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DYNAMIC THEORY OF INTEREST; A DIFFERENTIAL ANALYSIS

Approved:

Approved:

Dean ofvthe Graduate School

DYNAMIC THEORY OF INTEREST; A DIFFERENTIAL ANALYSIS

THESIS

Presented, to the Faculty of the Graduate School of the University of Texas in Partial Fulfillment of the Requirements

Por the Degree of DOCTOR OF PHILOSOPHY

By

Norman Stuart Spencer, 8.A., M.A. Austin, Texas June, 1931

350866

PREFACE

This work in "pure” economic theory is limited to an attempt to account for the existence of the net exchange value productivity of capital in industry, and for the market rate of interest for the use of loanable funds. It does not offer any theory of personal consumption nor set forth any social or political philosophy deduced from the dynamic theory of interest; and, except for a few incidental remarks, it offers no criticisms of other theories of interest. Its purpose is constructive.

In a sense neither new principles have been discovered nor new methods employed. While it is claimed that certain new laws are developed, these are based on other laws which have been worked out by classical and neo-classical economists. The method employed is largely deductive, but no assumptions are made of any society other than the dynamic one which is thought actually to exist. Historical and statistical data are now available in such quantities that static assumptions are no longer as necessary to the economic theorist as once they were.

Capital is defined from the point of view of exchange value income. Thus any property or wealth devoted to the acquisition of income through exchange is capital. From this point of view both land and industrial equipment are capital, and so are intangibles if they aid in

securing income through exchange and themselves can be sold apart from their owners. Of course, this approach is not new. Similar, if not identical, approaches are well known to all economists who are acquainted with the works of Hermann, J. B. Clark, Cannan, Hobson, Webb, and Commons. In the last edition of their Outlines (pp. 94- 108), 1930, which appeared after most of the present theory was elaborated, Ely, Adams, Lorenz, and Young employ a definition of capital essentially the same as that used in the development of this theory. Neither the present writer nor any of those mentioned above denies that each special category of capital has its peculiar qualities which are important. And if the present theory of interest were developed in great detail, it would necessarily contain some principles applicable to certain categories of capital but not to all. It is because the resemblances between special categories are more important than the differences that the present writer undertakes to explain the fundamental nature and causes of their net incomes by the same general principles.

Perhaps it is well to emphasize at the outset that the interest with which this theory is concerned is a private income derived from the ownership of private property , but that this approach does not necessitate a justification or condemnation of interest--that is left

to those interested in evaluating the present institu tions which make it inevitable. The existing institu tional situation is accepted as a given factor in the problem.

ihe elaboration of this theory was begun and brought to its present stage of development while the writer was studying economic theory under Professors Max Sylvius Handman and Edward Everett Hale of the University of Texas. Both are original thinkers as well as profound scholars and inspiring teachers, and he gratefully acknowledges his indebtedness to them. For valuable advice and constructive criticisms, the writer is especially indebted to Professor G-eorge Ward Stocking, also of the University of Texas. He, in his study of the potash industry which is now in press, and the writer of the present study independently arrived at what seems to be practically the same theory of the margin of discontinuance. Also the writer is indebted to Professor Robert Hargrove Montgomery of the University of Texas for much valuable assistance and information on difficult points pertaining to the theory and practice of financing business enterprise. He further acknowledges his Indebted ness to Professors Edmund Thornton Miller and Clarence Alton Wiley of the University of Texas for encouragement and valuable assistance. All of these former teachers,

while not necessarily accepting this theory as a whole, have taken an entirely constructive attitude toward it and thus have encouraged independent and constructive thought in its development. Consequently, the writer must acknowledge that much of whatever excellence it contains is due to them, but that he alone is wholly responsible for its deficiencies.

Norman Spencer

Austin, Texas

January 28, 1931

CONTENTS

Page PREFACE Hi CHAPTER I. THE PROBLEM OF INTEREST AND A SUMMARY OF OUR THESIS 1. The Problem Stated. 1 2. Our Thesis Summarized 6 CHAPTER 11, BUSINESS AND CAPITAL 1. A Business 13 2. Capital and Capital Goods 19 (11 Capital 20 (2) Capital Goods 22 Fixed Capital Goods 25 Land 26 Buildings and Equipment 29 Intangibles 31 (5) Working or Circulating Capital 55 CHAPTER 111. THE LAW OF EFFICIENCY OF OUTPUT 1* The Motivating Purpose of Business Activity 41 2. Means and Limitations 45 3. The Law of Efficiency of Output Stated 55 4. The Theory of a Moving Equilibrum 57 CHAPTER IV. THE MARGIN OF DISCONTINUANCE 1. The Doctrine of a Common Rate of Net Capital Returns 33 2. Interest as a Cost at the Margin of Discontinuance 71 (1) The Orthodox View 71 (2) Depreciation and Replacement 74 (3) Marginal Owners of Fixed Capital Goods 85 (4) The Theory of the Margin of Discontinuance Stated qq

Page CHAPTER V. THE MARGIN OP ENTRY 1. New Enterprises 92 2* The Theory of the Margin of Entry Stated " 94 3. The Margin of Discontinuance, the Margin of Entry, and the Market Rate of Interest 95 CHAPTER VI. THE MARGIN OF INTENSITY 1. Differential Net Capital Returns 99 (1) Agricultural Business 104 (2) Railway Business 107 (3) Manufacturing Business 114 Sugar Mills 114 Sugar Refineries 117 Animal and Vegetable Oil Refineries 123 2. The Law of Differential Net Capital Returns 130 (1) The Law Stated 130 (2) Significance of the Law 131 CHAPTER VII. THE MARGIN OF TRANSFERENCE 1. Opportunity Costs or Expenses 143 2. The Theory of the Margin of Transference Stated 146 CHAPTER VIII. THE MARGIN OF DEMAND FOR LOAN FUNDS 1. Business Demand for Loan Funds 154 2. Government Demand for Loan Funds 158 3. Consumers’ Demand for Loan Funds 159 4. The Margin of Demand for Loan Funds 160 CHAPTER IX. THE MARGIN OF SUPPLY OF LOAN FUNDS 1. Individual Savings 163 2. Institutional Savings 169 (1) Business Savings 169 (2) Bank Savings 171 3. The Theory of the Contemporaneous Process of Production 182 4. Interest as One of the Costs of Supplying Loan Funds 185

Page

CHAPTER X. THE MARGIN OF PRODUCTIVITY 1. Progress and the Supply of *Real H Capital Goods 187 2. The Control of Investment Opportunity and the Control of Loan Funds 198 3. The liargin of Productivity and the Function of the Market Rate of Interest 199 4. Discount and Capitalization 205 BIBLIOGRAPHY 208

CHAPTER I THE PROBLEM OP INTEREST AND A SUMMARY OF OUR THESIS

1. The Problem Stated

The problem of accounting for the existence of interest is one of explaining the net, or surplus, exchange value productivity of capital. Interest appears in the case of a loan of money where the borrower repays the lender the amount of money borrowed plus an additional sum, or premium, for the use of the money during the period of the loan. This additional sum for the use of the loan is called loan interest, and is usually expressed as a certain percentage of the principal sum lent, interest appears--and most significantly-- as that portion of the net exchange value product of Industry which is -attributed to the use of capital. Now the first and most obvious kind of interest, loan interest, cannot be explained, we think, until the net exchange value productivity of capital in industry is accounted for.

For a long time students of the problem of interest have correctly emphasized the fact that capital does not produce value directly. From a technical point of view, capital simply aids in the production of things which are economic goods only because they are wanted and their market supply is so limited that all

of it is taken by those offering some exchange value in return. But the value of the product of capital is not derived from the capital itself. To say that it is would be to put the cart before the horse. The valuation runs from the product back to the capital. The capital has exchange value because it assists labor in producing goods which have exchange value,and is limited in supply.

But the mere fact that capital has exchange value because the product which it helps to produce has value does not explain interest. This only tells us that capital is wanted neither for itself nor for its physical productivity, but for its indirect value productivity. Before interest can come into existence, the part of the value product attributed to capital must sell for a price which, in the aggregate, is greater than the aggregate expense of using the capital to which the product is attributed. Otherwise there is no surplus exchange value, and therefore nothing that can be called interest.

Yet, as Taussig says,

The essential problem concerning interest can be stated in simple terms. Why should an individual who borrows from another a given quantity of commodities--represented, in any except primitive communities, by a given quantity of money-- engage to return, after a fixed time has elapsed, not only what he has borrowed, but something in addition? That the amount borrowed should be returned, seems sufficiently easy of explanation. But why can the lender get the premium also? That premium, as is familiar enough, is expressed in terms of a percentage paid each year. The borrower engages to pay back, not only the principal, but five per cent or thereabouts in addition for each year that elapses, and a proportional percentage for each fraction of a year. To ascertain why this additional percentage is paid, is to solve the problem of interest. 3

Our solution will deal with the problem of inter est only as an exchange value or price phenomenon of present society. We shall employ the term “exchange value" in its most usual sense. The exchange value of any good in terms of another is in proportion to its power to command that good in peaceful exchange. The price of a good is its power to command money. Now, at any given time all goods for sale are evaluated in terms of money. Money makes them all commensurable to each other. Aristotle long ago stated it thus:

There must be some single standard then, and that standard upon which the world, agrees; hence is called money, for it is this which makes all things commensurable, as money is the universal standard of measurement. Let Abe a house, B

ten minae, C a couch. Now Ais half B, if the house is worth, or is equal to, five minae. Again, the couch is a tenth part of B. It is clear then that the number of couches which are equal to a house is five. It is clear too that this was the method of exchange before the invention of money; for it makes no difference whether it is five couches or the value of five couches that we give in exchange for a house.

It was also recognized by him that ’’money is subject to the same laws as other things; its value is not always the same; still it tends to have a more constant value than anything else."-" Over a period of time, the power of a good to purchase money and its power to purchase other goods may vary unequally. Where this variation is absent or unimportant, we shall employ price and exchange value as synonymous terms. We shall always so employ them in referring to relative values at any given time. Of course, our exchange value theory is applicable only to a specialized private property economy, where goods are produced at one price, or sum of prices, for sale in the market at another price, with the expectation that each price will be greater than the summation of preceding ones.

But in trying to explain interest as a problem of exchange or price economics, we have not narrowed the problem as much as a subjective critic might at first

suppose. Wesley C. Mitchell says:

The system of prices is our mechanism for regulating the process of producing and distributing goods. Prices make possible the elaborate exchanges, and the consequent specialization and cooperation in production which characterizes the present age, and so are one of the factors contributing to its relative comfort. They are the means by which all consumers in concert make known what goods the community wants and in what quantities; the signs which enable all business enterprises in concert to come as near as they do toward achieving a satisfactory allocation of productive energies amidst the million channels into which these energies might flow. Prices are the source from which family Income is derived, and the means by which goods are obtained for family consumption; for both Income and the cost of living—the jaws of the vice in which the family feels itself squeezed—are aggregates of prices. Prices also render possible the rational control of economic activity by accounting; for accounting is based upon the plan of representing all the unlike commodities, services and rights with which an enterprise is concerned as buyer or seller in terms of money price. 6

Most important of all for the purpose of explaining interest as a net exchange value product in terms of money price, “the margins between different prices within the syst-em hold out the prospect of money profit, which is the motive power that drives our business world.” 7 price is an objective fact and an explanation of interest as an exchange value or price problem can be scientifically proved or refuted.

Before stating our thesis it may be well to add that in trying to account for the existence of interest as a net exchange value return, we shall not purposely consider the social problems related to it; nor shall we purposely attempt directly or indirectly to justify or condemn the institutions which make it possible. That is, we shall not consciously express any economic or social philosophy of interest. This does not mean that we think that the field of economic studies would gain by an abandonment of economic and social philosophy. On the contrary, we think that the field is so intimately related to the problems of human welfare that both science and pnilosophy should have a place v/ithin its bounds. _t is the function of economic and social philosophy to evaluate the known facts and principles. It is the function of economic science to discover new facts and principles. While the philosophy should make use of such facts and principles as are known, it seems to us that original efforts to discover new facts and principles may well be disassociated from philosophy.

1 . Lorenz, and Xoung, Outlines of Economics, 4th edition, pp. 491, 492. 2 Bohm-Bawerk, Capital and Interest. Smart Trans. pp. 1-10. " ’

3 Taussig, F. W. , Principles of Economics, p.nd -Rid Vol. 11, p. 4. ' — J.Q.,

4 Aristotle, The Nicomachean Ethics, Book V, Chanter VIII, Yfelldon Trans. 5 Idem.

6 Mitchell, Wesley C., Business Cycles, The Problem and Its Setting, p. 116. ——“ Idem.

2. Our Thesis Summarized

We regret that we cannot state our thesis in a single declarative sentence. Other things being the same, a simple explanation is better than a more complex one. But we find that interest Is a highly complex rather than a simple problem. What we have is really a series of related theses and a corresponding series of related explanations; but this relationship does not mean that our theses must all stand or fall together; the proof of refutation of any one of them does not completely prove or refute any other. They are stated here merely to indicate the general course of our discussion.

First, the marginal costs of agricultural and non-agricultural products are determined in exactly the same way. A farm or other income-producing business is at the margin of discontinuance when its gross income is barely sufficient to cover all operating expenses, including depreciation, or at least all necessary replacements , and interest at the market rate on that part of the investment which can be economically withdrawn and invested elsewhere. Generally, it is the working capital that can be partly or entirely withdrawn. There is no net income, no interest, attributable to the fixed investment of a business operating at the margin of discontinuance, Whether it is an agricultural or a nonagricultural enterprise does not alter this principle. Price tends to coincide with the margin thus determined.

Second, the margin of entry into the productive field is at that point where the anticipated net returns on tne investment costs as a whole are barely eoual to

interest at the market rate.

Third, there is no tendency to equality of rates of net returns in industry. Each business enterprise tends to expand until it reaches the point where the greatest net returns are secured. This principle is called the law of efficiency of output. But concerns reach this point with very unequal average costs per unit of output. This gives rise to differential return's which are practically as permanent in non-agricultural industry as they are in agriculture. All supramarginal businesses seem to have an intensive margin.

Fourth, these differential returns are opportunity costs of production at the margin of transference; but the opportunity cost is not always equal to the different ial, for it can never be greater than the opportunity foregone.

Fifth, the margin of productivity depends upon the demand and supply of loanable purchasing power. The demand depends upon the investment opportunities possessed by the borrower. In a progressive economy, many new inventions and discoveries, changes in the quantity and the quality of population, changes in national and international policy, and so on, are continually taking place, ihe result is a constant shifting of demand and supoly relationships, which gives rise to new investment

opportunities. At the same time these changes force many businesses to discontinue, or force them to the margin of discontinuance. Now, the capital that is already sunk in the form of fixed capital goods cannot be economically employed in taking advantage of new investment opportunities, except to the extent that it enjoys alternative productive possibilities. Generally in our specialized economy, only new r savings whose equivalent in money is still in the hands of the saver or his agent, are available for use in setting labor and existing equipment to getting the new forms of capital goods needed to take advantage of the new opportunities. This supply of loanable purchasing power can come only from individual and institutional savings. Only that part of the total savings which is offered for loan directly affects the rate. The most elastic part of the supply of loanable purchasing power first takes the form of bank credit, and is sometimes called forced saving. But neither the individual nor the commercial banking, institution can expand loanable purchasing power at will. This is well understood in the case of the individual or the non-banking business institution. But banks are also limited. They have their costs of production. All things considered, banks tend, just as any other business, to keep their output, or their credit, expanded to the

point where they get the greatest net returns, which point, however, is a moving instead of a stationary one. Thus at any time the supply of loanable purchasing power is limited; and the demand for it is so great, in a progressive economy, that all of it is disposed of to those offering more than a zero rate of interest. Now it all tends to be disposed of in the same market at the same time at the same price, because dollars are interchangeable. The rate of net productivity imputed to marginal investments in economically mobile capital goods tends to coincide with the market rate of interest; but in the case of investments sunk in fixed capital goods—except at tne margin of entry--there is an absence of any such coincidence, which gives rise to differential returns or imputed differential productivity. It is the function of tne rate of interest to guide economically the flow of savings*

Sixth, because of the interest rate for the use of loanable funds, all future incomes are discounted at thi*- rate; or the market price of future incomes is determined by discount and capitalization.

The remainder of this monograph is offered as an outline of an explanation of these propositions. We do not expect to prove them to the entire satisfaction of

every one. We cannot expect to settle the problem of interest once for all. We do hope to offer a better explanetion of why Interest exists than has been offered so far.

CHAPTER II BUSINESS AND CAPITAL

1. Business. 2. Capital and Capital Goods: (1) Capital. (2) Capital goods.--Fixed capital goods.-- Land.--Buildings and equipment.--Intangibles. (3) Working, or circulating, capital goods.

It is unnecessary that we discuss the nature and advantages of the capitalistic as compared with the direct method of production. Adam Smith B and have ably treated this fundamental aspect of capitalism. A host of able writers have brought the subject down to date. Here our problem is primarily one of class ifying and defining capital from the point of viev/ of exchange value income. In doing this, we shall first give attention to the business unit, which is a complex of income-producing property. Second, we shall define and classify capital and capital goods. This order of procedure is followed because we want to emphasize the fact that an individual item of capital has no value except for use in connection with other capital necessary to constitute an income-producing unit.

8 Smith, Adam, Wealth of Nations. Bk. I. 9 : Bohm-Bawerk, Positive Theory of Capital, Bk. 11.

1. A Business

The fundamental economic unit of modern industrial society is the business. But what is a business? Certainly it is not an absolutely free and self sufficing unit. Hobson says:

The Intelligent observer studying his own business from inside, and others from outside, will soon see that the true size and limits of a separate business can best be determined by watching the element of management. Is there practically independent management, and if so, what is the area of his control? is the Important question to him. If a manager of a factory or a shop receives his orders from the outside, or in other important ways is instructed in the use to which he puts his employees, his machinery, etc., and in the buying and selling essential to his business life, it becomes evident that such a factory or shop is not a complete business, but only a part of some larger business.lo

Many a business which appears independent to the uninformed outsider.is tied by holding companies, contracts, and the like. However, "here, as elsewhere, liberty is a matter of degree. But at present it must suffice to say that substantial independence of management constitutes a business; where the employer has substantial liberty in buying and selling and arranging his factory or shop or warehouse," 11 or his farm or office or studio and so forth, "as he thinks best, we call that a separate business."

A business is run by and for some person or persons; but it is always distinct from those by and for whom it is run; and also, it is different from the government which protects, favors, or limits its activity. And whether it is large or small, whether it produces tangible or intangible economic goods, whether its productive property is largely tangible, as that of a farm, or intangible, as that of a bank or insurance company, does not alter the fact that it is a business--something different from labor and government.

Now in accordance with this three-fold distinction, the whole gross income of society is divided into three great divisions. The first is a reward to persons, and we call it the wages of labor. It is the payment for mental and physical services which cannot be sold apart from the person of the laborer. It may be a contract wage, as that in the case of the common laborer or salaried employee; or it may be at least partly a residual share for the services of the owner-manager. In the latter case, it is difficult to separate the wage from the reward to capital. Nevertheless, in such an instance, it can be allocated by imputation. Of course, for a detailed treatment of the problem of wages, it would be necessary to distinguish between unskilled labor, craftsmanship, professional service, management.

and the like; however, in no case should the nominal services of the absentee security owner be regarded as labor, for that is a service of the capitalist as such. But we shall not discuss wages in detail.

The second division of the income of society goes to government, and is called taxes. Indeed the separate governments--as the national, the state, and the municipal governments—may be thought of as great businesses; but we do not so regard them in this study. They are not typically guided by the profit motive, although there are instances where the government goes in business primarily for profit instead of service. If a government owns and operates a power and light plant for profit, we call this a business instead of a government activity. But generally the state is not motivated by the hope of profit. It has no net income, and its gross income is derived from taxes. If the services rendered by it are in some way worth more than they cost--and we think that they usually are--the net gain in terms of utility or money-making opportunity goes to private individuals and businesses. For this reason, in accounting for the existence of interest in industry, the state should be regarded as something economically different from the Individuals and business institutions over which it exercises legal

authority.

The third division of the gross income of society goes to business. The other two divisions may be regarded as great streams flowing from business enterprise However, this does not mean that in the final analysis, wages and taxes are a drain on the net income of business. Obviously the net income of business would not exist without labor and some kind of government. What we mean is that our whole economic system, our entire economic life, revolves around business institutions.

Furthermore, in our present society, the exchange value forming process, or at least the expression of it, is centered in business establishments. If a man wishes to sell his labor, he must either sell it to a business or become a personal servant or government employee. If he wishes to buy something for his personal consumption or for use in his business, he must buy it from a business. Typically in our specialized economy, a business is engaged in purchasing and combining many varieties of labor, natural agents, other material goods, and sometimes special privileges or fortuitous advantages into a few finished or semi-finished economic goods.

Nov/ the whole economic product of society, except that which is represented by direct payments for government services, flows into the hands of business men, who are compelled by legal or economic necessity to divide it into three parts; the first going to labor, the second to government, the third being retained by the business.

The business--that is, the farm, the store, the factory, or the establishments engaged in rendering personal services--is the residual claimant. The residual share belongs to the legal owners of the business, according to their property rights or equities in the business. It is presumed, and we think that it is usually true in practice, that wages are hardly residual even in the case of the owner-operator farmer or other so-called independent business men. Biological necessity and the standard of living tend to cause the owner-operators to withdraw a part of the gross income as wages without waiting until all other claimants are satisfieu. If they are entitled to a larger wage than they withdraw, it may be difficult, as we have stated, to separate this wage remainder from the reward to capital, except by imputation. The recent tendency is for owneroperators to pay themselves a salary commensurate with their ability and the prosperity of their business. This practice avoids many accounting difficulties. Here we do not maintain that the dividing line between labor and capital incomes is always clearly defined in

practice. We do contend that it generally is.

In practice, the owners of equities in business regard themselves as claimants of the net income. If, during any accounting period, the business has paid out and used up less than it has taken in, the difference is the net business income, the interest or business profit, for the period. No more than this net income for the period, or net income remaining in the business from previous periods, can be taken from the business without encroaching upon the original investment. The residual claimants actually get only the Interest, or business profits.

It will be noted that we employ “interest” and ’’business profits” as synonymous terms. We do this because, as far as this outline is concerned, we have no theory of pure-profits. It seems to us that the various theories of pure-profits have been developed in an effort to refine the theory of interest. We do not aim at any such refinements. In taking this attitude we are following the precedent set by many English economists, including the late Alfred Marshall. We are also following the scientific socialists and business practice. In criticising this attitude, F. H. Knight says that the use of the term pure-profits “is still some what loose in England, as is seen in Marshall. Even in this country the development of corporation accounting,

while separating the wages of management from profit, has tended to a new confusion of profit and interest.” We do not attempt to pass judgment on the question whether corporation practice has added or avoided confusion. We agree with Bohm-Bawerk, who said:

The discussion forms the subject of an independent problem--the problem of Undertaker’s Profit. The difficulties, however, which surround our special subject, the problem of interest, are so considerable that I do not feel it my duty to add to them by taking up another.l4

t/hy can the business man conduct a business so as to get this interest or business profit? We cannot begin to answer this question until we have analyzed the business--at least in outline.

10 Hobson, J. A., The Industrial System, Revised Ed., pp. 3, . 11 Ibid, pp. 3, 4. 12 Ibid, p. 4.

2. Capital and Capital Goods

Of what does the business consist? Capital; but what is capital? Y/e begin our answer with the trite statement that there are two concepts of capital. One is the money or exchange value concept; the other the goods concept. We hold that both concepts are logically consistent and of practical and theoretical value in a study of economic proolems of present society, and that their use does not necessarily lead to double counting. Every balance sheet of business is an example of this. Not only

are assets and liabilities balanced against each other; but on the left hand side of the respective columns of assets and liabilities is expressed the goods conception as land, machinery, and so on. Immediately to the right the actual or Imputed money value of the goods is entered. Whenever it is necessary to distinguish between the two concepts, we shall refer to the money price or exchange value of the capital goods as capital and to the goods themselves--whether tangible or intangible --as capital goods.

13_ Knight, F. H., Risk, Uncertainty, and Profit , p. 25. Bohm-Bawerk, Capital and Interest, Smart Trans«, P • 9 *

(1) Capital

.--The productive property of the business includes such things as land, buildings, machinery, inventories of raw and so-called finished goods, cash on hand, accounts and notes receivable, and various other tangible and intangible goods. The difference between the money prices of the assets and liabilities (other than capital liabilities) of the business is the net capital or equity belonging to the security owners or proprietors. No general distinction is made between land and other property used by the business. Nor is there any fundamental distinction between tangible and intangible property. Any property

necessary to enable the business to get the maximum net income is as legitimate as another from the point of view of exchange value income. There is no Physiocratic distinction between the agents of production, nor is there any metaphysics in the matter. A kind of specific exchange value productivity standard is employed. The use of more or less cash in the business undergoes the same empirical test as that of more or less buildings and machinery.

It is not without reason and convenience that all business property is reduced to a common denominator and entered on the books of businesses as so many dollars* worth. Not all economists have overlooked this advantage of summarizing capital in terms of exchange value. For example, J, B. Clark has adhered to a distinction between capital and capital goods. 1 * 5 Taussig recognizes the practical advantages of such a distinction. He says:

It is often convenient to measure and record capital in terms of value and price; --as so much money. In that way alone can the various constituent elements be reduced to a common denominator. An individual usually states his capital as being so much in money value. His capital obviously consists not of the stated sum of money, but of factories, machines, buildings, merchandise, stocks and bonds, if you please--

the various things which make up an individual’s ’capital*. He simply measures it in terms of the price for which the whole would sell. Similarly, we can reckon the community’s capital in terms of the price for which the whole would sell. If the total price, at current rates, of the various factories, instruments, materials, goods in stock, are added together, the sum will give an idea of how much capital the community possesses. It would give a very imperfect idea. Statistics of this sort, occasionally collected by public officials for census purposes, are in many ways misleading. Yet if we wish to measure total capital or total wealth at all, we can proceed only in this unsatisfactory way. Though some forms of capital can be measured in other terms, — machinery, for example, in terms of horsepower, or textile mills in terms of spindles and looms, — the only measurable element common to all forms is that they have value and price, and the only way of reaching a quantitative statement as to the whole is in terms of value and price. l ?

Now it would be a surprising phenomenon indeed if, in a money and exchange economy, the property used in production and distribution were not summarized in terms of exchange value. We are not inventing a new term at all when we refer to the value or price of income-producing property as capital, and whether we refer to the original cost price of capital goods, their replacement price, or their price arrived at by capitalization of net earning will be made obvious by the context or by specific statement.

15 Dewing, A. S., The Financial Policy of Corporations , pp. 453, 455. “

16 Clark, J. 8., Distribution of Wealth, Chapter IX.

(2) Capital Goods

But there can be no exchange value apart from the evaluator and the good evaluated.

Now, the business man seems to work from the price to the thing priced, for nothing has any business reality to him unless it has exchange value while on the other hand, the economist seems to proceed in the opposite direction. He approaches capital from the point of view of a hypothetical primitive economy. He assumes that capital in a specialized economy is the same as that in a self-sufficing economy, an assumption which is certainly in part fallacious. The primitive fisherman’s net and hook have value because, by first making nets and hooks, he secures more fish with a given amount of labor than he could by the direct method. Fortunately, v this analogy is by no means wholly untrue for present society. But more exchange value and not more "fish” is the motive back of specialized production. It may sometimes be more profitable to catch fewer "fish". The contemporary 'fisherman’s” most profitable investment may be employed in purchasing and keeping from use new devices, or in seeing that he has legally the exclusive right to use them.lntangible values are as real as others 20 in a money economy. For this reason, it is safer often to look for the price first, for the thing priced may be difficult to locate or determine. Nevertheless, the economist usually works from the concrete good to exchange value. Quite naturally he often fails to see any but the value of tangible goods, and the intangible capital entirely escapes him. Hence his difficulty in getting away from Physiocratic distinctions against which the economists have contended from the time of Adam Smith to the

But we do not make the term capital goods synony mous with property. We distinguish between capital goods and consumers* goods. We must do this because we have limited ourselves to an exchange economy. For example, when the food is taken from the retail store by the housewife it has sold for a price the last time. Exchange economy takes no further notice of its productive use. There is no further expression of its exchange value. But we recognize all property which is productive of exchange value, whether tangible or intangible, as capital goods. A capital good is any item Pi Qr intangible economic property which aids in the production of goods for the market, or which is Itself in process of production for sale in the market,

17 Taussig, F. w. , Principles of Economics. 2nd Ed Vni t pp. 84, 85, *

18 Boucke, 0. Fred, A Critique of Economics, p. 114. 19 Edie, Lionel D., Economics, pp. 258, 259.

20 Veblen, Thorstan, The Theory of Business Enterprise, Chapter VI. 21 Idem.

Fixed Capital Goods

--Capital goods are divided into fixed and working capital goods. Capital is similarly divided. The money price paid or imputed to the first class is called fixed capital; that paid or imputed to working capital goods is called working capital.

Fixed capital goods are not wanted for themselves at all. Their function is to aid in the production of other goods which are wanted for themselves. Land, buildings, machinery, goodwill, monopoly privilege, and the like belong to this class.

They are fixed assets, or producers' goods which can, ordinarily, be neither quickly nor readily sold or evaluated in terms of exchange value. Being producers’ goods, their value is insuperably bound up with the exchange value of the consumers ’ goods they produce. In other words, their value lies in their earning power. 22

All goods which are destined to be sold or used up in a single accounting period in the regular course of business are working or circulating capital goods. Ordinarily they consist of raw materials, partly finished goods, so-called finished goods on hand, notes and accounts receivable, and cash on hand or in the bank. This is the customary classification. We shall occasionally modify this by taking from the fixed

capital goods and adding to the working capital goods ’ category those goods, like railway equipment, which can be economically moved from one establishment to another.

22 * of Corporations,

Land

Land is the leading species of the whole fixed capital genus. Here we do not follow the English classical economists. They considered land something fundamentally different from other fixed capital goods. We do not need this distinction as far as this study is concerned. We approach the subject of capital goods from the point of view of income, as did the German economist Hermann.

He goes back to capital as the source of income, and makes this the object of his definition: Capital, he says, is ’every durable foundation of a utility (Nutzung) which has exchange value‘.24

*lmmaterial capital’ is also admitted, consisting of trade secrets, special privileges, etc. ’Personal capital*, however, he rejects on the ground that it cannot be exchanged and that the motives which lead to the production and education of men are different from those which obtain in the production of g00d5. 2 5

Manifestly there is. nothing in Hermann’s defi nition to prevent the inclusion of 1and....26

Hermann also distinguished between capital goods and their value, but it is not always clear what he means by 27 their value. The American economist, J.B. Clark, also regards land as a form of fixed capital goods. Like these economists, we find no fundamental differences between land and other forms of fixed capital goods from the economic point of view.

Bohm-Bawerk says

The theoretical explanation of rent from land. . . coincides. . . with the explanation of interest obtained from durable concrete capital, and land rent is nothing but a special case of interest obtained from durable goods.

He adds in a footnote:

Quite lately Carl Menger. . . has ably put forward the necessity of a comprehensive ’universal theory of returns to wealth. ’ I trust that in the contents of the present chapter (on interest from durable goods) he will see an earnest attempt to develop such a theory. 29

However much our explanation of interest may differ from that of Bohm-Bawerk, we agree with him that the net income obtained from the use of land and other durable, or

fixed, capital goods is explained by the same principle.(a) Cannan is of the opinion that economists who suppose ”land itself to be significantly different from humanly constructed capital” are now ”the exception.”3o

23 Hermann, Friedrich Bened. Wilh. v., Staatswirt schaftliche Untersuchungen, (1870), pp. 224-307. Bohm-Bawerk, Positive Theory of Capital, Smart Trans., p. 31. " 25 Haney, L. H., History of Economic Thought, Revised Ed., o. 507. — “ 26 Idem.

27 Bohm-Bawerk, Capital and Interest, Smart Trans., pp. 195 n, 196 n. Also, Haney, L.H., Op. Cit., p. 508 28 Clark, J. 8., The Distribution of Wealth, pp. 338-344. 29 Bohm-Bawerk, The Positive Theory of Capital. Smart Trans., pp. 355, 357 n.

i in she$ he case of other fixed capital goods, land is limited in supply. Like other capital goods, it is broken up into sub-groups. Some is devoted to one line of production and some to another. J. B. Clark says we should guard against ”noting the quantity of all land, as an all around agent of social production, and that of capital (goods) employed in a particular subgroup. In the one we are taking a social view, in the °^ er 4-? local . view. ”31 We should ”compare” all land with the capita,! goods; «let us take all society into the field of view. In every group and sub-group there is e r ry One there is the form of artificial instruments. Neither the one agent nor the other can be increased in the aggregate at will. At any one time, the amount of artificial capital in existence is as fixed as the amount of land.” 32 existence is as ”Land is, in an economic sense, mobile: since we can cease to use land for one kind of production and devote it to another.” 33 In the same way we take other capital goods out of one sub-group and nut them nn another as far as they have alternative uses. But we can quickly increase the supply in one sub-group ”onlv by diverting capital from other forms of investment *34 Here we agree with this quotation from J. b! Clark specialized toat^t^a^ 8126 that much ca Pital so .eciaiized that it has few or no alternative uses. The aggregate of land can be increased over a

30 Cannan, Edwin, "Land and Capital” American Review, March, 1930, p. 78. an Economic OX J. 8., Distribution of Wealth, p . 339> Idem. 33 ibid., p. 40. 34 Idem.

Buildings and Equipment.

--Under this title is included 11 factories, warehouses, stores, and other buildings and allied structures; tanks, vats, blns, etc; lathes, presses, drills, trucks, cranes, and other machines, tools, vehicles, appliances, and fixtures; patterns, molds, dies, (in so far as these are relatively durable); and adding machines, desks, filing cabinets, etc.” 35 Practically every small business has a considerable number of this sort of assets. Almost any large business has so many that operations are little disturbed by the wearing out and replacement of a single one. Even new

building are erected, and old ones remodeled or abandoned while the business continues to operate about as usual.

This is not saying that individual items of capi tai goods are of no importance. The abandonment of an old locomotive and its replacement is a matter of some importance even to the largest railroad., for example. We want to emphasize, however, that almost every business has so many individual items of fixed capital goods that the purchase of a new one is by no means the same as the replacement of the business; or that the replacement of some individual items may be profitable under conditions which would make the replacement of the business as a whole economically impossible.

period of time. Sometimes economists think of land as the materials and forces of nature; at other times they think of it as land used for agricultural and building purposes. The fallacy of regarding land as unique from uhe first point of view was pointed out by Say. 36 All that we can do is to move the materials about and cooperate with certain natural forces in securing desired ends. But nature aids the inventor and the ooerator in manufacturing and transportation, just as those in agriculture. Manufacturing as well as farming depends upon nature. This conception of land is too general to ue worth anything. For example, we want to know if the supply of agricultural land can be increased over a period of time. Phat can one mean by the economic supply of agricultural land? It can mean only the power to produce agricultural products. An increase in the economic suop y of land can mean only an increase in the quantity of agricultural products which we get with a given quantity of labor and other capital. Cassel says: general isposition to think of land as not producible is chiefy due to the fact that the matter is regarded more

35 Paton, h. A., Accounting. p. 264. 36 tot 3 U d r econonile politique (Paris, 1014;, Vol. 11, p. 3. —

from a physical rather than an economic point of view. From the economic point of view the land is not merely a piece of earth. It includes various physical and economic properties, such as Its fertility, its connection with the markets . . . These properties can be created to a great extent by productive activity, and are so produced as soon as the conditions of the market makes it profitable.“ 37 However, Cassel says: As regards the effect of price on the supply, there lr in the case of the use of land the special feature that land provided in nature is in a sense fixed once for all, and therefore independent of prices.“3B Agricultural land is not fixed in supply in"this sense, as Cassel contends. Upkeep and replacements are as truly necessary expenses In the case of agricultural land as they are in the case of other fixed capital This is Hobson’s view. 39 Likewise Cannan holds Fertility is producible’ and ’original’ fertility, if any,is destructible. i,4U ~ , , '’^ s 1:0 urban land, it is particularly notable that whole garden cities are now produced.“4l A change in transportation facilities or city zoning laws or ±ashion may make and unmake urban real estate exchange values. °

37 Cassel, Gustave, A Theory of Social Economy, McCabe Trans., pp. 257, 258. ~ 38 Ibid, p. 263. 39 Cannan, Op. Cit. , p. 78. Idem. 41 Cassel, Gustave, Op. Cit.. p. 278.

Intangible Fixed Capital Goods

—All fixed, capital t goods derive their exchange value—and hence their very existence as economic goods--from-their power to aid in producing goods which are sold at a price to final consumers. If we keep this general definition in mind, much of the customary distinction made by economists between tangible and intangible capital goods disappears* Why will a business man buy a machine? Because it will aid him in securing an income. Why will he buy a patent? Bor exactly the same reason. Patents, trademarks, copyrights, goodwill, and franchise, are all intangible, they are often the source of great income and are bought at fabulous prices.

Are these not monopoly privileges? Certainly some of them are. But we can hardly rule them out as exceptions, when most industrial enterprises own or rent several of them. Sole proprietorships, partnerships, and "almost every corporation utilizes something covered by a patent . . .

The franchise is another example of privilege. Seligman says:

A franchise of an individual or corporation is therefore simply a prlvilege--somethlng over and above the value of the (tangible) property, and in a measure analogous to the ‘goodwill* of a firm. It is the indefinite something which gives vitality to the enterprise and makes itsbusiness worth having. 43

Bennet says:

The business has material property of a certain definite value. It also has profitproducing power beyond mere interest and replacement returns on the material value of the capital and property invested. This is the goodwill; and the price for which a business is sold will, of course, include this goodwill . . .

"Goodwill is commonly regarded as a fixed asset since it represents a definite capacity for In many cases goodwill and trademark, which is difficult to separate from goodwill, 2^0 are the most highly valua ble capital goods possessed by the business. For example,

ihe Royal Baking Powder Company, when amalgamating with its competitors, is said to have valued the goodwill carried by the word ‘Royal’ at #12,000,000. The annual report of the B. F. Goodrich Company carries the item of ’goodwill’ at #57,789,000, while real estate, plant, etc. are valued at #12,679,150, and patents at $583,

Now we fully recognize that the valuation of intangible capital goods is highly difficult* Even their existence is often a matter of dispute in the case of well established firms. Often goodwill income is difficult to separate from wages. In this connection, we positively cannot regard as goodwill of the business anything which cannot be sold apart from the present owners. If a certain earning capacity accompanies persons, it is a personal something, and the earning which it secures is a wage. Nevertheless, intangible capital exists, and it is necessary to determine its amount in the case of the sale of a business, assessmexit for purposes of levying a property tax, and in many cases of legal procedure. Edie says:

This modern invisible capital is commonly discussed under the broad term ’goodwill*.

He adds further:

No matter how intangible or Immaterial goodwill capital may be, it must be admitted to the definition of capital if we are to face at all the realities of the present business world.4B

Intangible capital would be much less difficult to understand if we could rid ourselves of the idea that any business can be duplicated easily, and therefore its exchange value is equal to the summation of prices of the tangible equipment and labor necessary to erect another business just like it. The trouble with this kind of reasoning is that a going business usually consists of more or less than the summation thus arrived Nor can we rely upon historical costs when we are looking for income-producing property. Seligman says:

. . . no one would assert that the original cost of corporate property bears any necessary relation to the present value, much less its present earning capacity.s°

He further adds that this ’’method is so obviously unjust as to deserve no further mention” in determining capital value for taxation purposes.sl Perhaps Seligman would nevertheless refuse to recognize

intangibles as capital goods. But we see no reason why, in present society, intangible capital goods should not be fully recognized by the economic theorist.5 J

But land has this peculiarity: it may be abandoned recla imed. We cannot so well do this in the case of buildings and machinery. This difference is physical primarily, but has some economic significance.,

42 Seligman, E. R. A., Essays in Taxation, 9th Ed., o. 22 4. ' — “ 43 Ibid, pp. 222, 223. 44 Bennet, R. J., Corporation Accounting, o, 178. 45 Ibid, p. 179.

46 picksee and Tillyard, Goodwill and Its Treatment Accountl ng, 3rd Ed. , Chapters 111 and IV. Bennet, R. J., Corporation Accounting, p. 178.

48 Edie, Lionel D., Economics, pp. 258, 259* 49 Commons, John, R., Legal Foundations of Capitalism, up. 28, 163, 211. 50 Seligman, E. R. A., Essays in Taxation, 9th Ed., pp. 238, 239. 51 Idem.

(3) Working or Circulating Capital Goods.

— One fundamental distinction between working or circulating capital goods and fixed capital goods is functional. J. B. Clark says:

The goods that embody fixed capital can, in fact, be used repeatedly without any change in their economic status, while those that embody circulating capital acquire a new economic status at every use.s4 Some things, like artisans’ tools, help to fit for use the matter furnished by nature. They have an active rather than passive function to perform, for they impart utilities to other things. Machines that transform matter, vehicles that move it and buildings that protect it--all come in this category; and so do all appliances that, in the war between man and nature, range themselves on the side of man and help him to subjugate resisting elements to his use. These instruments constitute the active variety of concrete capital.ss

On the other hand, the materials on which these active goods work are passive. Circulating capital goods receive utilities, instead of imparting them; they undergo modification, and themselves modify nothing.s6 Clark’s classification seems to be essentially the same as that of Adam

The working capital ”is invested in raw materials, in stocks of partly finished and finished products, in accounts receivable, in salable securities, and in cash. Capital in all these forms is constantly being convertedafter whatever alteration in form is necessary--into cash, and this cash flows out again in exchange for other forms of working capital (goods). Thus, it is constantly revolving; or to use a more common expression it is being ’turned over’.”sB

Closely analogous to the functional is the durability classification. G-oods which the business retains possession of but a short time, say a year, are considered working capital goods* Those which last longer are fixed capital goods. Thus coal which is used up, goods which have utility or exchange value added to them and are sold, credit which is extended and the resulting receivables collected are working capital goods. It seems to us that this classification is slightly different from the functional in that it includes items of goods which are used up in the operation of the business in a short time. Clark would say that this is the functional classification, because it Includes the goods that are used only once in the business. We think that this

classification turns upon relative durability instead of function. This is similar to the distinction made by Ricardos9 and J. S. Mi 11,60 though they thought they were following Adam Smith.6l

A better way to approach the subject of working capital goods is from the point of view of expenses of operation. Except for a slight modification, we shall adhere to this classification as far as this study is concerned. All the investment necessary to meet the cost of continued operation is working capital. The original investment in fixed capital goods is already sunk; but the continued use of it calls for outlays for replacements and repairs. The investment which is necessary to buy raw materials for manufacture and for use in the business, to extend credit, to meet all expenses of upkeep and replacement so as to maintain the original investment intact, etc. is working capital. In a particular business as fixed capital goods depreciate and transfer a part of their value to their product, working capital tends to increase; while replacements tend to

restore the original value of the fixed capital goods and to reduce working capital and working capital goods. As we have already emphasized, the typical business has many items of fixed capital goods, While some items are being replaced others are transferring a part of their value to their product, which product is converted into cash, other working capital goods, and replacements, so that the ratio of the value of working capital goods to fixed capital goods tends to remain approximately constant. In practice there is found some fluctuation in the total business investment from one season or period to another, but those engaged in short-time lending take care of the fluctuating needs. This is one function of the commercial banks. Now while this classification of working capital seems difficult from the economic point of view, it is the most workable one yet developed in the business world. This is perhaps due to the well known fact that operating expenses are self-recording and are current rather than long time matters. The whole capital employed in buying materials and meeting operating expenses is working capital, and the tangible and Intangible goods in which it is invested are working capital goods and replacements and repairs.

At this point one of the subdivisions of working capital goods calls for some additional explanation.

This is liquid capital. U shall employ this term in a sense which we think accords with common usage. For example, we shall use it in referring to cash, bank deposits, and other assets which have such general acceptability as to make them practically equal to money. In short, we shall make this term synonymous with money when the latter term is employed loosely. Liquid capital or money constitutes a property right in undesignated economic goods, and for this reason is itself an economic good. This same idea is expressed by “generalized purchasing power”• It can be employed in securing any present or future consumers 1 or producers * goods of exchange value equivalent to it.

Another classiflcation--the one which we shall employ--ls based upon a particular kind of economic mobility. It is like the preceding classification except that we add something to it. Capital goods which can be used only where they are originally installed or can have their site changed only with great loss in exchange value are economically ’’fixed”. The road bed of a railroad, its terminal buildings, shops, and the like belong to this class of fixed capital. Rolling stock of a railroad, trucks, automobiles, and the like, which are usually classified as fixed capital are working capital from this point of view, because their

economic employment is not limited to one place* Here the economic mobility of which we are speaking should not be confused with physical mobility on one hand nor alternative uses on the other. It is physically possible to move either a locomotive or a round-house. Both possess physical mobility, but only the former possesses economic mobility. Its economic site is not fixed. This classification as compared with other classifications merely adds something to working capital and working capital goods and correspondingly moves something out of the fixed capital category. It is important that this classification be kept in mind, for the economic mobility of capital is highly significant in the development of our theory.

When we speak of withdrawing working capital or working capital goods from a particular employment, we shall include in the term working capital goods, such things as cash on hand and in the bank, assets which are turned into cash in a relatively short time in the regular course of their productive use--as inventories, and all equipment which can be moved from one place to another with little or no diminution in its exchange value; while all capital goods which lack this economic mobility are classed as fixed.

52 Seligman, E. R. A., Principles of Economics. 7th Ed., p. 317. 53 Veblen, Thorstein, Theory of Business Enterorise, Chapter VI. 54 Clark, J. B. , Distribution of Wealth, p. 143. 55 Ibid, p. 144. 56 Idem.

57 Smith, Adam, Wealth of Nations, Bk. 11, Chapter I. 58 Lough, W. H., Business Finance, pp. 356, 357.

59 Ricardo, David, Principles of Political Economy, Chapter 1, sec, 4. 60 Mill, J. S., Principles of Political Economy, Chapter Vl* 61 Senior, Nassau William, Political Economy, 6th Ed., pp. 62, 63*

CHAPTER III THE LAW OF EFFICIENCY OF OUTPUT

1. The Motivating Purpose of Business Activity. 2. Means and Limitations. 3* The Law of Efficiency of Output Stated. 4. The Theory of a Moving Equilibrium, or Equilibria.

In the last chapter it was explained that capital, or a capital good, has no value except for use in business. Now now much capital does a business want? Or what determines the size of the business? In answering this question we shall discuss: first, the purpose of business; second, the means and limitations of achieving this purpose; third, the law of efficiency of output.

1. The Motivating Purpose of Business Activity

What is the purpose or end of business activity? ’’There is one end . . . to business activity, and this is already decided upon before the business is founded; that is, to make money. Business profits mean business success.

But Business success gratifies a complex set of desires. In the first place business success means wealth; and wealth means economic, social, and, to a

large extent, legal security. In our present society neither physical strength, intelligence, education, skill, special aptitude, talent, nor genius, unless directed to money making, furnishes security in any way comparable to that which accompanies the possession of great wealth. Men desire security for their families, themselves, and their friends. Profitable business gratifies this desire.

But why should one wish to accumulate beyond the amount abundantly sufficient for security: Why does one wish to build a bigger and better business (if he does)? Dewing lists the ambition "to be somebody, to occupy *a place in the sun’ in the business world” as the chief motive for business

The race-old instinct of conquest becomes translated in our twentieth century economic world into the prosaic terms of corporate growth. Business expansion is the spirit of a modern Tamerlane seeking new markets to

But we cannot agree with Dewing that mere size is the most ostensible sign of achievement. Large business profits,' or net returns, rather thsn the possession of a large quantity of buildings and machinery or large output, is the goal whose attainment gratifies the

business man’s ambition

Also, it is said that business activity is the result of the creative impulse instead of the result of the desire for business profits. This seems to be an application to business of what Ratzenhofer has called the transcendental interest and Veblen has called idle 66 curiosity. Nov/ some men undoubtedly have a desire to create a business, just as others have a desire to paint a picture or write a book or invent a machine. But the creative genius wishes to produce a masterpiece, and the business masterpiece in present society is a great money making establishment.

Finally, there is the stewardship of wealth idea of the profit incentive. Business activity is looked ' upon as a moral or ethical duty. In modern business it is not practically possible for all capitalists actively to participate in the management of business. Some of them entrust their capital to other capitalists. Bond holders, preferred stock holders, and many common stock holders are in this class. Also, general creditors of a business have some legal interest in it, but no

active control. Now the interest of these non-managing security holders and creditors is best served by the profitable employment of the capital which they have entrusted to the business. Or it is often said that the business man is responsible morally or ethically for the right, perhaps we should say righteous, use of the wealth in his possession. He should use it for the greatest common good. When this idea is coupled with the acceptance of the utilitarian doctrine of the identity of public and private good, it logically leads to the conclusion that the business man ought to make as much net returns as possible for himself and the business in order that the community, or his fellow men, will receive the maximum of benefit.

Furthermore, it is generally believed that capitalism is good as compared with any other kind of economy which is practical at present. This leads, consciously or unconsciously, to the conclusion that capital ought both to maintain and increase itself. Of course, one may personally reject the business philosophy sketched in this paragraph. But certainly the business man who adheres to it may logically regard his profit motive as unselfish.

There are exceptions, but we think that the ortho dox theory of net gain, or money making, as the end of business activity, is well founded. This theory is in no wise invalidated when we say, in a general economic treatise, that consumption is the ultimate end of social production. Of course, all goods which are produced are consumed; but in a specialized economy we produce that we may get a money income, which we may or may not spend for goods for personal consumption. In this study we are not interested in a theory of consumption. We are interested only in that money or exchange-value income known either as business profit or interest. For our purposes the end of business activity is business profits, using the term profits as synonymous with net exchange value returns to the business.

62 Knight, F. H., Risk, Uncertainty, and Profit, p. 292

63 Dewing, A. S., Financial Policy of Corporations, p. 635* 64 Idem.

65 Ratzenhofer, G-ustav, Sociologische Erkenntnis, pp. 64-66. —— — 66 Veblen, Thorstein, The Instinct of Workmanship, P. 87. — " —

67 Dewing, A. S. , Financial Policy of Corporations, p. 636.

2. Means and Limitations

The means of establishing a successful business are the factors of production, labor and capital; or if land be not classed as capital, the means are land, labor, and capital. The limitations encountered in the establishment of a successful business are the tendency to diminishing quantity productivity and the tendency to diminishing vendibility of output.

There is an optimum quantity of output for any business. This is the output which it produces with least average costs per unit. But the greater the quantity produced, the less the price per unit at which it tends to sell to consumers. The purpose of the business is to make profit; and efficiency of business depends not upon the optimum scale of operation from the point of view of costs per physical unit. Boucke concludes: “So it is best to define productivity as net (business) profit per unit of article or service turned out. The optimum scale of business operation is that which affords the greatest difference between its total costs prices and its total sales prices.

Economists have not denied that the two optima do not necessarily coincide as far as agricultural and monopolistic production is concerned. Cultivation of the supra-marginal farm is pushed beyond the point of lowest cost per unit of output. The monopolist may find it profitable to stop expansion of output before the point of lowest cost is reached. But it is generally contended that under conditions of conpetition, the optimum of quantity productivity and the optimum of profit or net exchange value productivity coincide. At this point, we neither accept nor reject the generally accepted theory of the identity of the two optima, for this is considered elsewhere.

Just now we are most interested in the tendency to diminishing productivity. But why use the term “diminishing productivity” instead of the older term "diminishing returns”? Because the term ’’diminishing returns” has been employed in two different senses. The classical economists developed two “laws” of diminishing returns in agriculture. The first applies for short periods of time and the second for long periods. Neither the classical nor neo-classical economists have always carefully distinguished between the two.

According to the first ’’law”, at any given time the net returns resulting from the cultivation of the poorest land in use, or from the final outlays on better land, are barely equal to interest at the "common rate” on the capital employed, the poorest land in cultivation having no net income attributable to it, and therefore having no exchange value. Other things being the same, the quantity of agricultural products cannot be increased except at increasing costs per unit, for either poorer land must be taken into cultivation or relatively less productive outlays of capital and labor must be made on land already in cultivation.

The second classical theory of diminishing returns in agriculture is not so much like the first as the

classical economists probably thought. According to Ricardo, the theory of long time or secular diminishing returns rests upon the Malthusian ’’law" of population. It does not depend upon a denial of absolute improvements in agriculture, but only upon a denial of relative improvement; or a denial that improvements will keep pace with the increase in demand. Ricardo specifically recognized as an improvement in agriculture any invention or discovery which either increases the productive power of the land itself or makes it possible to get the same quantity of products from the same land with the use of less labor and other instruments of production. He says:

Improvements in agriculture are of two kinds: those which increase the productive power of the land, and those which enable us, by improving our machinery, to obtain its produce with less 1ab0r.69 The improvements which increase the productive power of the land Itself, are such as the more skillful rotation of crops, or better choice of manure.<o

Improvements of the second class are such as result from the use of improved plows and threshing machines and better knowledge ’•of veterinary art. ,, 71 Nevertheless,

Ricardo and the other classical economists held that the marginal costs of producing food increase over a period of time; that there is a tendency to secular diminishing returns in agriculture. According to them, every improvement ’’gives a great stimulus to population and at the same time enables us to cultivate poorer lands. . . ” This doctrine, or ’’prophecy”, is merely a statement of the Malthusian ’’law” of population. Improvements tend to make it possible to increase the food supply slowly, or arithmetically; while the population tends to Increase more rapidly, or geometrically.

But suppose that during a period of time the marginal labor and capital costs of obtaining a given quantity of the means of subsistence due to improvements, while the population, and therefore the demand, Increases less rapidly. In this case there is a tendency to secular increasing returns. This is what has happened in Europe and America during the last hundred years. 7s Because of this historical trend, we cannot accept the second classical ”law” or doctrine of diminishing returns, while we do accept and extend the

application of the first, which we call the law of diminishing productivity.

If we should call one of these the law of dimlnisning returns and the other the law of secular diminishing returns, we would have difficulty in keeping our nomenclature straight, because both of our summary expressions would contain the term, “diminishing returns” For this reason, we shall follow Clark and call the first diminishing productivity. This terminology has 74 also been adopted by Ely, Adams, Lorenz, and Young. And unless the context clearly indicates the contrary, we shall always mean diminishing exchange-value productivity.

Does this law of diminishing productivity apply to non-agricultural businesses? Neo-classical economists generally say that it does, notwithstanding the fact that they have made little use of it in explaining net productivity in non-agricultural industry. One popular text states it as follows:

Not only in agriculture is the lav/ of diminishing productivity fundamental in determining the proportion in which the factors of production are combined. Every manufacturer has the

option of using either relatively more machinery and relatively less labor, or relatively less machinery and relatively more labor in order to produce a certain quantity of goods . . . The entrepreneur in every kind of undertaking has to decide as to the advisability of a particular investment in land, capital goods, or labor, with reference to the fundamental question, ’will it pay’? And the profitableness of any such investment is always a matter of the cost of the unit of land, labor, or capital good, as compared with the selling value of the quantity it will add to the entrepreneur’s total product.7s

No writer has made greater use of the law of diminishing productivity than J. B. Clark, with the possible exception of J. A. Hobson. 76 According to Clark, every business man adds units of each productive agent until the point is reached where further additions will not pay. The productivity of the last unit of any agent is the final or marginal productivity per unit of that agent.

His whole theory of the distribution of income depends upon the law of diminishing productivity. It applies alike to land, labor, and capital.

(5) F rom this his son, J. M. Clark, has developed the law of the proportion of factors. 77

...land apportions itself among the different groups and sub-groups, until it is as productive in one as it is in the other. It has to be moved freely from sub-group to sub-group ( that is, transferred from one alternative use to another) until this equality is attained, and the same is true of artificial capital and labor... An entrepreneur in the shoe making business, for instance, has occasion to know, first, how many more cases of shoes he can make in a year if, without changing his capital in quantity, he gets a few more men in his mill. Again, he has occasion to know how many more shoes he can make in a year, by adding a few thousand dollars to his general capital... Within the sub-groups, or specific industries, productive agents have to be coordinated with each other-- the quantity of each has to be determined; and the first thing that determines this coordination is the specific power of each agent to produce goods.7B

Into this adjustment, moreover, value enters... The power of each agent to produce a commodity is one factor and the value of the commodity is anotner factor; while the working of the two together determines how much of each agent there shall be in each sub-group. Each general agent of social industry is, in short, subject to a law of uniform final productivity— measuring products in value, and not merely in kind-- in all the different uses to which it is put. 79

Two other American economists who have made contributions to the theory of dimishing productivity should be mentioned at this point. They are F.H. Knight and A.S. Dewing. They came forward with able articles on the subject of increasing and decreasing productivity at a time when there was much onfusion among American economists.

On account of the rapid progress of economic development in America, business men have tended to erect plants "with an eye to the future". Very often, if not typically, the capacity to produce has been in excess of present demand. As the "market is enlarged and as output increases, costs per unit will fall, because the supplementary (fixed) costs will be distributed among more units of product.F. H. Knight has particularly stressed this.® 1

But before Knight*s article appeared, Dewing had published his “Law of Balanced Returns".® 2 He made studies of several industries and found that there tends to be a "right size". He found that those industries in which fixed capital costs are large as compared with labor costs, tend to be characterized by lagre scale production* Thus the establishments manufacturing structural steel tend to be large as compared with establishments manufacturing steel instruments. He secured evidence showing that at any given time there is a point

in the expansion of a business beyond which further ex pansion does not pay. He states the law of balanced returns as follows:

The ratio between the quantitative values of labor and fixed capital in any unit of product determines the point at which increase in the scale of total production ceases to be economical . . .S 3

Dewing thinks this law is of great practical and theoretical value. First, "it indicates vzhether a business is better adapted to large or small scale production; and second, it refutes again the many times refuted Marxian socialists. He says that ’’the excuse of state control to justify the adoption universally of large scale units, loses entirely the force of its argument.”®®'

Hobson explains that the most efficient financial or marketing organization does not necessarily coincide with the most efficient size of producing plant. Small producing plants may be most economical in a particular Industry which can be most economically financed and generally supervised on a large scale. The same is true of

We would add that large scale ownership and control may be economical from a private point of view even though the commodities are produced at a greater cost per unit than they would be if produced by independent businesses. For, by the exercise of monopoly power, more exchange value may be produced by producing fewer physical goods. The increase in price due to monopoly may more than offset the increased cost if large scale production is more expensive than small. The investment employed in maintaining monopoly power may be more productive of exchange value than that employed in producing more physical goods.

In any case, increasing cost and. diminishing vendibility are operating. Sometimes one and sometimes the other is most active in cutting off the supply, but they are like the two blades of the shears in that one has no significance except in relation to the other. In any kind of business, expenses are only important relative to income; or cost price has no meaning except when compared with sales price.

68 Boucke, Fred 0. , Principles of Economics, Vol. 11, p. 39.

69 Ricardo, David, Principles of Economics, G-onner Ed., p. 57. ~ 70 Idem. 71 Ibid. p. 580

72 Ricardo, David, Principles of Economics, G-onher Ed., p. 59n. 77 Patton, p.L Diminishing Returns in Agriculture, Chapter Vil. .

74 Ely and Others, Outlines of Economics, 4th Ed., p. 385 n; also Maxwell, J. A. , ’’Some Marshallian Concepts”, American Economic Rev lev/, Dec., 1929, Vol. XIX, p. 627.

75 Ely and Others, Outlines of Economics, 4th Ed. o. 392. —•— 76 Hobson, J. A., The Industrial System, pp. 183-190. Also "The Law of the Three Rents 1 ’ Quarterly Journal of Economics, Vol. 5. ——e. 77 Clark, J. M., Economics of Overhead Costs, pp. 86. 87. — ——

78 79 Clark ’ The. Distribution of Wealth, p. 301. Ibid., p. 302.

80 Maxwell, J. A., "Some Marshallian Concepts'*, American Economic Review, December, 1929, Vol. XIX, p. 629. 81 Knight, F. H., "Costs of Production Over Long and Short Periods", Journal of Political Economy. April, 1929, Vol. 29, p7"W7“ — 82 Dewing, A. S., "The Law of Banance Returns”, American Economic Review, December, 1917, Vol. VII, p. 755.

83 Dewing, A. S. , Financial Policy of Corporations, PP* 653, 654. ’ ~ ’ 84 Ibid, p. 653. 85 Ibidi, p. 663 80 “ Hobson, J. A., The Industrial System, Revised Ed., pp. 191, 206. " — ~

5. The Law of Efficiency of Output Stated

We hesitated a long time before we decided to use the term "law", or “principle", in this monograph. Finally we decided to use it. It will enable us to refer to generalizations by title and thus economize in

the use of words. In the second place, the old objection to economic "laws” on the ground that economics is an Inexact science has lost its force because economics, through the aid of history, statistics, and accounting, has become more exact, while we have lost much of our faith in the exactness of the laws of the "exact" sciences. Economic laws are merely statements or generalizations of empirical facts. They are truisms. There can be no more economic laws than there are facts which ( can be generalized. The laws or generalizations are working hypotheses to be used at a particular time, and place, and under certain institutional circumstances.

Now we would call this particular principle under consideration at present the "law of balanced returns", but Dewing has already used this expression in a slightly different sense. It now serves a useful purpose It is a generalization or rule which may be employed in predicting whether a large or small scale plant will be most efficient. The general answer depends upon the ratio of fixed capital costs to labor costs.

The law of maximum efficiency of output or just efficiency of out put, is this: At any given time every business man tends to expand the business under his control to the point of greatest net exchange value returns, which may or may not be the point of lowest costs per

unit of output. Or it may be stated thus: In the expansion of any business there is a point where the combined operation of the law of diminishing quantity productivity and. of the law of diminishing vendibility is such that any increase or diminution of output diminishes the business profits or net returns of the business. This lav/ is of universal application in a specialized economy It applies alike to competitive and monopolistic businesses as well as to agricultural and non-agri cultural businesses. It is more fully developed in Chapter VI.

4. The Theory of a Moving Equilibrium

Quite obviously we have just committed ourselves to a theory of a tendency to equilibrium or equilibria. Now it becomes important that the reader know whether we are trying to explain the interest problem of present society or speculating about a hypothetical problem in an imaginary society. It makes a great deal of difference whether our equilibrium theory refers to a static or dynamic society, and also it makes a difference whether we are thinking in relative or absolute terms.

Economists often have developed whole systems of principles for an ideal society which differs in all or many respects from present society. It seems that the society selected has depended largely upon the theory of evolution generally accepted in intellectual circles at the time. In the seventeenth and eighteenth centuries, the economists and the political liberal intellectuals were thinking in terms of a society which had its beginning in the conscious coming together of formerly Isolated, non-socially contracted individuals. The inalienable natural rights—especially private property rlghts--possessed by the individuals in isolation were retained in the social compact. The individuals retained the right to be governed by ’’natural” laws. Social institutions were merely artificial makeshifts. For example, Hobbes, 8 ? Adam Smith, 83 and Locke, B9 held such views of society. We call this a metaphysicalnaturalistic, or pseudo-genetic, approach.

Next, the Hegelian theory of evolution came to be accepted widely by economic and social thinkers. This theory postulates an end and direction to the evolutionary process, some parts of which are completely consummated, while others are still unfolding as a result of some self-generating force of inner necessity. Whether Hegel was the cause or only one of the results of this type of thinking does not matter here. The point is that it has greatly influenced economic thought. Early nineteenth century economists gave expression to this idea under the caption of the “stationary state*, where the “normal forces of supply and demand, and hence “normal* values, obtain. As long as thought is directed along this line, dynamic phenomena can be viewed as mere ripples on the normally static economic sea, which is about to settle down to an eternal calm. From this point of view, static “laws” are the only ones of a permanent nature and worthy of profound study*

Many contemporary economists have not escaped this kind of a conception of economic society. They are unable to get away from classical doctrines. Veblen says that they have found no way of formulating a body of theory except in terms of an assumed “quiescent normal J.B. Clark has, perhaps, exceeded all contemporary economists in making a grand display of static economics. But with him static phenomena are merely the foundation. He wisely refrains from assuming that the dynami c phenomena will cease to appear.

Von Wieser is less doubtful* He says:

There can be no doubt that advances in production cannot be continued indefinitely . . . The present era of progressive scientific technology will . . . reach a point at which further progress is barred. Some distant age may then possibly start from new fundamentals of knowledge and once more advance toward the ultimate goal, until mankind shall arrive at the point where further efforts are unavailing. 92

Certainly if economics is a science at all, it must be a science of prediction. But not even the most highly developed of the exact sciences have sufficient data to recast ultimate beginning or forecast final goals. If economics is a science at all, it is because economists are able to recognize the recurrence of similar combinations of factors which are followed by similar results. But this kind of predicting applies only to the near future. Predictions concerning the end of economic evolution, and speculations about the isolated “wild” men have not greatly enhanced the reputation of economic science. It is also very doubtful if such assumptions have added anything by way of simplification of economic analysis, because premises for a static society may be less than approximately true for existing society which is dynamic.Of course, we recognize

is paradoxical that this criticism applies least to J. B. Clark, the economist who has assumed the that many ’’static” thinkers have greatly advanced eco nomic science, but we think their real contributions have been made in spite of false assumptions.

Fortunately, the classical stationary state and its post-classical vestiges are now being discarded. Many contemporary economists are thinking in terms of Darwinian evolution. Unlike the seventeenth and eighteenth century thinkers, they postulate no beginning of the evolutionary process. Unlike the Hegelian evolutionists they postulate neither direction nor end. Now this does not mean that economics is to be explained in terms of biology. It does mean that the economic world is being regarded as a moving rather than a static something; that the building up and tearing down processes, the organizing and disorganizing social and economic forces are significant facts that must not be brushed aside with the assumption that a hypothetical

most perfect static equilibrium. He never assumed that ' in the long run" actual society is like the assumed static society as did the classical economists. Indeed, it is he who most pointedly criticises the classicists for confusing their assumed society with existing dynamic society.>s. However, unlike Clark, we think it best to start- with society as it is and thus avoid the difficulty of getting over from static to dynamic society.

static society is the "normal” one. There is quite a difference between regarding everything as static and everything as moving. As compared with the old type of thinking, it is the difference between regarding change as tempora.ry and the results of change as permanent, and that of regarding the changing as permanent and the results of change as evanescent. Truth has ceased to be absolute and has become relative to time, place, institutions, and peculiar circumstances. Older economic thought is focused on a static equilibrium; while the new is focused on a moving equilibrium, such as we think actually exists in Europe and in America.

But change proceeds at a very uneven and unpredictable rate in different industries in different localities. It is well to keep in mind that neither supply nor demand is static. Relative values are constantly effected by changes in both factors of the equations. As Clark says:

Five generic changes are going on, every one of which reacts on the structure of society, by changing the arrangements of that group system which it is the work of catallactics to study:

1. Population is increasing. 2. Capital is increasing. 3. Methods of production are improving.

4. The forms of industrial establishments are changing: the less efficient shops, etc. are passing from the field, and the more efficient are surviving. 5. The wants of consumers are multiplying. 94

87 Hobbes, Thomas, Leviathan, Chapter XIV. 88 Smith, Adam, Wealth of Nations, Bk. 11, Chanter 111 89 Locke, John, !, 0f Civil Government”, Works. (London, 1777). —

90 Homan, Paul T., Contemporary Economic Thought. p. 125. 91 " ' * Thorstein, The Place of Science in Modern Civilization, pp. 173, 179, 231, 232?

92 Von Wieser, Social Economics, Hindrick Trans, p. 72. "

93 Clark, J, B. , Distribution of Wealth, pp. 69, 70.

94 Clark, J. 8., The Distribution of Wealth, p. 56.

CHAPTER IV THE MARGIN OF DISCONTINUANCE

1. The Doctrine of a Common Rate of Net Capital Returns. 2. Interest as a Cost at the Margin of Discontinuance: (1) The orthodox view. (2) Depreciation and replacement. (3) Marginal owners. 3. Theory of the Margin of Discontinuance Stated.

1. The Doctrine of the Common Rate of Net Capital Returns

Business is motivated by the hope of net returns or business profits. The success of the business is measured by its business profits. But what is the relative degree of success attained by different businesses when compared one with another?

Economists have always regarded this as an extremely important question. Almost all of them have given essentially the same answer, or perhaps we should say the same set of answers. They have divided businesses into three main classes and given three answers. They have classified businesses as monopolistic, agricultural, and competitive non-agricultural.

In the case of monopolies there is no tendency to equality of net returns on the actual investment outlays when monopolies are compared either with each other or with competitive businesses. The monopolist adds to his output and to his total expenses until the point is reached where the greatest net returns are secured. But often diminishing vendibility is more important in the determination of this point than diminishing quantity productivity. Efficiency of output may be obtained before the point of lowest cost per unit is reached. The plant may be producing under conditions of decreasing costs up to one point, say the point where its output is 2,000,000 units; while it is producing under conditions of increasing net exchange value returns up to another point, say only to the point where the output is 1,500,000 units. On the other hand, the capacity of the producing plant of the monopoly may be such that it has decreasing costs until its output is 1,500,000 units and increasing costs beyond this point; while the conditions of vendibility may be such that expansion of output is profitable up to 2,000,000 units. If the last unit be considered the marginal one, the marginal cost per 1 unit may be either lower or higher than the average cost per unit. Monopolies produce under widely varying conditions of costs and vendibility.

However, looked at from the point of view of income, we get a marginal equality between different monopolies as well as between monopolies and other businesses. The law of efficiency of output applies to all establishments. The monopolist expands output until the point is reached where the last unit of investment yields a net return barely equal to interest at the market rate.

Next, what is the doctrine of relative net returns in agriculture? In the case of the farm at the extensive margin, there is only one quantity of output which yields a net income sufficient to cover interest at the market rate on the investment cost. Of course, it can be shown that the marginal farm produces under what some economists call increasing productivity. Just assume that with small doses of labor and investment it does not pay costs. Keep adding investment and labor until the point is reached where income and costs including interest are equal. However, in this case there is no importance. attached to increasing or decreasing productivity. Here the last dose of investment, as well as the total investment, is supposed to yield the common rate, and therefore the average rate of net returns and the marginal rate of net returns are equal. The total investment is marginal. But in the case of a supra-marginal farm it is different. The ratio of net income to different "doses’ 1 of Investment may be something like the following: First $lOOO, 50%; second $lOOO, 40%; third $lOOO, 30%; fourth $lOOO, 15%; fifth $lOOO, 6%; and sixth $lOOO, 3%, etc. If the interest rate is 6%, the fifth "dose" is marginal. The marginal rate of returns is 6%, but

the arithmetic average rate is 50 plus 40 plus 30 plus 15 plus 6 per cent divided by five, or 26 per cent. Or costs per unit including interest may be something like the following: First 1000 bushels, 25 cents; second 1000 bushels, 35 cents; third 1000 bushels, 50 cents; fourth 1000 bushels, 75 cents; fifth 1000 bushels, 100 cents; sixth 1000 bushels, 150 cents; etc. If the sales price is $l.OO per unit, supply is cut off at the point where income and outgo (inducing interest) are equal; but average costs in the example are not $l.OO but only 57 cents. But cost per unit of output and net returns per unit of outlay are equal at both the intensive and extensive margins.

In the third class of businesses there tends to be perfect equality, according to the generally accepted doctrine. The marginal rates and average rates of returns on the investment tend to be equal. That is, what one unit of capital yields every unit yields. Operation is possible, without loss, only with the optimum of quantity output—average costs per unit of output and the rates of returns on investments from one plant to another tend to equality.

Here economists generally follow Ricardo who developed the theory of a "common rate of profits”. The net return to capital employed on no-rent land

determined this rate. According to him, the rates of net capital returns in different employments "bear a proportion to each other, and have a tendency to vary all in the same degree and in the same direction." 96 They cannot be otherwise, except temporarily, for high profits in any employment will draw additional capital to it until output is expanded and sales prices and business profits fall to the common level. Conversely, if the rate in any employment is lower than the common level, capital will be withdrawn from it, output reduced, and prices and business profits will rise to the common level. All competitive businesses, according to the Ricardian theory, are similar to the marginal farm, average returns per unit of investment and marginal returns per unit of investment are equal; obviously no additional "doses” will be invested unless it is expected that the net income will be increased by an amount sufficient to pay interest on the additional "doses”; but according to this theory, the net returns are, in the long run, equal to the “common rate" on the whole Investment; therefore the average returns and the marginal returns tend to be equal.

However, Ricardo did not apply the law of diminishing productivity to non-agricultural businesses, except as such businesses are indirectly affected by diminishing productivity in agriculture. Later economists who have applied this law to non-agricultural industries have, nevertheless, retained the Ricardian theory of a tendency to a uniformity of net capital returns. They assumed perfect mobility and interchangeability of units of capital over a period of time. Therefore, they reason, no unit can get more than the marginal one. J. B. Clark, who has most ably developed this line of reasoning, does not differ essentially from the classical economists, nor does he pretend to do He says: ”Capitalists in all the different sub-groups get a uniform rate of income, in proportion to their several capitals.”9B Like Ricardo, neo-classi cal economists recognize that there are ’’temporary” fluctuations.

For instance, Ely, Adams, Lorenz, and Young follow Clark and apply the lav/ of diminishing productivity to all industries. Yet like the classical economists, they hold to the doctrine of equality of net capital returns. They first develop the theory of the minimum rate, then the theory of maximum rate, and arrive at the conclusion that the two rates tend to coincide, so that we tend to have a “common rate net returns.” First, the minimum:

When experience has shown that particular forms of capital goods will not measure up to this standard of profitableness, these forms will not be replaced as they wear out.- 5 - 00

Second, the maximum:

When certain forms enable entrepreneurs to get any considerable surplus over and above interest and replacement, the tendency will be, so far as competition rules,to increase the investment in such forms, and in this way to force the earning of those especially advantageous forms of capital goods down to the common level of interest and replacement.- 5 - 0 - 5 -

Dewing accepts the same doctrine of equality.

He says: In the long run both the interest on the capital invested and the compensation for skill of

management tend to become equal among different kinds of enterprises. That is, the mere rate of return on capital, without considering the risk incident to carrying it on, tends to be the same for all businesses.lo3

Marshall and others may speak of quasi-rents, but this does not mean that they have given up the doctrine of a tendency to a common rate of net capital returns. For example, Gide and Rist present the criticisms of this doctrine and conclude:

We do not deny the existence of rent from fixed capital, such rent being approximately measured by comparison with the current rate of interest.

They think the doctrine has successfully withstood all adverse criticisms.

Numerous quotations might be added, but we shall end them, as far as this chapter is concerned, with Marshall’s carefully considered conclusion, as follows:

... v.'here equal capitals are employed, profits tend to be a certain per centum per annum of the total capital, together with a certain percentage on the wages-bi 11.105 b

95 Ricardo, David, Principles of Economics, Conner Editions, pp. 10$, 100. — > 96 Ibid, p. 87.

Clark was talking about an assumed static society. He. never vrrote a comprehensive work on dynamic economics. 99 Nevertheless, this is an excellent statement of the generally accepted neo-classical doctrine of a tendency to equality in present society.

97 Clark, J. 8., Distribution of Wealth, pp. 69, 70. 98 Ibid, p. 304. 99 Homan, Paul T., Contemporary Economic Thought, P. 93.

assume that it generally does rule.- 5 - 00

100 Ely, J. T., and Others, Outlines of Economics, 4th Ed., p. 501. 101 Idem. 102 Ibid, p. 26.

103 wing » s *» Financial Policy of Corporations. 104 Gids, Charles, and Rist, Charles, History of Economic Doctrines, Richard Trans., p. 583. ~~ 105 Alfred, Principles of Economics, Bth Edition, p. 614. Also, Homan, Paul T., Contemporary Economic Thought, pp. 250, 251. Also, A — Memorials of Alfred Marshall, p * * ’’

2. Interest as a Cost at the Margin of Discontinuance

We shall examine this long accepted doctrine of the tendency to a "common rate” of net capital returns. In doing this we shall consider the minimum and the maximum rates separately. Do the two rates tend to coincide except for temporary deviations? We shall postpone any consideration of the maximum rate until we come to the chapter on the margin of intensity. In this chapter we shall consider interest as a price determining cost at the margin of discontinuance in the case of going establishments. Neo-classical economists have given special attention to this margin. It seems to be regarded as the first line of defense of the doctrine of a ’’common rate.”

(1) The Orthodox View of Interest as an Expense of Production at the Margin

First, which capitalistic enterprises are the marginal ones? Those that are yielding an income barely sufficient to cover all expenses of production is the answer most generally accepted. Other things remaining the same, these marginal enterprises must cease to operate if their expenses of production increase without at least a corresponding increase in the market price of the goods which they pro duce for sale, or if the price of the goods produced for sale decreases without at least a corresponding

decrease in their expenses of production. These concerns are producing at what we shall call the margin of discontinuance of production or simply the margin of disc ont inuanc e.

But what are the expenses of production which society must pay in order to induce these concerns to continue to operate and deliver to the market an undiminished supply of goods? This is the important question to be answered. Rent of land, or that part of the income attributable to the use of land, must not be included, for according to the generally accepted theory, rent plays no part in determining market prices. Hence it would be inconsistent to say that the payment of rent forces any enterprise out of business, and thus decreases the supply of a particular good and increases its price per unit. Nor can pure profits be an expense at the margin of discontinuance; for "pure” profits are a reward to the temporarily supra-marginal concern whose products sell at the same price per unit as those of the marginal concern. Hence ’’pure” profits cannot, as a necessary expense, force any enterprise out of business and thus diminish supply and affect prices. Then the expenses of production in the employment of capital at the margin of discontinuance must be made up of wages of labor including management, cost of materials, unavoidable losses which do not force the marginal concern out of business, repairs and replacements, and Interest of capital.

We are here concerned primarily with the latter expense--the interest of capital. • Suppose the enterprise is one having a large amount of capital invested in buildings, machinery, and the like. Must its income cover interest paid or imputed at the current market rate to this part of the investment in order for it to continue to operate? The generally accepted answer is: Yes, in the long run; but often temporarily a concern may operate without returns sufficient to cover interest at the current market rate on the whole capital investment; for if operations ceased, interest on fixed capital and depreciation of fixed capital goods would continue, and losses would be greater than would be sustained by continuing to operate. But orthodox economists hasten to emphasize that this is highly temporary. They maintain or imply that for continued abstinence the capitalist must receive a reward at the same rate per dollar per year as is offered to the initial saver; that depreciation will not be attended to, and the plant must soon cease to operate unless at least the current market rate of Interest is earned on the cost or replacement price of the fixed capital goods. Depreciation of fixed capital goods, according to the orthodox view, is the open door through which fixed capital makes its exit, if it

is not receiving at least the current market rate of interest.

Hence the doctrine or theory of interest as a necessary return to fixed capital employed at the margin of discontinuance cannot be accepted, modified, or rejected without an examination of the problem of depre elation or replacement of fixed capital goods.

(2) Depreciation and Replacement.

-- Some economists tell us specifically and many others imply that there is a capital goods replacement fund which makes the continued abstinence of the capitalist more burdensome. Some, however, take it for granted that the continued abstinence of the capitalist is a sacrifice so obvious that the idea of the fund need not be invoked. The best contemporary expression of the latter view' is offered by Ely and his collaborators. They say:

The stock of capital goods in existence at any one time is the result of past saving. But this stock of goods cannot be maintained intact without more saving. (The Italics are theirsj. From this point of view we may say that the sacrifice of present satisfactions for future satisfactions which society undergoes in order to reap the advantages of capitalistic production is not something done ’once for all’, but is a continuous something.

It may be that this statement can properly be regarded as a certain application of the time preference theory to which these writers claim to adhere; but it seems to us that it is the abstinence theory without Senior’s qualifications. The latter would say that if you inherit a controlling interest in an enterprise, and it continues to operate and yield a net income to you, you are not being rewarded for abstinence but are receiving a rent, a differential return. Only those who perform the original act of saving make a sacrifice. "He thus makes abstinence coextensive with saving.” Now even if we grant that the sacrifice of the capitalist who invests in fixed capital goods is continuous, we are nevertheless arguing beside the point unless it is shown that society must pay for this sacrifice at the current market rate of interest or suffer the penalty of having the capital escape by way of depreciation of fixed capital goods from a particular kind of production. Now the exit is ma.de easier if capitalistic production is such that a capital replacement fund is always in the hands of the capitalist whose plant has been used for some time. But is there such a fund? Smart tells us:

A balance sheet will generally show ... a depreciation fund . . . sometimes called Sinking, Wear and Tear, Repair, or Replacement of Capital Fund.lo9

Homan, in criticising J. B. Clark, says:

the setting up of sinking funds to replace capital goods as they perish through wear and tear is a form of abstinence as truly as the initial act of saving.

Then he concludes:

It would, perhaps, be better merely to say that Clark takes sinking funds for granted.llo

If we grant the existence of this fund, presumably a liquid fund of the individual enterprise, or a kind of wages fund of subsistence goods for industrial society, we must agree that it may be invested in replacing the fixed capital goods of the enterprise to which it belongs, or employed in some other way so that it is withdrawn from the plant against whose depreciating fixed capital goods it was set up. Other things being equal, it would as a matter of fact be invested so as to take advantage of the greatest anticipated interest or profit returns,orbe used in purchasing consumers’ goods.

But do capitalistic enterprises typically have such a fund for the replacement of capital? And does fixed capital typically flow out of an enterprise by way of depreciation of fixed capital goods, unless the income of the enterprise is sufficient to cover interest at the current market rate on the original cost price or replacement price of the fixed capital goods? If we examine the balance sheet of a typical Industrial enterprise, we are likely to find an entry referring to a sinking fund or funds. But an examination will usually show that these funds are set up to repay loans incident to the original purchase of capital goods. Now the business world makes a distinction of fundamental importance between operating expenses and additions to the capital investment. Of course, in case an item of old equipment is replaced by a new of a higher money price, the difference between the prices of the two--but only this difference--ls counted an addition to total capital Investment. But depreciation amounting to the full price of the old item of equipment is an operating expense. All expenses necessary to keep the old capital goods and the capital investment as a whole intact are expenses of operation. If it were otherwise, and the fixed capital goods of an enterprise had been replaced ten times in the history of its existence, the capital investment would be eleven times the original amount. Yet, if all other things have remained the same, its present price is the same as the original--a million

dollars, let us say, instead of eleven million. In modern practice, the ten million are taken care of by a deduction from gross income for depreciation. But the reserve or contra-asset account to take care of depreciation is not a fund accounted for on the asset side of the balance sheet but a liability. A typical going concern has many different items of fixed capital goods such as machines, tools, buildings, and the like; and repairs and replacements are taking place annually. Of course, outlays for repairs and replacements vary some from year to year, unless the concern is very large and highly diversified. But there is no periodicity in the sense that a major portion of the fixed capital goods wear out and are replaced at the same time. Various items are replaced so gradually and so piecemeal that the flow of products from the plant as a whole continues with but little interruption. Indeed, the complete stoo page of production for some time, as in the case of the Ford Plant, is an international event in industrial history. If the various items of fixed capital goods were not replaced as the need arises, a diminution of income due to a decreased productivity would immediately ensue, and before long the whole plant would cease to operate, and the whole income that could have been secured by continued operation will have been sacrificed. To fail to take care of depreciation is not economical conduct,

unless the operating capital employed in meeting replacement and other operating expenses offers less than the current market rate of returns for its own use, as will be further explained. Typically depreciation reserve accounts, or contra-asset accounts, as cost account ants often call them, are set up to take care of deprecia tion as it accrues. This kind of a reserve set up against any piece of fixed capital goods distributes the expense of its replacement over the period of its life. From time to time adjustments are entered on this account so as to reconcile the estimates with what has actually come to pass, but there is no particular fund for depreciation. Reserve accounts are found but they do not consist, as economists seem to imagine, of funds of cash or property set aside for the purpose of meeting a future replacement of the plant as a whole. The purpose of this liability entry is to keep the capital of the enterprise as a whole intact; and the whole capital of the enterprise is typically invested in capital goods of various kinds used by the enterprise, except, of course, as regards a relatively small quantity of petty cash on hand and a small bank deposit.

As an exception among economic theorists, Taussig seems to understand the contemporaneous nature of depreciation and replacements. But he makes no use of this

conception, his best statement being relegated to a footnote. He says:

Commonly, capital is maintained intact; not in the sense that the same machinery or materials are maintained indefinitely, but in the sense that, as they wear out, other machinery and materials are regularly produced to take their place.m

BUt

In practice the actual setting aside of money, and its investment over a period of years, as a separate fund toward depreciation, is probably rare. Usually a sum is each year debited on the books against earnings, for depreciation. On the other hand, one or another item of plant is renewed or repaired each year--the whole does not become useless at one fell swoop--the sums spent for replacement are charged against the depreciation account.ll2

This practice is forced upon those responsible for management, and even if it is a sacrifice, it cannot be avoided without incurring other sacrifices. Bankers, those from whom goods are purchased, capitalists from whom funds are or may be sought for investment purposes, and any others from whom accommodations are likely to be sought, demand that depreciation be treated as an operating expense, as a deduction from gross income as a regular accounting practice, and failure to do so carries the penalty of denial of accommodations or a

very high charge for risk. There is in our society still another reason for treating depreciation as an operating expense. It is fully recognized as a legal deduction from gross income in arriving at net income for taxation purposes. There is yet another well-established legal principle that tends to prevent fixed capital from being transmuted into liquid capital and paid out as dividends as fixed capital goods depreciate. This principle is that dividends shall be paid only out of net income and never out of capital.

Professor Paton of the University of Michigan correctly summarizes the method of handling depreciation when he says:

In modern practice it has finally come to be well-nigh universally recognized that all fixed assets subject to decline in value should be periodically revalued, and that the amount of such estimated expirations should be treated as an operating expense. That is, in determining net income the current depreciation of plant assets must be accrued... 113

An examination of the method actually employed in handling depreciation and replacement of capital goods seems to show that the capital replacement fund is something like the classical wages fund which Henry George ll4

and J. B. have refuted to the satisfaction of the present writer. Neither the individual capitalist nor the enterprise typically has such a fund; nor does society have such a fund for the replacement of fixed capital goods; for, in industry as a whole, all stages of production are contemporaneous in the sense that they are all going on at the same time from the mining of ore to the scrapping of the worn-out machine.

For example, if an enterprise has fixed, capital goods that could be replaced for $20,000,000, but the usual annual replacement expense is only $1,000,000, depreciation of fixed capital goods would be typically accounted for at 53 per year. Suppose it employs |5,000,000 in meeting operating expenses, and the current market rate of interest is 6%. Now in order for operation to continue, must it have an annual net income or surplus of $1,500,000, or 6% of $25,000,000? The $20,000,000 invested in fixed capital goods cannot be withdrawn. It is sunk. But the $5,000,000 invested in meeting operating expenses can be withdrawn in a short time. Hence interest as an inducement price for continued operation must be paid only on working capital; or the net income need be only of $5,000,000, or

1300,000 instead of 6% of §25,000,000, or §1,500,000. If, however, there is a periodicity of depreciation and necessary replacement in the sense that the whole of the fixed capital goods must be replaced at the same time, replacement must rank with the initial act of bringing the enterprise into productive use. There would be no economic reason for reproducing the old plant, if it offered less than the current market rate of returns on the replacement price. If such periodicity did typically exist, it is probable that depreciation would not have come to be so universally treated as an operating expense and on the contrary a fund for replacement would have been provided. If such periodicity did typically exist and depreciation were nevertheless accrued and deducted from gross income, typically depreciation funds would be found, for it is hardly probable that a concern having a large portion of its investment originally in fixed capital goods could economically employ an amount of working capital in the enterprise equal to the whole original capital investment without an increase in fixed capital also; and if such an amount of working capital were really needed, the purchasing of the new fixed capital goods would be an additional Investment, not a replacement from the point of view of the whole capital employed; and after the replacement

the capital investment would be the original amount plus an additional amount equal to the price of the fixed capital goods. But typically no such periodicity exists, and depreciation is treated as an operating expense and deducted from gross income; replacements are made piecemeal, and no capital replacement fund is provided. The enterprise continues to operate as long as its income is sufficient to cover all operating expenses and interest at the market rate on working

If, for example, an enterprise, say a railway, is unable to pay the current rate of interest on the cost price of the fixed capital goods employed, but there is no prospect of its being unable to pay this rate of returns on working capital, there is no economic reason for the enterprise to cease to operate. If the fixed capital goods have been mortgaged, receivership may result from insufficient earnings to pay interest. Change of ownership and management may occur, but this need not in the least affect continued operation, as long as the income is sufficient to cover all operating expenses including interest on working capital. If new securities are issued, and their aggregate par value is equal to the reasonably anticipated net income capitalized at the current market rate, they will sell at par; and whether it is a public service enterprise is of no fundamental importance, for it is not because the law commands or that charitable or patriotic buyers would be grieved to see the enterprise discontinue operation, but because buyers are offered the current market rate of returns on their investment, that the securities are sold in the market.

106 Ely and Others, Outlines of Economics, 4th Ed., p. 497-

107 Senior, Nassau William, Political Economy, 6th Ed., o. 129. 108 Cannan, Edwin, Theories of Production and Distribution, p. 213.

109 Bohm-Bawerk, Capital and Interest, Smart Trans., Preface, p. vi. 110 Homan, Paul T., Contemporary Economic Thought, pp. 65.

11l Taussig, F. W. , Principles of Economics, 3rd Ed., Vol. I, P. 78. ' 112 ibid, p. 78n.

113 Paton, W.A., Accounting,, pp. 563, 564. 114 George, Henry, Progress an£ Poverty. Twenty-fifth Anniversary Edition, pp. 73-78.

115

Clark, J. 8., The Distribution of Wealth, pp. 153-156.

(f)By first excluding depreciation from prime costs Alfred Marshall thought that he was justified in saying later that to expect fixed capital goods to operate without any returns attributable to them is like expecting a man to work without food. He can work perhaps a day, the fixed capital goods operate a year--perhaps a little longer. Marshall has proved only that he should have recognized depreciation as a prime cost in the first place.ll6

116 Marshall, Alfred, Principles of Economics, Bth Ed., pp. 359-360, 420-421. ' ’

(3) Marginal Owners of Fixed Capital Goods.

--Now at this point let us digress a moment to emphasize that we must guard against confusing marginal ownership or marginal management with marginal enterprise. Of course, an Individual owner of certain fixed capital goods may become badly dissatisfied with the payment he receives for the use of his capital. In this case, he does not need to try to consume these goods for his personal enjoyment; nor does he need to forego replacements as long as returns are sufficient to pay the current rate of returns on the capital employed in meeting operating expenses. He can go into the market and sell his enterprise for a price determined by the capitalization of its net earning at the current market rate of interest. He will receive liquid capital which he can employ in buying either consumers' or producers’ goods. But the sale of his property right in the enterprise need not, in any way, affect its continued operation. Nor would the continued operation of the enterprise

necessarily be at all affected by creditors forcing some individual or individuals to yield control. Nor does it matter in the least whether the working capital is owned by the enterprise or a commercial banker, for in this chapter we are not interested in the personal distribution of net capital income by the enterprise, but only in the necessity of the payment of this income by society to the capital employed at the margin. We are concerned with marginal enterprises, not marginal natural persons.

(4) The Theory of the Margin of Discontinuance Stated.

Let us return to the main theme. At what point does an enterprise cease to operate? If an enter prise is able to meet all operating expenses and interest at the current market rate on working capital, but nothing remains as a return to fixed capital, and there is no prospect of a change for better or worse, its

continued operation is a matter of indifference, disregarding some possible scrap or salvage exchange value. The concern is already devoted to its most productive opportunity. The fixed capital goods can be used economically for nothing else; but the income is still sufficient to take care of all operating expenses and interest on working capital. It has already been stated that working capital is employed in buying raw material, taking care of depreciation, hiring labor, and the like. Furthermore, working capital must return interest on itself at the current market rate. If this is not done, as materials are finished and sold, labor can be discharged, no more raw materials purchased, and operations discontinued. Then the working caoital will be in a liquid form and can be invested at the current market rate of interest. But nothing is gained by liquidating working capital as long as it yields the current market rate of interest; and if a particular owner wanted to sever his connection with a concern marking only operating expenses and interest on working capital, and there were no prospects of less income to the enterprise, he could sell it for a price equal to the amount of working capital invested. An enterprise, which is barely yielding an income sufficient to cover all operating expenses and interest on working capital

and having nothing left that may be paid or imputed as net income to fixed capital, is operating at the margin of discontinuance.

Therefore, interest on fixed capital including land is not an expense of production at the margin of discontinuance, for it does not here exist. This margin is purely price determined, and is a measure of the least favorable condition under which production can be continued, and the market supply of any good which is wholly or partly produced at this margin remains undiminished.

Hobson undertook a marginal analysis very similar to that which we have just presented. He started out to show that marginal capital goods in the case of the going enterprise are barely self-sustaining; but, like many other economists, he was unable to locate the marginal goods except in the case of agricultural land. He could not see why it would be to the interest of the owner of such goods to provide for maintenance. Finally he excused himself by saying that he had been considering a hypothetical static society, and that no-net income capital goods, except land, do not operate in a progressive society. We contend that change or

progress is the chief causes of the existence of such marginal capital goods.

So far we have followed business practice and treated replacements, or depreciation, as an operating expense; but our theory can be illustrated equally well without calling depreciation an operating expense. Let us suppose that an enterprise has (1) income before deduction for replacements, (2) necessary replacements, (3) net income, and (4) capital which can be withdrawn as follows:

(1) (2) (3) (4) Income be- Replacements Net Capital which can fore deduc- necessary to income be withdrawn and tion for continued employed else- necessary operation where, not includ' replacements ing replacement costs which could be avoided for current period

Year 1918 <2,250,000 <1,000,000 <1,250,000 <5,000,000 1919 2,850,000 600,000 2,250,000 6,000,000 1920 2,150,000 1,400,000 750,000 4,000,000 1921 1,550,000 800,000 750,000 5,000,000 1922 2,450,000 1,200,000 1,250,000 4,500,000 1923 2,450,000 700,000 1,750,000 5,500,000 1924 2,550,000 1,300,000 1,250,000 5,000,000 1925 1,750,000 1,000,000 750,000 5,750,000 1926 2,600,000 1,100,000 1,500,000 4,000,000 1927 1,900,000 ■ 900,000 1,000,000 4,250,000 Av. <2,250,000 <1,000,000 $1,250,000 $5,000,000

Suppose that it would cost |30,000,000 to replace the business as a whole. Now if the market rate of interest be 6 per cent, the capitalized value of the business is only $20,833,333, assuming that its prospective earnings are

neither better nor worse than its earnings during the ten years used in the example. We say approximately, for the irregularity of net income as shown in the illustration would somewhat affect the problem of capitalization. The capital which can be withdrawn during any year is approximately $5,000,000 plus $1,000,000, which need not be spent for replacements if operations be discontinued but which must be spent if operations be continued. Clearly it would be uneconomic conduct to destroy an enterprise having a capitalized value of in order to withdraw’ $6,000,000.

The $6,000,000 invested at 6 per cent would yield $360,000. If the prospective annual net returns to the enterprise were only $360,000, approximately its continuance of discontinuance would be a matter of indifference. The fixed capital goods would be fully maintaining themselves, and that part of the capital which could be withdrawn would be securing as much as could be secured by investing it in another undertaking In this case the fixed capital would have no value, and the enterprise would be at the margin of discontinuance

This principle of discontinuance applies to all industries, and its importance, as compared with former theories of discontinuance, varies directly with the percentage of the total investment which is sunk in

fixed capital goods and with the periodicity of depreciation. We do not deny that there are some instances where our theory of discontinuance is of no particular importance as compared with the older theory. Actually there are all degrees of fixity and liquidity of capital goods; but typically businesses must be replaced piecemeal. Generalizing so as to include both typical and exceptional cases, we may say that at any given time a business is at the margin of discontinuance if its net income is barely equal to the alternative net income which could be had by withdrawing its economically mobile capital and investing it in another undertaking, and any replacement economically can be made if the resulting addition to net income or prevention of loss to the business is at least equal to interest at the market rate on the replacement cost.

117 Hobson, J. A., The Industrial System, Revised Ed, , pp. 70, 70n.

118 Knight, F. H., Risk, Uncertainty, and Profit, p. 304.

CHAPTER V ths Margin of entry

1. New Enterprises. 2. Theory of the Margin of Entry Stated. 3. Theory of the Margin of Entry, the Margin of Discontinuance, and the Market Rate of Interest

1. New Enterprises

New enterprises enter the productive field above the margin of discontinuance. Of course, this is also true of additions and replacements of the fixed capital of going enterprises as far as the additions and replacements themselves are concerned. If society wishes a greater supply of any consumers’ good, and this increased supply can be had only as new enterprises come into productive use; that is, the increase cannot come from the transference of capital goods from other productive operations, and the new capital goods required to give this increase are no more efficient than of old, it must promise to pay a price for the consumers ’ good that is high enough to make the current market rate of interest possible on the whole capital investment.

But new concerns often operate under conditions or with productive organization or with equipment and land of greater exchange value productive efficiency than the old. As far as this is the case, society may enjoy a greater supply of consumers’ goods without a rise in their price per unit. Here the old fixed capital goods will continue in use as long as their income is sufficient to cover all operating expenses and inter est on the Investment in working capital goods, which may he indefinitely. Poor judgment in making the orlgi nal outlays for fixed capital goods is another reason for the existence of concerns at the margin of discontinuance. In fact, many changes in demand and supply conditions are such that they cannot be predicted with any degree of certainty for a long period of time; and for this reason many concerns probably find themselves at this margin, in spite of the fact that those responsible for bringing them into original productive use took every reasonable precaution. Of course, what often happens is that old enterprises gradually introduce the most efficient equipment and organization as various items of producers’ goods are replaced and changes in productive organization are economically possible. But it is not always economically possible to do this. There are many concerns at the margin of discontinuance in our present society, judging by the number that annually sink below this level and are

unable to meet operating expenses and must discontinue, and by the number which are annually reorganized as to ownership, because their income is insufficient to pay interest on fixed capital at the market rate as was originally anticipated, but which continue to operate because their incomes are still sufficient to cover all operating expenses. We must conclude that the margin of discontinuance is significant in a progressive society, notwithstanding the fact that no new concerns enter the productive field unless at least the current market rate of returns is anticipated on the whole investment.

ii 9 Anight, F. H. , Risk, Uncertainty, and Profit, pp. 151, 152. ~ —

2. The Theory of the Kargin of Entry Stated

But for society as we think it is, we do not contend that the reasonably anticipated rate of net returns on the whole investment in a new enterprise or on the investment in a newly discovered way of expanding a going enterprise is never more than equal to the market rate. Anticipated net returns may often be much greater than this in a dynamic society. All new investments do not necessarily come in at the margin of entry. The margin of entry into the productive field is at that point where the investor anticipates a net return equal to interest at the market rate on the whole investment required for production and operation.

3. The Margin of Discontinuance, The Margin of Entry, and The Market Rate of Interest

Before proceeding further with our marginal analysis, we wish to assure the reader that we are not forgetting the market rate of interest. It is the function of the market rate of interest to cut off the flow of liquid capital at the margin of entry. It is also a function of the market rate for the use of liquid capital to secure the flow of capital away from employments where it is yielding less than this rate. But usually only the working capital can flow; and the market rate cannot cause the withdrawal of this capital as long as it yields a net income equal to interest at the market rate. The market rate itself is a supply and demand price for the use of loanable funds of generalized purchasing power, which fund arises out of saving, as we shall later explain at length. Our theory of the margin of discontinuance and of the margin of entry are perfectly compatible with the existence of the market rate of interest for the use of generalized purchasing power.

The problem of getting from the net exchange value productivity of capital goods, or the so called natural rate of interest, to the market rate--or on the other hand, from the market rate to the so called natural rate—seems hitherto to have been unsolved. The first real effort, it seems to us, was made by the German

economist Friedrich Benedikt Wilhelm von Hermann as long ago as 1832. He started with the premise that the income attributable to land and other fixed capital goods is fundamentally the same. It is a matter of differential returns. But it seems that unlike Ricardo in the case of agricultural land, he fixed his attention upon the superior fixed capital goods instead of the most inferior in operation. l2o

Then came the problem of reconciling the natural interest with the market rate for the use of loanable funds. He could have solved this problem as we have by recognizing that in a progressive society liquid capital can be invested above the margin of discontinuance. But in fixing his attention on the superior instead of the inferior capital goods he failed to locate the margin of discontinuance except in the case of land. He ended by developing the "use theory” which had been suggested by J. B. Say. l2l

In England Hobson has attempted the same approach Like Hermann he is unable to locate the margin of discontinuance and correlate it with the market rate of

interest. We have already referred to his final conclusion that no-net Income capital goods do not operate in 1 pp present society. Two other English writers, Sidney and Beatrice Webb, have undertaken a differential analysis of capital returns. They seem to have a physical concept of the margin. They say: ’’The interest with which we are concerned must clearly be a definable quantity of produce. in a specialized economy inter est either in industry or in the loan market is an exchange value phenomenon.

Certainly as long as the market rate of interest is a given fact, any explanation of net capital returns in industry is worthless unless it can be reconciled with this rate. We consider it very fortunate for us that our theories of the margin of discontinuance, the margin of entry, and the market rate of interest do not tend to contradict each other. This will be more

obvious after we have presented the chapter on '’The Margin of Productivity."

120 Oide and Rist, History of Economic Doctrines, Richards Trans., p. 556. 121 Hermann, Friederich Bend. Wilh. von, Staatswirtschaftliche Untersuchungen, (1870), Part VIII.

B. Clark, of course, did not encounter this problem. He assumed perfect mobility and interchangeability of capital. What one unit gets every other unit gets. His marginal capital goods are supposed to get the market rate of interest. It could not be otherwise, assuming both interest and perfect mobility of capital.

122 Hobson, J. A., The Industrial System, Revised Ed., pp. 70, 70n. — 123 Webb, Sidney and Beatrice, Problems in Modern Industry , p. 227.

CHAPTER VI THE MARGIN OF INTENSITY

1. Differential Net Capital Returns: (1) Agricultural business. (2) Railway business. (3) Manufacturing business.--Sugar mills.--Sugar refineries.-- Animal and vegetable oil refineries. 2. The Law of Differential Net Capital Returns: (1) The law stated. (2) Some significance of the law.

1. Differential Net Capital Returns

Introduction. —According to the lav/ of efficiency of output, every business man tries to operate his enterprise so as to secure the greatest possible net returns; but in the expansion of any enterprise there is a point beyond which the operation of the law of diminishing quantity returns and diminishing vendibility are such that further Increase in output reduces the total net returns. rhe returns are said to be balanced when the scale of operation reaches the point where either an increase or a diminution of output diminishes net returns, or that additional ”doses n of investment in the business fail to result in additional net income equal to the market rate of interest on the additional '’dose”. Here the equilibrium tendency is not static but a moving something, which means that the typical establishment Is faced with a constant problem of adjustment instead of making it once for all. Of course, most of the adjusting must be

done with the mobile part of the investment instead of with that part which is sunk. Equilibrium is thus a constant tendency with no important distinction between the long run and the short run. But do establishments tend to attain equilibrium or efficiency of output with equal rates of net returns on the Investment necessary to produce and operate them?

It was shown in Chapter IV that, according to the generally accepted classical and neo-classical economic thought, net capital returns tend to equality. Now our theory of net capital returns is exactly the opposite of this.

In Chapter IV the generally accepted theory was partly disproved. It was shown that the margin of discontinuance is not at that point where net returns are equal, or approximately equal, to interest at the market rate on the whole investment employed in producing and operating the enterprise; but at a lower point where net returns are barely sufficient to cover interest at the market rate on that part of the investment which can be withdrawn and invested elsewhere. We think that we have shown that our theory offers a better explanation of the lower limit than the generally accepted one. But is there a general tendency to concentration at some upper limit just high enough to afford the market rate of interest on the whole investment? In this chapter we

shall show that logically and according to available empirical evidence, non-agri cultural as well as agricultural industries are characterized by intensive and extensive marginal expenses of production and differential net returns.

But before proceeding with the formal presentation of arguments and evidence, a few general remarks may be helpful. All establishments tend to sell their finished product of like kind at the same price per unit in any particular market during a given period of time. Of course, there are some differences. For example, "Data collected by the Tariff Commission show that, while there is some difference in the prices at which individual sugar producers dispose of their product, the differences are small as compared with differences in costs .... (Furthermore) the low cost producers are as likely to 1 94 get a high price as the high cost producers.' Such differences in sales prices bear no relationship to the expenses of production of the establishment. Here statistical evidence confirms the generally accepted theory of the tendency to equality of price; but nevertheless, statistics show that there is no tendency to equality of costs and of net capital returns, in spite of the fact

that such costs and returns are price phenomena.

Certainly many different manufacturers purchase large quantities of producers’ goods at approximately the same price per unit. For example, they purchase raw sugar for refining purposes at the same price in the New York market. But it usually takes many producers ’ goods for the combination necessary to turn out a finished product. And the quantity of each per unit of output varies greatly from one establishment to another. Two enterprises operating with efficiency of output may produce an equal number of units per given period of time, and yet have different expenses and hence different rates of net income per unit of output. They may employ different quantities of capital and labor, and therefore be unequally affected with every relative change in the rates of wages and interest; for there is no general tendency for capital and labor to combine in approximately equal proportions in different enterprises, as Ricardo was inclined to hold. Furthermore, differences in location mean differences in transportation costs per unit of product delivered to the market. Also, many old establishments have well established clienteles and as a result smaller selling expenses per unit than other enterprises less well established. At least from the point of view of the established enterprise, this advantage is regarded as a rather permanent one. Business

men consider it one of the chief factors in the determination of the sales price of the establishment itself. Of course, it is inseparable from goodwill, trademark, and the like. On the other hand, new enterprises may be better able economically to take advantage of the latest inventions and discoveries as well as changes in demand for particular types of commodities. In this connection, it is important to bear in mind that the disadvantage of the old enterprise may not be such that it can economically afford to scrap its old equipment; for the expense of the new equipment to it would be the price of ths new plus the present capitalized exchange value of the old minus the salvage price—if any. Or what is perhaps more often the case in our present institutional system, some enterprises have exclusive rights to the use of certain patents, copyrights, franchises, and other monopolistic advantages. We do not assume a society other than the actual. Nevertheless there is no difficulty in finding possible causes of differential net capital returns; and, contrary to the generally accepted theory, they are practically as permanent in other industries as they are in agriculture. Ricardo and Marshall are correct in saying that rent is not peculiar to agriculture. Their mistake is that they consider differential net returns permanent in agriculture and temporary in non-agricultural industries.

124 Wright, Philip G-., Sugar in Relation to the Tariff, pp. 113, 114.

125 Ricardo, David, Principles of Political Economy, G-onner Ed., note at end of chapter on "Poor Rates”. 126 Marshall, Alfred, Principles of Economics, Bth Ed. D. 424 n. —

(1) Agricultural Businesses.

--It is generally agreed that there is no tendency to equality of net returns in agriculture except at the margin. Agricultural expenses of production, as we ordinarily think of price determining expenses, include interest on the whole cost price of producing and operating the farm. By price of producing the farm, we mean the investment in clearing, irrigating, draining, erecting buildings, fences, and the like. By price of operating it, we mean the investment necessary to maintain the soil, improvements, and the like, as well as to make necessary replacements, and pay wages, taxes, feed costs, and so on. Now it is an elementary principle of equilibrium economics that the investment necessary to meet all of these expenses of producing and operating the farm can and will be had if the anticipated net exchange value product is large enough to equal interest at the market rate. Of course, the generally accepted doctrine assumes that the capital goods other than the land itself tend to yield equal rates of net returns on their respective cost prices. The differential exchange value income is attributed to the land only; while we attribute the differential to all that part of the investment which is sunk. Ricardo, as a ’’second thought", l2 ? did the same. But an explanation of this was fully presented in connection with the explanation of the margin of discontinuance and need not be further considered at this point; for we are now interested in the existence of differential net returns and not in the particular items of concrete or intangible goods to which they should be attributed. The generally accepted theory, with which we fully agree, is that any group of farms selected at random have differential or uneo x ual rates of net returns, or they produce at varying costs per unit but tend to sell at the same price per unit.

A group of farms operating with efficiency of output have average costs and net returns something like the following:

Now why will not farm number 1, with an average net income of forty cents per unit of product expand its

production until its net returns are equal to interest at the market rate on the investment necessary to produce and operate it? The answer is that it has already expanded production until the intensive margin has been encountered, that the part of the investment employed in producing the last part of the output receives a net return approximately equal to interest at the market rate. It is operating with efficiency of output. This is illustrated in the following table.

with the interest rate 6 per cent, the intensive margin is reached with the |IO,OOO investment. With this investment, efficiency of output is attained. The tenth additional investment is the intensive marginal one. The farmer could not economically borrow an eleventh |l,ooo at 6 per cent and invest it at 4 per cent. Nor could he economically invest an eleventh |l,ooo of his own money if he could lend it at 6 per cent. Now, as a matter of fact, successive investments are not of equal magnitude. It is a matter of Investing in a barn, a fence, a tractor, or some fertilizer, and so on. Thus actual ’’doses" vary in size with the variation in costs of units of producers* goods; but the ’’dosing” system of economic reasoning used since the time of John Stuart Mill seems to us to have practical significance. Now, if we had started ’’dosing” with a four thousand dollar investment, the fifth thousand dollars would have had a net yield of 150 per cent and the ra.te of net returns per ’’dose” would have had a general tendency to diminish throughout the series, but there would have been a difference between the average rate and marginal rate of net returns just the same. Here we are particularly interested in noting that the marginal rate of net returns, 6 per cent, is far different from the average rate, sixty-seven per cent.

127 Gannan, Edwin, "Land and Capital”, American Economic Review, March, 1929, Vol. XX, p. 78“ ~

Expenses Sales Price Net Returns Rate of Net Farm No. per Unit per Unit per Unit Returns per Unit 1 $0.60 |1.00 |0.40 67% 2 .65 1.00 .35 54 3 .70 1.00 .30 43 4 .75 1.00 .25 33 5 .80 1.00 .20 25 6 .85 . 1.00 .15 18 7 .90 1.00 .10 11 8 .95 1.00 .05 5 9 1.00 1.00 .00 0 10 1.05 1.00 -.05 -5

Table 1

Total Total Net Rate of Net Returns Rate of Net Re- Invest- Returns to Total Investment turns to Each ment or Average Rate of Successive $1000 Net Returns | 1,000 100 10% 10% 2,000 200 10 10 3,000 500 16 30 4,000 2,000 50 150 5,000 3,500 70 150 6,000 5,000 83 150 7,000 6,000 .86 100 8,000 6,500 82 50 9,000 6,600 73 10 10,000 6,660 67 6 11,000 6,700 61 4 12,000 6,020 50 -8 13,000 4,000 38 -200 14,000 700 5 -330

Table 2

(2) Railways

.--Next, let us look at the American railway industry. The investment necessary to produce and operate the roads is |24,873,474,285, according to the ’’Preliminary Abstract" of the valuation by the 1 PA Interstate Commerce Commission for 1928. We have

no exact data as to the increase in this valuation, if the roads be reevaluated according to replacement cost, in keeping with the O’Fallon decision. With such a large part of the capital of the nation tied up in railways, we should hardly feel justified in considering this industry an exception not covered by our explanation of interest. As far as we know, railway economists never contend that net returns tend to equality in the railway industry. Furthermore, they recognize that the differential rates are permanent from all practical points of view. The problem of the weak roads cannot be brushed aside as due to temporary reverses. Nor can the high returns of other roads be regarded as the result of a year or a few years of good luck. This is recognized to some extent by the Recapture Clause of the Esch-Cummins Act (1920). In this connection Eliot Jones says:’*...it is impossible to establish uniform rates upon competitive traffic which will adequately sustain all the railroads that are engaged in such traffic, without enabling the more favorably located or better managed roads to receive an income unreasonably in excess of a fair return upon the value of their property.”l29 Furthermore, it is fully recognized that a weak road can operate indefinitely as long as it has a net income sufficient to cover interest

at the market rate on the part of the investment which can be withdrawn and employed elsewhere.

Yet economic theorists have not seen the margin of discontinuance. On this point Cassel makes a good beginning but a poor ending. He says: ’’Once it (the railway) is constructed, the cost of construction plays no further part . ... If the cost of construction has a bad rate of interest, there is no help for it, because the capital is now tied up in the installation and cannot be freed from it.” Then in the next paragraph he falls back upon the generally accepted theory of the mar gin of discontinuance. The statement quoted above refers only to a temporary situation. He explains: “If said capital does not succeed in paying interest (at the market rate), in the course of time there will, naturally, be no capital sacrificed for maintenance and renewals, and the real capital will be destroyed.

But statistics of American railways confirm our theory of the margin of discontinuance. Many roads have net returns which are less than Interest on the investment necessary, in the estimation of the Interstate Commerce Commission, to produce and operate them; and yet they show no signs of discontinuing. The data likewise

FIGURE 1

DIFFERENTIAL RATES OF NET RAILWAY OPERATING INCOMES

Earnings on

Investment 13#

Establishments

show that many roads have net incomes much in excess of interest at the market rate on their investment, which differences the generally accepted theory would attribute to monopoly.

For purpose of illustration we selected eighteen steam railways at random from Moody * s Steam Railways (1928) and divided their eight year average annual net operating incomes by their respective final valuations by the Interstate Commerce Commission for 1928. From the results thus obtained we constructed figure 1. Strict accuracy would have required that we employ a weighted average valuation for the same years for which the average incomes were taken; but the variations in valuation for most of the roads were probably slight and tended to affect the roads about equally, so that the relative rates of earnings on investment are little affected by the error. We are interested only in noting that some roads have a very low rate of net earnings, roads which are at or very near the margin of discontinuance; while other more fortunate roads have high rates. When the roads are arrayed according to their respective rates of net income, they arrange themselves at gradation; and the figure is similar to the one which economists often employ in illustrating the differential economic rents attributable to various grades of agricultural land.

The relative permanence of differential rates of net railway incomes is further illustrated in figure 2. This figure shows graphically the differential net operating incomes per mile for twenty-four roads selected at random from Moody 1 s Steam Railways, 1929. Curve "a" in the figure is an eight-year average, and curves "b”, "c", n d”, and n e” are two-year averages. On ”a” roads are arrayed by the eight-year average, and then the different establishments are left in the same order from left to right for the other array curves. The curves in the figure show that the establishments tend to maintain their relative Income position in comparison with each other year after year. Two weak roads may shift positions with each other, and so may two strong ones, but there is no general tendency for the low net income and the high net income roads to change positions. Of course, if the array included all railroads for a very great period of time some exceptions would undoubtedly be found.

Now we must not confuse differential rates of net earning on investment necessary to produce and operate a road, or differential rates of net earning per miles, with differential prices at which the shares of different establishments sell in the market. A weak road may have undergone a financial reorganization and now be capitalized on the basis of its net

earning so that its securities are selling around par, while a high income road may he so overcapitalized that its securities sell for less per given unit of par value than those of the low income road.

128

Statistics of Railways of the United States, 1928, p. 89.

129

Jones, Eliot, Principles of Railway Transportation , p. 550•

130

Cassel, Gustav, A Theory of Social Economy, MacCabe Trans., p. 201.





FIGURE 2 NET RAIWAY OPERATING INCOME PER MILE BY ESTABLISHMENTS

(3) Manufacturing Businesses.

131

Sugar Mills

.--Next, let us take a group of mills engaged in producing raw sugar. These are capitalistic enterprises, but on account of the bulk and weight of sugar beets and sugar cane they tend to be small scale producers. A study of Cuban mills by establishments for the years 1920 to 1923 inclusive reveals widely varying expenses of production per unit of output from one mill to another. The data are for average expenses by mills, and average expenses and marginal expenses coincide only in the case of the high cost, or marginal mills. 11 It follows that all lowcost producers make profits, which are increased to the extent that (average) costs are reduced.unfortunately for our purposes, the data for the same establishment over a period of years are not given; so we can not ascertain the relative standing of the particular mills year after year. It seems that such is included in the confidential part of the Commission’s report. The Commission concludes that these mills have differential

returns like agricultural establishments. The differential expenses of production per unit of Cuban raw sugar, 1920-1923, are shown in the following “cumulative less than” table:

The per cent of the raw sugar produced at each price for the year 1922-23 is graphically illustrated in figure 3, 3*25 cents per pound being used as a lower limit in order to calculate mid-value points from table 3.

Perhaps it will be well to digress a little at this point and say something in regard to expense data and

net income data. Expense curves illustrating average expenses by establishments or groups of establishments, and net income curves for the same establishments must show the same general characteristics. One is the reverse of the other, as they tend to sell their respective outputs at approximately the same price per unit. We could either assume or find out from statistical records, the average price at which the output was sold, and then subtract expenses and secure differential net income per unit of output; but as far as illustration of differential net returns is concerned, nothing is gained; for every one recognizes that differential net income per unit and average expenses per unit tend to vary inversely 'when a group of esta.blishments producing the same commodity are compared.

U. 8. Tariff Commission, Sugar, 1926, p. 93.

132 U. S. Tariff Commission, Refined Sugar, p. 27. 133 U. S. Tariff Commission, Sugar, 1926, p. 94.



FIGURE 3 DIFFERENTIAL COSTS OF PRODUCING CUBAN RAW SUGAR 1922-1923

Per Cent of Output Expenses per Unit of Output 1920-21 1921-22 1922-23 25 5-65 r.Psn+.R P-17 f»Ar>+..et 5. RP 50 4.26 2.16 3.84 55 4.36 2.52 3.95 60 4.47 2.53 4.04 65 4.50 2.57 4.15 70 4.57 2.60 4.18 75 4.65 2.62 4 19 80 4.82 2.74 4 25 85 4.12 2.83 4»40 871 4.18 2.88 4 50 90 4.21 2.94 4 57 92t 4.35 3.15 4.67 95 4.69 3.54 • 5 17 974 4.06 3.65 5.29 100 4.18 4.77 5.92

Table

Sugar Refineries

■Further examples of differen- tial returns are furnished by the U. S. Tariff Commission. In many of the studies undertaken by the Commission it was assisted by Philip G. Wright, formerly of the Institute of Economics. Some of the results of the studies are found in monographs written by Wright and published by the Institute under the editorship of Harold G. Moulton. We think the Commission’s statistics are thoroughly reliable in spite of the political difficulties with which it must have been confronted*

The statistics for the sugar refining industry by establishments are entirely in agreement with our theory of differential net capital returns. On the basis of the data collected, the Commission reached some conclusions which may be summarized as follows:

First, "sugar is refined by different refineries at very different (average) costs (per unlt).” x^4

Second, ’’The price is seen to correspond to the highest or nearly the highest cost refineries, a cost which, for brevity’s sake, may be called the marginal costs. This situation has long been understood by economists to apply to industries subject to the law of diminishing returns--especially agricultural and extractive industries. Now, while the manufacture of raw sugar is such an Industry, the refining of sugar is not.(h) It is distinctly a manufacturing rather than an agricultural industry. The refineries have an equal opportunity to secure their raw material (sugar) at an approximately uniform price for whatever quantity they choose to buy. i,lsj

Third, “There is no limit imposed upon the potential economies of large scale production as is imposed in the case of agriculture by limitation of high grade 1and.” 156 "it would therefore be expected (according to the generally accepted faith in the equal' ity of net returns in manufacturing) that the low cost refineries would increase their output, underbid their competitors and either drive them out of business or compel them to improve their efficiency. There would, therefore, be a constant gravitation toward a uniform cost, which cost would be that of the low-cost refineries,” and average costs by establishments and marginal costs would tend to coincide, if the doctrine of a tendency to equality of cost in manufacturing were true.

Fourth, the Commission was forced to do more than modify the generally accepted doctrine of equality In the face of empirical evidence it turned out to be a tenet of ’’faith” rather than a scientific principle. As a working hypothesis the Commission found it necessary to employ a principle of differential net returns. The differentials seem to be practically as permanent in manufacturing as they are in agriculture. Of course, particular establishments have good and bad years and so does any given industry as a whole, but there is no empirical evidence showing that there is a general tendency for the differential nature of the rate of net returns to disappear. Some establishments are characterized by high costs and others by low costs year after year. This is illustrated by figures 4 and 5. Figure 4 is for one year only and -might be considered as the result of accident. Eut the diagram, figure 5, shows "that the varying costs of production and the relation of marginal costs to price” are "not simply due to exceptional conditions. . . ”138 ”j n this diagram the total cost lines and the price lines for the years 1914- 1917 inclusive are drawn in the same manner as in figure . . (4) . It will be seen that as the war progressed both the cost and the price rose, but in each year the two lines are of a similar character and bear similar

relation to one another. The cost line ascends step by step (each step being represented by a separate establishment) and is crossed by the price line at a point near the right hand margin.'

(h)if the Commission is stating the orthodox posi tion, it is wrong. According to the orthodox theory small establishments are ideal for illustrating uniform costs and uniform net returns.

154 U. S. Tariff Commission, Refined Su^ar, Tariff Information Series No. 16, 1920, p. 27.'

135 U. S. Tariff Commission, Refined Sugar, Tariff Information Series No. 16, 1920, p. 27. 136 Idem. 137 Idem.

138 U. S. Tariff Commission, Refined Sugar, Tariff Information Series No. 16, 1920, p. 28.



FIGURE 5 DIFFERENTIAL COSTS OF REFINING SUGAR, 1914-1?!?, INCLUSIVE

Costs per Unit Price line - r — — — — — — —- — ■— — — — — Catan Domestic Beet Hawiian Islands Porto Rico Louisiana Establishments

FIGURE 4 DIFFERENTIAL COSTS OF REFINING SUGAR 1916-1917

Animal and Vegetable Oil Refineries.

•The Tariff Commission has made worldwide studies by establishments for the animal and vegetable oil industries. The conclusions reached from these studies further confirm our theory of differential net capital returns. They indicate that there is an Intensive as well as extensive margin in manufacturing. As in the case of sugar refining, the evidence shows that net returns in manufacturing are like those in agriculture. . these studies were made by establishments. The average cost per unit for each establishment was ascertained. But it may be safely assumed that each (supra-marglnal) establishment was producing units of output at varying costs up to a cost approximating the marginal costs, otherwise a low cost producer would have already increased output, thus lowering the price and squeezing out one by one the higher (average) cost producers until the price was reduced to his own costs. Hence, when the price rises (without a corresponding rise in

expenses) it will not be merely one producer at the margin who will find it profitable to increase his output, but all the low cost producers as well.”^ 0 In other words, the intensive and extensive margins both shift with price; but there is no tendency for average returns and marginal returns to coincide.

Now the vegetable oil refining industry should not be considered a crude extractive process commercially possible only in the proximity of the farms and groves. In the case of coconut oils the dried neat or cobra from which it is obtained sells in a world market. Proximity of the refinery to the source of raw materials is no great advantage. For example, American refineries import much of their cobra from the Philippines and successfully sell their refined oil in competition with that produced by the Philippine refineries. In the case of most vegetable oils, the crude is extracted near the source of supply and then sold to refineries in a world, or at least a national, market. “Several factors favor the importation of crude vegetable oils rather than refined oils. In shipping refined oils, contamination is possible and greater care must be exercised in selecting containers and in packing than is necessary with crude

oil.” 141 ”ln the case of cotton seed oil, the crude is usually extracted near the source of raw material, the mills often operating in connection with the gin. The crude is then shipped in tank cases to the refineries. ” 14 2

In the light of statistical evidence the tendency of net capital returns to differentials is unmistakable. The re joiner that the economic world is going to ’’tailoff” into some kind of a static condition, where static laws or long run tendencies will have been consummated, is only a prophecy. Individual establishments are not going to adjust themselves to an equilibrium point or point of efficiency of output at some time in the future. In general, they are already adjusted at any given time. It is the nature of this adjustment or equilibrium in the present world that is of scientific importance. With this adjustment, differential rather than equality of costs and net income is the rule. Wright has arrived at the same conclusion. Here we may borrow his diagram and let him describe it. He says: “The diagram, figure . . . <6) will help to make clear the above statement. The ’steps’ AB, smoothed into the curve A. 8., are typical of the Commission's cost curves when (average) costs are taken by establishments. Consider the producer whose output is EF. His average cost is GE, but his unit cost may be assumed to range from IE to KF. Since what is true of this producer is true of all, it is clear that a “true” cost curve would show a much greater part of the output produced at or near the marginal costs. That is, there are intensive as well as extensive margins in all industries and differential net returns in all industries.

Although we independently arrived at this theory of the margin of intensity, we find that it was also briefly but clearly stated by Sidney and Beatrice Webb a quarter of a century ago. They say;

Those who are most favored will nroduce the greater utility, but even the best will find a limit beyond which the humblest may successfully compete with him. Beyond this point, the ’lav? of diminishing returns' becomes patently effective; and though, for instance, there are in London printing establishments varying in magnitude from the proprietor of a hundred machines down to the ■ jobbing compositor with his hand-press, a whole century of competition leaves the various businesses competing with each other on apparently equal terms, for they continue to exist side’by side.

It is in this way that capitalists compete with capitalist. The statement Is true that, abstraction made of land and ability rent, ’profits ’--that is, the return to capital--'tend to equality’; but it is

equality only of the return to the last increment of capital employed in each case. The possessor of a prosperous mine or business does not go on increasing it beyond the economic ’margin of cultivation’ merely because on the average of the whole capital employed, he could still earn the market rate of loan interest. He will not borrow to extend his operations unless the extension itself will yield more than the loan interest on the new capital employed therein. He, like the tiller of the soil, stops at the point where further profit would be a relative loss; and he thus maintains safely the ’economic interest’ of the more advantageous earlier

Our statistical examples refute Marshall ‘s.idea of a normal or representative firm, which Taussig has described as ”. .one not far in the lead, not equipped with the very latest and best plant and machinery, but well equipped, well led, and able to maintain itself permanently with substantial profits. Side by side with them are also the weak and struggling —'Some under inept management and doomed to failure, and others under good management but still in the early stages of scant capital and unestablished connections. Prices tend to adjust themselves to the expenses of production at the hands of the representative firm. We think that Taussig correctly summarizes Marshall, but we find no evidence

of any concentration of costs of production per unit such as would justify our saying that one group of firms is more representative than another. It seems as impossible to find representative firms in non-agricultural industry as it is in agriculture. Nor is there any evidence that price tends to coincide with the cost of production of the Marshallian representative firm, 1 unless we consider the marginal firm representative. Price approximately coincides with the cost of production of the firm at the margin of discontinuance, which has no net income attributable to its fixed capital. Anticipated price also must coincide with costs, including interest on the whole investment, in the case of the firm at the margin of entry; but there is no evidence that firms actually enter at this margin in sufficient numbers to give a marked concentration of a rate of returns approximately equal to interest at the market rate on the total cost of production and operation.

But may it not be that classical and neo-class! cal economists have had in mind-a mere arithmetic average rate of net returns--an average which is about the same in all lines of production? Could such an average be called a ’’common rate”? We think not* Of course, there is an everage rate of net returns in industry. It is possible to secure an average for any group of phenomena which can be expressed in commensurable quantities. But unless there is marked concentration or grouping of cases about a particular point, the deviation or dispersion is so great that the average has little or no significance. It would be an absurd and unjust criticism to say that men like Ricardo, Marshall, Taussig, and other able classical and neo-classical economists have spoken of a mere arithmetic average as ’’normal", typical, or ’’representative”. The mistake has been due to a lack of data, we think, and not at all to any lack of ability to select and emphasize significant facts where such facts are known.

139 U. S. Tariff Commission, Refined Sugar, Tariff Information Series No. 16, 1920, p. 30.

140 Wright, Philip G., The Tariff on Animal and Vegetable Oils, p. 293.

141 U. S. Tariff Commission, Certain Vegetable Oils, 1926, p. 78. — 142 ibid, p. 80.

143 Wright, Philip G. , The Tariff on Animal and Vegetable Oils, pp. 293 n, 295n7~

144 Webb, Sidney and Beatrice, Problems of Industrial Democracy, (London, 1902), op. 220, 221. 145 Taussig, F. W. , Principles of Economics, 3rd Ed.,VoLH p. 184.

146 Marshall, Alfred, Principles of Economics, Bth Ed., p. 460.



FIGURE 6 TYPICAL DIFFERENTIAL COSTS BY ESTABLISHMENTS IN MANUFACTURING

2. The Law of Differential Net Capital Returns

(1) The Law Stated.

--The law of efficiency of output has been stated, and so has the margin of discontinuance. They and the lav? of differential net capital returns are closely connected. Summarily stated, the latter law is this: At any given time every business establishment tends to expand production to the point where the greatest total net exchange value returns are secured. Price changes or changes in supply and demand conditions cause this point to shift, so that the equilibrium point, or point of efficiency of output, gives a

moving rather than a static equilibrium tendency. There tend to be equi- intensive and extensive marginal net capital returns and unequal average net capital returns, so that the rate of net returns on the whole investment in producing and operating respective establishments varies widely. The varying rates of net returns from one establishment to another arrange themselves at gradatum. At the lower extreme the net returns are barely sufficient to approximate interest at the market rate on that part of the investment which can be withdrawn and Invested elsewhere; while at the upper extreme the net returns are much more than equal to interest on the whole investment necessary to produce and operate the establishments .

(2) Significance of the Law.

--The law of differential net capital returns may be said to be significant from the point of view of both “pure” and applied economic science. From the point of view of "pure" economic science it answers the old question why, under conditions of competition, the capital good does not tend to sell at a price equal to that of its aggregate product. More than a hundred years ago Ricardo answered the question for land by explaining that it does at the margin. We give the same answer for capital goods in general. In the case of the enterprise at the margin of discontinuance there is no net return attributable to that part of the investment which is sunk. It is as easy--really much easier on account of differences in available statistics --to locate no-net income non-agricultural producers’ goods as it is to locate no-net income agricultural producers’ goods. No-net income capital goods, employed by enterprises at the margin of discontinuance, are abundant and significant, because they aid in producing a fairly large part of the consumers’ goods offered in the market and hence Influence prices. At the same time other capital goods have a differential rate of net returns attributable to them. Since the time of Ricardo this has been recognized in agriculture; but we have shown that the law of differential net capital returns applies to all income-producing property.

But what of it? This question, often asked or implied in critical discussion, usually means, of what practical importance is it? Does it help to explain market price? Can it be used as a tool in regulating price and production? And so on. We again say: Economic laws are merely statements or generalizations of empirical fact. They are truisms. And there can be no more principles or laws than there are facts. The laws or generalizations are working hypotheses to be used at a particular place, time, and under certain institutional circumstances. We think the law of differential net capital returns meets the test of a scientific economic law. We have already explained that it answers the old question in regard to the difference between the price of the producers’ good and that of its product. But socalled practical examples of the significance of the law are not lacking.

Our theory emphasizes the difference between marginal returns and average returns of production. The generally accepted theory that for non-agricultural industries marginal and average returns tend to be equal is fallacious. This is important because it is marginal costs that tend to coincide with price. The fact is that the supply produced at less cost sells for the same price per unit and hence gives a differential return. This does not mean that marginal costs directly determine price. The margin shifts with price, but the price also shifts with the margin. If price rises, expenses not rising, the enterprise can expand production until a new margin is reached. Price thus determines the margin; but if the marginal expenses of production were

not so high, the supply would be greater and the price per unit less. There is nothing mysterious about this. It is like saying that the blow of the hammer would drive the nail further, if the resistance of the wood were not so great. Disregarding opportunity expenses for the present, the conclusion is that the average expenses of production have nothing to do with determining supply and price.

If prices be lowered for any cause, the expenses of production remaining unchanged, enterprises at the margin of discontinuance are forced out of business. Other enterprises become marginal. But this is not all. A new intensive margin for supra-marginal enterprises is established. So supply is reduced as a result of discontinuance of production at both margins. It is important to recognize this when any maximum price fixing is contemplated. A price could easily be fixed so low that the demand would more than exhaust the supply and make it difficult to prevent producers from selling at a price higher than the legal maximum. That is, if price is fixed lower than marginal expenses, that price will determine a new margin. Some enterprises will discontinue. The supply will be further reduced by a rise in the intensive margin. Then at the legal price demand may greatly exceed supply. Suppose the commodity whose

price is thus fixed is sugar.’*., there will be a scarcity, and the government will be forced either to permit a higher price or undertake the distribution of sugar."l4B

It is important that the margin of discontinuance be correctly understood when any protection to industry takes the form of equalization of costs of production. For example, the government should not start with the idea that home prices should be high enough to yield a net return equal to interest at the market rate on the whole investment employed by the high cost domestic establishments. If prices are raised by means of a tariff duty for this purpose, other enterprises will soon be found at the margin of discontinuance notwithstanding the protection. In fact, the imposition of the duty probably would catch some enterprises which were in the process of discontinuance and hold them at this margin. More and more protection may be granted until the duty becomes prohibitive and still there will be enterprises at the margin of discontlnuance--establishments which receive a net return equivalent to less than Interest at the market rate on the investment employed in producing and operating them.

Section 315 of the United States Tariff Act of

1922 provided for duties to equalize costs of production of certain goods between the "United States and foreign countries. In most instances a duty was already being im posed on these goods and there was the problem of raising or lowering the old duty. Let us take the case of sugar again, for it presents a real problem. "Since sugar is produced at many different costs in all regions of production, both foreign and domestic, it becomes necessary to make some selection among the numerous domestic costs and the numerous foreign costs in order to find a differential between the domestic cost and the foreign cost which shall fix the duty that is to equalize these costs. Marginal cost cannot be used for this purpose. If production be considered complete when the sugar is delivered at a particular market, say New York, the marginal costs of all regions with reference to the New York market are equal. The imposition of any duty raises marginal costs of imported goods. It is now the former marginal expense plus the duty. The increase in costs will cause foreign output to decrease. After the imposition of the duty, the marginal expenses of production of the two countries with the duty not figured in will show a difference equal to the duty. But the duty

is a marginal cost to the foreign producers. In other words, marginal cost and price tend to equality, and for this reason marginal costs cannot be used as a tool with which to determine differences.

But we have explained that average costs and marginal costs are different in all industries. Average costs can be used in measuring regional differential advantages in production. The highly favored regions will have many establishments whose average costs of production are low as compared with the less favored regions. This is what the advantage consists of. The United States Tariff Commission has recognized this and has used weighted average costs in measuring differences in expenses of production between different regions.

Thus, in dealing with price problems it makes a great deal of difference whether we recognize the existence of differentials or cling to the old faith in equality of marginal and average costs. We have shown that the present price system operates so that finished products tend to sell at the same price in the same market during any given period of time. Here empirical evidence confirms the orthodox theory. But the summation of cost prices of production per unit of output varies greatly from one establishment to another. These differentials are independent of any particular manager. The enterprises themselves are evaluated according to their net returns and not according to the cost of producing them.

As we have stated, the classical and neo-classical economic theorists have generally accepted the ’’law” of a "common rate” of net business returns. We do not mean that they have considered the rate of net returns in industry perfectly uniform at any given time. We mean only that they have considered all units of capital perfectly mobile and interchangeable over a period of time, so that what any one unit gets every other unit must tend to get in the long run, given competition such as actually exists. The differential losses and gains have been regarded as only temporary deviations from the "common rate". The deviations have been called “pure profits”. Using the term in this sense, one may correctly preface his history of the theory of ’’profits”, as F. H. Knight does, with the statement that there is a "universal recognition of the ’tendency 1 of competition to eliminate profit,”lso differentials in non-agricultural and non-monopolistic businesses.

Here we are not much interested in the particular name that should be given the differential. It is a

matter of indifference to us whether it is called “pure profits”, “economic rent”, or simply differential net returns. We are not trying to make any contribution to economic terminology as such.

The term "pure profit”, meaning something in excess of the "common rate", has already undergone several changes in meaning. For instance, Frances A. Walker elaborated a management theory. More recent economists have generally regarded management as a form of labor which receives a wage payment. Economists are now divided into two groups on the question of the cause of these "temporary” differentials. One group hold the risk theory and the other the dynamic theory. We agree with the latter, except that we regard the differential as relatively permanent, while they regard it as temporary. But we fully recognize that management and risk must be paid for.

Now if our theory of the margin of discontinuance is true, it completely destroys the generally accepted theory of the minimum rate of net returns necessary to prevent a business from discontinuing. The business man’s opportunity to lend all of his capital at interest in the loan market is largely gone when it is once “sunk” in a going business, as was explained in Chapter IV. We have shown also in the present chapter that there is no marked tendency to a concentration of the rate at a point approximately equal to the market rate of interest. Proof of the generally accepted theory of the tendency to uniformity of net returns in industry would require that there be found marked cone ent rat ion about such a common rate as a. central tendency.

No doubt many differentials are due to monopoly. But monopoly differentials and dynamic differentials are hard for us to separate because present society seems to us to be typically semi-competitive. If we were elaborating a theory of monopoly, we should differ from the common run of writers in that we should treat monopoly as something less absolute than they do. On the other hand, we should insist that almost every individual business has some monopoly or differential advantages. We think absolute monopoly and absolutely free competition are the exceptions in present society. Consequently a normative economic science must treat present society as semi-competitive.

But there are differential business returns which are not accounted for by what economists would call monopoly power or privilege. As J. B. Clark contends, they are due to dynamic changes. “(1) Population is

increasing. (2) Capital is increasing. (3) Technical processes of Industry are changing and improving. (4) Modes of organizing labor and capital are changing in the direction of improved efficiency. (5) The wants of mankind are becoming multiplied and refined. It is out of these types of change that the phenomena arise which constitute the data of dynamic economics.”ls2 disagree with Clark, however, in regard to the permanence of the differentials. He regards them as temporary. We regard them as relatively permanent.

Of course, a dynamic theorist cannot hold to any but relative permanence. Looked at over a period of five, ten, or twenty years, the establishments in a given line of production are seen to have very different average rates of net returns. Low income and high income establishments generally retain their positions relative to each other year after year. They are likely to continue relatively as they are for an indefinite length of time. The general practice of evaluating the businesses themselves by the capitalization of their net Incomes is a recognition, in the market place, of the permanent nature of differential rates of net business returns; but there is no assurance that either the low

or the high income establishments will be in existence a hundred years from now.

In closing this chapter we wish to stress that, we think, we have reduced a very large part, but not all, of the net returns in industry to differentials. We say not all, for working capital tends to get the ’’common rate", or the market rate. Also the business as a whole tends to have an exchange value determined by the capitalization of its net earning at the market rate. We shall postpone any consideration of the market rate and of capitalization until after we have presented the chapter on the margin of transference.

. . the exploitation of the capacities of any factor encounters elastic limits and increasing resistance. ”147

147 Clark, J. M. , Economics of Overhead Costs, p. 72.

148 U. S. Tariff Commission, Refined Sugar, Tariff Information Series No. 16, p. 28.

149 Wright, Philip, G., Sugar in Relation to the Tariff, pp. 122, 123. “

150 Knight, F. H. , Risk, Uncertainty, and Profit, p* 22. '

151 Knight, F. H. , Risk, Uncertainty, and Profit, pp. 30, 31.

152 Homan, Paul T., Contemporary Economic Thought, p. 85. Also, Supra, p. 62.

153 Dewing, A. S., Financial Policy of Corporations p. 99. ~

CHAPTER VII THE MARGIN OF TRANSFERENCE

1. Opportunity Costs, or Expenses. 2. The Theory of the Margin of Transference Stated.

1. Opportunity Costs or Expenses

In the case of an enterprise operating above the margin of discontinuance, is there no way whereby the net return attributable to fixed capital, or fixed capital goods including land, can be an expense of production? Any agent of production has exchange value only because its product has exchange value, not the contrary. The exchange value of fixed capital goods is price determined, but so is that of any other productive good including labor. The replacement of capital goods in industry as a whole and the replacement of laborers in society as a whole are expenses that must be met if the total supply of these productive agents remains undiminished. Whatever an agent receives above this amount is a net surplus to it; and a surplus can affect prices, if at all, only as an opportunity cost. But maintenance cannot be such a cost. It has already been explained

that a concern at the margin of discontinuance must have a surplus Income great enough to cover interest at the current market rate on the working capital employed, because the owner of this capital can--and as far as his conduct is economical wlll--wlthdraw it from the enterprise which offers less than this rate and avail himself of the opportunity to employ it at the current market rate. Thus Interest on working capital is an opportunity cost that must be paid, if the concern is to continue to operate and deliver its supply of goods to the market.

It is because fixed capital goods are “fixed", that fixed capital cannot be liquidated like working capital, and hence does not enjoy the practically unlimited investment opportunities of liquid capital. We are well aware however of the fact that capital, or capital goods, of all degrees of liquidity and fixity are now in existence; nevertheless we think that there are two great categories of capital which are on the whole distinct from each other, and that in our present society, which is characterized by unforeseen economic opportunities occurring over a period of time, there is a vast difference between the possibilities of utilizing liquid capital and fixed capital in the exploitation of these opportunities.

The surplus attributable to fixed capital goods cannot be an opportunity cost except to the extent that these goods possess alternative opportunities. The amount of opportunity expense depends upon the opportunity foregone. An enterprise may have a surplus attributable to fixed capital, but at the same time be so highly specialized that it can operate above the margin of discontinuance in the production of only one good. In such a case interest on fixed capital or economic rent is no opportunity cost, for no opportunity is foregone. If an enterprise can operate above the margin of discontinuance in the production of two goods, and the surplus attributable to fixed capital in one case is and in the other only |5,000,000, the second alternative income, which quite obviously will be foregone, is so much less than the first that no difficult problem arises as to which opportunity will be selected, and no importance is here attached to opportunity costs. Certainly differential returns to fixed capital including the economic rent of land and opportunity costs are not coextensive; and any unqualified statement that such differential returns are opportunity costs is not correct.

Opportunity costs or expenses, like any otherexpenses, can affect the price of a commodity only by first affecting its supply. For example, if the price of consumers’ good A declines or the price of consumers’ good B rises, and some of the fixed capital goods used in the production of A have as their next highest alternative opportunity the production of B; to the extent that this alternative is possessed, the production of B will be substituted for A when the returns offered in the production of B becomes greater than those offered in the production of A. In this way the market supply of A will be decreased and its price per unit will tend to rise or its decline to be arrested; while the market supply of B will be increased and its price per unit will tend to decline. The demands respectively for A and B constitute competitive bids for the use of agents that may be used in the production of either. Where two commodities may be produced by the same agents of production, society cannot have more of one of these commodities except by the sacrifice of having less of the other; and of course, the alternatives are often many fold instead of two.

154 Davenport, H. J., Economics of Enterprise, Chapters V-VIII; Hayes, H. Gordon, Our Economic System, Vol. 11, pp. 432-437.

2. The Theory of the Margin of Transference Stated

If an enterprise has two or more equally advantageous productive opportunities, it is at the margin of transference. If a steel mill is producing munitions and from the point of view of net Income it could equally well produce railway equipment and materials, it is at the margin of transference in the production of munitions. Or if a farm is producing wheat and from the point of

view of net income it could equally well produce oats, it is at the margin of transference in the production of wheat.

Of what importance are our margins? Some of the fixed capital goods used in the production of many, perhaps most, commodities have at least some alternative opportunities; and observable changes that are being made indicate that many concerns not only have productive alternatives, but that they are at, or near, the margin of transference. Other things remaining the same, if the price of commodity A declines, the enterprises operating at the margin of transference in its production, will transfer production to a superior alternative, say the production of B; but this alternative which is rising relatively may be exploited also by investments at, or above, the margin of entry. The production of B may be further increased by an expansion at the intensive margin in the case of enterprises already producing it. And at the same time, the decline in the price of commodity A may force concerns operating at the margin of discontinuance in its production out of business; while supra-marginal concerns engaged in its production contract output at the margin of intensity. Hence not only are all of our margins of importance in a dynamic society, but more than one of them may be important at

the same time with reference to the same commodity.

We may now give some further consideration to the margin of discontinuance. It seems that some industries employ little or no capital goods at this margin. For example, it is difficult at present to find wheat production on no-rent land. Nevertheless, the margin of discontinuance indirectly affects the supply--and hence the exchange value--of wheat, as long as any product of land at the margin of discontinuance--say product X-- could also be produced on the present wheat land. For illustration, let us suppose that the maintenance of the land, which is producing X at the margin of discontinuance, becomes more expensive due to an increased scarcity of a particular fertilizer which it requires. Other things remaining the same, a part of the supply of X will be gradually cut off at the margin of discontinuance, and its price per unit will rise. But suppose that before the rise in the price of X is sufficient to prevent further discontinuance, it is nevertheless high enough to cause some of the land devoted to vzheat production to be transferred to the production of X. This in turn will cause a decrease in the supply of wheat and a consequent rise in its exchange value. As

this takes place, other productive transfers will also occur, as, for example, the transference of oat and maize land to the production of wheat. Furthermore a rise in the exchange value of X will affect the economy of its use, regardless of whether it be a so-called finished consumers' good or a producers* good. If it be a producers* good, the rise in its price may force marginal producers out of the field in other industries which use it. As the enterprises in the latter industries raise their prices to customers, the number of units sold will decrease, and the fixed capital goods em ployed at the margin of discontinuance will pass out of use, unless the rise in their sales prices is sufficient to compensate for the diminished number of units sold. Here the plight of concerns at the margin of discontinuance is probably aggravated by the fact that the supramarginal enterprises of the same industry find it advantageous to absorb some of the rising costs in order to more fully utilize their plants. In this way discontinuance in one industry may affect an almost endless chain of directly and indirectly related industries. The discontinuance of the fixed capital of a steel mill, for instance, may greatly affect the supply a,nd demand relationships of certain coal mines, iron ore mines, banks, mercantile establishments, etc; and these enterprises may in turn transfer some of the disturbance on

to all other enterprises with which they have economic relations as buyers, sellers, and borrowers or lenders. With our intricate supply and demand relationships between different industries, or different fields, of pro duction and distribution, whatever affects one of them tends to affect them all. But an initial disturbing force, such a force being generally unforeseen and unpredictable, probably never finds complete rest or equilibrium before it meets, collides with, or is accel erated by numerous other forces also seeking equilibria which are never attained.

155 Hayes, H. Gordon, Our Economic System, Vol. I pp.

CHAPTER VIII THE MARGIN OF DEMAND FOR LOAN FUNDS

1. Business Demand for Loan Funds. 2. Government Demand for Loan Funds. 3- Consumers’ Demand for Loan Funds. 4. The Margin of Demand for Loan Funds.

It was shown in the preceding chapters that the differential net returns attributable to all fixed capital goods are fundamentally the same as those attributable to land. It was shown that all surplus income which any enterprise receives in excess of the current market rate of interest on the investment in working capital goods should be attributed to fixed capital goods; that is to that part of the capital which is “sunk" so. that it. cannot economically be withdrawn from its present employment. Further it was explained in detail that an enterprise ? agricultural or other, continues to operate as long as its net income, or its anticipated net income, is approximately equal to interest at the market rate on the investment in the working capital goods employed; that is, on that part of the investment which is represented by liquid assets and other assets which can be -liquidated, so that it can be withdrawn and employed elsewhere at the common rate. It was particularly stressed that replacements, repairs, and the like, of fixed capital goods must be taken care of as the need arises regardless of the accounting device employed. Depreciation, or replacement costs if no depreciation reserve account be set up, is a part of the operating expenses. This, as was explained, is fully recognized by contemporary accounting and business practice in general. Now in the case of an enterprise which is at the margin of discontinuance there is no net income attributable to the investment that is sunk in the form of fixed capital goods; but such capital goods must fully maintain themselves. If the gross income sinks to the point where it is not sufficient to meet all operating expenses and interest at the market rate imputed to or paid for the investment in working capital, the establishment is submarginal and cannot economically continue to operate. Thus the net return attributable to fixed capital goods is a differential and may be measured from the no surplus income, or marginal fixed capital goods, which have a zero net income, but which continue to operate and deliver to the market a supply of goods which is as effective in helping to determine the market price as that of the supra marginal business. Now available statistical evidence, where such evidence is recorded irrespective of the amount of the net income, shows that many businesses are at or near this margin. Such reports also reveal the greatest

lack of uniformity of rates of net incomes on total investment costs when establishments are compared with one another. It cannot be said that there is a rate, or the rate, of net returns attributable to the Investment in fixed capital goods, or that there is a rate of econo mic rent in industry.

Yet there is a market rate of interest. This is a price for the use of loan funds. But are not loan funds merely liquid capital? Loan funds are always liquid capital; hut all liquid capital is not loan funds. As has been explained, liquid capital, to be ideally liquid, is in a form of a medium of exchange, such as cash and demand bank deposits. It is a claim or property right to undesignated economic goods. The owner of it can use it in demanding consumers’ goods, convert it into a property right in a going business, or use it as an aid in bringing a new business into productive existence. Still it is not a part of the market supply of loan funds. But he can also offer to lend all or a part of his claim to undesignated economic goods at a certain rate per year; then the part of this claim so offered is a part of the loan funds in the market at the time.

These funds can be lent at a price because of their economic productivity. They are goods which immediately aid us in securing producers’ goods, governmental goods, or consumers* goods. They possess scarcity, are the objects of property rights, and are wanted only because of their usefulness in securing goods which are wanted for themselves. Loan funds have these three.requisites of economic productivity.

Nov/ the market rate, or price, for the use of these funds is a demand and supply phenomenon. For this reason we shall discuss first (1) the demand side and then (2) the supply side. Next, (3) we shall explain that the control of investment opportunity and the control of loan funds are not always incident to the same persons. Then (4) we shall discuss the marginal productivity of capital and the function of the market rate of interest. Finally, (5) we shall briefly describe discount and capitalization which are the result--not the cause--of the market rate of interest for the use of loan funds. The present chapter and the two remaining ones will be devoted to a discussion of these subjects.

156

Mill, John Stuart, Principles of Political Economy, Chapter IV.

1. Business Demand for Loan Funds

The chief demand for loan funds is for business purposes. In a positively progressive society new invest ment opportunities are constantly occuring. Nev/

inventions call for capital to exploit them. Some examples of this are the steam engine, textile machinery, automobiles, radio, airplanes, and so on. Discoveries of new things of economic value, or of new processes, like the Bessemer and later the non-Bessemer process of refining iron ore, or the multitudinous methods of generating and applying electricity, create demands for loan funds. Added to new inventions and discoveries is the demand for loan funds due to the newly discovered or newly made opportunities to expand them after they have been long in use, as with the railway. The last kind of opportunities are'often due to changes in general economic conditions, to the accumulation of wealth, to the growth of population, and to the stabilization of the institution of private property in the so-called backward countries. Then there are the constantly recurring opportunities due to the changes in fashion, etc. Also general changes in the education of people and changes in the distribution of wealth create new demands for certain economic goods of a kind and quantity not formerly demanded. Changes in credit policy, as from cash to installment selling, create investment opportunities for those wishing to finance such selling. We should also note that the opportunity to secure monopoly through financial control may lead to borrowing on a large scale. Finally the business

cycle exercises such an influence on the demand for loan funds and upon the general level of prices that it belongs to a separate field and can be touched upon only incidentally in this outline. Now if all of these investment opportunities were exploited without a resort to the loan market, if only common stocks were sold and sold by the promoter directly to the public, there would be neither lending nor borrowing of liquid capital nor a rate of interest as far as business is concerned. But in actual practice such opportunities are not usually exploited without a resort to the loan market.

But do not inventions and discoveries belong on the supply side of the equation? In a study of the factors which determine the rate for the use of loan funds they figure on the demand side. Yet from other points of view, they are the most important items on the supply side. With them society can get more goods with a given outlay of capital and labor than without them. They are the things which mark man’s control over nature without which an industrial civilization such as we now have would be impossible. The whole accumulation of capital rests primarily upon inventions and discoveries and only secondarily upon savings. But in a study of the loan market they are clearly the cause of the demand for loan funds. In present society new inventions and discoveries, using these terms in a very broad sense, are the chief 157 cause of an ever expanding demand for loan funds. First, comes the invention or discovery and then the demand for the liquid capital which can be used to direct capital and labor so as to give form to capital goods or industrial equipment needed to exploit the Invention or discovery. Mere duplication of machines, or mere increase in savings, other things remaining the same, would not pay beyond a certain point. This leads Taussig to conclude that maintenance of anything like the present rate of interest "depends on a race between accumulation and improvements. ,f

Finally, there is the demand foi loan funds which arises out of the seasonal nature of business. The amount of capital needed in a given business varies. For l example, the farmer*s needs are usually greater during the planting, cultivating, and harvesting seasons. If he has surplus funds of his own, it may be more profitable to invest in more land or in securities and depend on the loan market for that part of his working capital which he needs during only a part of the year. Merchants, manufacturers, and others also have varying needs for working capital. They depend on the commercial bankers and other purchasers of short term paper to help them carry the peak loads, which occur at different seasons in different industries, so that a large volume of steady demand for the loan funds of the community is due to the seasonal nature of business.

157 Taussig, F. W. , Principles of Economics, 3rd fh Vol TT p. 32. ** ’’ 158 Idem.

2. Government Demand for Loan Funds

Modern governments borrow considerable sums of loan funds. In ordinary peace times most of these funds are employed in meeting current operating expenses. Usually they are paid back in a short time in the case of any given government agency; but not all such agencies demand and pay these loans at the same time. Consequently as a whole, the demands for loans to meet current government operating expenses are fairly large and constant. These demands are mostly satisfied by the commercial banks and are therefore analogous to the short term demands of the business world. But usually during a war or other great emergency the operating expenses of any governments involved are met by long term borrowing. Also typically all public improvements of a so-called permanent nature are financed by long time borrowing. Of course, the employment of these borrowed funds does not directly add to the future income of the government. If the promises to pay are kept, the means are secured

through some form of taxation. Nevertheless, if such loans are an aid in the exercise of any function which adds to the social welfare, they are socially productive-but not productive in the business sense, because their employment does not yield an exchange value return to the borrower.

3. Consumers' Demand for Loan Funds

Consumers* demands for loan funds are of two kinds The first has consumption for immediate enjoyment as an end, "If the country is prosperous, if the standard of living is rising, families are prompted to anticipate their increase in earnings, or at least their accumulation of savings, and extend their scale of living by borrowing." The purchase of dwellings, radios, automobiles, furniture, and such things on credit or installments furnishes some very real examples of consumers* demand. However, it is easy to exaggerate the importance of the demand for this kind of loans. For example, we should guard against double counting. Selling of consumers ' goods on credit usually causes the business to enter the loan market to borrow in order to meet its own obligations. If we count the borrowing of the consumer

in addition to that of the business, we have counted double. Here only one demand is effective in the loan market. Also we should remember that ordinarily neither the borrower nor the lender anticipates that the employment of loan funds for the purpose of enjoyable consumption will yield an income with which to pay the principal and interest.

The second kind of consumers* demand is similar to business demand. immediate consumption itself is not the end but only the means to an end. in a democratic country many individuals borrow in order that they may avail themselves of an education or other personal improvements by which they hope to increase their earning capacity. The borrower consumes that he may produce.

159 Hayes, H. Gordon, Our Industrial Svstem, Vol. 11, pp. 405, 406.

4. The Margin of Demand for Loan Funds

Certainly in present,society the demand for consumers ’ loans and government loans together is by no means as significant as that for business loans. Ely, Adams, Lorenz, and Young say that it is business use which makes it possible to pay most of the interest which is paid; and the withdrawal from the loan market of the 1 (business) borrowers would exercise a greater influence upon’’the interest rate than the withdrawal of all other borrowers combined.“l6o p.n. Knight

says: “At present consumption loans are negligible in comparison with loans for conversion into new productive goods; when they are made they, of course, take the same rate of interest, allowance being made for degree 161 of security against loss of principal and interest.” By far the greatest part of both the total and the margi nal demand for loan funds is for business purposes. However, we cannot say that no part of the marginal demand is for governmental and consumption loans. At any given time, a rise in the market rate of interest may cause some of the demand for each class of loans to disappear. Likewise a fall in the rate may cause an increase in the quantity of funds demanded by each class of borrowers. Any borrower who will borrow at the present rate but not at a higher one is a marginal borrower Or in the case of business, we may, if we like, define the margin as a point of indifference, and say that the margin is at that point where the income anticipated from the investment of the funds is equal to their cost. Summarily stated: any current borrowing is at the margin of demand if it would not take place at any rate of interest higher than the present one.

160 Ely and Others, Outlines of Economics, sth Ed.., pp. 470, 471.

161 Knight, F. H., Risk, Uncertainty, and Profit, p. 328

CHAPTER IX THE MARGIN OF SUPPLY OF LOAN FUNDS

1. Individual Savings. 2. Institutional Savings: (1) Business savings. (2) Bank savings. 3. Theory of the Contemporaneous Process of Production. 4. Interest as One of the Costs of Supplying Loan Funds.

Let us first take account of the supply of money. At any given time society needs a certain quantity of money for general circulation in order to reap the full ■benefits of a specialized economy with the division of labor, territorial specialization, and private profits as the motivating reward to business. If society had less than this amount a premium might be paid in order to acquire more money, but this would merely take the form of lower money prices which would cause goods other than money to flow out while money flowed into the country; or a bank might offer relatively high interest in order to secure an increase in its gold reserves. But a mere increase in the total supply of money within a country does not Increase the supply of loan funds relative to demand. Such an Increase tends to cause prices to rise; while the Interest rate tends to remain unchanged, because a correspondingly larger number of units of money are demanded by borrowers, and they pay a correspondingly higher price per unit for the goods which

they buy , so that the demand relative to the supply tends to remain unchanged. The opposite is true in case the supply of money is diminished, as long as society can still give the maximum effect to the specialization of its economy as far as money has anything to do with it. In this connection it should be emphasized that any kind of credit money produces the same results as standard money as far as it does all that standard money does. A change in the quantity of either does not affect the rate of Interest unless it first affect supply and demand unequally so as to change their relationship.

1. Individual Savings

Loan funds come into the market as a result of two methods of saving, individual and institutional* But the creation of other capital goods and the creation of loan funds are not the same thing necessarily. For example, the surplus income of an individual or business may be only the difference between the imputed value of the assets at the beginning and at the end of a certain time. Yet if the same methods and care in evaluating have been used in both cases, at the beginning and at the end, and there is a positive difference, there is a saving but no loan fund. The prize fighter, the speculator, or the hank rohher may come into the possession of millions of dollars in liquid capital and still there is no loan fund until they offer to lend it. If they do, the fact that they have furnished neither food, clothing, nor shelter for labor and have created no supply of consumers' goods for such a purpose and have made no capital equipment during the process of accumulating the millions is immaterial. They have property rights in undesignated economic goods and can become lenders if they wish. If they had gained their money directly or indirectly by making producers 1 goods, there would tend to be a greater supply of producers 1 goods and hence a cheaper price per unit for them, and the loan fund would tend to have greater purchasing power per unit; and society would have had less entertainment, speculation, and robbery in the past. The point is that with the division of labor such as exists at present, no fund of either durable or subsistence goods needs to be brought into existence along with the loan funds even in the case of individual savings. Nor does the absence of such a fund have much to do with the use of the funds lent. Production of all kinds of goods is a .contemporaneous process and no wages fund of subsistence or other goods is required.

Nov/ individual savers annually contribute a large amount to the loan funds of society. Many individuals save and lend a part of their wage income; however, capital income in the form of dividends and interest received is the most important source of individual contributions to this fund. Taussig has emphasized that a large portion of these contributions come from the wellto-do and the rich, and that consequently to the extent that this is true, little or no abstinence, or sacrifice cost, is involved. 1 " 4 Ely and his co-authors say:

V/hen considering the various classes of people who supply capital, we begin with the small class of savers who—if necessary—would pay some trustworthy custodian to keep their saving for them, i.e., who would take negative interest rather than make no provision for future want. Then comes an important class of savers who are bent upon putting aside enough money before they die to leave their families with a minimum income, the amount of which is more or less definitely fixed in their minds. Such people would actually save more when interest rates are low than when they are high.!64

As a matter of speculation, it seems to us that this class of savers would save even more if no Interest were paid at all, for then the principal alone would have to suffice.

Nevertheless, Taussig and Ely and his co-authors

emphasize the importance of sacrifice costs in the determination of the supply of loan funds. The latter authors say:

At any given time, accordingly, the interest rate is considerably higher than is necessary to induce a large part of the waiting that devolves upon those who furnish capital funds for productive purposes. It is just high enough, however, to compensate for marginal waiting, which is the waiting that would not take place if the interest rate were any 10wer.166 As to the amount of savings at or near this margin, it seems to us that Taussig tends to contradict himself. When he considers what he thinks is the historical steadiness of the rate in modern times, he concludes that it is ” perhaps not an unjustified inference that there is a large volume of savings at the margin.” l67 Later he says ”So ingrained is the habit of accumulation among the prosperous classes of modern society, that it seems to proceed irrespective of the rate of interest.” 168 Still later, when he discusses the ‘reward of abstinence*, he concludes that ”it remains true that most saving is done by the wellto do and the rich. ”^ 6 $

But historically have we had a remarkably steady

rate of interest as many economists contend? Ely says that the rate show.s great varibility over short periods of time but looked at historically over a long period its steadiness is evident. l^0 Cassel emphasizes that the rate has not fallen below about per cent in west ern Europe in modern times.Taussig thinks that the rate for long term loans has usually not fallen below 3 per cent nor gone above 6 per cent. Hayes also speaks of the limits of the variations of the rate, saying that it has usually varied from 2 or 3 per cent to i 77 about 10 per cent. ■ The staunch defendants of the steadiness of the rate admit that it has varied a hundred per cent or more, taking the lower level as the base and disregarding any extreme fluctuations on short term or any other loans.

It seems to us that there is nothing about the historical steadiness or unsteadiness of the rate so remarkable as to afford much proof or disproof of any theory of marginal savings. It seems to us that if the contributions of Individuals to the loan funds of society are significantly related to the market rate of interest, then the amount of these contributions must noticeably fluctuate with the market rate of interest. The supply phenomenon accompanying, preceding, or following a rise or fall in the price for the use of loan funds should be analogous to that following a rise or fall in the price of iron, or wheat. But no such analogous supply phenomenon has been observed. For example, Cassel, notwithstanding his acceptance of the abstinence or waiting theory, says that the influence of the market rate of interest on the supply of loan funds ”is not particularly visible at ordinary rates. Hl 74 Woodworth says:

That savings are prompted in practically all cases by reasons other than the rate of Interest is the general belief of bankers.l7s

According to Edie:

The traditional economics commonly estimates that marginal saving is the great bulk of all saving. More recently, however, economics shows a tendency to reduce estimates of marginal savings to a small fraction of the total. The recent view is partly born out by the observation of the fact that a great part of saving fluctuates

independently of the interest rate. It is observable that savings often increase very greatly when the interest rate is falling, and that savings often decrease very greatly even though the interest rate rises sharply. Fluctuations in the supply of savings seem in large measure to defy the’influence of changes in the Interest rate. 1 - 0

Here Edie is speaking of what we call Individual and bus iness savings. This is substantially in agreement with A. B. Wolfe’s brilliant criticism of the traditional theory of the sacrifice cost margin. He concludes: ”To say that this is a responsive marginal rate would be far from the truth. Yet we do not say that marginal abstinence, time preference, or waiting does not exist at all. As far as our theory is concerned we merely conclude that it now seems to be rather generally accepted that the marginal psychological cost theory, or theories, of interest belong to the realm of speculative economics

162 Hume, David., ”0f Interest”, Political Discourses.

163

George, Henry, Progress and Poverty, 25th Anniversary Ed., p. 75.

164 Ely and Others, Outlines of Economics, sth Ed., p. 471. 165 Marshall, Alfred, Principles of Economics, Bth Ed., pp. 230-236.

166 Ely and Others, Outlines of Economics, sth Ed pp. 469, 470. 167 Taussig, F.W., Principles of Economics, 3rd Ed.. Vol. 11, p. 31. 168 IM£. , p. 32. 169 Ibid., p. 49.

170 Ely and Others, Outlines of Economics, sth Ed., op. 472, 473. 171 Cassel, Gustav, Theory of Social Economy, McCabe Trans., o. 202. 172 Taussig, F. W. , Principles of Economics, 3rd Ed., Vol. 11, pp. 31, 32. 173 Hayes, H. Gordon, Our Industrial System, Vol. 11, p. 414.

174 Cassel, G-ustav, Op. Git., p. 237« 175 Woodworth, L. D., Economic World, January 22, 1921 p. 18.

2. Institutional Savings

(1) Business savings

-- Institutional savings are of two kinds, business, or corporation, savings and bank

savings. Business profits are today one of the large sources of new savings.

Dr. W. I. King, in a study of the total amount of savings in the United States from 1909 to 1918, concludes that ’business enterprises of the country are normally responsible for about 40 per cent of the entire saving of the nation, ’ although, he adds, ’this percentage increases in years of bus iness prosperity and dimishes in times of depressions. ’

But most corporate savings consist not of loan funds but of a net increase in capital assets. Hayes sayes:

They usually pay a nominal rate of returns, from 4 to 6 per cent interest to the stock - holders and retain in the business any earnings in excess of this amount... Such savings on the part of corporations are very significant in auuing to the total amount of our savings. They do not, however, immediately affect the rate of interest which we are here considering, as they do not come into the money market in the form of loan funds.

The amount of business savings depends directly upon the amount of business profits, but an increase or decrease in such profits seems to lead to more than a proportionate change in the amount of savings. ’’When business profits slightly more than doubled between 1914 and 1916, business savings more than quadrupled. When corporation profits declined slightly between 1916 and 1919

corporation savings declined one-half. When corporation profits declined yet more sharply in the depression of 1921, corporation savings fell to about one-quarter of what they had been in 1919. The recovery of corporate savings in 1923 was traceable in large measure to the fact that corporate profits in that year were again high/^® l But “Corporations do not build up surpluses to take advantage of high interest rates but for entirely different purposes: to stabilize dividends; to make extensions and a variety of other purposes not connected with the interest rate.“^ d 2

176 Edie, Lionel D., Economics, p. 263*

177 Wolfe, A. 8., ”Savers’ Surplus and the Interest Rate”, Quarterly Journal of Economics, Vol. XXXV, p. 26. 178

Knight, F. H. , "Abstinence”, Encyclopedia of the Social Sciences.

179 Ely and Others, Outlines of Economics, sth Ed., p. 481. 180 Hayes, H. Gordon, Our Economic System, Vol. 11, p. 411.

(2) Banking savings

— Whenever a bank credits the checking accounts of borrowers with an amount in excess of its cash reserves it has created bank credit. It has manufactured loan funds at one price --as we shall further explain--and sold them at another as truly as the shoe making enterprise manufactures shoes at one price, or sum of prices, and sells them at another. However the bank has sold not a physical something like shoes, but an intangible something--demand liabilities which it must satisfy with cash payments on demand or discontinue

business because of insolvency. Not only is a cash reserve indispensable to commercial banking, but experience has proved that the ratio of cash reserve to deposit liabilities may not safely be allowed to fall below a fairly definite figure. In most countries this cash reserve is kept in central banks, and its amount is a matter for the bankers themselves to decide. In the United States it is a subject of legal enactment. At present the United States is divided into twelve Federal Reserve districts; and every national bank of each district must be--and by complying with certain regulations every state bank and trust company may be--a member of the Federal Reserve Bank of that district. The legal reserves of the member banks must consist of deposit credit with the Federal Reserve banks. If a member bank be located in New York or Chicago, which are called central reserve cities, its account must at a minimum be equal to 13 per cent of its demand liabilities; if located in any one of a number of other cities, which are officially designated as reserve cities, its reserve need be only 10 per cent; and if located in any of the smaller cities or towns, which are collectively called the country area, its reserve account need be only 7 per cent of its demand liabilities. For purpose of simplification, it may be said that the reserve accounts of American national banks are equal approximately to 10 per cent of their demand liabilities.

It is the Federal Reserve banks which maintain actual reserves of gold money. Their reserves must be equal to at least 35 per cent of their deposit liabilities, their liabilities all being in favor of member banks, for the reserve banks accept no accounts for private individuals. Thus for f 1,000,000 in gold in the Federal Reserve banks, member banks may borrow 100/35 times or $2,857,143. If the member banks use this to increase their reserve accounts, they can legally manufacture ten times $2,857,143, or $28,571,430, of loan funds. The legal reserve ratio for the country as a whole is thus seen to be approximately one to twenty eight, and this ratio may be suspended by action of the Federal Reserve Board. This minimum is probably about what the banks would impose on themselves for their own protection, if they were free from legal restraint; it is approximately equal to the minimum reserve ratios ordinarily found in European countries which Impose no legal restraint of this

But since the passage of the Federal Reserve Act of 1913, the banks as a whole have never reduced their reserve ratios to the legal minimum. Consequently we must conclude that although reserves are indispensable to commercial hanking, there are certainly other factors which help to limit the supply of loan funds furnished by American commercial banks.

Hitherto economists have over-emphasized reserves as the limiting factor in the supply of loan funds. They usually explain that expenses of production are of almost supreme importance in the determination of the ‘'normal" price of manufactured goods. They also state that hanks manufacture a large part of our credit money or loan funds. They further state that the value of standard metallic money coincides with its marginal cost of production. Yet it seems seldom to have occurred to them that the costs of commercial hanking deserve some consideration.

However, this consideration involves some difficulties, What banks produce and sell is the right to the disposal of capital goods and services. The purchaser receives an intangible which is expressed in terms of standard money, and may ordinarily be exchanged for that money on demand; hence these rights are themselves money for all practical purposes as far as they do all that standard money does. If in some respects this bank money or credit is something less than standard money, in other respects it is something more. It guides a part of the disposal of existing goods and services into the hands of business men; and it is to the Interest of the bankers to guide this disposal into the hands of those who can use it most profitably, for repayment of principal and interest depends largely upon the successful employ ment of the borrowed funds. Neither an increase in the supply of gold nor an increase in the supply of government paper money directly aids in this way the business man who has an opportunity to profit by adding to his disposal of capital goods and services.

It is this disposal which the business man pays for. He can pay because of differential or monopolistic opportunities, which we shall further explain in the next chapter. He must pay because these funds have a cost scarcity.

If the shoe merchant pays §l,OOO to the bank for the use of loan funds and §l,OOO to the shoe manufacturing enterprise for shoes, the §l,OOO is not net income either to the banker or manufacturer. It is only gross income. For example, a successful small bank and a successful small shoe manufacturing concern may have annual incomes and expenses as follows:

The Bank”“ The Shoe Total earnings $315,342 Sales $1,100,000 Deduct: Deduct: Interest paid 35,551 Interest paid 2,000 Salaries and Materials 571,650 wages 80,151 Salaries and Depreciation 3,445 wages 238,466 Advertising 4,251 Depreciation 10,894 Advertising 50,000 Soliciting Salesmen’s accounts 1,056 expenses 67,059 Selling ex- Office supplies 3,466 penses 29,059 Office suDolies 1,000 Taxes 17,286 Taxes 32,000 Losses of all Losses of all kinds not kinds not insured 18,745 insured 20,000 Insurance 212 Insurance 15,000 Sundries 9,179 Sundries 18,000 Total W Total $1,054,000 Net income $132,000 Net income $ 46‘,000 Capital invest- Capital invested $1,650,000 ed $575,000 Ratio of earnings to Ratio of earnings to investment, 8% investment, 8%

The shoe manufacturer and the banker are alike interested in Increasing sales and loans which Increase gross income and they are alike interested in internal economies,

because in either line of business net income is the dif ference between total income and total expenses.

Next, let us consider the problem of marginal costs in the production of loan funds. The margins of discontinuance and transferrence may be considered first Probably most of the buildings and equipment used in commercial banking, can be used for other purposes. Con sequently it seems that fixed capital goods are ordinarily withdrawn from banking at the margin of transferrence. This means that the supply of loan funds is only indirectly related to the margin of discontinuance, just as the supply of wheat is so related, as was explained in the closing paragraph of Chapter VII. Also in so far as all of the fixed capital goods employed by a commercial banking enterprise must be replaced at one time, there is a periodicity of replacement and the margin of discontinuance and the margin of entry must more nearly coincide than they do in industries where no such periodicity exists.

Let us next consider the margin of entry. Investors in a new commercial banking enterprise estimate, or should estimate, the probable ability of the prospective enterprise to secure customers at a rate of Interest which will leave enough income after the deduction of expenses to afford at least the correct rate of returns on the investment costs. This will of course depend on internal efficiency, the securing of “primary” deposits, the sale of loan funds, and advantageous connections with other banks, including central reserve banks. If it be estimated that the net returns will barely equal the market rate of interest to the Investors, the production of the new banking enterprise, or the expansion of a going one, is a matter of Indifference.

If at any given time it appears to business men that the margin of entry is higher in banking than in other Industries, the margins in all cases being weighted for relative uncertainty as far as human foresight makes weighting possible, the flow of investments into banking will tend to be more rapid than into other industries until the margin of entry in banking is judged to be no higher than in other industries.

The margin of intensity in commercial banking is similar to that in other industries. The banker makes additions to his outlays until the point is reached where further outlay would yield less than the current rate of interest on the outlay, assuming that he stops not short of but at the point of indifference. This point of

Indifference, or the intensive margin, shifts with changes in the rate of interest. It is largely due to this elasticity at the intensive margin that the total supply of loan funds responds to changes to the market rate of Interest. The rate of interest at which the commercial banks can furnish loan funds is a responsive marginal rate in the sense that an increase in demand, which is expressed by a rising rate of interest, is followed by an increase in the supply of loan funds.

Fundamentally banking is like every other field in which business is conducted for profit; but every distinct field of business must have at least some peculiar characteristic. In the case of commercial banking one peculiarity is found in the fact that deposit liabilities--that is credit money--must be satisfied normally with specie payments on demand. It cannot be de nied that this is difficult during a period of great expansion of loan funds by the commercial banking system as a whole. This is because of the perverse elasticity of gold reserves. As the circulating medium is expanded through an increase in loan funds, an increasing absolute quantity of specie is demanded for general circulation. For reasons stated in the following sentences this tends to decrease both the gold reserve ratio and the absolute quantity of gold reserves of the commercial banks. The

increase in the circulating medium incident to the expan sion of loan funds tends to raise the general level of prices, or to decrease the general purchasing power of money. The output of gold mines tends to vary inversely with the general level of prices, or directly with the purchasing power of money, and also directly with the more or less accidental discovery of new deposits of ore At the same time, if prices are high in one country relative to those of other countries, gold tends to flow out of the high price country in payment for goods purchased in the low price countries. But this perverse elasticity of gold reserves has Been greatly offset by the mobilization of reserves by central banking systems. At present the supply of reserves seems highly elastic for the individual bank which can borrow from the central bank of the system of which it is a member. Also high interest rates may attract gold from abroad, or counteract the tendency for gold to flow out of a country which has both a relatively high general level of prices and a relatively high rate of interest. Nevertheless, the fact remains that at present, for the commercial banking system, or systems, as a whole, gold reserves are a necessary but perversely elastic element used in the production of an elastic supply of loan funds. Consequently during periods of great expansion of loans, reserves acquire an increasing scarcity value, which value is one of the costs tending to cause a rise in the market rate of interest.

Nevertheless, the conduct of a banker seems to be essentially like that of a merchant, manufacturer, or farm er. When the demand for his product lags, he tends to cut prices as he finds himself able to dispose of only a diminishing output at former prices. He tries to offset diminishing sales and falling prices by ridding his business of such expense items as are necessary to a large output but not to a small one. He contracts his business at what may be called the intensive margin. At the same time he looks for outside or non-commercial business. He utilizes his plant partly by lending to the brokers and to the building and equipment manufacturers, directly or indirectly, for whatever the traffic will bear as long as variable costs are covered. But in the meantime the rate of interest is more than a passive factor. As Edie says: ’’With the business demand for capital weakened, the rate of interest falls to a low level, and reserves, savings, and unused business deposits accumulate in the banks. But ’’Low interest rates and consequent low cost of capital offer an incentive to business men to

borrow and expand production.”- 1 - 0 ® As the bank’s resources are more fully utilized in the extension of regular commercial loans, the rate on non-commercial loans is raised and a large portion of the non-commercial borrowers soon feel the effect of a rising rate of interest which tends to check further expansion. It seems that the supply of loan funds is related to marginal cost prices and marginal sales prices in essentially the same way that the supply of any other good is related to these two prices. In speaking generally of enterprises which deal in "less tangible services", Wesley C. Mitchell says:

They are the subject of an organized business traffic, in which price margins play the same role as in the buying and selling of commodities. Therefore, the prices charged by the bank, the advertising agency, the railway and the insurance company, are systematically related both to the prices which these enterprises must pay for their own producers* goods, and to the prices of the wares delt in by the enterprises which borrow money, use publicity, ship goods and carry insurance.

181 Edie, Lionel D. , Economics, p. 273, 274. 182 Ely and Others, Outlines of Economics, sth Ed., p. 481.

183~ Rodkey, Robert G., The Banking Process, p. 200.

184 The Shaw Banking Series, Accounting and Costs, op. 22-35. ' “ — 185 Small, Frederic L., Treatise on Comprehensive Accounting Methods Adapted to Shoe Manufacturing and Other Industries, p. 88.

186

Curtis, Frederic, Operating Costs and Profits in 1927; Federal Reserve Bank of Boston, Member Bank Income and Expenses for the Calendar Year 1928.

187 Edie, Lionel D., Economics, p. 585-

3. The Theory of the Contemporaneous Process of Production

In our present society bank savings are practically as effective as any others in increasing the supply of capital equipment. The truth of this is evident if

we grasp the significance of the principle of the contemporaneous process of production for society as a whole, present labor is not necessarily maintained by subsistence goods produced by past labor. The wagesfund doctrine as stated by classical economists 100 and more recently restated by Professor Taussig is false. 151 Henry George was the first economist decisively to criticise this classical doctrine. ’‘lt is not necessary to the production of things that cannot be used for subsistence, or cannot be immediately utilized, that there should have been a previous production of the wealth required for the maintenance of the laborers while the production is going on. It is only necessary that there should be, somewhere within the circle of exchange, a con temporaneous production of sufficient subsistence for the laborers, and a willingness to exchange this subsistence for the things on which the labor is being bestowed.“

If a group of investment bankers secures a loan from commercial banks in order to enable some one to build a railway, loan funds are simply used in directing labor and existing capital so as to secure a finished transportation business. Neither the railway equipment nor the subsistence for the laborers needs to have been in existence at the time the loan funds came into existence. And whether the commercial banks ally themselves permanently with the railway business--either openly or through a subsidiary investment company or through the fact that the commercial banks are really subsidiaries of the investment banks--or the investment bankers sell the securities finally to individual and business savers and repay the loan, it remains true that the loan was effective in increasing the supply of capital goods.

Now if bank loans do not increase so rapidly as to cause the general level of prices to rise, it is difficult to say whether or not any one bears a burden as a result of bank savings. But if bank loans increase more rapidly than the supply of other economic goods and services, the story is different. Professor Hansen says: ’’The effect is an increase in prices and therefore no increase in real purchasing power. The nominal incomes of people generally are as before, but their real purchasing power is reduced because of the increase in prices. The issuance of bank credit simply redistributes purchasing power, reducing the real purchasing power of

income receivers generally, and increasing the purchasing power of entrepreneurs able to secure bank credit. It is needless to elaborate on the fact that those whose real incomes are reduced have no effective choice in the matter. Regardless of the nature of the social burden, the contemporaneous nature of the productive process makes bank savings practically as effective as any others --or indeed more effective, if elastic savings be more effective than inelastic ones.

188 Edie, Lionel D., Economics, p. 585* 189 Mitchell, Wesley C., Business Cycles, The Problem and Its Setting, p. 111.

190 M’Culloch, J. R., Principles of Political Economy, 4th Ed., p. 397. 191 Taussig, F. W. , Wages and Capital. Chanter XV. 192 George, Henry, Progress and Poverty, 25th Anniversary Ed., p. 73.

4. Interest as One of the Costs of Supplying Loan Funds

We may now briefly summarize the conclusion of this chapter which are important for present purposes. It has been found that individual and business savings vary directly with the amount of income received by the individuals and businesses respectively. They are not sensitive to changes in the market rate of interest for the use of loan funds. On the other hand it was found that the part of the supply of loan funds furnished by commercial banks does tend to vary directly with the market rate of interest. Here we emphasize however that banks furnish primarily an elastic supply of loan funds and only secondarily or incidentally an elastic supply of

currency. We agree with Moulton that one should speak of an expansion of bank credit as an increase in the supply of loan funds, or ’’’capital 1 using the term in the popular business sense", instead of an increase in the circulating medium. But interest is one of the marginal costs in the supply of loan funds furnished by the commercial banks. Consequently there must be something other than banking costs which limits the supply of rights to the disposal of capital goods and services--that is the supply of loan funds for business use—so that these rights command a positive rate. Indeed It would be arguing in a circle to find the sole cause of this limitation in banking costs as long as Interest itself is any part of the cost.

193 Hansen, Alvin, Cycles of Prosperity and Depression in the United States, Great Britain and Germany, p. 106

194 Moulton, Harold G., ”Commercial Banking and Can! tai Formation", Journal of Political Economy, June’ 1918, p. 649. " —

CHAPTER X THE MARGIN OF PRODUCTIVITY

1. Progress and the Supply of ’’Real” Capital G-oods. 2. The Control of Investment Opportunity and the Control of Loan Funds. 3* The Margin of Productivity 4. Capitalization and Discount.

We have seen that loan funds are usually furnished by individual savers and commercial banks, and that for all practical purposes the funds furnished by one are as effective as those furnished by the other, except that banks supply loan funds at a responsive marginal rate of interest. We also saw that banking costs cannot be used as the sole factor which limits the supply of savings so as to make interest possible. It was found that investments tend to flow into and out of the banking field, so that marginal net returns to investment costs in banking are equal to marginal returns in other fields of production, and that banks tend to operate at all times with efficiency of output, just as other enterprises do.

1. Progress and the Supply of "Real" Capital Goods

Next, let us consider the supply of and the demand for "real” capital goods. We say ’’real" capital goods with quotation marks around the word ’’real”.

because loan funds are no less real than mechanical equip ment. By this term we mean fixed and working capital goods other than loan funds.

Here it will serve our purpose well if we consider the flow of these goods, or the quantity of them which economically can be supplied during any given period of time. It has been noticed that fixed capital goods possess some economic mobility due to alternative productive opportunities* It has been noticed also that working capital can ordinarily be liquidated so that it economically can be withdrawn from one enterprise or industry and invested in another. But it has been explained that there is no economic reason to withdraw it unless the fixed capital in connection with which it is employed falls below the margin of discontinuance. Consequently only a small part of the total flow, or production, of new capital goods during any given period of time is the result of the withdrawal of Investments from old employments. It is mostly new savings which business men use in expanding old concerns or in producing new ones; but why are “real" capital goods so scarce that additional investments in them may ordinarily be expected to yield a net return?

This is due primarily to the fact that we have a progress of technology, and secondarily to the fact that we have a progress at large. This general idea of progress is well summarized by Ross. He says: “Ideas born of gifted individual minds deserve credit for most of the changes in society which are of a progressive character. For the most part, these transforming ideas are either the industrial-martial inventions, or the rellgio-scientlfic innovations, the reason being that these are condition making. Since there is no herdsmanship without the training of animals, no agriculture without the domestication of plants, no water communication without the boat, invention had much to do with the expansion of population or of wealth . . .

“Next in importance are the inventions which have facilitated transportation and communication-- wheeled vehicale, boat, sail, compass, rail, steam, airplane, wireless. These call into being cities, promote diffusion and commingling of races, hasten crossing of cultures . . ~ abolish frontiers, make possible vast political units and supersede local associations by national, even international, association. More than this, they accelerate progress by transmitting everywhere good new ideas which arise anywhere; so that every section of mankind is served not only by its own inventive spirit, but by the productive geniuses of the whole

race.

We do not contend that all accepted changes have improved the lot of mankind. We do contend that historically society always has "been changing, and that the rate, the duration, the intensity, and the direction of changes have been largely unforeseen and unpredictable. Here we do not deny that we may predict the consequent rearrangement of economic forces in the immediate future with some degree of accuracy after the initial appearance or contact with an economic invention or innovation ’Within certain limits economics is a science of prediction. But we do not so definitely predict a steam engine before its invention as to enable us to provide materials for the construction of railway equipment. We invent the steam engine first and provide materials and equipment to go with it as we learn more and more about its economic possibilities and impossibilities. We cannot very well manufacture receiving sets before we discover radio. We build garages and spend billions of dollars on the construction and improvement of highways after we invent and adopt the use of the automobile and the auto-truck.

If we were attempting a minute historical descrip tion of technological and institutional progress, we should divide our innovations into at least two classes, major and minor ones. For example, it is known that major technological innovations constantly undergo minor modifications. They condition and are conditioned by changes in the institutional situation and by changes in the quantity and quality of population, by changes in the width of markets and by changes in distribution of wealth, and by changes from a war to a peace economy. As long as this changing continues, conditions of efficiency or profitableness must vary from enterprise to enterprise, from industry to Industry, and from region to region, so as to cause differential rates of net returns to investment costs, unless the amount of investment be determined by capitalization rather than by original or replacement costs.

The cost which society pays for its present supply of consumers ’ goods must be great enough to keep many relatively inefficient enterprises in productive use. But how inefficient? At any given time there are a great number of subms.rginal enterprises in operation which cannot economically continue to operate. Some of them are breaking even, and as long as they continue to do this, they may be operated indefinitely, provided that the conduct of the managers or owners is so

uneconomical as to disregard the net income to be had by withdrawing some part of the capital and investing it in supra-marginal undertakings. An enterprise which is unable to break even must have a continuous inflow of capital if it continues to operate; but the least efficient enterprises which can economically continue to operate are those at the margin of discontinuance. With these enterprises, present and future prospects are such that fixed capital goods are barely self-sustaining and working capital, or that part of the capital which can be withdrawn, is yielding, barely the current rate of returns. It must follow that all more efficient enterprises have at least some net income attributable to fixed capital. It must also follow that new savings will yield a positive rate in so far as they can be invested in expansion or in new enterprises similar to those of greatest efficiency. It must further follow that all old capital capable of flowing must receive a positive rate of interest if this flow is to be prevented.

We are not forgetting that the duplication of the most efficient enterprises is a highly difficult task. We have in mind that not only monopolies but also the state and other institutions may obstruct any progress which is not calculated to benefit vested interests.

ihe flow of real capital goods is perhaps usually considerably dammed up and diverted by the power of monopoly the autnorlty of state, and the efforts of other conserving institutions. But historically we always have had changing economic and social conditions in spite of vested Interests and conserving institutions. The institutional system, designed to maintain the status quo, Is constantly being broken down and repaired. He know only a dynamic society.

Gan we hasten the flow of real savings so as to decrease the spread between the least efficient and the most efficient capital goods in productive use, and thus decrease the differential net returns. If competition were freer than it now is, if men could and would become more concerned with the future than they are at present, a greater portion of our present supply of capital goods and labor could be employed in making more capital goods designed especially to make still more capital goods. Indeed, as compared with other civilizations, our present bourgeoise regime, .ushered in by the technological and Institutional innovations of the seventeenth and eighteenth centuries, has done just this. But we know that real savings have not so caught up with technological progress that all enterprises are equally efficient from a technical point of view. Real saving- -that is the making of capital goods--is stimulated by inventions and discoveries; but it probably is true also that savings encourage more technical improvements, as is generally contended.

At present we seem as far as ever from the universal utilization of our maximum potential efficiency in production, meaning by the maximum no better than that which is now an established fact in some enterprises oi* industries. It is inconceivable that it could be otherwise except in a relatively or in an absolutely static society. All technology and institutional changes could be foreseen and provided for ahead of time in a changing society only if all changes were always in the same direction and always moving at the same rate, Also it is perfectly conceivable that it could be otherwise in a society which is absolutely without change, provided of course that we can conceive of such a society at all. it seems that if economic Improvements were to cease and the present institutional situation should remain approximately the same —that is, if society should approach the “stationary state”--the manufacture of the most efficient equipment and the exploitation of differential business advantages would continue to the point where final equilibria would be established with all differentials other than economic

rent and monopoly gains absent. Capital would flow into the most advantageous channels until all differential due to dynamics disappeared. It seems that there would be no function for a market rate of Interest in the stationary state. Professor Henry L. Moore says:

It takes time to make a readjustment with the existing machinery of production (we would say through changes at the margin of transference), and it takes a still longer time to make a readjustment involving the saving of capital and the creation of new machinery. (We would say through changes at the margin of entry). If the readjustment is made with the existing technical equipment, there may be other tentative equilibria where demand and supply are balanced but where prices and costs are at variance. Readjust ment will now be made by altering the instruments of production, and, if there are no new perturbations, will proceed until a stage is reached in which not only demand and supply with reference to all commodities and services are balanced, but costs of production and market prices are likewise equated.l96

We are not sure whether Moore means that average costs and marginal costs would coincide. Such coincidence would of course require perfect mobility of capital and perfectly free competition. We say that if the present Institutional system and the present conditions of capital mobility were to continue in the stationary state, what is commonly called economic rent and monopoly gains would continue to exist. But we get nowhere speculating about the stationary or static state and final equilibria As far as we know, final equilibria are purely imaginary Moore is correct in adding:

New perturbations always do occur, and, consequently, the final equilibria become shifting ideal goals whose lines of motion trace out the trends of a system of economic quantities. Perturbations of final equilibria start the changes whose immediate goals are tentative equilibria; but the occurrence or prospect, of new perturbations disturbs the immediate adjustment of the results of earlier changes with the consequence that the tentative equilibria likewise become ideal goals whose lines of motion trace out the oscillations about the trend of final equilibria. l97

In present dynamic society the supply of economically mobile capital is limited, while new investment opportunities continue to be discovered or invented, and judging by past history, we seem justified in saying that the stationary state is improbable.

it is obsolescence from the rear rather than the lack of progress ahead which threatens the continued existence of interest. This is due to the fact that no industry is so over-supplied with capital that new investments in it offer no prospects of net returns, provided only that the new investment be used in securing the mosu efficient capital goods. A very real danger faced by almost every enterprise is that it as a whole, as well as the individual goods of which it is composed, may become obsolete before it yields enough income to

cover all costs other than interest. However, from a profit point of view, this is not as serious as it may at first appear when we study the statistics of the longevity of the average concern. A business which yields a so-called annual net income at approximately the current rate of interest for twenty or twenty-five years has returned more than the original cost of its production. We think that historically differential and monopolistic advantages have been sufficiently great, on the whole, while they lasted more than to compensate for original costs, so that the private receipt of interest represents a considerable portion of the total income of society. Patents, copyrights, franchises, trade agreements, combinations, goodwill, and the like are powerful aids in maintaining positive interest, but it seems to us that differentials are not so small or so transitory ordinarily as to make Interest impossible even if all monopolistic advantages were absent. However, it is only by carefully reinvesting, a part of the so-called annual net returns that original savings may probably yield a continuous flow of net returns to the saver or owner.

But the margin of net productivity, or net returns, cannot be described definitely except in financial terms. A summary of such a description will be undertaken after have discussed the control of investment opportunity and the qontrol of loan funds.

195~ Ross, Edward A., Principles of Sociology, (1920), pp. 538, 539.

196 Moore, Henry L. , Synthetic Economics, pp. 22, 23.

197 Moore, Henry L., Synthetic Economics, p. 23.

3. Control of Investment Opportunity and the Control of Loan Funds

The control of investment opportunity and the control of loan funds are not always incident to the same person. One may control valuable natural resources, such as confer differential advantages over . others which are being exploited. let such an owner may not wish to sell his property or may not have the opportunity to sell advantageously. At the time he may not have the other capital needed to develop his possession. He becomes a borrower. But such cases are not limited to natural resources such as coal, oil, and the like. This applies to agricultural land, business sites, and so on. Or one may by the right of invention or discovery, or--what is more usual--by buying, come into possession of patents, copyrights, franchises, concessions, knowledge of secret processes, contracts, etc., which he cannot exploit without borrowing. Needless to say such differential advantages place him in a strategic position in the loan market as compared with others who control inferior investment opportunities. A promoter may have valuable leases and contracts and for these reasons be in a strategic position as a borrower. Then there is the opportunity to expand which is controlled by the going enterprise which has its goodwill, trademark, and all such intangibles which characterize a successful

going establishment. Certainly these opportunities are not equally open to all. Outsiders have no immediate access to such advantages except as lenders.

On. the other hand, many individuals and enterprises having liquid capital at their disposal can lend more advantageously than they can invest directly, because their investment opportunities are inferior to those of the borrower. Small savers nearly all belong in this group. Savings banks and Insurance companies also belong in this group, because their other activities or legal restrictions cause them to enter the market as lenders. Then there is the whole commercial banking system which is engaged primarily in making and administering loans. Thus we have some fairly well defined groups of lenders and borrowers.

Then there are many individuals and firms which control both the opportunity to invest and adequate wealth fully to exploit it. Such individuals and businesses have no direct connection with the loan market. They furnish no part of the demand or supply of loan funds. As long as Henry Ford never appears in the loan market he does not directly influence it.

4. The Margin of Productivity and the Function of the Market Rate of Interest

We think that real social savings consist of an increase in productive power available for future use. In this sense saving depends first upon inventions and discoveries and secondly upon the production, or saving, of the capital goods necessary to their utilization. But here we must remember that we have a private property, or business, economy. If inventions and discoveries are improvement from the business point of view, they are introduced gradually as new forms of capital goods can be profitably provided and as new business methods can be profitably

As was pointed out in the last topic, if at any time an individual for business) privately possesses an improvement, or investment opportunity, and has not the liquid capital necessary to give economic expression to it, he enters the loan market and offers to divide his prospective differential returns with those having such capital to lend. But because units of liquid capital are interchangeable, he pays only the current rate of interest, unless the lenders are so organized as to enable them to exact a monopoly class price, which--needless to explaln--ls different from a monopoly price exacted from all alike, We think that, other things being equal, only the common rate is ordinarily exacted. Now if the

business yields a net return barely equal to interest at the common rate on the amount of ’’owned 1 ’ and borrowed capital invested, the new enterprise--or expansion or change of a going enterprise as the case may be--actually has entered the productive field at the margin of entry-. If the net returns are greater than this, it has entered the productive field above the margin of entry, and some or all of those having equities in the enterprise secure a return more than equal to interest at the current rate on their investment. If the net returns to the business are equal to less than interest at the market rate on the amount of investment costs, it has entered the field below the margin of entry, and some or all of the investors have sold their rights to receive future income at less than the market price. Of course, it is the anticipated returns which governs the commitment, as was stated in Chapter V.

Nov/, as we have already stated the demand for loans is limited by investment opportunities possessed by those who cannot develop them most advantageously without a resort to the loan market. Some can pay a thousand per cent where others cannot pay even one. Every borrower has a maximum rate that he can pay, which is determined by his investment opportunity. Every borrower will also pay a lower rate than this maximum if possible. This

gives a different total quantity of demand at each rate, because as the rate rises it cuts off that part of the demand whose maximum rate it exceeds.

On the supply side, as we have already pointed out, individual savings do not appreciably vary with the interest rate. Yet institutional savings are quite elastic with a central banking system functioning, but as long as banks cannot do business without expenses of production, loan funds cannot be had except at a price. If a bank lends |lOO at 6 per cent for six months, it gets only the three dollars as an Income and must defray expenses out of this amount. As it is at present,the supply of free or liquid capital which is offered in the loan market is so small as compared with the demand that it is all exhausted long before the zero rate is reached.

Next, what is the relationship between the market rate of interest and the rate of net exchange value productivity attributed or imputed to investments employed in the production and operation of business undertakings? In so far as investments are employed in the purchase of economically mobile capital goods, there is a tendency for the two rates to coincide at the margins. Approximately these margins are determined mutually by improvements and savings, or by the demand for and the supply of loan funds. Concerns at the margin of discontinuance have capital goods which can be liquidated in a short time and certain cash and bank deposits; that is, part of their assets are either in a form that can be liquidated or in a liquid form already. Such assets can be withdrawn from a particular employment and invested at the market rate of interest. That part of the invest' ment which can be withdrawn--which is not sunk in fixed capital goods--is called working capital because of its economic mobility. Hence the rate of net exchange value productivity imputed to the investment in the working capital goods of an enterprise at the margin of discontinuance tends to coincide with the market rate of interest.

The same is true with reference to the margin of intensity. The last unit of investment employed, in expanding the production of an enterprise cannot economically be pushed beyond the point where it promises net exchange value returns less than interest at the market rate on the last unit of investment. The market rate tends to secure economy by preventing the intensive margin from being further extended when savings have a greater marginal productivity elsewhere. In the case of savings that are already invested, if they are not sunk in fixed capital goods, the market rate secures their flow away from those employments which offer less than

the market rate. As far as business management secures economy in the use of capital, there is a tendency for the market rate of interest to coincide with the rate of net value productivity attributed to the investment at the margin of intensity.

Also, in the case of enterprises at the margin of entry, the anticipated net returns are at least equal to interest at the market rate on the whole investment cost of their production. Under less favorable conditions an enterprise cannot be economically brought into productive existence at all. Many investors may expect a much higher rate of net returns on their investments. It is the marginal investor whose anticipated net returns are such that borrowing at the market rate is a matter of indifference. A going enterprise is at the margin of discontinuance when its net returns are barely equal to interest at the market rate on that part of the investment which can be withdrawn; but the production of a new enterprise is a marginal employment of savings if the net returns, or productivity, are barely equal to interest at the market rate on the whole investment cost of its production and operation.

Furthermore, the function of interest as an opportunity cost at the margin of transference is fundamentally the same as that of the market rate for the use of loan

funds. It is the comparative net exchange value to be had in alternative employments that causes one line of production to be substituted for another. Opportunity net capital productivity functions so that the net product secured in one alternative tends to be at least as great as that which can be had in another. In this way economy is secured in the use of the fixed capital goods of a going business.

Briefly, then, it is the function of interest to guide the flow of capital into the most productive alternatives , so that the least productive opportunity exploited is more productive of net exchange value than the most productive opportunity left unexploited.

198 Taylor, Horace, Making Goods and Making Money, Chapter I; Veblen, Thorstein, ’’lndustrial and Pecuniary Employments u , The Place of Science in Modern Civilization and Other Essays.

5. Discount and Capitalization

As long as liquid capital, or money, can be lent at the market rate for business purposes, it tends to command the same rate when lent for all other purposes. ’’When once the payment of interest is a familiar ana accepted fact, it is extended to all other cases where present means are in one person’s hands and are turned over to another person. He who has money to lend can always get interest on it. He who borrows must pay for the veriest fraction advanced to him and for every day of the advance. The competition and interaction of a highly developed banking and credit system is always

keeping the possessor of present means in connection with those who are the eventual users of capital (loan funds).

. . . and interest can be continuously and unfailingly secured on every scrap of disposable cash. This is true because units of liquid capital are interchangeable and the use of any one dollar tends to command the same price per unit of time as the use of any other.

If the market rate of interest be five per cent, one hundred five dollars in cash a year hence are worth only one hundred dollars in cash now. Or compounded annually one hundred ten dollars and twenty-five cents two years hence are worth only one hundred dollars now. This is so because one hundred dollars can be lent now so as to secure a return of one hundred five dollars at the end of the first year, and then the one hundred five dollars can presumably be lent so as to secure a return of one hundred ten dollars and twenty-five cents at the end of the second year. That is, a sum of money at a future date is worth a present sum which lent now at compound interest will equal it at that date. All future money incomes from whatever source derived tend to be discounted at the market rate of interest in determining their present worth, or money price. This, in brief, is the theory of discount.

Similarly, the present money price of the right to receive an indefinite series of annual money incomes is equal to that sum of money which lent at the current market rate will yield equal incomes. If the market rate be five per cent, a business which has a prospective net income of fifty thousand dollars per year for an indefinite period of time will sell for one million dollars, because fifty thousand dollars are equal to five per cent of one million dollars. This is called the theory of capitalization, which is merely the theory of discount applied in determining the present worth of a series of future incomes; but discount and capitalization seem to be a result--not the cause--of the market rate of interest.

Equal amounts of capital yield equal returns, whenever the amount of capital is determined by the process of capitalization, in which case average net returns and marginal net returns coincide, so that there is a common rate of net. returns.

199 Taussig, F, W. , Principles of Economics. Vol. 11, PP* 44, 45.

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