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matter of psychology. Among people who are gifted with
a large degree of forethought, saving is less irksome than it
is among people who live mainly in the present. Among
people of the latter class very little saving will take place
unless there is a distinct reward for it. Among people of the
former class a great deal of saving would take place even if
there were no reward. A community with little forethought
is therefore always a community in which interest rates are
high, because there will be small accumulations of capital and,
the supply being small, there is great need for more. It is
the need for more of a thing which induces people to pay a
price for it.



THE COST OF CAPITAL AND ITS PRICE 437

The functional theory of interest. This theory of interest
may be called a functional theory of interest, to correspond
with the functional theory of value and the functional theory
of wages, which have already been outlined. The function of
a high price, as has been pointed out, is to call forth a larger
supply ; the function of high wages is to induce a larger sup-
ply of the labor which receives high wages ; and the function
of a high rate of interest is to call forth a larger supply of
capital for which interest is paid. A community that needs
more capital can get it only by inducing larger savings. These





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COST OF PRODUCTION




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larger savings may be secured either by compulsion (that is,
by taking a part of the social income by authority and setting
it aside) or by attraction (that is, by offering a reward for saving).
There is no other possible way that has ever been suggested,
even on paper, of accomplishing this necessary result.

Let us assume that the amount of a certain kind of capital is measured
along the line AC, and its marginal productivity along the line AE, the
descending curve EC representing the decline in the marginal productivity
as the supply increases. If there were nothing to check its production
but the cost of producing it, the supply would normally increase to the
point Z7, where the marginal product would just cover the marginal cost,
and there would be no interest. This point is located by the intersection of
the cost curve GB' with the productivity curve EC. But in addition to the



438

cost of production there is the disadvantage or sacrifice of waiting. The
effect of this is illustrated by the rising curve HB. This curve represents,
by its distance above or below the cost curve GB, the positive or negative
sacrifice of saving the different parts of the supply of capital. Where this
curve is below the cost curve, it means that there is an advantage rather
than a disadvantage connected with the exchange of present for future
goods which saving implies. Where this curve coincides with the cost
curve there is neither advantage nor disadvantage connected with saving,
but when it rises above the cost curve there is a disadvantage connected
with saving which becomes a check upon the production of capital in
addition to that effected by the cost of producing it.

If the production of capital should stop at the point K, where, as shown
by the intersection of the abstinence curve HB with the cost curve Off,
there is neither advantage nor disadvantage connected with saving, its
marginal productivity would be represented by the line KL. This would
give its owner an advantage far in excess of any disadvantage connected
with its production, and this would stimulate its further production. But
in order to increase its production it would be necessary to do more wait-
ing as well as more work. From this point on, further waiting begins to
be burdensome, acting as a positive check upon production. The normal
tendency would be for capital to increase up to the point Z>, where the
combined disadvantage of working and waiting, or of cost of production
and abstinence, would be just compensated by the marginal productivity of
that kind of capital. At this point the marginal productivity would be
represented by the line DB, the marginal cost of production by the line
>/, and the marginal abstinence by the line IB. The total present value
of that kind of capital would then be represented by the parallelogram
ADIF'. The total product of the present supply of capital during its
lifetime would be represented by the parallelogram A DBF, and the total
surplus, or interest, by the parallelogram F'IBF.

THE PURCHASER'S DEMAND FOR AGENTS OF PRODUCTION

The same result is reached by approaching the subject from the side of
demand, and regarding the disadvantage of waiting as reducing the pur-
chaser's demand 1 for capital instead of checking its supply. It is, generally
speaking, the amount which purchasers will pay for it which constitutes
the reward of the makers of capital and serves as an inducement to con-
tinue the work of production. So long as the purchaser's demand will give
plows, for example, a price equal to the cost of producing them, the

1 As distinguished from the borrower's demand.



THE COST OF CAPITAL AND ITS PRICE 439



producers will continue their work. As already pointed out, if there were
no disadvantage connected with saving, men might be expected to pay as
much in cash for a piece of capital as they expect it to return them in the
way of income during its lifetime. In that case the purchaser's demand
curve for capital would coincide with the productivity curve of the fore-
going diagram. There would then be an equilibrium of supply and demand
at the point where the demand-productivity curve EC intersects the cost
curve GR. But since there is a certain disadvantage connected with
saving, and men are not always willing not even those who inveigh

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INTEREST


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TOTAL PRESE


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VALUE OF CAI


ITAL




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against interest on capital to pay as much in cash, or present consumable
goods, for a piece of capital as it will produce during its lifetime, the pur-
chaser's demand curve does not coincide with the productivity curve, and
the equilibrium of demand and supply is reached at some other point.

This way of approaching the problem may be illustrated by means of
the above diagram, which is a modification of the diagram on page 437.
The purchaser's demand for capital is, in this case, represented by the
descending curve HM, which bears the same relation to the productivity
curve EC as the abstinence curve HB bore to the cost curve GR in
the last diagram. Where this demand curve is above the productivity
curve, it means that men are so anxious to provide against the uncertainties
of the future that they will give a larger number of present goods for the



440 PRINCIPLES OF POLITICAL ECONOMY

sake of having a smaller number at some time in the future, or that men
of enormously large incomes would have so much trouble trying to consume
them all that they would rather invest a part in some enterprise for the
sport of carrying it through, even though they may never get all their
money back, while men of moderate incomes would rather provide against
a rainy day than to consume all their incomes, even though their savings
shrink in the interval. Yet if the enterprises return a surplus, and the
savings expand, both classes of savers will take advantage of the possibility
of getting an increase. Where the demand curve coincides with the pro-
ductivity curve, it means that there is neither advantage nor disadvantage
connected with saving ; and where the demand curve falls below the
productivity curve, it means that there is a disadvantage connected with
saving, and therefore less will be paid for a piece of capital than it will
earn in the future.

Under these conditions the equilibrium of demand and supply, which
determines the present selling value of agents of production, would be
reached when the supply of capital was represented by the line AD, for
this would be the point where the purchaser's demand for the different
forms of capital would give them a value just equal to their marginal cost
of production. Yet the marginal productivity of that amount of capital
would be represented by the line DB ; the present selling value of capital,
which is equivalent to the present value of its future product, would be
represented by the line DI\ and the surplus which would come to the
buyer who took it at its present selling value and waited for its earnings
to mature would be represented by the line IB. The total present value
of all now-existing capital would be represented by the parallelogram
ADF'I; its total future earnings, computed on the basis of its marginal
productivity, by the parallelogram ADFB ; and the total interest or surplus
which would come to those who buy the capital at its present value and
wait for its product to mature would be represented by the parallelogram
F'IFB. The annual interest would have to be computed by dividing this
gross amount by the average lifetime of the now-existing capital. This
would give the lump sum going as interest to the owners of capital each
year. The annual rate of interest would have to be computed by find-
ing what percentage the annual interest is of the total present value of
the capital. 1

1 T. N. Carver, The Distribution of Wealth, pp. 242-249. The Macmillan
Company, New York.



CHAPTER XXXVII

PROFITS

What are profits? Profits may be broadly defined as the
income of the independent business man who receives neither
stipulated wages, rent, nor interest. In a somewhat narrower
sense they include whatever he has left over after he has
allowed himself interest on his own capital, rent for his own
land, and wages for his own labor. This would seem to narrow
the meaning of profits down to the reward for taking risk,
though risk must be defined rather broadly. The enterpriser,
as the independent business man may with fair accuracy be
called, is essentially the man who undertakes something and
relieves others of a part at least of the risk which they would
otherwise have to take.

It would be quite possible, for example, for a group of labor-
ing men to borrow capital, build their own factory, and run it.
But if they did so, they would always be in danger of losing
not only what they themselves had invested, but even their wages
for a time ; that is to say, if there should come a bad season,
when the demand for products fell off, they might have to
work for very low wages or for none at all. If some individual
or group of individuals will undertake to run the business for
them and guarantee them a certain fixed rate of wages, they
are relieved of a part of that risk.

Profits as payment for insurance. Again, the men who
furnish the capital may jointly assume all the risks of the
enterprise. They may, however, be in part relieved by having
one individual or group of individuals undertake the business
and guarantee them interest on their capital. In such a case,
however, the enterprisers usually have to invest some of their

441



442 PRINCIPLES OF POLITICAL ECONOMY

own capital. In such cases they, the enterprisers, put their
own capital in the most hazardous position. This is virtually
the distinction between common stock and preferred stock in
a corporation. Those who own the common stock take the
greater risk. So long as the enterprise is running at all, the
owners of the preferred stock must get their interest, whether
the owners of the common stock get anything or not ; but if
the enterprise is very successful, the owners of the common
stock get larger returns than the owners of the preferred stock.
These larger returns over and above the rate of interest will
be called profits.

The lure of an enterprise. In a smaller business, run, let us
say, by an individual rather than by a corporation, the individ-
ual may borrow a part of his capital, and in this case, so long
as he is in business at all, he must pay interest on what he
borrows, whether he has anything left for himself or not. In
case the business succeeds very well, he gets a surplus which
may be called profit. The lender of borrowed capital gets no
more than the stipulated rate of interest. It is the function of
the independent business man or the enterpriser to insure the
other participants in the industry against at least a part of
their risk. Any income which the insurer gets over and above
the normal rate of interest on the capital which he himself
puts in may be called profit. This is the lure which induces
men to undertake risks of this kind.

This suggests a functional theory of profits which fits in
with the functional theories of value, wages, and interest
already described in the previous chapters. The function of
high profits is to induce a larger number of men to undertake
independent enterprises. Where a larger number of such
enterprises are needed, there are only two ways of getting
them started. One is for the community as a whole to take
a part of the social income and by authority invest it in new
enterprises ; the other is to offer a special inducement to pri-
vate individuals to undertake the new enterprises voluntarily.



PROFITS 443

This is usually done by the offer, on the open market, of high
prices for the products of the enterprise.

Necessity of taking risk. Risk-taking is no more meritorious
in itself than is waiting or working. It is meritorious only
when it results in increased production and well-being. Still,
the well-being of society or the increased production of the
goods which society needs makes it absolutely necessary that
some risks should be taken. Risk is therefore something which
cannot be avoided. These risks are of many kinds and degrees.
The tastes of the people may change so that the product
which is to be produced may be no longer desired. Some
new invention may render obsolete the processes used and
the machinery which has been installed. Strikes, insurrections,
wars, and unforeseen physical calamities, such as fires, storms,
and earthquakes, must also be taken into account. It would
be very difficult to imagine any productive undertaking that
did not involve risk. In the case of the farmer, bad weather,
insect pests, and diseases of all kinds threaten to decrease or
destroy his income. Risk-taking is therefore as necessary as
working or waiting in order to get effective production
under way.

Irksomeness of risk. Unless, however, risk-taking were in
some way irksome or disagreeable, it would not deter men
from entering business, and there would be nothing here that
would have to be paid for. That is to say, if people liked to
take risks, there would be no hesitancy in entering a risky
occupation. It would therefore not be necessary to offer a
reward to induce men to enter it. But since risk-taking is
irksome or disagreeable, since men would rather not hazard
their accumulations and their present income, they must be
paid something as a lure, or attraction, to overcome this disin-
clination. The reason here is precisely the same as the reason
for paying wages or interest, or for paying the price of any
commodity. The function of price, in a free country, is to
overcome the disinclination to work, wait, or to take risks.



444 PRINCIPLES OF POLITICAL ECONOMY



NOT ALL RISK IS IRKSOME

It is not to be inferred, however, that all risk is burdensome. The
gambling instinct is so strong in some people that they will eagerly hazard
their wealth on chances which they know to be against them purely for the
excitement of the hazard. Different individuals differ greatly in this par-
ticular, but in general it will be found that small sums will be risked on the
chance of winning large ones more readily than large ones will be risked on
the chance of winning small ones, even when the chances in the latter cases
are more than proportionally superior. So great is the preference for the
former class of hazards that a great many men one might almost say the
majority of men will risk $i on the chance of winning $1000, even when
it is well known that there are 20001 chances to one against their winning.
That is why lotteries flourish where they are not suppressed by law. But
very few will risk $ i ooo on the chance of winning $ I , even if they know
that there are 2000 chances to one in favor of their winning. If a company
should offer to sell 2000 tickets at $1000 each, only one of which was a
blank, all the rest drawing prizes of $1001 each, it would be making a
better offer than any lottery ever has made or ever could make; but it
would probably not be able to induce 2000 individuals to buy tickets. And
yet such a company would be offering a good risk, as risks go, and anyone
who kept on buying them would gain in the long run, though he might lose
all his money on the first venture.

DIFFERENCE BETWEEN GAMBLING AND LEGITIMATE
RISK-TAKING

Things are happening all around us every day which cannot be foreseen.
We can therefore very easily discover or invent ways of taking risk that
have no connection whatever with production or any kind of useful work.
Men may bet upon the weather, the speed of horses, the outcome of an
election, the way a flipped coin will fall, or which way a cat will jump, but
in none of these cases is there anything accomplished as a result of the
wager, except the transfer of money from one person to another. These
are pure gambling risks and have no connection with any economic function.
The farmer takes risk when he plants seed. He does not know what the
weather will be, how late the frosts will come in the spring or how early
in the fall, what insect pests may destroy his crop, what thieves may steal
it, nor what other circumstances, fair or unfair, may occur. Nevertheless,
if no one were willing to take such risks, we should never have any food.
This kind of risk-taking cannot properly be called gambling. The manu-
facturer likewise, when he erects his building, fills it with expensive



PROFITS 445

machinery, and hires his help, does not know how soon a change of fashion
may upset his calculations, how soon a strike may occur to stop his produc-
tion, when financial panic or industrial depression may cause his prospective
customers to stop buying, or when a change of government policy or some
other fortuitous circumstance may send him into bankruptcy. If no one
were willing to take such hazards, consumers would have no manufactured
products, and labor would have no employment. Such risk-taking, again,
could not be called gambling. It is absolutely necessary to the normal work
of production. In short, a hazard of money or anything else of value, on a
chance which is not necessary to production, is gambling; a hazard on
work which is necessary is not gambling but legitimate risk-taking.

ORDINARY INDUSTRIAL RISKS ARE IRKSOME

Outside of mining and a few extrahazardous enterprises, industrial and
commercial risks belong in the class where relatively large sums must be
hazarded on the chance of small gains. Such risks do not appeal to the
gambling instinct, and consequently they do not attract men except where
the chances are good in the long run that is, where the gains, on the
whole, considerably exceed the losses. Those who embark on such enter-
prises will, in the long run, receive profits ; but in such extrahazardous
enterprises as appeal to the gambling instinct, by the chance of large gains
from small investments, men are so overanxious to invest that the losses,
on the whole, exceed the gains, and there are no profits for such men as a
class, though of course a few win large prizes. It is in the former class of
enterprises that the " irksomeness of risk " deters men from embarking,
reduces competition, and improves the chances of those who have the
foresight or the hardihood to enter. 1

Relation of risk to abstinence. There is a close parallelism
between the part played by risk in the determination of profits,
by abstinence in the determination of interest, and by cost pro-
duction in the determination of the price of a reproducible
commodity. It was pointed out in Chapter XXXVI, on The
Cost of Capital and its Price, that the necessity of waiting,
combined with the fact that waiting beyond a certain point is
disagreeable, tended to reduce the present price of a piece of
capital to something less than the sum of its future earnings.

1 T. N. Carver, The Distribution of Wealth, pp. 282-283. The Macmillan
Company, NeW York.



446 PRINCIPLES OF POLITICAL ECONOMY

The one who buys it at its present selling price and waits for
its earnings to mature will normally and in the long run find
himself in the possession of a surplus as the result of his wait-
ing. Since men are generally disinclined to waiting, they never
bid against one another for the possession of future goods vig-
orously enough to raise their present price to the level of the
sum of their future earnings. The result of this is that the
normal selling price of a piece of capital is low enough to
allow its purchaser a surplus. In a similar way the risk con-
nected with carrying on any enterprise, particularly a new
enterprise in a changing society, may reduce the present value
of the whole equipment somewhat below the probable value of
its products even after allowance is made for interest. Because
of the general disinclination to assume risks of the kind ordi-
narily met with in business, the competitive investments, that
is, the competitive buying of productive goods and embarking
on productive enterprises are less intense than they would other-
wise be. It is for this reason that those who undertake such
enterprises may be expected, in the long run, to secure a profit
over and above the interest on the capital which is invested.
It was also pointed out in Chapter XXXVI that not all
waiting is irksome, and that some waiting is done without
any hope or expectation of surplus income. The parallelism
between risk and waiting may be carried a step farther. Not
all risk is irksome. Some risks are undertaken for the sake of
the excitement. Boys sometimes like to skate over thin ice just
because it is dangerous. Men sometimes like to gamble their
money just because it is dangerous. All sorts of risks are taken
for the sheer excitement of the hazard. When you find a busi-
ness enterprise which appeals to the gambling instinct, men
will be found so eager to buy or to invest in the risk as to give
it a market value somewhat greater than its mathematical or
economic value. Those who persist in buying such risks invari-
ably lose in the long run, though they may now and then win
on some individual venture.



PROFITS 447

Egotistic belief in luck. Adam Smith long ago pointed out
that men are not only egotistical regarding their own abilities,
but that generally they are rather fond believers in their own
luck. Even though they are convinced that mathematically the
chances are against them, their egotism leads them to believe
that their own luck may offset the effect of mathematics. Of
all superstitions the belief in luck is one of the most wide-
spread. It is this sort of superstitious egotism on which the
professional gambler and the lottery flourish.

Relation of the market to the mathematical value of a risk.
In the case, however, of an enterprise which does not appeal
to the gambling instinct, men are generally so reluctant to
invest that the market value of the risk is usually somewhat
less than its mathematical value. Men who persist in buying
such risks inevitably gain if they continue long enough and if
they are not ruined by their early losses. In the class of risks
which appeal to the gambling instinct, the more one invests the
more certain one is to lose. If one were to buy all the lottery
tickets, one would be absolutely certain to lose, because the
lottery sees to it that the price of all the tickets exceeds the
value of all the prizes. In the other class of risks, namely,
those which do not appeal to the gambling instinct, the market
value is less than the mathematical value, as already stated. It
follows from this that if you were to buy all such risks, you
would be absolutely certain to gain, for the sum total of the
market values is less than the sum total of all the mathemati-
cal or economic values. Those who invest in the gamblers'
risk as a class lose rather than gain ; those who invest in the
ordinary business risks as a class gain rather than lose.



Online LibraryThomas Nixon CarverPrinciples of political economy → online text (page 36 of 48)