error to assume that in this respect land or other property services will be different from labor. These agencies also have alternative non-pecuniary uses, and if, say, the rent on land were to rise, landowners could afford to use more of it for lawns, flower gardens, athletic grounds, game preserves, pleasure parks, etc., and less for cultivation and marketable crops; and if they calculated closely they would do so.

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

66. Cf. Taussig, Principles of Economics, chaps. 12, 13, 14.

67. Economic literature is full of the contrary assumption, but it is a definite error, in dealing with long-time normal price. The existence of differences in costs in different establishments in an industry is proof, when not due to differences in accounting practice, that the competitive adjustment is imperfect. The current conception of marginal cost necessarily falls away through the same reasoning. The producer's calculations are made in terms of cost per unit and selling price per unit.

68. The Distribution of Wealth, p. 85; cf. also Davenport, Economics of Enterprise, chaps. XI and XXII.

69. Reference has been made to the absurdity of the two-factor analysis, as exemplified particularly in the work of Professor J. B. Clark. The same author falls into the closely related fallacy of measuring separate agencies by their productive contributions. He recognizes and clearly states the difficulty (The Distribution of Wealth, p. 374, note) and ostensibly gets around it by setting up an absolute subjective standard of measurement. It is very difficult for the present writer to criticize this reasoning, and out of the question in the space available; I can see nothing in it but a complete failure to make connections, a palpable non sequitur. It is to be observed that the fallacy is equally involved in all other distribution theory which makes use of "factors" at all—the number is immaterial—and this includes most of the literature of the subject.

A conspicuous exception is Davenport's discussion (Economics of Enterprise, chaps. XI and XXII) already mentioned, which is excellent for this phase of the question. Where it falls short is in failing adequately to separate the long and short period problems of distribution. It is this failure which in the writer's view explains most of the controversial differences between economists in so far as they relate to the scientific explanation of distribution, and not to questions of propriety or policy. It is essential to take account of the fact that from the long-time point of view the question of classification takes on a different aspect, becoming a question of the conditions of supply of different types of agents. The case for the conventional tripartite division (or more especially the separation of land and capital) is argued at length in A. S. Johnson's Rent in Modern Economic Theory. (See especially pp. 35 ff.) This phase of the problem will presently come up for discussion, and it will be pointed out that there is danger of over-simplification here also. (See below, chapter V.)

It may strike the attention of the reader that while the tripartite classification is emphatically repudiated, the factors are still commonly referred to in the present essay as "land, labor, and capital." If explanation is called for, it is to be found in the necessity, for mere expository purposes, of some expression which explicitly covers the whole group. The significance is the opposite of classificatory; "animal, vegetable, and mineral," or "solid, liquid, and gaseous agencies" could have been used but for their unfamiliarity in this connection. Also the familiar terms have social and ethical significance if none of a strictly economic sort.

70. See above, p. 119 [II.IV.33-34—Ed.].

71. The notion of sacrifice has been overworked in economics. Economists as well as employers have been too prone to assume that subjective willingness is the principal limitation on the amount of labor obtained from given persons or for a given outlay. And employers as well as economists are waking up to the efficiency of well-paid labor. There is no doubt that employers as a class have lost much money (not to mention the higher considerations involved) through working their employees beyond, and feeding, clothing, and amusing them below, the point of maximum physical efficiency. This would not be done with a dumb animal! Of course it may be profitable to the individual employer to pay a wage below what is necessary to maintain maximum efficiency and an adequate supply of labor from generation to generation (if the working class maintains the labor supply partly at its own cost); what is meant is that they have paid uneconomically low wages even from the standpoint of the short periods for which they have to deal with the same individual laborer. The presence of idle equipment is a great temptation to an employer, and the debit side of overworked help is less conspicuous to view. Of course the ignorance and imprudence of the workers are as much in point as those of the employer. It is of interest that Lord Leverhulme has recently put forth the contention that a six-hour day, without decreased pay, would be profitable to British employers in many industries, if the men would consent to two shifts during each twenty-four hours.

72. This is being recognized in the case of child labor by many employers who refuse to employ children simply on the ground that it does not pay in the business sense. This whole problem becomes more important as the amount of capital per worker increases. It is also true that the increasing use of machinery provides tasks which a lower and lower grade of human capacities are required to perform. The net result is difficult to estimate. The social problem of the "unemployable"—how to identify him and what to do with him—is surely forbidding enough. Like most of our new troubles, it is partly a product of the disintegration of the family as well as of industrial changes directly.

73. The point may be illustrated by the anecdote of a tramp who, finding a hundred-dollar bill, made a bee-line to the nearest quick lunch and excitedly ordered a hundred dollars' worth of ham and eggs. That men do not behave after this fashion does not prove that, other things equal they prefer a future satisfaction to a present one of the same magnitude.

74. H. Sidgwick similarly takes the view that a preference on the ground of time alone is irrational, criticizing Bentham for including "propinquity" as a basis of preference between otherwise similar enjoyments. See History of Ethics, p. 241, note. Cf. also Jevons's discussion, Theory of Political Economy, pp. 72 ff., where the same position is taken. Jevons's illustrative problem of the consumption of provisions on a vessel at sea is very effective in bringing out the issue.

It will be noted that the effect of the uncertainty of the future is very complex. Against the chance of loss of future enjoyment through death or incapacitation must be set the danger of future privation due to other contingencies. We are more likely to suffer loss of earning power than of power to enjoy, and the consequences of need without ability to gratify need are very unpleasant. Perhaps the perfectly rational homo œconomicus would discount the present up to the point of making provision for the more urgent necessities as far ahead as he was at all likely to live and discount the future beyond this point in increasing degree. The point is significant chiefly as showing the absurdity of hedonistic rationalism as a theory of actual behavior.

75. Cf. Spencer, First Principles, chap. X, "The Rhythm of Motion."

76. It is fundamental to the actual phenomenon of capital accumulation, that the principal, once saved, never is consumed; if it is consumed later, there is no net addition to the capital supply of society. Men save in large measure with no thought of ever consuming the capital, or even the income which it yields. For this reason the older term "abstinence" seems to me far more descriptive than its modern substitute "waiting." To be sure, an income of five dollars a year in perpetuity represents more consumption than one hundred dollars now; but no one consumes an income in perpetuity or expects to do so. Even if the saver consumes the entire income from his investment as long as he lives, he may or may not consume a total amount equal to the principal saved. Capital formation is the result of abstinence rather than waiting.

In fact, the term "saving" itself is misleading. Men do not generally produce wealth to consume it and then decide to invest it instead. Most of that which is invested is destined to that purpose in the first place and would otherwise never be produced at all.

77. We pass over here the effects of divergence in suitability for accumulation of different classes of goods, due to differences in bulk, perishability, universality of appeal, elasticity of demand, etc.

78. We must here assume it to be made absolutely dependable by insurance or otherwise.

79. Wicksteed has an excellent discussion of this point. (See Common Sense of Political Economy, chap. VII.) It is noteworthy that the "usury" against which moralists have universally thundered in pre-industrial society corresponds to the phenomenon just described rather than to modern interest. The productive investment of accumulated wealth was nearly unknown in earlier times and even the purchase of existing productive property was rare. Practically the only productive agencies known were land and slaves. Land was not private property in the modern sense and was hardly ever bought and sold commercially, while slaves were used almost exclusively in connection with land and by its owner even when not legally attached to the land itself. If there had been a free market for consumption loans the correspondence with the phenomenon we have described would have been complete except for the element of risk. The absence of a competitive market was the source of much of the evil of usury, and the payments made doubtless did represent extortion largely. Be it observed, also, that historically speaking modern interest developed out of the consumption loan through the intermediary of passive partnerships in trade ventures and not out of dealings in canoes, fish nets, etc., in which the fancies of a certain school of interest theorists are prone to revel.

80. With the actual history of property we are, of course, not concerned. Doubtless, the first approximation to private productive property was in human beings, slaves, or, perhaps, women or children, while the last thing to become really privately owned was land. But the proper order for our purpose is not chronological, but rather that of increasing complexity.

Part II, Chapter V.

81. Marshall's organization of economic theory about the fundamental problems is not very clear. We have already seen that he does not bring out the relations between market and normal price in the case of consumption goods. He refers to the problem of secular changes in normal price, but relegates discussion of the subject to later volumes not yet published. In his treatment of distribution he fails to make clear that the short-time distribution problem is a phase of the same fundamental analysis as normal prices of consumption goods. Moreover, he has very little interest in this short-time distribution problem. Book VI of the Principles is almost entirely devoted to the long-time equilibrium tendencies of the distributive shares, hardly more than passing notice being given to the conditions of equilibrium from the standpoint of distribution at any given time or for short periods when the supply is to be taken as fixed. Nor does he identify or even explicitly connect the question of the long-time tendencies in distribution with that of secular changes in normal price, which are phases or points of view in the analysis of the same fundamental problem of social economic organization. In the writer's view the problem of intelligible exposition and of fundamental comprehension of the price organization can be greatly lightened by the recognition and emphasis of these lines of relation. In addition, it is helpful to stress the close analogy in methodology of treatment between the short-time price theory of value and that of distribution, and similarly with respect to the two long-time or normal price theories.

In this connection it is interesting to compare Marshall with Professor J. B. Clark, who is especially known in connection with the use of the static hypothesis in this country. Clark's organization is even more inadequate, and it is especially striking that he does not acknowledge the connection between his method and that of Marshall. The "static state" of Clark is the same problem as Marshall's long-time normal price, while his economic dynamics corresponds with the secular changes in the field of value and the long-time tendencies in distribution. But Clark, under Austrian and German historical influence as Marshall was under English classical, gives us as the theory of distribution the short-time analysis, and hardly goes beyond recognizing the existence of the problem of progressive change, the long-run results or conditions of equilibrium of which are Marshall's almost exclusive concern. He is, indeed, much less satisfactory in this field than is Marshall in the short-time theory, for the latter does give, in passing, a very fair statement of the productivity analysis. It would, of course, be a serious error to confuse Clark's "static state" with the "stationary state" of the classical economists. The stationary state of these writers was the naturally static or equilibrium condition, which is the goal of progress or the subject matter of the third division of the study, not a state made static by arbitrary abstraction as a methodological device. It seems, however, that virtually all discussion of static conditions is vitiated by the failure to distinguish adequately between these two concepts. And we still lack a complete discussion of distribution which will give due weight to both the short-time and long-time problems; i.e., separate the assumption of fixed supplies of productive agencies from the assumption that supply is a function of price. A rough tabulation of the natural divisions of the theory may help to clarify their relations:

Value
(i.e., consumption goods)
Distribution
(productive services)
Problem I.
Given supplies of goods and given wants to be satisfied. (The situation at a moment.)
Market price. No problem of distribution involved.
Problem II.
Given productive resources and given wants to be satisfied.
Normal price. (Marshall's long-time normal price.) Supply of each good a function of price. Short-time or market price distribution theory. (Fixed supply of thing being priced.)
Problem III.
Use of resources to increase resources and change wants as well as satisfy wants.
Secular changes in normal price. Long-time distribution theory. Supply a function of price.

82. Cf. Principles of Economics, 6th ed., p. 379.

83. The Distribution of Wealth, chap. V.

84. This distinction follows conventional usage; it will be examined presently and shown to be untenable. (See below, pp. 159 ff. [nn95—Ed.])

85. Theories of Production and Distribution, chap. VII.

86. Mills, Principles of Political Economy, book IV, chap. IV, sec. 4.

87. It is a neglected fact that in the "lower" strata of society the production of children is by no means so unrelated to the ordinary economic calculation as generally assumed. The age of marriage and the size of families probably depend much more in fact on the amount of economic gain or loss between the prospective earning of children and the cost of their keep while under their parents' control than they do upon calculations as to the possibility of maintaining standards of living from one generation to another. (Of course, the two sets of considerations are interrelated.) A comparison of birth-rates with living conditions in the city and country and in different social environments, also a study of the effects of child labor and compulsory education laws on birth-rates, are very suggestive in this connection.

88. It is hardly necessary to point out that the famous "iron law" of wages of Lassalle and the Marxian socialists is this classical theory of the equilibrium wage taken over bodily, but with the logical foundation on which it rested repudiated indignantly. If the tendency of wages to a minimum is based on a principle of population, all schemes of social reorganization (except in so far as they affect that principle) are helpless to produce any result save possibly a temporary amelioration, with a later increase in misery. This, it will be recalled, is the very thesis which the essay on population was originally written to prove in answer to the millennial hopes held out by Godwin's Political Justice.

89. The above discussion of population problems is admittedly superficial, but other factors must be passed over here. Students will recall that the over-simple treatment of labor as homogeneous in its conditions of supply was brought somewhat nearer to reality by Cairnes's discussion of non-competing groups. To-day the social interest in the question has completely shifted. It is not Malthusianism as a general proposition which is worrying us—perhaps rather its contrary, race suicide; but much more than either, the differential aspects of the case, the over-multiplication of the incompetent and the failure of the upper classes to reproduce themselves. It seems plausible that below a certain standard an increase in wages means an increase in population, while beyond a critical point not far above physical comfort, the reverse relation begins to hold. The effect of popular education, industrialization and city life, and inscrutable factors in the Zeitgeist complicate the problem beyond measure. The great World War, in particular, has wrought changes in human attitudes about which it would be rash to say anything except that they are certain to be far-reaching.

90. Strong social disapproval of any line of business or occupation undoubtedly tends to aggravate any real evil connected with it, by throwing it into the hands of persons (of whom there is never any dearth) to whom social approval and disapproval are a matter of indifference. Conspicuous examples are money-lending in the Middle Ages (and the same type of money-lending now) and the liquor business in modern times.

91. Efforts on the part of society, the public, organized and unorganized, to direct consumption along approved lines, fall outside the scope of a study of private competitive organization.

92. Disparagement of competing commodities must be eliminated from consideration for the same reasons as burglary and such crude fraud as the dispensing of gold bricks, liquozone, etc. It will be recalled that we have expressly eliminated effects of interest not represented in market transactions.

The suggestion may seem fanciful, but I find it impossible to differentiate between elements in the physical form and appearance of a commodity which make no difference in its efficiency for the purpose intended (an agreeable color, decorative ornament often actually interfering with its uses, fancy containers, etc.), on the one hand, and on the other an element of appeal due to a high-sounding name or any other form of "puffing." These things do make a difference in the commodity to the consumer and in an exchange system the consumer is the last court of appeal. If they are different to him, they are different; if he is willing to buy one sort in preference to the other, then the first is superior to the second; it contains "utilities" which the other does not have. I do not see that it makes any real difference whether these utilities are in the thing itself or in some associated fact.

93. It will be kept in mind that from the standpoint of short-time problems, where changes in supply are not at issue, and demand alone determines distributive relations, no classification at all is valid.

94. The fact that so many opportunities for the profitable investment of resources in the development of human potentialities are neglected, and so many wasteful investments of the same kind made, is perhaps one of the most serious criticisms of existing society. The fault, however, is in the family system rather than in the private enterprise organization of industry in any sense in which the two may be dissociated.

95. The differential theory of rent has long since been recognized as applying equally well to the other shares. See J. B. Clark, "Distribution as Determined by a Law of Rent," and J. A. Hobson, "The Law of the Three Rents," Quarterly Journal of Economics, vol. V. It is not so generally recognized that in consequence it explains none of them. It is especially remarkable that the theory of distribution propounded by General Francis A. Walker, whose book was long a standard text in American colleges, amounted to nothing more than an elaboration of the proposition that each factor gets what is left after the others are paid. It is easy to show that the differential theory when stated in its significant form is identical with the specific productivity theory. Cf. A. A. Young, Ely's Outlines of Economics, 3d ed., pp. 415-16.

96. Ideas are not, however, free from these costs, as sometimes assumed. Thus A. S. Johnson (Rent in Modern Economic Theory, p. 120) contends that an idea cannot be regarded as productive, because it is "its nature" to multiply itself indefinitely. It would simplify the problem of education if it were so! But perhaps we should wish some discrimination to be exercised in the extension of the quality to ideas generally! Even so, if the "natural" tendency is obstructed, the idea limited in application seems to be productive in the sense in which anything else is productive. (See below, chapter VI.)

97. The classical writers' view of capital as "advances to laborers" was correct except for the failure—natural from their labor theory point of view—to include the other productive factors as well as labor.

98. Beyond the dogma that the desire to secure the income from capital is the sole motive for saving, it is a still further and questionable assumption that the strength of the motive varies in proportion to the size of the income expected or is connected with it by some simple law. Again we make, for convenience, the conventional simple supposition, merely taking this opportunity to record grave doubts as to the validity of any of this procedure. The saving of capital seems to us to be in fact the result mainly of two or three motives of which the desire for increased consumption of goods in the future is only one and probably one of the less important. Like other acts of man in society, it is largely a mere matter of established social custom, good form, the thing to do, the mores. Then we must emphasize the impulse to create. Probably the greatest single source of saving is the putting of income back into a business, because of sheer interest in the business and the desire to make it grow. That the desire for the increased income is not the dominant motive in much of this is proved by the fact that men invest as desperately in an enterprise never likely to be profitable as they do in the most prosperous concern, and by the further fact that much of the reinvestment in society is made by directors of corporations who will not get the fruits of the work for themselves at all. The truth is, we believe, that the real motives of human life, at least of those people who do big things, are idealistic in character. The business man has the same fundamental psychology as the artist, inventor, or statesman. He has set himself at a certain work and the work absorbs and becomes himself. It is the expression of his personality; he lives in its growth and perfection according to his plans.

99. The statement is applicable to the other methods of investing resources—the development of new natural agents, training of labor and improvement of technology—as well as to the creation of capital goods in the narrow sense. The use of resources to increase population in numbers appears to be exceptional as population subsists upon consumption goods themselves, and no change in the forms of production is involved. This action, however, is only to a very limited extent a matter of the calculated exchange of present for future goods.

100. A caution is in place against taking this equilibrium as strictly analogous to the normal price of a consumption good. A consumption good is destroyed in use. The equilibrium condition in regard to it is equality in the rates of its consumption and production with a negligible amount of the good actually in existence. (Durable consumers' goods are, of course, capital in fact.) Capital, on the other hand, accumulates, new production being constantly added to the whole net product of the past. The equilibrium in its case is a constant amount in existence, current production and consumption amounting in the equilibrium condition only to replacement of wear and tear. In this respect capital is like gold in the theory of its valuation. It is like gold, again, in the respect which we proceed to discuss, that the equilibrium condition is actually an indefinite distance in the future, that new production is constant and sure, but still small in amount in comparison with the existing supply, and that, therefore, conditions of production have a negligible effect on value over moderate periods of time.

101. Principles, 6th ed., p. 536.

102. Mention should also be made of banking, speculation, and the vicissitudes of foreign trade, which may completely dominate the rate for very short periods. Passing over such phenomena as the call-loan rate and the relation of international transactions to the interest rate, a word should be said on the subject of the bank rate. An issue of new currency by banks through an expansion of loans creates a momentary new supply of capital and, other things equal, tends to lower the interest rate. The effect is chiefly limited to those short-time loans in which banks mainly deal, but perhaps not entirely so. It is imperative to recognize, however, that inflation produces its effect through an actual saving, a diversion of income from present consumption to capital goods creation. The new currency which the bank lends to the investor is not new purchasing power from the standpoint of society as a whole. It is axiomatic in theory that the aggregate real value of the circulating medium is independent of the number of units of which it is composed. When inflation occurs, therefore, purchasing power is not created, but merely transferred from the previous owners of circulating medium to the persons into whose hands the new currency is placed for its first expenditure. The enormous rôle played in history by inflationism and the persistence of the heresy rest upon the fact that the effects of the expenditure of the new money are more conspicuous than the diminished effects of that which already existed. It is another case of the familiar type, "ce qu'on voit et ce qu'on ne voit pas."

However, it is to be emphasized also, that the psychology of business is fundamental in the economic process and that it is a very complex, sensitive, even treacherous thing. It will not do to draw conclusions as to policy from mere cause-and-effect reasoning based on any simple or reasonable assumptions about human behavior. Bank loans may, after all, create more demand for capital than they supply. But it is outside our plan to enter into the intricate problem of changes in business conditions or the business cycle. Some interesting suggestions in this field may be found in a series of articles on "Commercial Banking and Capital Formation," by H. G. Moulton and Myron W. Watkins, Journal of Political Economy, 1918 and 1919.

103. In real life, where uncertainty is present, it is the product generally anticipated in the market, which may not be the same as that subsequently realized in any particular case.

The correct statement of the productivity theory as given in the text manifestly sidetracks the objection of Professor Fetter and the time discount school that the product of capital is not homogeneous with the capital, and that consequently no such ratio can exist until the capitalization process has been applied to the capital itself. Before the investment is made the capital and its anticipated product are quite homogeneous, and it is in the market for capital not yet invested that the interest rate is determined. Capital goods once created are, of course, valued by capitalization; this operation presupposes an interest rate, which is therefore in no wise affected by the relation between capital goods and their income.

104. It is noteworthy that in the fourth great field for the investment of resources, the improvement of productive methods through research and experiment (we are not including the numerical increase of population) perpetual rights to the earnings of the improvement are not conferred upon the person who makes the advance. The individual may retain a monopoly on his idea as long as he can keep it secret or otherwise prevent its being copied, but this is usually quite impracticable for any length of time. In the case of specified sorts of technical inventions, society confers and protects a temporary monopoly in the form of a patent. (In the United States we find a growing tendency to limit the method of exploitation of even this temporary monopoly. Witness the prohibition of tying contracts.)

Part II, Chapter VI.

105. There is one important exception to this statement. As observed in chapters I and II, the presence of uncertainty in regard to individual events does not necessarily obstruct the workings of competition or prevent the realization of its theoretical result in a remainderless distribution of the product of industry among the productive agents. If the uncertainty in a particular case is measurable, it may in effect be eliminated by the grouping or clubbing of a sufficient number of cases to secure certainty in regard to the group. This point cannot be dealt with until after the general theory of risk and uncertainty has been presented. (See chapter VIII.)

106. Specifications numbered (2) and (5) in chapter III—that people are perfectly rational and that there is perfect intercommunication among them—are clearly phases of the problem of perfect knowledge to be taken up in Part Three. In the present chapter we are concerned especially with numbers (3) and (4)—formal freedom of action and perfect mobility, implying perfect divisibility; (6) and (7) the absence of monopoly and predation. Numbers (8), (9), (10), and (11) have already been considered, but some further remarks will be in place in regard to the first point mentioned under number (8), the relations of social as contrasted with individual wants. We may note here that the timelessness of the production process necessary to secure perfect mobility has been dealt with in one aspect in chapter IV. In addition it retards the speed of readjustments by holding productive forces committed to certain uses for an interval after it would otherwise be profitable for them to change. But it does not affect the final results, the character of adjustment when achieved. Some discussion of the intermediate effects is necessary in connection with the study of profits, and the whole subject of "friction" will be gone into after the treatment of uncertainty has cleared the way for a discussion of profit.

107. It is not necessary that he be an infinitesimal fraction of the productive power of a particular establishment. The imputation process works itself out through the competition of establishments for the different agents. If a number of establishments exist in which a certain type of agencies is on an indifference margin, the income of all similar agencies will be accurately determined.

108. Paper entitled "Outlines of a Theory of Wages," read at the twenty-second annual meeting of the American Economic Association. See Proceedings, pp. 143-44, note.

109. Notably Professor J. B. Clark. Cf. above, p.109 [II.IV.22—Ed.]. The concessions of Professor J. M. Clark (loc. cit.) seem to me to cover only a portion of the ground. I see nothing morally ideal in a distribution according to innate personal ability—certainly not ability measured by pecuniary demand for its products, unless the rest of the human race are idealized—and suggest that such a distribution would yield vastly more inequality, misery, and despair than does the present order. Nor, in the abstract, can I see any connection between innate ability and moral desert. Is inherited ability on any better footing morally than inherited property?

110. See Davenport, Economics of Enterprise, chap. IX, especially p. 127; and cf. L. H. Haney, "The Social Point of View," Quarterly Journal of Economics, vol. XXVIII, pp. 319-21.

Though the case of the pickpocket offers no real difficulty and is not likely to be taken seriously, there are many cases where standards of productivity are very hard to define. Gambling, for example, is definitely ambiguous. If the men who gamble know what they are about, play for fun, at a game which is "fair," and do not risk more than they can afford to pay for the excitement, I should say that the gains of the banker represent product. If all are interested in winning only, and play because they expect to win, I suppose the operation is unproductive and produces a transfer, not a production of wealth. It will doubtless be conceded that there is such a thing as a transfer of wealth, distinguishable from production, or else receiving gifts must also be classed as productive work!

Other cases are more difficult still, since no clear line can be drawn between being tricked and gratifying a perverted taste. The difficulty is the ultimate impossibility of saying what one "really" wants. In cases where each knows what he is getting and what he is giving—no "compulsion" (artificial manipulation of alternatives) being present—and actually gets the means of satisfying his actual want, we must hold that the operation is a production of utility in the economic sense. But what we may call "crude" fraud must be classed outside of exchange relations along with forced transfers. The man who sells whiskey, patent medicine, corrupt literature or art, etc., to people who want them and are willing to pay for them is productive; but one who sells gilded chunks of lead to unsuspecting rustics for gold bricks clearly is not. If the buyer be in a position where it never can make any difference whether the metal is lead or gold and never could find out which it is, the action is hard to classify, but we must consider that he could have had what he got for vastly less money, if he had known. Is the buyer of an imitation jewel or antique for a genuine, and who never knows the difference, really cheated? And suppose the purchaser of Liquozone or Peruna is really cured of his (real or imaginary) ailment! And suppose he is not! Was it the medicine, or a cure, that he really bought?

We are carried back to the already oft-reiterated observation that any scientific thinking about conduct presupposes that wants are given entities, and that exchange organization of the satisfaction of wants presupposes that their character is known. Capricious and experimental conduct are not amenable to scientific treatment (unless subject to prediction in large groups, a case which we have postponed for later consideration). In the language of abstract logic, a must remain a throughout the discussion. This it can do either by remaining sensibly unchanged or by changing in accordance with a known law. The last alternative reverts to the first, since such a change can be thought of only as an expression of an inner, unchanging attribute of the thing changing.

111. Bertrand Lavergne, Théorie des marchés Économiques. Paris, 1910.

112. Rent in Modern Economic Theory, p. 120, note.

113. Supposing the desideratum to be the greatest possible consumption of commodities. Supposing it to be maximum happiness, the case is not so clear, while the question of maximum "welfare" involves us in still greater uncertainty.

114. There is a danger in over-emphasizing the difference between these two views of productivity. Remembering that all production is joint, it is clear that any separate productivity of a particular agency means ultimately superior productivity conferred upon others used in connection with it.

115. It seems in place to remark that a confusion is involved in laying down "appropriability" or what might be called competitive self-assertion, as a condition of economic productivity. Productivity is a matter of limitation. If an agency is limited relatively to the need for its use, it must be appropriated by some one, to be administered, to decide who is to have the use of it and who is to do without. And any productivity conferred on an object by appropriation must come through and in connection with restriction on its use. Thus Professor Young (Outlines of Economics, by R. T. Ely and others, ed. of 1908, pp. 555-56) contends that the Strait of Gibraltar would be productive wealth if the British Government were to charge for its use. But they could not charge for its use without reducing its volume; it would be a case of monopoly merely. This and several other confusions are involved in Veblen's contention (on the "Nature of Capital," Quarterly Journal of Economics, vol. XXII, pp. 917 ff., ., and vol. XXIII, pp. 104 ff.) that the world's stock of knowledge is its most important "capital," which is without value merely because not privately exploited. It could be exploited only by having its use restricted; i.e., by monopoly. The notion that capital is significant as limiting access to the world fund of technical knowledge is absurd, for the reason, already noted, that production is joint, and the productivity of anything may be viewed as a productivity conferred on other things.

116. Willett.

117. Johnson, pp. 106, 107.

118. Cf. chapter III.

119. In addition to the incentives to combination afforded by the gains through increase in the size of the bargaining unit, another tendency might work in the same direction. In many cases it might be profitable for the owner of a considerable block, though not the whole supply of an important productive service, to restrict its use and so increase the value of the product. Whether the owner of a part of a supply can gain by withholding some of that part from use will depend upon the fraction of the supply which he holds and on the flexibility of the supply obtainable from competing sources and the elasticity of the demand for the product. In view of the fact that practically every business is a partial monopoly, it is remarkable that the theoretical treatment of economics has related so exclusively to complete monopoly and perfect competition.

Attention may be directed to another tendency fatal to free competition under theoretical conditions. This is the matter of the inflation of credit. With all forms of friction eliminated there would seem to be hardly a limit to the substitution of credit for any sort of commodity as a medium of exchange and a stable value-standard would apparently be impossible to establish.

120. Concerning the "economic surplus" of which much has been made by some writers, notably Hobson, the remark made above (page 188 n. [nn115—Ed.]) is applicable. The payment necessary to secure the performance of any service depends on how much of that service is desired. The question is much complicated by human mortality and the fact of inheritance, but in general there are no surpluses available without reducing the volume of the service. This will not be true of monopolized or highly specialized agencies, and there are, no doubt, many remunerations which are too high absolutely and which if reduced would positively increase the volume of the services for which they are paid.

End of Part II. Notes.

Part III, Chapter VII

1. The problem of uncertainty and risk in economics is, of course, not new. Some reference has already been made to the literature. It has been recognized and discussed in three connections: (1) insurance; (2) speculation; and (3) entrepreneurship. For a full treatment of the last-named it is necessary to go to the German works cited in the historical portion of this study. English economics has been too exclusively occupied with long-time tendencies or with "static" economics to give adequate attention to this problem. For a very general discussion of uncertainty see, in addition to works already cited, Ross, Uncertainty as a Factor in Production, Annals, American Academy, vol. VIII, pp. 304 ff. See also Leslie, T. E. Cliffe, "The Known and the Unknown in the Economic World," Essays in Political Economy, pp. 221-42; Lavington, F., "Uncertainty in its Relation to the Rate of Interest," in Economic Journal, vol. XXII, pp. 398-409; and "The Social Interest in Speculation," ibid., vol. XXIII, pp. 36-52; Pigou, A. C., Wealth and Welfare, part V; Haynes, John, "Risk as an Economic Factor," Quarterly Journal of Economics, July, 1895.

In this superficial sketch of the theory of knowledge it has not seemed important to give extended reference to philosophic literature. It will be evident that the doctrine expounded is a functional or pragmatic view, with some reservations. By way of further "reservation" we should point out that the tone of the discussion merely results from the fact that it is the function of consciousness and knowledge in relation to conduct that we are interested in, for present purposes, and the text must not be taken as expressing any view whatever as to the ultimate nature of reality or any other philosophic position. The writer is in fact a radical empiricist in logic, which is to say, as far as theoretical reasoning is concerned, an agnostic on all questions beyond the fairly immediate facts of experience.

2. See the brilliant lectures of E. DuBois-Raymond, "Uber die Grenzen des Naturerkennens" and "Die sieben Welträtsel."

3. Cf. Comte's Classification of the Sciences.

4. Professor Cooley's descriptive phrase. See Social Organization, chap. I.

5. See James, Psychology, chap. XXII, on "Association by Similarity."

6. Marshall remarks that the business manager's decisions are guided by "trained instinct" rather than knowledge. (Principles, 6th ed., p. 406.)

7. When variations in degree in the attributes X and Y are taken into account, the problem must be dealt with by applying the statistical theory of correlation, which is a further development of probability theory. See especially the works of K. Pearson and F. Y. Edgeworth. An elementary discussion will be found in any treatise on statistics. A. L. Bowley's Measurement of Groups and Series is particularly serviceable for the general reader. A rough idea may be obtained from Elderton's Primer of Statistics. Pearson's Grammar of Science, chaps. IV and V, may be consulted on the whole ground of the present chapter.

8. The calling of bonds by lot is an illustration. In Germany bondholders often insure against this chance.

9. Professor Irving Fisher is particularly insistent upon the interpretation of probability as due to ignorance alone. See The Nature of Capital and Income, chap. XVI, sec. 1.

10. Cf. E. Borel, Le Hasard, pp. 196-97.

11. See Karl Pearson's essay on "The Scientific Aspects of Monte Carlo Roulette," in The Chances of Death and Other Studies in Evolution. The necessity of constant appeal to a dogmatic preference of simple to complicated hypotheses is brilliantly treated in Poincaré's chapter on "Probabilities," in The Foundations of Science, Science and Hypothesis, chap. XI. See also Poincaré's fascinating treatment of the relations between small causes and large effects in the same volume, Science and Method, chap. IV. Poincaré bases the doctrine of equal probability on the mathematical principle that for small changes any continuous analytical function changes in the same ratio as the variable. The same unsatisfactory, if not absurd, doctrine of "intrinsic reasonableness" (for how can one thing be "intrinsically" more probable than another?) is developed from a different point of view in Balfour's Theism and Humanism, lecture VII, on "Probability, Calculable and Intuitive."

12. For an excellent brief discussion of the issue, with references to the literature, the reader is referred to Arne Fisher, The Mathematical Theory of Probability, chap. I: "General Principles and Philosophic Aspects." The writer's position is that taken by Fisher and designated the principle of "cogent reason" in opposition to the older view common among mathematicians, of "insufficient reason." Compare also La Place, Essay on the Philosophical Theory of Probability.

13. "The Philosophy of Chance," Mind, vol. 9, 1884.

14. See The Nature of Capital and Income, p. 266.

Part III, Chapter VIII.

15. The chief limitation in fact relates less to the proposition as stated than to the dogma of "conduct" or activity exclusively in order to a future reward. Means and end seem to be the form in which we think about our behavior rather than the actual form of the behavior itself. The literature of ethics is one long record of failure to find any absolute end; in life every end becomes a means to some new and farther goal. The attempt to rationalize human behavior seems to be a perpetual chase after one's own shadow, and the conclusion forces itself upon us that the "summum bonum" or any other objective "bonum" is an ignis fatuus. We are compelled to believe that in a great proportion of cases we take more interest in action whose fruition is only probable than we would if it were certain.

16. Professor Irving Fisher's term (The Nature of Capital and Income, p. 288). I should prefer simply "grouping" as both shorter and more descriptive.

17. It would be out of place here to go into the social aspects of life insurance, but one observation may be worth making. From the social point of view it is arguable that all classification of risks is a bad thing, except in so far as the special hazard is purely occupational and the cost of carrying it can be transferred to the consumer of the product. It is hard to discover any good reason why the unfortunate should be especially burdened because of their handicaps. It would, therefore, be better if all were insured at a uniform rate. Indeed, we may go farther and contend that the rate should be graduated inversely with the risk (occupational risks excepted, as noted). It goes without saying that only a state compulsory insurance scheme could operate on any such principles; under private profit incentives, competition will compel any insurance agency to classify its risks as accurately and minutely as practicable.

18. Cf. Huebner, Property Insurance, chaps. XVI, XVII.

19. Haney (Business Organization and Combination, chap. XXIII) uses the terms "The Corporation Problem" and "The Trust Problem" to designate what I have called the "internal" and "external" problems respectively. He properly emphasizes the importance of the former in view of the tendency of the evils of monopoly, etc., to overshadow it in the popular mind and in much of the literature of the subject.

20. On the production and sale of "guidance" see J. M. Clark, Journal of Political Economy, vol. 26, Nos. 1 and 2.

21. Cf. Willett, Economic Theory of Risk and Insurance, chap. III.

22. Cf. chapter XII.

Part III, Chapter IX.

23. The situation which we here endeavor to delineate is what Dr. A. H. Willett appears to have in mind under the designation of the "approximate static state." See The Economic Theory of Risk and Insurance, pp. 15, 16.

In this connection, again, we cannot be rigorously logical and definite without getting off into mere subtleties. We do not know whether there is ultimately real uncertainty and caprice in either physical nature or human nature. It may be that all changes are self-compensating some time, and that if progress were eliminated we should finally achieve prophetic powers in regard to phenomena in the aggregate (through application of the principle of consolidation) if not in individual instances. But in view of the tragically limited success of science in predicting the weather, for example, it is clear that there is no strain on credulity in assuming a large amount of real uncertainty. We must not forget that the periodicity of change or the interval required for canceling out of fluctuations is in practice relative to the length of human life. If such a cancellation would occur ultimately (as some writers, notably Nietzsche, have ventured to suppose) the period is so long in relation to human life that no advantage of it could be taken.

24. Chapter V, the reader will recall, dealt with the effects of progress with uncertainty absent. We here retrace our steps somewhat in order to consider uncertainty with progress absent, thus completing the design of studying the two factors separately. After completing the present task we shall (in chapter XI) study them in combination. A confusion between the effects of uncertainty and those of progress, which are largely, though never quite completely, separable facts, has been seen to underlie the reasoning of the "dynamic" theory of profit.

25. See above, chapter IV, p. 106, note [nn46—Ed.].

26. The statement implies that a man's judgment has in an effective sense a true or objective value. This assumption will be justified by the further course of the argument.

27. As already observed, the theoretical features of contractual income are those associated with rent in the conventional distributive analysis. From the point of view of our present assumptions, all productive goods being fixed in amount and in their distribution among the members of society, such incomes might naturally be called wages. As we have insisted that there is no significant causal or ethical difference in the sources of income it does not particularly matter what they are called.

28. In actual society freedom of choice between employer and employee status depends normally on the possession of a minimum amount of capital. The degree of abstraction involved in assuming such freedom is not serious, however, since demonstrated ability can always get funds for business operations. A propertyless employer can make the contractual payments secure by insurance even when they may involve loss, and complete separation of the risk-taking and control function from that of furnishing productive services is possible if there is a high development of organization and a high code of business honor. But the conditions generally necessary in real life for the giving of effective guarantees must also be taken into account as we proceed.

29. As has been well observed in connection with games of skill. It is not necessarily a proof of high skill to make a twenty-foot putt in golf or pierce a two-inch bull's-eye at a hundred yards with a rifle; nor a lack of skill to miss a three-foot putt or strike outside the eight-inch circle. Either would happen sometimes with good shots or poor; only the proportion of successes and failures in a fair number of trials gives any indication of real ability to do the trick.

30. The diminishing returns of management is a subject often referred to in economic literature, but in regard to which there is a dearth of scientific discussion. For an interesting, but in the present writer's view fundamentally unsound, treatment, see H. C. Taylor, Agricultural Economics, chap. VI. Our own discussion of the theory of enterprise is admitted to be vague and unsatisfactory. A complete and logically rigorous discussion would be a large undertaking. In view of the extreme complexity of the elements involved in uncertainty, most of which may be independent variables, the number of possible suppositions which might be followed out is prohibitive. At least it would require so much space and be so difficult to follow, and of so little practical significance, that the probability of its being read does not justify the attempt. It is hoped that the above discussion covers the principal points of interest. The essential factors are men's ability in the entrepreneur field, which includes foresight and executive capacity, and their knowledge of their own powers and disposition to trust them in action. The factors likely to be neglected are the last two, self-knowledge and self-confidence or initiative, which are closely related, but not identical. In addition, knowledge of, and willingness to trust, other men's powers and judgment is a still more important consideration, not yet discussed.

31. It does not follow that he would have to own property, though in the real world this is the practical consequence. It is easily conceivable, however, that one might secure the payment of his obligations by pledging his own earning power. Such an arrangement need not call for more difficult feats of organization or involve greater strain on human nature than is true of indemnity insurance at present.

Part III, Chapter X.

32. That is, the most important characteristic from the standpoint of organization. Of perhaps equal importance is the legal nature of the corporation as an entity separate from its member owners. The term "limited liability" is not descriptive. The members of a corporation have, strictly speaking, no responsibility at all; only the property of the corporation, which property does not directly belong to the owners, is liable for the corporation's obligations.

33. It need hardly be pointed out that the principle of consolidation of risks is operative here to a certain extent. The employer of men passes judgment on their "average" competency to do the things that they are expected to do, an average in the case of each individual and an average involving a further canceling-out of errors if he selects a number of employees. A still higher order of responsible judgment is involved in laying-out and subdividing the work of the establishment so that the task of each single employee is adapted to a certain fairly uniform grade of ability.

34. Cf. Hawley's contention (Quarterly Journal of Economics, vol. XV, p. 88) that the hired manager makes decisions, but the enterpriser takes the consequences of decisions, and that the former is therefore not an enterpriser.

35. Of course, the machinery by which control is exercised becomes more indirect and the control itself more remote. Stocks approximate to the real position of bonds as well as bonds to that of stocks. One form of the change is a tendency to cover a larger proportion of investment by stock issues (as compared with bonds) than formerly. The increased recourse to borrowing from banks shows the same tendency, for banks in particular keep in touch with the management of businesses in which they invest.

36. The case of the ultimate entrepreneur, dealing with and knowing men rather than things, suggests again the analogous political problem. The progress of democracy toward intelligent efficiency seems to depend on a tendency for the ultimate sovereign, the electorate, to center its attention on the selection of competent agents, leaving to them the actual formulation of policies and conduct of affairs. Commission government, and still more the manager plan of municipal government, is a case in point. In the political sphere there is a real problem of ultimate ends, which must, of course, be dealt with by the electorate if the system remains democratic. And perhaps more than in the case of business the voter's judgment of the candidate must be connected with passing an opinion upon the issues, partly because major issues to some extent involve a question of ultimate social ideals. Professor Cooley (Social Organization, p. 129 and chap. XIII) bases an optimistic view of democracy on a belief in the capacity of the populace, admittedly ignorant in regard to political issues and the technique of government, to select men wisely on the basis of a sort of intuitive recognition of personal superiority.

37. By "interest" is here meant property income merely. The relation between interest and rent is essentially a "dynamic" problem, and will be taken up for discussion in the following chapter. It is questionable whether interest would be met with at all in an unprogressive society, and certain that the distinction between interest and rent would be of small importance. Cf. also above, chapter V.

38. We must again refer to the use of the term "interest" as meaning property income merely, though superficially this is not quite consistent with treatment of it as a "rate." Pure interest is much more easily defined than a pure competitive return on actual property, but even the latter offers less difficulty than an appraisal of the competitive value of the services of an independent entrepreneur.

39. To the extent that he does not give adequate security the owners of the productive services exposed to loss are the true entrepreneurs.

40. Including, of course, monopoly elements in the situation. Cf. above, chapter VI.

41. The hiring of men to meet uncertainty can be illustrated by many examples from different fields. Corporations employ at set, fixed wages inventors, experimenters, prospectors for minerals, weather and crop forecasters, market predictors, speculators, etc. Gambling-houses pay men weekly salaries to play poker with their clients. It is clear that such employees, like the hired manager, make decisions as a matter of routine, without taking responsibility. The responsible decision is made by the employer, who selects them for their tasks, and the operation of the principle of consolidation of uncertainties is also apparent. The latter point is not so clear in other cases; the doctor makes decisions, but his patients take the responsibility for their correctness!

42. See chapter V.

Part III, Chapter XI.

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.

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.

End of Notes.
Top of File Notes

Return to top