But it is important also in other connections. It has been the dominating factor in many absorbing controversies upon high policy regarding the ownership of land, or the taxation of land values, upon which we can touch but lightly here. It has seemed to many writers a reasonable proposition to lay down, that the ordinary course of the progress of society, the increase of population and industry, must mean, as a broad general rule, a constant increase in the demand for land. And, if that be granted, it seems to follow that the price and rent of land will tend constantly to increase. John Stuart Mill, accordingly, in the middle of the last century, a.s.serted that "the ordinary progress of a society, which increases in wealth, is at all times tending to augment the incomes of landlords; to give them both a greater amount and a greater proportion of the wealth of the community, independently of any trouble or outlay, incurred by themselves,"[1] and upon the strength of this a.s.sertion, he justified the policy of imposing a special tax upon what we have come to call the "unearned increment" of land. But how far does actual experience bear his a.s.sertion out? In Great Britain we have seen in the last half-century an undoubted increase in urban rents; but over long periods at least, there was a marked fall in both the prices and rents of agricultural land, despite the fact that the country was "increasing in wealth" as rapidly as ever before. This was due, of course, in the main to the increased supplies of wheat and other foodstuffs coming from the New World: and if, accordingly, we choose to lump together not only our own urban and agricultural land, but the land of other countries as well, and to speak vaguely of the demand for land as a whole, it might seem as though we could argue that Mill's generalization still holds good. But even this is by no means certain and in any case such a generalization is of very little service: what the ill.u.s.tration should rather suggest to us, is the danger of speaking of land vaguely as a whole, and the importance of turning our attention to the variations in value between different kinds and different pieces.

[Footnote 1: _Principles of Political Economy_, by John Stuart Mill.]

--3. _The Differential Aspect_. Most ordinary commodities are not produced on a single, uniform pattern. As a rule there are many variations of grade and quality, and consequently of price. But these variations are usually designed to meet the differences of taste among the purchasers, and we do not expect to find that any variety of an ordinary commodity will be produced, which is so poor in quality as to be entirely valueless. But since it is nature which has produced the land, without any a.s.sistance or guidance from man, there are many pieces of land which are so unfertile, or are otherwise so unsuitable for productive purposes, as to be quite valueless from the economic standpoint. Even in a densely populated country like Great Britain, there are considerable tracts of land which it is unprofitable to employ for any economic purpose whatsoever, and which possess no further value than what the mere pride of ownership may give them. This fact makes it possible to apply the conception of the margin to the case of land with particularly illuminating results.

In the first place, however, it should be observed that the value of any piece of land does not depend solely on the intrinsic fertility of the soil. The fact that land is an immobile thing makes its _situation_ a factor of great importance. In the case of urban land, situation is, of course, the only thing that counts. The value of a site in Bond Street or the City is entirely unaffected by its capacity or incapacity for potato-growing purposes. But even for agricultural land, situation is a most important matter. A farm, which is so remote that considerable transport charges must be incurred to bring its produce to market, will be less sought after, and less valuable, than one which is much better situated though somewhat less fertile. In what follows, therefore, we must speak of the "quality" of a piece of land in a broad sense to include advantages of situation, as well as of fertility. Let us now, imagine the different pieces of land in Great Britain to be arranged in order of quality, so that we have a long series, with land of the best quality at one end, and of the poorest quality at the other. At the latter end, we will have such land as is found near the top of Snowden or Ben Nevis, which it clearly does not pay to cultivate at all. Somewhere, then, between these two extremes, we shall come to a point where the land is just, but only just, worth cultivating, or where, to revert to a form of words we previously employed, it is a matter of _doubt_, whether the land is really worth using for a productive purpose. Such land we can regard as the "marginal land"; and since the variety of nature is at once infinite and fairly minutely graduated we shall probably find that on one side of this margin there is much land which is only slightly superior, and on the other, much which is only slightly inferior, to the marginal land itself. What, then, is likely to be the value and the rent of this marginal land, this land which is just on the "margin of cultivation"? Some readers may find the answer startling. The rent of the marginal land will be nil, because it will not pay to cultivate it, if any appreciable rent is charged. A piece of land for which it is worth a tenant's while to pay an appreciable rent, will not be the marginal land, because there will be land just slightly inferior to it which it will also pay to cultivate if a somewhat lower rent is charged. And so we can pa.s.s to poorer and poorer qualities of land, with an ever diminishing rent, until at the margin of cultivation the derived utility of the land is negligible and the rent vanishes.

This certainly is a somewhat abstract conception; but it is by no means so remote from reality as may at first sight appear. The reader may protest that in the course of an extensive and varied acquaintance with landowners, he has not yet run across this peculiar marginal type, who lets his land for no rent at all. But there, if his experience is really extensive, I think he is mistaken. It so happens that the ordinary agricultural landowner leases out his land, not by itself, but together with a variety of other things such as farm buildings, which it costs him a considerable sum of money to provide. He will not as a rule be willing to go to this expense, unless he sees his way to obtain for the farm an annual payment, which represents at least a fair return on this capital outlay, as big a return as he could have got, for instance, by investing the same amount of money in some gilt-edged security. This annual payment will, it is true, be called rent; but the significance of this is that what we term rent in ordinary life is usually a complex thing, made up of two essentially distinct elements, viz. the normal return on the capital goods supplied together with the land, and what we may call the "net rent," or the "pure rent" attributable to the land itself. Now will any reader make so bold as to say that there is no land under cultivation, in respect of which this net rent is either nil or negligible? The landowners will not agree with him. It is not a question, it should be observed, as to whether the rent obtained represents more than a fair return on the purchase price paid for the land; that is quite another matter. The question is whether the rent obtained exceeds a fair return on the capital sum spent on the buildings, etc.; with which every farm must be equipped to let at all. In fact there are not a few farms where there is no such excess, and where accordingly there is no "net rent" or "pure rent" which can be attributed to the land.

The question whether it would be profitable to cultivate any piece of land, turns upon whether the receipts which would be obtained by selling the produce would exceed the costs of cultivation: and under these costs of cultivation we must include, of course, the remuneration of the farmer's services. Farmers, like other people, have to live; and they would not take on the troublesome job of farming, unless there seemed a prospect of making a living out of it. The remuneration of the farmer takes, of course, the form not of a salary, but of profits: and these profits vary very much from year to year, and from place to place, and from man to man. But they are essentially payment for work done, and an ordinary profit must be regarded therefore as part of the necessary costs of farming. Thus it will not be worth while to cultivate a piece of land, and the land will in fact lie unused, upon which a careful farmer might obtain a profit in the ordinary sense, of no more than $50 or $100 a year. The marginal land will be land which yields a decent profit to a decent farmer, as well as a gross rent to the landowner, sufficient to compensate him for his capital outlay, but nothing further.

What, then, will be the rent of a fertile and well-situated farm, about which there is no doubt that it is well worth cultivating? Part of the gross rent which the landowner receives must again be regarded as merely a return for the capital expended in equipping the farm for use; but in this case, there will be a residue left over, which const.i.tutes the net rent of the land. The net rent will measure the derived utility of the land to its occupier, and will in general represent (very roughly, of course, in practice) the differential advantage of cultivating the land in question rather than land on the "margin of cultivation." This differential advantage may take either, or both, of the forms, of a larger produce per acre, or a lower cost of production and marketing. But, in any case, the extra profit, which, if no rent were charged, a decent farmer could obtain by cultivating the farm in question, rather than a marginal farm, will be roughly equal to the net rent which his landlord can exact from him, if his landlord so chooses. The landlord may, of course, not choose to exact a rent as high as this; and as a matter of fact, in a country like Great Britain landlords often content themselves with less. The traditions a.s.sociated with the ownership of agricultural land, and with the relations between landlord and tenant serve to soften the edge of economic law, and to subject the rents which are actually fixed to the control in no small measure of the general sense of what is fair or customary. In such cases the landlord makes the farmer a present, for the time being, of part of the economic rent. On the other hand, as Irish agrarian history well ill.u.s.trates, the landlord may sometimes expropriate under the name of rent, permanent improvements which are due to the labors or the expenditure of the tenant. This is, of course, particularly likely to happen, whenever it is the custom to leave to the tenant the obligation of providing the capital equipment of the farm, which in Great Britain is, for the most part, the recognized duty of the owner. Again, in the case of urban land in the South of England, expropriations of this kind are an essential and well-understood feature of the leasehold system. The owner grants a lease for a long period of time, usually ninety-nine years, for a ground rent, which is notoriously below the true economic rent of the land, subject to the condition that the leaseholder must erect upon the land and keep in good repair certain buildings, which on expiry of the lease will become the property of the ground owner. Here the nominal ground rent is only part of the total rent which is really paid; the ultimate transference of the buildings representing often the more important part. There is, in fact, a great variety of systems of land tenure, some of which are highly complex, the respective merits of which vary greatly, and which const.i.tute a most important problem for statesmen and legislators. Considerations of this kind in no way diminish the importance of the general a.n.a.lysis of rent, which we are pursuing in the present chapter. Rather they make it the more important, because we cannot properly weigh the merits of any system of land tenure, until we have grasped clearly the principles governing the rent of land in the purest form. But certainly we must never forget that the rent we are discussing may differ very greatly from, though it will vitally influence, the money payments which are called rent in actual life. It is the pure economic rent, the rent which represents the _full_ annual payment which it would be worth paying to obtain the use of the land alone, which will measure, as we have said, the differential advantage of the land in question over land on the margin of cultivation.

A clear grasp of this relation helps us to perceive that an increase in the prosperity of the community may sometimes influence rents in an unexpected way. It all depends on the causes which have given rise to the increased prosperity. An advance, for instance, in agricultural science will facilitate a more abundant supply of foodstuffs; but it will not necessarily increase the aggregate rents of agricultural land. For if it takes the form, say, of the discovery of some new artificial manure, it will very likely facilitate production on the less fertile soils far more than it will on the more fertile soils where artificial manures are not so necessary. It will thus tend to diminish the differential advantages of working on the more fertile farms, and their rents will accordingly fall, possibly by much more in the aggregate than any increase in the rents of the farms near the margin of cultivation. The point may, perhaps, be better understood if we pa.s.s from agricultural to urban land, and ask what would be the effect on site values of a great improvement in the facilities of internal transport. Push the case to an extreme, and suppose pa.s.senger transport to become so cheap and so quick that there ceases to be any advantage in living in a town so as to be near your place of work.

Urban landlords would no longer be able to obtain the high rents they now receive for the sites of houses in or near a town. For most people would prefer to move out into the country where sites can be obtained at little more than an agricultural rent. The country covers so large an area relatively to the towns that the supply of rural sites would be still very plentiful as compared with the demand. Their rents would not, therefore, rise by very much, although the rents of the housing sites in towns would fall heavily. Of course, there are other factors to be taken into account before we could p.r.o.nounce upon the effect on aggregate rents. Central sites for shops might, for instance, fetch a higher rental than before. The purpose of this discussion is not to generalize but to show the danger of generalizing about rents in the aggregate, or land as a whole.

--4. _The Margin of Transference_. The last ill.u.s.tration may serve, however, to remind us of an obvious fact which we must now take into account. The same piece of land may be used for a variety of purposes.

It may have been used for growing corn, and later it may be devoted to the building of houses, or, as at Slough, to a repair depot for motor vehicles. It need hardly be said that the land will, as a general rule, be put to the use in which its value is greatest; or to speak more strictly, in which the biggest rent, or the biggest selling price can be obtained. But the notion of the differential advantages which a piece of land possesses over the marginal land becomes decidedly more complicated when we take account of this variety of uses. Let us turn our attention, for instance, to the sites used for shop and office purposes, and consider what we can regard as the marginal site in this connection. Clearly it will not be the marginal land of which we spoke above, which it only just paid to cultivate, and which yielded no rent at all. For this will probably be agricultural land in an out-of-the-way district, where no one would dream of setting up an office or a shop. Any site upon which a sane man would contemplate setting up a shop will certainly possess value for other purposes, such as house-building. Hence the marginal site for shopkeeping purposes will not be like our marginal farm, a site which yields no rent.

As regards many pieces of land, there is no doubt as to the purposes for which they can most profitably be used. This piece will command a much higher rent as a shop site than in any other capacity; for that piece house-building is the obvious employment; for another, agriculture. But in quite a number of instances there is considerable uncertainty. It is not clear whether upon this site it will be better to erect a house or a shop, or if the latter, what kind of a shop. It is not clear whether it will pay to use that farm land for a building scheme; and, within the domain of agriculture, which of course comprises an immense variety of really different industries, it is often a very moot point indeed whether a certain field should be left under gra.s.s, or brought under the plow. Cases of this sort are not phantoms of the imagination; they emerge on every side as concrete problems with which some one or other is dealing every day, and it is these cases which const.i.tute the marginal land for the purposes of a particular occupation. The marginal sites for shops are the sites for which it is only just worth while to pay rents sufficient to entice them away from houses. And the rent for a site in Bond Street, or elsewhere, which is so much more suitable for shop purposes that no alternative use would be worth considering, will exceed the rent paid for one of these marginal sites by, roughly speaking, the extra advantage it possesses for shop purposes. Or will fall short of it, it may be well to add, to the extent of its comparative disadvantage. For there may be many such marginal sites, some of which will fetch low rents, and others very high rents indeed; the same site being often of great potential utility for a large variety of occupations. Between any two occupations there will thus usually be a _margin of transference_, which we must conceive not as a point, but as an irregular line, upon or near to which there will be many pieces of land, differing greatly in the rents which they fetch. These variations of rent will correspond to the differences between the advantages or derived utilities which the sites possess for _both_ the occupations in question. The position of such margins of transference will of course alter as industrial conditions change, and, when they alter, the rents of sites which are not near any margin of transference will be affected also. Thus an increased demand for the products of any particular industry will make it profitable for that industry to offer higher rents, and thus draw land away from other occupations. This will have the effect of raising, though possibly to a very slight extent, the rents of sites which still remain in other uses; for there will be fewer of them available; and their derived utilities will consequently be increased.

But here, as everywhere, it is upon the margin that our attention should be focussed, because it is round about the margin (wherever it is found) that the changes are taking place which really matter for society. When Mr. Mallaby-Deeley buys an estate in Covent Garden from the Duke of Bedford, the transaction hardly deserves the degree of public interest it excites. Nothing has happened which is of material consequence to anyone except the two gentlemen concerned; the various sites are still used for the various purposes for which they were used before; nothing has occurred that really matters. But when houses are pulled down for the erection of a cinema, or when a field is diverted from tillage to pasture, something has happened which affects for good or ill the interests of the whole community. Conversion from tillage to pasture represents, indeed, a tendency which has been very marked in Great Britain during the last generation, and has aroused misgivings in many public-spirited observers. Possibly for a variety of reasons, these misgivings may be justified; certainly the problem is well worthy of attention. But when in this way the issue is raised of tillage versus pasture, it is essential, if we are to discuss it rationally, that we should envisage it clearly as applying only to a limited portion of agricultural land, to the portion which lies somewhere near the margin of transference, as things are now, between the two forms of agriculture. It might be socially desirable to bring under the plow a field which the farmer finds it only _slightly_ more profitable to lease under gra.s.s; but this would be highly improbable in the case of a field where the balance of argument to the farmer in favor of pasture is overwhelming. The position of the margin of transference between different uses may, in other words, be somewhat out of place from the social point of view, and it may be desirable by appeals and propaganda, even conceivably by the devices of State subsidy and compulsion, to push it forwards or backwards in greater or less degree. But it will be necessarily a matter of degree, and nothing could be more foolish than to speak as though there was, or could be, some ideal method of cultivation equally applicable to all lands, without regard to their climatic and other conditions. Needless to say, none of the agricultural experts who sometimes deplore the decline of arable farming are guilty of such foolishness. But the sense of the diversity of nature which is very vivid to them may sometimes be lacking in people who live in towns, and a firm grasp of the marginal notion may serve best to keep the latter from forgetting it.

--5. _The Necessity of Rent_. Behind all such detailed applications there lies a more general consideration which deserves attention. The way in which the land of a country is used, the way in which it is apportioned between the countless alternative employments that are possible, is a most important matter, more important perhaps than any questions as to the size of the incomes which particular landowners receive by virtue of their rights of ownership. How is this apportionment effected as things are now? The answer is clear: mainly by the agency of either rent or price. The business which finds it worth while to offer the highest rent or the highest price for any piece of land will, as a rule, be able to command its use. And, with this as the governing principle, an apportionment is secured between shops, offices, factories, agriculture, between the immense variety of different employments covered by each of these broad headings; not a rigid unvarying apportionment, but one which constantly changes as economic circ.u.mstances change, and as the margin of transference between different occupations moves. .h.i.ther and thither. This apportionment takes place at present as the result of the independent decisions and bargains of many private individuals, who are thinking mainly of their own interests, and not of those of the community. But this state of affairs might be altered. The land might be nationalized and allocated to its various uses by the co-ordinated labors of a great State department, or some other agency of the collective will. However improbable such a change, it is perfectly conceivable.

But what is not conceivable is that any State department should handle the job with a success even approaching that of the present system, unless it continued to use, as its main instrument, the criterion of either rent or price. That a piece of land would yield a higher rent in one occupation than in any other is not conclusive evidence that it is best to devote it to the former purpose, but it is very good evidence, and it should be allowed to prevail unless it is demonstrably outweighed, as it possibly might often be, by considerations of a different kind. That it would not be well for the community to employ land in the city of London for corn-growing purposes, however desirable might be a revival of home agriculture, is so obvious that it may seem to have no bearing on the present issue.

But it is only an extreme indication of the absurd and wasteful use of our natural resources, which would grow up slowly but surely, if we dispensed with ideas of rent and price as sordid irrelevancies, and allocated our land on the basis of a balancing of the loftiest arguments of a vague and sentimental character. If you are prepared for the distribution of land to become stereotyped, for each piece to continue indefinitely in its present use, then indeed you might dispense with rent, as primitive societies very largely do. That would mean stagnation and, for an industrial country, decay. But if changes are ever to be contemplated, a simple quant.i.tative measure is the only safeguard against utter chaos. Thus rent, like interest, will be found indispensable as a measure under any efficient system of society, even if it might not always represent the payment of sums of money to private individuals. And that is why the principles governing rent possess, as I indicated at the outset of this chapter, an importance more fundamental than our present system of ownership and tenure.

--6. _The Question of Real Costs_. But we must not forget the preliminary question that started us upon our a.n.a.lysis of the agents of production. The rent which a manufacturer or farmer has to pay for his land he naturally includes in his cost of production. But does this money cost to the individual correspond to, and measure, any real cost to the community as a whole? Here let us note in the first place that if only we could disregard the variety of uses to which land is put, if we could suppose that all industry was agriculture, and that agriculture was a single industry with a single product, we could argue that rent does not enter into marginal costs at all. For we could regard the marginal producer as the one working on a marginal farm, whereas we have seen there is no pure rent. The rent which other producers have to pay would thus represent merely the destination of the surplus profits which arise wherever actual costs fall short of marginal costs. This way of looking at the matter has proved attractive to some thinkers, not in the least because of a desire to palliate the effects of landlordism, but because it fits in so well with our general sense of rent as a "surplus," and a surplus as something distinct from a necessary price. But it is clearly illegitimate in an economic theory which professes "to describe the facts." The marginal land for many purposes fetches, as we have seen, a considerable rent; and this rent is certainly part of the marginal costs and of the necessary price of the products of the particular industry. The answer to our question is, however, not now very difficult to see. Land, greatly as it differs in many respects from the other agents of production, resembles them in the very important respect that, being used for one purpose, it is not available for other purposes, and that the productive powers of the community in other directions are thereby diminished. This is the real cost to the community, which attaches to the products of any industry, in virtue of the land which it occupies; not any human labors or sacrifices required to produce the land itself, but the curtailment of the natural resources available for productive use elsewhere. This is the real cost of which rent is the money measure, and generally speaking an accurate measure at the margin of transference between one occupation and another. A somewhat fanciful use of the term cost, this may seem perhaps, one not quite in accordance with our instinctive sense of what real costs should be. But possibly the real costs represented by wages and profits may turn out to be not so very different, and we had best leave the matter there, until we have examined the nature of these other costs.

--7. _Rent and Selling Price_. In this chapter we have spoken mainly of the rent rather than the price of land: the relation between the two things is fairly obvious and well understood, but it will be well not to close the chapter without a brief account of it. The price of any piece of land is affected by all the considerations on which its rent depends, but it is also affected by another factor which has no influence whatever upon rent. This factor is the rate of interest. The higher the rate of interest, the higher the return which a man could obtain by buying gilt-edged securities, the lower will be the price that he will pay for a piece of land which yields a given rent. We can express the relation more precisely by the formula Price = (Rent * 100)/(Rate of Interest), though we must be careful, in applying this formula in practice to allow for the possible deviations between the nominal and the true rent, and similar complications. The price, it must be observed, is derived in this way from the rent, not the rent from the price.[1] Rent is thus logically the simpler, price the more complex thing. It is well, therefore, to a.n.a.lyze in the first instance the principles of rent, if we live in a country where the practice of leasing land for annual rent is less common than it is in Great Britain, even if, for whatever reason, it is the price of land with which we are concerned in practice. The problem of price contains two distinct elements which it is not easy to handle when mixed up together. For the rate of interest represents in itself an important branch of economics, which will require a separate chapter to itself.

[Footnote 1: In this the rent of land differs fundamentally from that of other things, such as houses. For the price of a house is largely influenced by the costs of construction of new houses, and should correspond closely to them in the long run. The same relation between rent, price and rate of interest will hold good; but the rents will be affected by changes in the rate of interest, owing to the reactions of such changes on the supply of houses.]

CHAPTER VII

RISK-BEARING AND ENTERPRISE

--1. _Profits and Earnings of Management_. The profits of a business, as they are ordinarily reckoned, whether for the purposes of income tax or of a balance sheet, comprise several elements which are fundamentally distinct. The relative importance of these various elements varies greatly from one type of business to another. The profits of a private business include, for instance, the remuneration of the work of management, which in the case of a Joint Stock Company is mostly paid for by salaries or directors' fees. It is to their profit that farmers, small shopkeepers, and the partners of a private firm look not merely for a return upon their capital, but for the reward of their own labors. "Earnings of Management," as they are usually termed (though in truth they often cover other and humbler forms of labor) are thus frequently one of the ingredients of profits.

--2. _The Payment for Risk-bearing_. There is another element of great importance about which our ordinary ideas are apt to be so vague that it will be well to devote a chapter to its examination. This is the element of payment for risk, or rather the reward of risk-bearing.

Risk is inherent in all business, as it is inherent in all life. The vagaries of nature and the vagaries of man are alike responsible. The farmer may find his harvest ruined by a drought or by a deluge; the coal or the gold, for the extraction of which you have perhaps set up an extensive mining plant, may come to an end which is unexpectedly abrupt. You may put your money into roller-skating rinks and find that cinemas have become the rage with the fickle public; sometimes "the market" may decline for causes which remain obscure but with consequences which are disagreeably plain. But while risk is always present in some degree, the degree varies enormously from one industry to another. Now, it is obvious enough that in an exceptionally risky industry, where there is a considerable possibility that the capital invested will yield no return at all, the profits of those concerns which succeed are likely to exceed the rate of interest on gilt-edged securities. But what is likely to be the magnitude of this excess? Is risk-taking rewarded if there is any such excess, however small? Or will it suffice that the gains and losses should average out to a fair rate of interest over the whole industry? To enable us to think closely let us suppose for a moment that we can measure accurately what the chances are.

Suppose, then, that there were a precisely equal chance of success on the one hand and failure on the other in any enterprise, failure involving a complete loss of all the capital invested. Suppose, further, 6 per cent to be at the time a fair return on a perfectly secure investment. What would be the return which must be expected from the risky enterprise, in the event of its succeeding, before it will be undertaken? The reader may be tempted to answer, 12 per cent.

But 12 per cent would not suffice. An equal chance of 12 per cent or nothing, as compared with a certainty of 6 per cent, does not mean that the risk in the former case is paid for to the tune of 6 per cent. It means that it is not paid for at all. In each case what a mathematician would call the _expectation_ is a return of 6 per cent. The odds are evenly balanced; in the long run, over a large number of cases, if the law of averages works as we a.s.sume it does, you would get just as much from the one type of investment as the other. Now, risky enterprises will not, as a rule, be undertaken on terms like these; investors and business men will not take risks with the odds precisely equal; they must have them, or believe that they have them, in their favor.

--3. _Monte Carlo and Insurance_. To a.s.sert this is not to ignore the strength of the appeal which the gambling instinct makes to many, if not to most of us. The taste for gambling is, indeed, so deep and widespread that it would be foolish to leave it out of account in this connection. It is clear enough that at places like Monte Carlo people are prepared to have the odds unmistakably against them, apparently for the sheer pleasure and exhilaration of taking risks. Moreover, though for most people play at Monte Carlo represents a mere holiday indulgence, it would be unsafe to a.s.sume that what appeals to them there will not also appeal to them in their business affairs. But what exactly is the secret of the charm of Monte Carlo? It is the great attractive force of a small chance of a large gain, as compared with the deterrent force of a large chance of a small loss. People will readily pay $5 for one chance in a hundred of making no more, perhaps, than $400 or $450. And it is very likely that this holds good in the world of business. If, for example, we were to suppose that the promoters of a new enterprise were confronted with one chance in fifty of a profit of 50 per cent per annum on their capital, as against forty-nine chances of a profit of 5 per cent, this might well prove a more attractive prospect than a certain return of 6 per cent, although the strict _expectation_ of profit would be smaller in the former case. But the risks of business enterprise are not often of this type. They conform more usually to the opposite type of a large chance of a relatively small gain, balanced by a small chance of serious loss or entire failure. Now for almost everyone the possibility of a great loss will count as a deterrent (just as the possibility of a great gain may count as an attraction) for much more than its strict actuarial value.

The truth of this proposition is demonstrated by the existence of inst.i.tutions more impressive than Monte Carlo--the Insurance Companies, which play so large a part in the economic life of modern times. Every year, and upon an ever-growing scale, both private individuals and business concerns pay sums of money, which reach in the aggregate a colossal sum, as premiums to insure themselves against loss by Fire, Shipwreck, Burglary, Death, Death Duties, against every risk which Insurance Companies will cover. Now Insurance Companies are not, as we say, in business for their health. They find their business profitable, and pay good dividends to their shareholders.

Moreover, they incur a considerable expenditure on offices, on clerical staff, on agents, and the like. All these payments must be defrayed out of the premiums they receive; so that it is plain that the premiums greatly exceed the _expectation_ of the risks insured.

The odds are heavily in favor of the Insurance Company--of that the stupidest person can have no shadow of doubt. Yet we continue to insure, as private individuals and as business men, and so far from being ashamed of our proceedings as a weak and nerveless folly, which somehow we are unable to resist, we blazon them forth in the strong accents of conscious pride. We preach insurance to our neighbors as the core of self-regarding duty, and, if ever we feel a twinge of uneasiness, it is lest we, too, may have omitted in some particular to practice what we preach.

The significance of this is unmistakable. Be our psychology what it may, however deep and irrepressible our taste for derring-do, however inadequate the scope which the dull routine of modern life affords for our adventurous impulses, we are most of us anxious to avoid the risk of great financial loss. We are very glad to find someone to take it off our shoulders if we can; so glad that we are prepared to pay him for the service, to pay him a sum which covers not only the actuarial equivalent of the risk, but something substantial over and above. In this we are entirely rational. Our conduct is justified by the law of the diminishing utility of money, which was noted at the end of Chapter III. It would be plainly foolish, for instance, to subst.i.tute for the certainty of an income of $2500 per annum an even chance of $5000 or nothing, since the utility to us of $5000 is not twice as great as that of $2500.

The majority of business risks are not of a kind against which it is possible to insure. Insurance companies confine themselves to risks which are mainly a matter of what we call objective rather than subjective chance, i.e. risks in respect of which knowledge of detailed facts peculiar to the individual case is of minor importance. But such knowledge is of paramount importance in the case of ordinary business risks. If, for example, a new enterprise is to be undertaken, the special knowledge and experience which its promoters possess is a vital factor in determining their estimate of the risk involved. An outsider with no special knowledge would necessarily require to estimate the risk far more highly if we were to form a rational opinion on the basis of _his_ knowledge. So great, indeed, would be the risk to him, that we can lay it down as a sound maxim that people are extremely rash who invest their money in risky undertakings about which they know very little. This subjective aspect of business risk has a significance to which it will be necessary to revert.

But, though most business risks are not and cannot be a matter for premiums and policies, the principle, which the practice of insurance ill.u.s.trates, applies none the less. In the light of their knowledge and experience, the promoters of a new undertaking must weigh up the chances of failure and success, though they will not do so by the precise methods of an actuary. They will require that any chances of serious loss should be balanced by such chances of exceptional gain, as would raise the _expectation_ of profit well above the normal return on secure investments. The more risky the project seems the greater, generally speaking, must be the _expectation_ of profit required to induce people to undertake it.

If we suppose business men to calculate reasonably, it follows that the average profits in any industry over a long period of years, reckoning in the losses of the concerns which disappear altogether, are likely to be higher, the more risky is the industry. Such a result will not, of course, occur in every case. Even when the calculations are reasonable, they may be entirely falsified by the event. Moreover, business men may not calculate reasonably on the information which they have. But, unless we suppose their judgment to be subject to a prevailing bias in one direction, i.e. to be unduly optimistic as a general rule, _we_ should expect, and in any case _they_ must expect, profits above the ordinary in a risky industry.

This conclusion is sufficiently important. Far too many people, though they admit it when it is expressly stated and dismiss it even as a tiresome commonplace, are apt to neglect it when the occasion for applying it arises. For example, the great importance to any industry of good management is generally recognized, and the consequent desirability of paying adequate salaries to the managerial staff. The importance of securing a supply of capital is very widely recognized, and the practical necessity of paying a fair rate of interest is thus, however grudgingly, conceded. But the "residuary profits," as they are called, which accrue at present to the owners of a business, are denounced in some quarters in a sweeping fashion, which seems to ignore altogether the all-pervading element of risk. People speak as though you might appropriately limit profits in every industry to some uniform percentage on the capital employed, without making it clear whether you would even be allowed to make up in good years for the losses incurred in bad. The effect of introducing any such crude device into our present industrial system could only be to paralyze enterprises of an unusually risky kind, which, so far from being pushed to an excess at present, are more probably curtailed unduly from the standpoint of what is socially desirable. Like the fixing of a low maximum price for a commodity it would cause the supply to wither up and disappear.

--4. _Risk under Large-scale Organization_. While this is true of the present economic system, the question is worth considering whether it represents a fundamental necessity, whether, for instance, under our world socialist commonwealth the factor of risk-bearing need play so important a part as it does in the actual business world. This question cannot be answered with a conclusive simplicity; opposing considerations present themselves, between which it is not easy to strike a balance. On the one hand, in accordance with the law of averages gains and losses tend to cancel out over a large series of transactions, _when reasonable calculations have been made_. Thus Insurance Companies, while they take heavy risks off the shoulders of policy-holders, incur relatively trifling risks themselves; they can predict the aggregate sums which they will be called upon to pay within a small margin of error. In the same way it might seem that every enlargement of the scale of business would make for an automatic insurance and a consequent economy of risk; and thus that if all businesses were comprised in a single financial unit, gains and losses would cancel out over so wide a range that the degree of risk remaining would be almost negligible.

This might indeed happen, if business risks were mainly of that objective kind in which the insurance companies specialize; for then we could a.s.sume that the chances of success or failure would be estimated reasonably. But, in fact, most business risks, not being of this kind, must be estimated by processes of human judgment, which are very fallible. And here we must take account of the law of averages in another aspect, with a different bearing on the argument. When an industry comprises a large number of separate concerns, and the decisions accordingly are taken by many men, acting independently of one another, the errors of calculation will tend to some extent to cancel one another out. The undue optimism of one man will be balanced by the undue pessimism of another; and, if there is no prevailing bias in either direction, the errors of judgment will not affect the results for the industry as a whole. But where the effective decisions are taken by very few men, the chances are far greater of a preponderating balance of error in one direction. The risks dependent on the factor of human judgment tend therefore to increase.

This truth can be ill.u.s.trated by a phenomenon which is fairly familiar. It is recognized by intelligent persons that the risks of speculation in a particular commodity market or stock market increase more than proportionately to the scale of operations. A man who sets out as a "bull" upon a small scale can buy without sending up the price against him in the process, and, if he decides later that his judgment is mistaken, he can at any time cut his losses and sell out without much difficulty. But a "bull" on a very large scale cannot complete his purchases except at a price which has been raised in consequence of his own action, and he cannot count on being able to "unload" at or near the market price, should he decide to do so. If, accordingly, he miscalculates, he cannot save himself from serious loss as a smaller man might do by a prompt discovery of his error. His difficulties spring from the fundamental fact that the effects of his calculations are too great to be offset by those of the different, and often opposite, calculations of other men.

Upon the issue whether a growth in the size of the business unit is likely to diminish risk, the law of averages thus cuts both ways. The risks arising from the element of pure chance are more likely, those arising from miscalculation are less likely, to cancel out. Upon these grounds alone, it would be unsafe to conclude that there would be on balance an economy of risk under any system of national or world socialism.

--5. _The Entrepreneur_. There remains, however, an aspect of the problem which is perhaps more important than those discussed above. It is probable that risks would be estimated and undertaken more wisely or less wisely under a different system of society or of industrial organization? Upon this issue, methods of precise a.n.a.lysis are out of place, but we may have something to learn from the emphatic testimony of tradition. It has become an axiom of business men that, while Governments can manage with more or less competence a safe and routine business like a Postal Service, their success would be unlikely to prove conspicuous in undertakings where the element of risk is great. There, it is said, we owe everything in the past to the enterprise of individual men (for even joint-stock companies have not been notable as pioneers) adventuring their own fortunes in accordance with their own unfettered judgment. This contention, however much we may desire to qualify it, has unquestionably a large measure of truth, and the explanation is not difficult to discover. For the wise taking of risks in industrial development of an experimental character, peculiar conditions and special qualities are required. First, it is necessary to envisage distinctly the promising though risky opportunity, and this calls not infrequently for imagination of a none too common order. Then it must be studied with insight and expert knowledge and weighed by processes which are as much intuitive as intellectual. The reasons for or against taking a particular business risk are seldom such as can adequately be expressed in terms of arithmetic, or even by clear arguments the soundness of which is proportioned to their logical cogency. The mysterious faculty of judgment enters in; and from mental processes which defy a.n.a.lysis there emerge ultimately conviction and the will to act. But it is precisely here that Government Departments are apt to fail. It is here that the individual, who need consult no one but himself, has a pull over any form of organization, where decisions are reached by the method of debate and agreement among a heterogeneous committee. Hence it is that we have come to regard exceptional risk-taking as the peculiar province of individual enterprise. It is probable that these deficiencies of corporate organization are tending to diminish, and it is an interesting question how far it may be found possible to eliminate them in the future.

Meanwhile the above considerations have an important bearing on the rewards which can often be obtained from risky enterprises. The number of individuals who are in a position to envisage a business opportunity, and to a.s.sess with some confidence the chances of success and failure is very limited. Not only must they possess special knowledge, ability, imagination, confidence in their own judgment, and the capacity to act on it; they must also have at their disposal considerable financial resources. To combine all these advantages represents a union of circ.u.mstances which is distinctly rare. The fortunate few, who do combine them, are thus generally able to extract in the form of profits a high price for their services, a price which covers not only the strict reward of risk-bearing, and the necessary remuneration of their own service, but a handsome payment for the special qualities and advantages which have been indicated. Profits, moreover, may vary between one industry and another, not only in accordance with the real risk which is entailed, but with the degree to which the supply of special knowledge, etc., is scarce or abundant.

This consideration goes a long way to explain the large fortunes which enterprising business men are often able to ama.s.s. It also throws some much-needed light upon the functions which such men discharge. They perform to a large extent the work of management; they supply capital on what may be a considerable scale; but it is the taking of business risk which is perhaps their most characteristic function. It is the union of these functions which distinguishes them as an essentially different type from the salaried manager who has invested his savings in rubber or in oil. In other languages there is a specific name for the man who combines all these three functions; in French he is called an "entrepreneur," in German an "Unternehmer." It is much to be regretted that in English we have no clear corresponding word. The word "capitalist" is not uncommonly employed to do duty in this connection, but this is a source of much confusion. For the word is also used, and more appropriately, to include all investors, whether or not they are active business men.

--6. _Risk-taking and Control_. But there is an allied confusion of more importance. We commonly suppose it to be a leading feature of our present "capitalist system" that the control of industry rests in the hands of those who supply the capital. Nor, as a general statement, is this untrue. But it conceals the essential point. Strictly speaking, it is risk-taking with which control is a.s.sociated. The mere lending of money carries with it no t.i.tle to control. Governments and munic.i.p.alities concede no such t.i.tle to the subscribers to their loans; nor does a company to its debenture holders. The shareholders'

ultimate control is based upon the fact that they bear the financial risks of the concern. Nor is this a matter of mere legal form. It is not uncommon for ordinary shares to carry with them a greater voting power than the preference shares of a corresponding value. The principle which such arrangements endeavor to express is clear: control should rest with him who bears the risk. It is with this principle rather than with a mulish insistence on the rights of property, that advocates of "workers' control" and the like have got to reckon. It is upon this ground that (as they may quite conceivably do) they must make good their case.

--7. _General a.n.a.lysis of Profits_. Let us conclude this chapter by clearing the ground for the next. Earnings of management, payments for risk-taking and for the special knowledge and advantages a.s.sociated with it, are ingredients of the gross profits of a business. The chief element that remains is that of interest on capital. Frequently, indeed, it is not the only one. As we saw in the last chapter, a farmer may not be required by his landlord to pay the full economic rent for his farm; and he may therefore make profits above the normal level, above the ordinary return for his own services, his own capital expenditure, and the risks to which he is necessarily exposed. In such a case the farmer is really the recipient, as we have already suggested, of part of the economic rent of the land; and an element of rent accordingly enters into his gross profits. But profits may include a surplus element which may arise in a great variety of other ways. A business may possess some decided advantage which is not open to compet.i.tors; and it may reap high profits accordingly. You can, for instance, if you choose, regard the high money profits, which, as was suggested in Chapter IV, are likely to accrue in future to the owners of pre-war factories, as a surplus profit of this kind. But while, as this ill.u.s.tration indicates, the phenomenon of surplus profits becomes of very great importance when we seek to study the distribution of wealth, it need not detain us here. For the surplus element arises only in so far as the costs of a business are lower than the marginal costs; and it is the marginal costs, which, with good reason, we are now endeavoring to a.n.a.lyze. The marginal costs must include a normal profit, i.e. a profit which will cover earnings of management, the reward of risk and enterprise, interest on capital, but nothing further. It remains, then, only to consider this last element of interest.

CHAPTER VIII

CAPITAL