Cyclopædia of Political Science, Political Economy, and the Political History of the United States
PROFITS. The theory of profits, as developed by the leading English economists, has been simple but inadequate. Starting from English agriculture as a type of productive industry, they have divided the returns into rent, wages and profits; have described profits as the surplus remaining after rent and wages are paid; and have analyzed this surplus into the three elements of interest, insurance and wages of superintendence. This treatment has caused several mistakes. It has led men to speak of profits as an element in the cost of production in the same way that wages is an element. It has led them to think that what is here called wages of superintendence is properly classed with ordinary wages. It has been based on a circle in the definitions: for after defining rent as what is left after wages and profits are satisfied, they go on to speak of profits as what is left after rent and wages are satisfied. It was adopted to meet the case of a large body of men doing business on other people's land with their own capital, in the production of staple articles comparatively little subject to speculative change in value. If any of these conditions are changed, the theory needs re-statement. And in the United States to-day nearly all these conditions are changed. In those industries which furnish the most serious problems for a theory of profits, we generally find men doing business on their own land, but depending for their circulating capital upon an exceedingly elastic credit system; dealing in goods and services whose values may change or vanish in a hundred different ways, and are made the subject of speculation at every turn.
—In business as now organized the current expenses may be grouped under three heads; 1. raw materials; 2. insurance and repairs; 3. wages. The first of these elements may take the form of a rent charge, as in certain systems of agriculture and mining, or may fall away almost altogether, as in transportation of certain kinds; the second and third are tolerably constant in their form, though of course not in their importance. Any excess in the value of the product over these expenses may be termed gross profits, and nearly coincides with the definition of profits used by the English economists. But gross profits are received by the capitalists as a return for two distinct services. As owners of capital they receive a reward for their saving in the form of interest; as employers of capital they receive a reward for their business abilities in the form of net profits. Gross profits consist of earnings less current expenses; net profits consist of gross profits less interest on capital invested.
—A century ago it was natural to group these two elements together, because these two services were largely rendered by the same men. The employer of capital was then the owner of capital. In many localities and industries the same thing is true to-day; mainly so in the case of handicraft, and partially so in the case of joint stock companies. But it is certain that the tendency of the day is to separate these two functions; for a man of business ability to control far more capital than he really owns, and in some form pay the owners a fixed interest on which he himself takes the chances of loss or of extraordinary gain. There is no room here for a systematic discussion of the causes which affect the rate of interest. We must confine our main attention to the element of net profits, or entrepreneur's profits, as they are called by Gen. Walker, who has done more than any one else to develop this distinction.
—The minimum of net profits is roughly determined in the same way as the minimum of wages. The business man, like the workman, must make a living according to his own standards of comfort and decency. But the application of this principle to profits is less simple than its application to wages. In the latter case we have a large body of men ready to work for a certain remuneration, but liable to become a burden on society if the pay sinks below that amount. In business the margin of difference between what will induce men to begin and what will compel them to stop, is far greater. No man will begin business unless he expects to make more as a capitalist than he was previously earning as book-keeper or foreman. But once engaged in business he can not go out of it when he fails to make the expected profits, without sacrificing a great part of his invested capital and losing the chance of ever again doing business on the same terms. He will then hold on as long as he can meet his expenses and sees any chance of making a profit in the future. In hard times he will actually produce at a loss to save his capital and connections, in the hope of a better future. Thus, we have not a fixed but a varying minimum, in times of expanding credit and increasing production on a level with the wages of a superintendent, foreman or head clerk in the same industry; in times of diminished credit and production falling away to nothing, or less than nothing.
—Now, the price of goods is approximately determined by the cost of production of those produced at the greatest disadvantage that is, by men earning this minimum of profits. If any individuals carry on the business on more advantageous terms, so that the cost of production is less, every such advantage means, for the time being, just so much increase in their profits. Cheap raw materials, cheap transportation, cheap labor, will, other things being equal, have the effect either to drive less favored competitors out of the business or to secure the margin of advantage to the capitalist in the form of additional profit. It is to causes like these that local variations in the rate of profit are due. These are not as great as might seem likely, because in the presence of any of these special advantages other things are not often equal. In general, cheap raw material means high interest, cheap transportation means high rent, cheap labor means inefficient labor. It is to the personal qualities of the capitalist rather than to his environment, that extraordinary instances of profit are to be ascribed. Skill in organizing labor, quickness in utilizing improvements, and sagacity in foreseeing high prices, are qualities which give the capitalist the power of raising his own profits almost indefinitely above the minimum.
—The effect of skill in organizing labor manifests itself chiefly in capacity for carrying on business on a large scale. A man who can make a given profit by superintending the work of ten men, ought to be able to make nearly twice as much if he can superintend the work of twenty with equal efficiency; or to sell his goods cheaper (in case he must do so to extend his market) without sweeping away all the added profit. Why, then, it may be asked, does not production on a large scale prevail altogether in competing against smaller concerns? It undoubtedly tends to do so. In 1850 the establishments enumerated in the United States census of manufactures employed on an average less than 8 hands, with an average of $4,300 returned capital. In 1860 the averages were 9 hands, and $7,100. In 1870 this advance had received a check; but in 1880 the numbers had risen to 10.7 hands, and about $11,000 capital. But there are two causes which operate to restrain this tendency. In most industries and with most men the efficiency of superintendence rapidly decreases when carried beyond a certain moderate limit. And, on the other hand, a man's power of borrowing capital can not be extended out of all proportion to his own property. Both borrower and lender feel the growing insecurity as the proportion of borrowed capital increases. The former is unwilling to take the risk of bankruptcy for the chance of inordinate gain. The latter indemnifies himself for the extra risk by a high interest rate, which soon sweeps away the margin of profit.
—The matter of utilizing improvements in production requires a word of explanation. The ultimate tendency of any such improvement is to cheapen both the cost of production and the price of the goods. But until the use of this improvement has become widely extended, the price will not fall very rapidly; and those capitalists who first use the new method gain a great temporary advantage during the time of adjustment. In connection with this opportunity of gain, there is an opportunity of loss. The effect of such improvements will render valueless a certain amount of capital already invested. The existence of a new and better machine makes it impossible to run the old machine except at a loss. In many branches of industry these changes are so slow that the expense incurred on their account may fairly be classed under the head of repairs. But there are other branches where the liability to sudden changes of this kind forms a main item of risk and expense; and the impossibility of estimating this risk forms a main difficulty in attempting to draw deductions from the statistics of industry.
—The third element increasing profits is the power of foreseeing high prices. It differs from the other two in the fact that the additional profit is made, not by lessening the cost of production, but by knowing when to produce a larger quantity. Apart from this adaptation of the quantity to the market, these changes of price affect, not the margin of extra profit, but the minimum rate; not advancing or depressing the special gains of a few individuals alone, but the general profits of the trade. Unless the business is a virtual monopoly, they thus of necessity cause a reaction. Men of no special business talent are attracted by the high temporary rate for every one; they rush into the business, and cause an over-production, from which they are themselves the first to suffer. A sudden increase in demand, or "boom," in a particular line of business, furnishes one example of these effects; a distinct advance in price from the imposition of a tariff, furnishes another. It is the men who are already on the ground that gain the great benefit from the change; those who follow after them come just in time to suffer from the over-production.
—It is these high margins of extra profit of a few individuals, who manage to sell at prices far in excess of what the goods have cost them, that constitute the important fact for us to recognize and explain. It is not enough to treat them as a mere appendage to interest, or to set them aside as wages of superintendence. Nor can we, in general, properly speak of them as insurance against risk. The term is used because in those industries where there is a chance of great gain, there is apt to be a chance of great loss. As long as a capitalist offsets his own losses at one time or place by his own gains at another, the use of the term is legitimate. But when we attempt to offset as insurance one man's gain against another man's loss in the same industry, it is as unwarranted as it would be to apply the term insurance to the gains of a practiced stock operator. The justification of high profits is found in the fact that society can far better afford to pay high rewards for this kind of work than to let any of it go undone. In our present complicated system of industry, production and consumption are so widely separated in time and place that it is easy to make fatal mistakes in adjusting one to the other. We want to do the right thing with the least waste of labor; and as long as a business man helps to secure that end, society can afford to pay him almost any price for so doing. As long as he reaps the advantage of high prices under free competition without securing artificial monopoly, the interests of the capitalist and of society coincide.
—We may sum up our conclusions as follows: 1. The minimum of net profits is, in good times, equal to wages of superintendence; in hard times, it will fall away entirely; 2. Any exceptional advantage that an individual has over his competitors raises his profits for the time being just so much above the minimum. This excess is not properly regarded as wages of superintendence, nor, except in a limited degree, as insurance against risk; but as a premium paid by society in order that its working forces may be applied in the way best adapted to meet the economic wants of the community.
—Had the figures obtainable been more trustworthy, this explanation might well have been cut short to make more room for statistics concerning the rate of profit in different times, places and industries. But almost every cause combines to prevent our obtaining such statistics. The business men who know the most striking facts have an interest in keeping them secret. The reports of experts are few and fragmentary. The European states make no attempt to give such figures in their census. The United States makes the attempt, but with so little power of enforcing accuracy that the total amount of invested capital may not improbably vary 300 per cent. from the amount returned. ("Compendium of the Census of 1870," p. 798.) The returns of capital are thus all but useless for our purposes. Those of product, wages and materials are much better, and can be studied with advantage. The figures of gross profit obtained from these data will necessarily include more than our definition authorizes, because we have no means of making any deduction for repairs. They mean value of product less materials and wages.
—1. Variations in Time. Much has been said of the tendency of profits to fall as a nation advances. The reasons given are such as affect interest rather than net profits. Even for interest the figures do not show this tendency as markedly as we might expect. Perhaps the most careful investigation of the facts, though based only on English data, is given by Farr. ("On the Valuation of Railways, Telegraphs, Banks, etc.," Journal of the Statist. Soc., xxxix, 465.) There is no a prior reason why net profits should show this tendency. They are kept above the minimum by complex organization, new improvements, new wants. These are to-day increasing faster than ever before. Compare the figures of four successive censuses.
The values for 1870 should be reduced one-fifth, on account of the gold premium. Compare, also, figures cited above as to hands employed and capital invested.
—2. Variations in Place. Here again the variation of interest has been studied instead of that of net profit, and the attempt has been made to value the disinclination of capital to emigrate. The variations in profit do not seem as great as we should expect. In these comparisons we may make a guarded use of the returns of invested capital, since the causes which give rise to an underestimate in one locality may be assumed to operate in the same way in another.
The average rate per cent. on reported capital for the whole country is 36 2/3. While these figures warrant us in no positive conclusions except as to concentration of industry, we are put on our guard against the danger of assuming too great difference in rates as due to locality.
—3. Variations in Different Industries. The figures below are presented as a summary of the facts in the leading manufacturing industries in the United States, rather than as a basis for generalizations. Agriculture could not be included, on account of inadequate wage returns. Mining, transportation and mercantile business were, on various accounts, unavailable for direct comparison.
It is worthy of mention, that the two industries showing decidedly the largest gross profit per establishment—cotton and iron—also show decidedly the lowest percentage of gross profit to capital invested, namely, 24 and 22. This fact may easily be a mere accident of the returns. The other percentage results have no special interest to justify their insertion.
—This article has been based on the facts of manufacturing industry, as furnishing, on the whole, the best type for treatment. It has not seemed necessary to show how all the individual points would have to be modified in applying the same explanation to business of other kinds.
ARTHUR T. HADLEY.
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