Risk, Uncertainty, and Profit

Frank H. Knight
Knight, Frank H.
(1885-1972)
CEE
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1921
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Boston, MA: Hart, Schaffner & Marx; Houghton Mifflin Co.
Pub. Date
1921
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1st edition. Based on award-winning dissertation essay.
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Part III, Chapter IX

Enterprise and Profit

III.IX.1

We must now consider more concretely and in detail the effects of uncertainty on the general form of organization of economic life. The best method seems to be to take up a society in which uncertainty is absent, imagine uncertainty introduced, and try to ascertain what changes will take place in its structure. We therefore return to the argument of chapter IV in which the mechanics of exchange and competition were studied with uncertainty (and progress) absent. The same method will be followed, beginning with the problem in as simple a form as possible and studying the effects of different factors separately, analyzing the complexity of real life "synthetically" by building it up in imagination out of its elements.

III.IX.2

To secure the minimum degree of uncertainty and at the same time keep the discussion as close to reality as possible, it is necessary to exercise some care in defining the assumptions with which we are working. The most obvious initial requirement is to eliminate the factors of social progress from consideration and consider first a static society. But this postulate calls for discrimination in handling. In an absolutely unchanging social life there would, as we have repeatedly observed, be no uncertainty whatever, and our analysis in chapter IV proceeded on this assumption. Such conditions are thoroughly incompatible with the most fundamental facts of the world in which we live, but their study serves the analytic purpose of isolating the effects of uncertainty. For different kinds of change and different degrees of change are real facts, and it will therefore involve less abstraction to study hypothetical conditions under which change is restricted to the most fundamental and ineradicable kind and amount. Societies may be and have been nearly unprogressive, and the obvious simplification to make is therefore the elimination of progressive change.

III.IX.3

After abstracting all the elements of general progressive change enumerated in chapter V a large amount of uncertainty will be left in human life, due to changes of the character of fluctuations which cannot be thought away without violence to material possibility. Strictly accurate formulation of conditions involving a realistic minimum of uncertainty cannot be made, but are not necessary; it is sufficient to indicate in a rough way the situation we propose to discuss. Several factors affect the amount of uncertainty to be recognized, and have to be taken into account. The first to be noted is the time length of the production process, for the longer it is, the more uncertainty will naturally be involved. Of very great importance also is the general level of economic life. The lower wants of man, those having in the greatest degree the nature of necessities, are the most stable and predictable. The higher up the scale we go, the larger the proportion of the æsthetic element and of social suggestion there is involved in motivation, the greater becomes the uncertainty connected with foreseeing wants and satisfying them. On the production side, on the other hand, most manufacturing processes are more controllable and calculable as to outcome than are agricultural operations under usual conditions. We must notice also the development of science and of the technique of social organization. Greater ability to forecast the future and greater power to control the course of events manifestly reduce uncertainty, and of still greater importance is the status of the various devices noted in the last chapter for reducing uncertainty by consolidation.

III.IX.4

All these perplexities about which some more or less definite assumption must be made can be disposed of by being as realistic as possible. Let us say simply that we are talking about the United States in the early years of the twentieth century, but with abstraction made of progressive changes. That is, we assume a population static in numbers and composition and without the mania of change and advance which characterizes modern life. Inventions and improvements in technology and organization are to be eliminated, leaving the general situation as we know it to-day to remain stationary. Similarly in regard to the saving of new capital, development of new natural resources, redistribution of population over the soil or redistribution of ownership of goods, education, etc., among the people. But we shall not assume that men are omniscient and immortal or perfectly rational and free from caprice as individuals. We shall neglect natural catastrophes, epidemics, wars, etc., but take for granted the "usual" uncertainties of the weather and the like, along with the "normal" vicissitudes of mortal life,*23 and uncertainties of human choice.

III.IX.5

Returning now to the kind of social organization described in chapter IV,*24 let us inquire as to what will be the effects of introducing the minimum degree of uncertainty into the situation. The essential features of the hypothetical society as thus far constructed need to be kept clearly in mind. Acting as individuals under absolute freedom but without collusion, men are supposed to have organized economic life with primary and secondary division of labor, the use of capital, etc., developed to the point familiar in present-day America. The principal fact which calls for exercise of the imagination is the internal organization of the productive groups or establishments. With uncertainty entirely absent, every individual being in possession of perfect knowledge of the situation, there would be no occasion for anything of the nature of responsible management or control of productive activity. Even marketing operations in any realistic sense would not be found. The flow of raw materials and productive services through productive processes to the consumer would be entirely automatic.

III.IX.6

We do not need to strain the imagination by supposing supernatural powers of prescience on the part of men. We can think of the adjustment as the result of a long process of experimentation, worked out by trial-and-error methods alone. If the conditions of life and the people themselves were entirely unchanging a definite organization would result, perfect in the sense that no one would be under an incentive to change. So in the organization of the productive groups, it is not necessary to imagine every worker doing exactly the right thing at the right time in a sort of "preëstablished harmony" with the work of others. There might be managers, superintendents, etc., for the purpose of coördinating the activities of individuals. But under conditions of perfect knowledge and certainty such functionaries would be laborers merely, performing a purely routine function, without responsibility of any sort, on a level with men engaged in mechanical operations.

III.IX.7

With the introduction of uncertainty—the fact of ignorance and necessity of acting upon opinion rather than knowledge—into this Eden-like situation, its character is completely changed. With uncertainty absent, man's energies are devoted altogether to doing things; it is doubtful whether intelligence itself would exist in such a situation; in a world so built that perfect knowledge was theoretically possible, it seems likely that all organic readjustments would become mechanical, all organisms automata. With uncertainty present, doing things, the actual execution of activity, becomes in a real sense a secondary part of life; the primary problem or function is deciding what to do and how to do it. The two most important characteristics of social organization brought about by the fact of uncertainty have already been noticed. In the first place, goods are produced for a market, on the basis of an entirely impersonal prediction of wants, not for the satisfaction of the wants of the producers themselves. The producer takes the responsibility of forecasting the consumers' wants. In the second place, the work of forecasting and at the same time a large part of the technological direction and control of production are still further concentrated upon a very narrow class of the producers, and we meet with a new economic functionary, the entrepreneur.

III.IX.8

When uncertainty is present and the task of deciding what to do and how to do it takes the ascendancy over that of execution, the internal organization of the productive groups is no longer a matter of indifference or a mechanical detail.*25 Centralization of this deciding and controlling function is imperative, a process of "cephalization," such as has taken place in the evolution of organic life, is inevitable, and for the same reasons as in the case of biological evolution. Let us consider this process and the circumstances which condition it. The order of attack on the problem is suggested by the classification worked out in chapter VII of the elements in uncertainty in regard to which men may in large measure differ independently.

III.IX.9

In the first place, occupations differ in respect to the kind and amount of knowledge and judgment required for their successful direction as well as in the kind of abilities and tastes adapted to the routine operations. Productive groups or establishments now compete for managerial capacity as well as skill, and a considerable rearrangement of personnel is the natural result. The final adjustment will place each producer in the place where his particular combination of the two kinds of attributes seems to be most effective.

III.IX.10

But a more important change is the tendency of the groups themselves to specialize, finding the individuals with the greatest managerial capacity of the requisite kinds and placing them in charge of the work of the group, submitting the activities of the other members to their direction and control. It need hardly be mentioned explicitly that the organization of industry depends on the fundamental fact that the intelligence of one person can be made to direct in a general way the routine manual and mental operations of others. It will also be taken into account that men differ in their powers of effective control over other men as well as in intellectual capacity to decide what should be done. In addition, there must come into play the diversity among men in degree of confidence in their judgment and powers and in disposition to act on their opinions, to "venture." This fact is responsible for the most fundamental change of all in the form of organization, the system under which the confident and venturesome "assume the risk" or "insure" the doubtful and timid by guaranteeing to the latter a specified income in return for an assignment of the actual results.

III.IX.11

Uncertainty thus exerts a fourfold tendency to select men and specialize functions: (1) an adaptation of men to occupations on the basis of kind of knowledge and judgment; (2) a similar selection on the basis of degree of foresight, for some lines of activity call for this endowment in a very different degree from others; (3) a specialization within productive groups, the individuals with superior managerial ability (foresight and capacity of ruling others) being placed in control of the group and the others working under their direction; and (4) those with confidence in their judgment and disposition to "back it up" in action specialize in risk-taking. The close relations obtaining among these tendencies will be manifest. We have not separated confidence and venturesomeness at all, since they act along parallel lines and are little more than phases of the same faculty—just as courage and the tendency to minimize danger are proverbially commingled in all fields, though they are separable in thought. In addition the tendencies numbered (3) and (4) operate together. With human nature as we know it it would be impracticable or very unusual for one man to guarantee to another a definite result of the latter's actions without being given power to direct his work. And on the other hand the second party would not place himself under the direction of the first without such a guaranty. The result is a "double contract" of the type famous in the history of the evasion of usury laws. It seems evident also that the system would not work at all if good judgment were not in fact generally associated with confidence in one's judgment on the part both of himself and others. That is, men's judgment of their own judgment and of others' judgment as to both kind and grade must in the large be much more right than wrong.*26

III.IX.12

The result of this manifold specialization of function is enterprise and the wage system of industry. Its existence in the world is a direct result of the fact of uncertainty; our task in the remainder of this study is to examine this phenomenon in detail in its various phases and divers relations with the economic activities of man and the structure of society. It is not necessary or inevitable, not the only conceivable form of organization, but under certain conditions has certain advantages, and is capable of development in different degrees. The essence of enterprise is the specialization of the function of responsible direction of economic life, the neglected feature of which is the inseparability of these two elements, responsibility and control. Under the enterprise system, a special social class, the business men, direct economic activity; they are in the strict sense the producers, while the great mass of the population merely furnish them with productive services, placing their persons and their property at the disposal of this class; the entrepreneurs also guarantee to those who furnish productive services a fixed remuneration. Accurately to define these functions and trace them through the social structure will be a long task, for the specialization is never complete; but at the end of it we shall find that in a free society the two are essentially inseparable. Any degree of effective exercise of judgment, or making decisions, is in a free society coupled with a corresponding degree of uncertainty-bearing, of taking the responsibility for those decisions.

III.IX.13

With the specialization of function goes also a differentiation of reward. The produce of society is similarly divided into two kinds of income, and two only, contractual income, which is essentially rent, as economic theory has described incomes, and residual income or profit. But the differentiation of contractual income, like that of profit, is never complete; neither variety is ever met with in a pure form, and every real income contains elements of both rent and profit. And with uncertainty present (the condition of the differentiation itself) it is not possible even to determine just how much of any income is of one kind and how much of the other; but a partial separation can be made, and the causal distinction between the two kinds is sharp and clear.

III.IX.14

We may imagine a society in which uncertainty is absent transformed on the introduction of uncertainty into an enterprise organization. The readjustments will be carried out by the same trial-and-error methods under the same motives, the effort of each individual to better himself, which we have already described. The ideal or limiting condition constantly in view would still be the equalization of all available alternatives of conduct by each individual through the distribution of efforts and of expenditure of the proceeds of effort among the lines open. Under the new system labor and property services actually come into the market, become commodities and are bought and sold. They are thus brought into the comparative value scale and reduced to homogeneity in price terms with the fund of values made up of the direct means of want satisfaction.

III.IX.15

Another feature of the new adjustment is that a condition of perfect equilibrium is no longer possible. Since productive arrangements are made on the basis of anticipations and the results actually achieved do not coincide with these as a usual thing, the oscillations will not settle down to zero. For all changes made by individuals relate to the established value scale and this price-system will be subject to fluctuations due to unforeseen causes; consequently individual changes in arrangements will continue indefinitely to take place. The experiments by which alone the value of human judgment is determined involve a proportion of failures or errors, are never complete, and in view of human mortality have constantly to be recommenced at the beginning.

III.IX.16

We turn now to consider in broad outline the two types of individual income implied in the enterprise system of organization, contractual income and profit.*27 We shall try as hitherto to explain events by placing ourselves in the actual positions of the men acting or making decisions and interpreting their acts in terms of ordinary human motives. The setting of the problem is a free competitive situation in which all men and material agents are competing for employment, including all men at the time engaged as entrepreneurs, while all entrepreneurs are competing for productive services and at the same time all men are competing for positions as entrepreneurs. The essential fact in understanding the reaction to this situation is that men are acting, competing, on the basis of what they think of the future. To simplify the picture and make it concrete we shall as before assume that there exists some sort of grouping of men and things under the control of other men as entrepreneurs (a random grouping will do as a start) and that entrepreneurs and others are in competition as above stated.

III.IX.17

The production-distribution system is worked out through offers and counter-offers, made on the basis of anticipations, of two kinds. The laborer asks what he thinks the entrepreneur will be able to pay, and in any case will not accept less than he can get from some other entrepreneur, or by turning entrepreneur himself. In the same way the entrepreneur offers to any laborer what he thinks he must in order to secure his services, and in any case not more than he thinks the laborer will actually be worth to him, keeping in mind what he can get by turning laborer himself. The whole calculation is in the future; past and even present conditions operate only as grounds of prediction as to what may be anticipated.*28

III.IX.18

Since in a free market there can be but one price on any commodity, a general wage rate must result from this competitive bidding. The rate established may be described as the socially or competitively anticipated value of the laborer's product, using the term "product" in the sense of specific contribution, as already explained. It is not the opinion of the future held by either party to an employment bargain which determines the rate; these opinions merely set maximum and minimum limits outside of which the agreement cannot take place. The mechanism of price adjustment is the same as in any other market. There is always an established uniform rate, which is kept constantly at the point which equates the supply and demand. If at any moment there are more bidders willing to employ at a higher rate than there are employees willing to accept the established rate, the rate will rise accordingly, and similarly if there is a balance of opinion in the opposite direction. The final decision by any individual as to what to do is based on a comparison of a momentarily existing price with a subjective judgment of significance of the commodity. The judgment in this case relates to the indirect significance derived from a twofold estimate of the future, involving both technological and price uncertainties. The employer in deciding whether to offer the current wage, and the employee in deciding whether to accept it, must estimate the technical or physically measured product (specific contribution) of the labor and the price to be expected for that product when it comes upon the market. The estimation may involve two sorts of calculation or estimate of probability. The venture itself may be of the nature of a gamble, involving a large proportion of inherently unpredictable factors. In such a case the decision depends upon an "estimate" of an "objective probability" of success, or of a series of such probabilities corresponding to various degrees of success or failure. And normally, in the case of intelligent men, account will be taken of the probable "true value" of the estimates in the case of all estimated factors.

III.IX.19

The meaning of the term "social" or "competitive" anticipation will now be clear. The question in the mind of either party to an employment agreement relates simply to the fact of a difference between the current standard of remuneration for the services being bargained for and his own estimate of their worth, discounted by probability allowances. The magnitude of the difference is altogether immaterial. The prospective employer may know absolutely that the service has a value to him ever so much greater than the price he is paying, but he will have to pay only the competitively established rate, and his purchase will affect this rate no more than if he were ever so hesitant about the bargain, just so he makes it. It is the general estimate of the magnitudes involved, in the sense of a "marginal" demand price, which fixes the actual current rate.

III.IX.20

In many respects the nature of the organization we are now dealing with is the same as that described in chapter IV, with uncertainty and progress absent. The value of a laborer or piece of material equipment to a particular productive group is determined by the specific physical contribution to output under the principle of diminishing returns with increase in the proportion of that kind of agency in the combination, and on the price of this contribution under the principle of diminishing utility with increase in the proportion of productive energy devoted to making the particular product turned out by the establishment in question. But the facts upon which the working-out of the organization depends can no longer be objectively determined with accuracy by experiment; all the data in the case must be estimated, subject to a larger or smaller margin of error, and this fact causes differences more fundamental than the resemblances in the two situations. The function of making these estimates and of "guaranteeing" their value to the other participating members of the group falls to the responsible entrepreneur in each establishment, producing a new type of activity and a new type of income entirely unknown in a society where uncertainty is absent.

III.IX.21

Even in the hypothetical situation dealt with in chapter IV there would be likely to be a concentration of certain control and coördinating functions in a separate person or group of persons in each productive group. But the duties of such persons would be of a routine character merely, in no significant respect different from those of any other operatives; they would be laborers among laborers and their incomes would be wages like other wages. When, however, the managerial function comes to require the exercise of judgment involving liability to error, and when in consequence the assumption of responsibility for the correctness of his opinions becomes a condition prerequisite to getting the other members of the group to submit to the manager's direction, the nature of the function is revolutionized; the manager becomes an entrepreneur. He may, and typically will, to be sure, continue to perform the old mechanical routine functions and to receive the old wages; but in addition he makes responsible decisions, and his income will normally contain in addition to wages a pure differential element designated as "profit" by the economic theorist. This profit is simply the difference between the market price of the productive agencies he employs; the amount which the competition of other entrepreneurs forces him to guarantee to them as a condition of securing their services, and the amount which he finally realizes from the disposition of the product which under his direction they turn out.

III.IX.22

The character of the entrepreneur's income is evidently complex, and the relations of its component elements subtle. It contains an element which is ordinary contractual income, received on the ground of routine services performed by the entrepreneur personally for the business (wages) or earned by property which belongs to him (rent or capital return). And the differential element is again complex, for it is clear that there is an element of calculation and an element of luck in it. An adequate examination and analysis of this phenomenon requires time and careful thinking. The background of the problem should now be clear: the uncertainty of all life and conduct which call for the exercise of judgment in business, the economy of division of labor which compels men to work in groups and to delegate the function of control as other functions are specialized, the facts of human nature which make it necessary for one who directs the activities of others to assume responsibility for the results of the operations, and finally the competitive situation which pits the judgment of each entrepreneur against that of the extant business world in adjusting the contractual incomes which he must pay before he gets anything for himself.

III.IX.23

The first step in attacking the problem is to inquire into the meaning of entrepreneur ability and its conditions of demand and supply. In regard to the first main division of the entrepreneur's income, the ordinary wage for the routine services of labor and property furnished to the business, no comment is necessary. This return is merely the competitive rate of pay for the grade of ability or kind of property in question. To be sure, it may not be possible in practice to say exactly what this rate is. Not merely is perfect standardization of things and services unattainable under the fluctuating conditions of real life, but in addition the conditions of the entrepreneur specialization may well bring it about that the same things are not done under closely comparable conditions by entrepreneurs and non-entrepreneurs. Hence the separation between the pure wage or rent element and the elements arising out of uncertainty cannot generally be made with complete accuracy. The serious difficulty comes with the attempt to deal with the relation between judgment and luck in determining that part of the entrepreneur's income which is associated with the performance of his peculiar twofold function of (a) exercising responsible control and (b) securing the owners of productive services against uncertainty and fluctuation in their incomes. Clearly this special income is also connected with a sort of effort and sacrifice and into the nature and conditions of supply and demand of the capacities and dispositions for these efforts and sacrifices it must be pertinent to inquire.

III.IX.24

It is unquestionable that the entrepreneur's activities effect an enormous saving to society, vastly increasing the efficiency of economic production. Large-scale operations, highly organized industry, and minute division of labor would be impossible without specialization of the managerial function, and human nature being as it is, the guaranteeing function must apparently go along with that of control; indeed, in the ultimate sense of control the two are not even theoretically separable. Thus there would be a large saving even outside of any question of the superior abilities of certain individuals over other individuals for the performance of this function. And there is still another gain of large magnitude through the reduction of uncertainty by the principle of consolidation, which also is independent of the personal attributes of the entrepreneur. But these economies, due to the system as such, and not to activities of the individuals performing a special function, accrue to society; no cause can be discovered in this connection alone which would give rise to a special distributive share.

III.IX.25

As to the actual comparative magnitude of the various elements of gain secured through the enterprise system it would be rash to guess, but certainly a very large real gain is secured through the selection of managers having superior fitness for the work. Now it is of supreme importance that such selection is possible only because and in so far as such fitness can be identified in advance of its demonstration in each particular case. The prospective entrepreneur himself has an opinion of his own suitability, in so far as he forms an estimate of the true value of his prognostications and policies. Other persons may or may not agree with his opinion of himself. A man may actually get into the position of entrepreneur in several ways. If he has property or known personal productive powers of a technological sort he may assume the functions of entrepreneur without convincing any one outside himself of any special fitness to exercise them. As long as his own resources safeguard the interests of the persons to whom he agrees to pay contractual incomes these persons need not worry about the correctness of the judgments on which the entrepreneur's policies are based. If he cannot make such guarantees he must, of course, convince either the persons with whom he makes wage or rent bargains or some outside party who will underwrite the guarantees for him. The effect of this transfer of the guarantee function on the nature of entrepreneurship is a subtle question and will be taken up presently. It might even conceivably happen, in the third place, that a person not judging himself especially fit to control industrial policies would get into the place of entrepreneur, if other persons have a sufficiently high opinion of his abilities and trustworthiness. This case is more complicated still and its treatment must also be deferred. Discussion of divided entrepreneurship will lead naturally to the problem of the hired manager, most difficult of all. Let us consider first the simple case of unique and undivided exercise of the function, the control and uncertainty-bearing being all concentrated in the same individual, under the assumption that outsiders whether employed by him or not have neither opinions upon nor interest in the question of his competence. It will further simplify the problem if we begin by assuming that this is the only type of entrepreneurship in our society.

III.IX.26

First, a further word as to the character of the process by which the entrepreneur's income is fixed. It may be distinguished from the contractual returns received for services not involving the exercise of judgment, and which are paid by the entrepreneur, by pointing out that the latter are imputed, while his own income is residual. That is, in a sense, the entrepreneur's income is not "determined" at all; it is "what is left" after the others are "determined." The competition of entrepreneurs bidding in the market for the productive services in existence in the society "fix" prices upon these; the entrepreneur's income is not fixed, but consists of whatever remains over after the fixed incomes are paid. Hence we must examine the entrepreneur's income indirectly, by inquiring into the forces which determine the fixed incomes, in relation to the whole product of an enterprise or of society.

III.IX.27

Assuming perfect competition in the market for productive services, the contractual incomes are fixed for every entrepreneur by the competitive or marginal anticipations of entrepreneurs as a group in relation to the supply of each kind of agency in existence. Whether any particular individual becomes an entrepreneur or not depends on his believing (strongly enough to act upon the conviction) that he can make productive services yield more than the price fixed upon them by what other persons think they can make them yield (with the same provision that the belief must lead to action). After any individual has become an entrepreneur, the amount of his income depends on his success in producing the anticipated excess, and in this sense is a matter of the correctness of his judgment. But it is clear that his success is equally a matter of (a) the failure of the judgment, or (b) an inferiority in capacity, on the part of his competitors. The two factors of (a) capacity and (b) judgment of one's capacity are inseparably connected, and business capacity is again compounded of judgment (of factors external to the person judging) and executive capacity.

III.IX.28

Moreover, there is in the exercise of the best judgment and highest capacity an inevitable margin of error. A successful outcome in any particular case cannot be attributed entirely to judgment and capacity even taken together. The best men would fail in a certain proportion of cases and the worst perhaps succeed in a certain proportion. The results of one trial or of a small number of trials can at most establish a certain presumption in favor of the view that ability has or has not been shown.*29 A dependable estimate of ability can only come from a considerable number of trials. Even then there are differences in kind of ability, as well as degree. And in business management no two instances, perhaps, are ever very closely alike, in any objective, describable sense. It is one of the mysteries of the workings of mind that we are able to form estimates of "general ability" which have any value, but the fact that we do is of course indisputable.

III.IX.29

Still further, the venture itself may be a gamble, as we have repeatedly pointed out. Most decisions calling for the exercise of judgment in business or responsible life in any field involve factors not subject to estimate and which no one makes any pretense of estimating. The judgment itself is a judgment of the probability of a certain outcome, of the proportion of successes which would be achieved if the venture could be repeated a large number of times. The allowance for luck is therefore twofold. It requires a large number of trials to show the real probabilities in regard to which judgment is exercised in any given kind of case as well as to distinguish between intrinsic quality in the judgment and mere accident. And bearing in mind again the extreme crudeness of the classification of instances at best, the marvel grows that we are able to live as intelligently as we do. Let us now attempt to state the principles determining entrepreneur income more accurately and in the form of laws of demand and supply.

III.IX.30

The demand for a productive service depends upon the steepness of the curve of diminishing returns from increasing amounts of other kinds of services applied to the first. In the familiar case of land, the more rapidly the returns from increased applications of labor and capital applied to a given plot of land fall off, the higher will be the rent on land. Now there is evidently a law of diminishing returns governing the combination of productive services with entrepreneurs. It is based on the fact already stated of limitation in the space range of foresight and executive capacity. The greater the magnitude of operations which any single individual attempts to direct the less effective in general he will be—"beyond a certain point," as in other cases of the law. The demand for entrepreneurs, again, like that for any productive agency, depends directly upon the supply of other agencies.

III.IX.31

The supply of entrepreneurs involves the factors of (a) ability, with the various elements therein included, (b) willingness, (c) power to give satisfactory guarantees, and (d) the coincidence of these factors. If society as a whole secures a high quality of management for its enterprises it will be through a coincidence of ability with willingness, or of all three factors, as well as through an abundant supply of the elements separately. Willingness plus power to give guarantees, not backed up by ability, will evidently lead to a dissipation of resources, while ability without the other two factors will be merely wasted. To find men capable of managing business efficiently and secure to them the positions of responsible control is perhaps the most important single problem of economic organization on the efficiency side.

III.IX.32

The supply of entrepreneur qualities in society is one of the chief factors in determining the number and size of its productive units. It is a common and perhaps justifiable opinion that most of the other factors tend toward greater economy with increasing size in the establishment, and that the chief limitation on size is the capacity of the leadership. If this is true the ability to handle large enterprises successfully, when it is met with, must tend to secure very large rewards. The income of any particular entrepreneur will in general tend to be larger: (1) as he himself has ability, and good luck; but (2), perhaps more important, as there is in the society a scarcity of self-confidence combined with the power to make effective guarantees to employees. The abundance or scarcity of mere ability to manage business successfully exerts relatively little influence on profit; the main thing is the rashness or timidity of entrepreneurs (actual and potential) as a class in bidding up the prices of productive services. Entrepreneur income, being residual, is determined by the demand for these other services, which demand is a matter of the self-confidence of entrepreneurs as a class, rather than upon a demand for entrepreneur services in a direct sense. We must see at once that it is perfectly possible for entrepreneurs as a class to sustain a net loss, which would merely have to be made up out of their earnings in some other capacity. This would be the natural result in a population combining low ability with high "courage." On the other hand, if men generally judge their own abilities well, the general rate of profit will probably be low, whether ability itself is low or high, but much more variable and fluctuating for a low level of real capacity. The condition for large profits is a narrowly limited supply of high-grade ability with a low general level of initiative as well as ability.

III.IX.33

The analysis of profit is much simplified for students of political economy by the fact that the conventional distribution has placed such (misguided) emphasis on the concept of residual income, notably, of course, in the treatment of rent. Yet it will not do to press the parallel too far, for there is this important difference: Rent—and as every one now understands, any other share as well—is residual after the products of the other shares are deducted (product being the marginal contribution of a single unit multiplied by the number of units). But profit (under the simplified conditions we are now dealing with) is the residue after deduction of the payment for the other agencies, determined by the marginal bid of entrepreneurs as a class for all agencies as aggregates. The residue in the latter case is not a product residue, but a margin of error in calculation on the part of the non-entrepreneurs and entrepreneurs who do not force the successful entrepreneurs to pay as much for productive services as they could be forced to pay.

III.IX.34

As the argument is quite complicated, it will be well to recapitulate. We have assumed in this first approximation that each man in society knows his own powers as entrepreneur, but that men know nothing about each other in this capacity. The division of social income between profits and contractual income then depends on the supply of entrepreneur ability in the society and the rapidity of diminishing returns from (other factors applied to) it, the size of the profit share increasing as the supply of ability is small and as the returns diminish more rapidly. If men are poor judges of their own powers as well as ignorant of those of other men, the size of the profit share depends on whether they tend on the whole to overestimate or underestimate the prospects of business operations, being larger if they underestimate. These statements abstract from the question of possession of means to guarantee the fixed incomes which they contract to pay; limitations in this respect act as limitations on the supply of entrepreneur ability. If entrepreneur ability is of such high quality that it practically is not subject to diminishing returns, the competition among even a very few such men will raise the rate of contractual returns and lower the residual share, if they know their own powers. If they do not, the size of their profits will again depend on their "optimism," varying inversely with the latter.

III.IX.35

A man's knowledge of his own powers involves knowledge of the amount of uncertainty he deals with in trusting his own judgment, which, if the scale of operations is large enough, means the absence of uncertainty in the effective sense, if the knowledge is complete. Even if judgment itself subject to error is exercised in regard to the real probabilities in an intrinsic gambling situation, we have for the uncertainty in the situation as a whole an objective probability with predictable results for a large number of cases. The presence of true profit, therefore, depends on an absolute uncertainty in the estimation of the value of judgment, or on the absence of the requisite organization for combining a sufficient number of instances to secure certainty through consolidation. With men in complete ignorance of the powers of judgment of other men it is hard to see how such organization could be effected. Yet so elusive is the mechanism by which we know our world, so great the capacity of mind for seizing upon indirect methods of increasing certainty, that a further sweeping reservation must be made. If men, ignorant of other men's powers, know that these other men themselves know their own powers, the results of general knowledge of all men's powers may be secured; and this is true even if such knowledge is (as it is in fact) very imperfectly or not at all communicable. If those who furnish productive services for a contractual remuneration know that those who bid for the services know what they are worth to themselves, the bidders, or if each bidder knows this to be true of the others, the latter will be forced to pay all that they are willing to pay, which is to say all that they can pay. To be sure, competition under such conditions would be likely to take on the character of a poker game, a bluffing contest. But it must be admitted that actual wage bargains are in no slight degree of this character.

III.IX.36

The case of European exploiters among primitive peoples illustrates the possibility of large profits to be made by a small number of men who know what they are doing among a large number who do not. But if they compete among themselves there must come a time, if their number increases, when they will force prices to their competitive level without any action on the part of the exploited masses more shrewd than that of accepting a larger offer in preference to a smaller one. The number of competitors required to bring about this result depends upon the steepness of the curve of diminishing returns from entrepreneurship, upon the limitation of the scope of enterprise one man can deal with effectively. And the idea of scope must be extended to include the variety of situations to be dealt with. The question of diminishing returns from entrepreneurship is really a matter of the amount of uncertainty present.*30 To imagine that one man could adequately manage a business enterprise of indefinite size and complexity is to imagine a situation in which effective uncertainty is entirely absent.

III.IX.37

The entire foregoing argument has dealt with a simplified situation inasmuch as the members of our society have been assumed to know something about the true value, each of his own judgment and ability to control events in accordance with it, but to know these things about each other only as the other man's own opinion of himself is manifested in his dispositions to act. In fact men form judgments of other men on the basis of watching their performances over a period of time, and in addition form impressions having some claim to validity from mere personal appearance, conversation, etc. Such knowledge of others is one of the most important factors in our efforts to live together intelligently in organized society. It is the most difficult to discuss scientifically of all the data connected with the practical bearings of knowledge and uncertainty.

III.IX.38

Estimates of the worth of other men's opinions and capabilities probably form by far the largest part of the data on which any individual makes decisions in his own life, at least in the sphere of economic activity where such activity is highly organized. Such estimates function as an indirect indication of what we may expect to happen in any set of conditions; we know and give ourselves credit for knowing nothing of value about the problem itself, but we know what is the belief of other men whose judgment we respect and which we accept in place of an opinion of our own. The degree of confidence which we feel in our own situation is simply the degree of confidence we feel in the value of the judgment of the "authority" whose pronouncement we accept as the best information available on the merits of the case. To be sure, the mode of formation of these opinions of others' opinions is complex and obscure, and is rarely free from all passing of judgment on the case itself independently. There is a mutual reinforcement; we have some ideas of our own in the premises, and these agree with the views of some authority. We often if not in general believe what we do because the authority believes it, but to some extent we believe in the authority because he holds the view to which we were already inclined. In large measure we even believe in ourselves because and in the measure that we think others believe in us, though, on the other hand, again, . . . But it is enough to indicate the complexity of the relations between our own and others' opinions without attempting to set all these relations out in logical statements. The importance of indirect knowledge of fact through knowledge of others' knowledge is the point we wish to emphasize.

III.IX.39

Correspondingly, the uncertainty of the knowledge on the basis of which we act is in large measure the margin of error in our estimates of the authorities whom we elect to follow. The uncertainties of business are predominantly of this character, and the genus calls for particularly careful study. Our discussion hitherto has assumed pure and undivided entrepreneurship, which would follow from the impossibility of knowledge by one person of another person's capabilities. In the absence of such knowledge it is clear that no one would put his resources under the direction of another without a valid guarantee of the payment agreed upon, and no one could become an entrepreneur who was not in a position to make such guarantees without assistance,*31 it being equally clear that no one would make such a guarantee for another. That is, entrepreneurship would be completely specialized in a pure form, responsibility and control completely associated. When men have knowledge, or opinions on which they are willing to act, of other men's capacities for the entrepreneur function, all this is changed; entrepreneurship is no longer a simple and sharply isolated function. This is, of course, the state of affairs in real life, and it is this partially specialized and more or less distributed entrepreneurship which merits most careful consideration. Several forms of organization distribution of the function call for notice.

III.IX.40

The simplest division of entrepreneurship which we can think of is the separation of the two elements of control and guarantee and their performance by different individuals. This is a natural arrangement, for it must often happen that entrepreneur ability will not be associated with a situation on the part of its possessor enabling him to make satisfactory guarantees of the contractual incomes promised. Under such circumstances it may be mutually profitable for him to enter into agreement with some one in a position to underwrite his employment contracts, but not himself possessed of the ability or disposition to undertake the direction of enterprises. The form of this partnership and conditions of division of the profit may be highly various. As a matter of fact we know that it commonly takes the shape of a new wage bargain, the guarantor hiring the director in much the same way as the latter hires the productive services which he organized and controls. This transfer of function involves a transformation in character also which must be considered at length, and will be taken up in the next chapter. Let us note here that it is usually impracticable to separate all the guaranteeing responsibility from the control of the enterprise. It is rare that a hired entrepreneur receives a contractual income as his only interest in the business. He is usually a part owner, or at least his salary is so adjusted as to make it clear that his continuance in the position is contingent upon its prosperity under his direction.

III.IX.41

An effect of the evaluation of ability nearly as important as the transformation in entrepreneurship with its partial transfer to another individual is that the specialization of the function within the enterprise may be quite incomplete. That is, it is no longer true that men are necessarily unwilling to entrust productive services, of person or property, to an outsider without an effective material guarantee of the fixed payment agreed upon. If they have confidence in the manager's ability and integrity they may gladly work with only a partial or imperfect security for their remunerations. To the extent that this is the case such owners of productive services manifestly share in bearing the uncertainty or "taking the risk" involved in the undertaking. That they also share in the effective control will appear in the course of a more careful examination of the entrepreneur function under the complicated, vague, and shifting conditions of real life (except that progress is still abstracted), which is the next stage in our inquiry.


Notes for this chapter


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

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

24.
Chapter V, the reader will recall, dealt with the effects of progress with uncertainty absent. We here retrace our steps somewhat in order to consider uncertainty with progress absent, thus completing the design of studying the two factors separately. After completing the present task we shall (in chapter XI) study them in combination. A confusion between the effects of uncertainty and those of progress, which are largely, though never quite completely, separable facts, has been seen to underlie the reasoning of the "dynamic" theory of profit.
25.
See above, chapter IV, p. 106, note [nn46—Ed.].
26.
The statement implies that a man's judgment has in an effective sense a true or objective value. This assumption will be justified by the further course of the argument.
27.
As already observed, the theoretical features of contractual income are those associated with rent in the conventional distributive analysis. From the point of view of our present assumptions, all productive goods being fixed in amount and in their distribution among the members of society, such incomes might naturally be called wages. As we have insisted that there is no significant causal or ethical difference in the sources of income it does not particularly matter what they are called.
28.
In actual society freedom of choice between employer and employee status depends normally on the possession of a minimum amount of capital. The degree of abstraction involved in assuming such freedom is not serious, however, since demonstrated ability can always get funds for business operations. A propertyless employer can make the contractual payments secure by insurance even when they may involve loss, and complete separation of the risk-taking and control function from that of furnishing productive services is possible if there is a high development of organization and a high code of business honor. But the conditions generally necessary in real life for the giving of effective guarantees must also be taken into account as we proceed.
29.
As has been well observed in connection with games of skill. It is not necessarily a proof of high skill to make a twenty-foot putt in golf or pierce a two-inch bull's-eye at a hundred yards with a rifle; nor a lack of skill to miss a three-foot putt or strike outside the eight-inch circle. Either would happen sometimes with good shots or poor; only the proportion of successes and failures in a fair number of trials gives any indication of real ability to do the trick.
30.
The diminishing returns of management is a subject often referred to in economic literature, but in regard to which there is a dearth of scientific discussion. For an interesting, but in the present writer's view fundamentally unsound, treatment, see H. C. Taylor, Agricultural Economics, chap. VI. Our own discussion of the theory of enterprise is admitted to be vague and unsatisfactory. A complete and logically rigorous discussion would be a large undertaking. In view of the extreme complexity of the elements involved in uncertainty, most of which may be independent variables, the number of possible suppositions which might be followed out is prohibitive. At least it would require so much space and be so difficult to follow, and of so little practical significance, that the probability of its being read does not justify the attempt. It is hoped that the above discussion covers the principal points of interest. The essential factors are men's ability in the entrepreneur field, which includes foresight and executive capacity, and their knowledge of their own powers and disposition to trust them in action. The factors likely to be neglected are the last two, self-knowledge and self-confidence or initiative, which are closely related, but not identical. In addition, knowledge of, and willingness to trust, other men's powers and judgment is a still more important consideration, not yet discussed.
31.
It does not follow that he would have to own property, though in the real world this is the practical consequence. It is easily conceivable, however, that one might secure the payment of his obligations by pledging his own earning power. Such an arrangement need not call for more difficult feats of organization or involve greater strain on human nature than is true of indemnity insurance at present.

Part III, Chapter X.

End of Notes


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