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 X

Enterprise and Profit (continued)
The Salaried Manager

III.X.1

The typical form of business unit in the modern world is the corporation. Its most important characteristic is the combination of diffused ownership with concentrated control.*32 In theory the organization is a representative democracy, of an indirect type. The owners elect directors whose main function is to choose the officials who are said actually to carry on the business of the company. The directors themselves, however, exercise real direction over the general policies of the corporation. Moreover, if it is a large enterprise, the executive officials chosen by the directors have only a general oversight over business policy, and their chief function in turn is to select subordinates who make most of the actual decisions involved in the control of the concern. And of course the process does not stop there; there may be many stages in the hierarchy of functionaries whose chief duties consist of choosing still other subordinates.

III.X.2

The first necessary step in understanding the distribution of control and responsibility in modern business is to grasp this fact: What we call "control" consists mainly of selecting some one else to do the "controlling." Business judgment is chiefly judgment of men. We know things by knowledge of men who know them and control things in the same indirect way. Nor can this conclusion be escaped, as there is some tendency to pretend, by distinguishing between judgment of ends and judgment of means. The only problems with which we have any concern are all problems of means. There is only one end, finally, to business activity, and this is already decided upon before the business is founded; that is, to make money. The decisions made by members of the business organization all relate to means, at whatever state of "generality" they may be taken; the difference between decisions as to general policy and operative detail is one of degree only, in which all degrees exist; it is an arbitrary distinction. Decisions as to ends in any proper sense are made only by consumers—persons outside the productive organization altogether.

III.X.3

These statements hold good in fact for all other departments of organized social activity as well as for business. They are even more true of political organization. It is hardly an exaggeration to say that the political officeholder's business is to get the job and then find some one else to perform its duties. In the field of organization, the knowledge on which what we call responsible control depends is not knowledge of situations and problems and of means for effecting changes, but is knowledge of other men's knowledge of these things. So fundamental to our problem is this fact that human judgment of things has in an effective sense a "true value" which can be estimated more or less correctly by the man possessing it and by others—so fundamental is it for understanding the control of organized activity, that the problem of judging men's powers of judgment overshadows the problem of judging the facts of the situation to be dealt with. And if this is true of knowledge it is manifestly true of uncertainty. Under organized dealings with our environment, attention and interest shift from the errors in men's opinions of things to the errors in their opinions of men. Organized control of nature in a real sense depends less on the possibility of knowing nature than it does on the possibility of knowing the accuracy of other men's knowledge of nature, and their powers of using this knowledge.

III.X.4

The fundamental principle underlying organized activity is therefore the reduction of the uncertainty in individual judgments and decisions by grouping the decisions of a particular individual and estimating the proportion of successes and failures, or the average quality of his judgments as a group. It is an application of the broader principle of consolidation of risks, but the circumstances are peculiar. The result can never be calculated, either from a priori data or from tabulations of instances observed. It is an estimate in the purest sense, an estimate into which previous observation may enter little. We form our opinions of the value of men's opinions and powers through an intuitive faculty of judging personality, with relatively little reference to observation of their actual performance in dealing with the kind of problems we are to set them at. Of course we use this sort of direct evidence as far as possible, but that is usually not very far. The final decision comes as near to intuition as we can well imagine; it constitutes an immediate perception of relations, as mysterious as reading another person's thoughts or emotions from subtle changes in the lines of his face.

III.X.5

The great complexity and difficulty in the analysis of business uncertainty and of profit as the remuneration connected with meeting it arises from this peculiar distribution of responsibility in the organization. There is an apparent separation of the functions of making decisions and taking the "risk" of error in decisions. The separation appears quite sharp in the case of the hired manager, as in a corporation, where the man who makes decisions receives a fixed salary, taking no "risk," and those who take the risk and receive profits—the stockholders—make no decisions, exercise no control. Yet a little examination in the light of the preceding discussion of indirect knowledge and indirect responsibility will show that the separation is illusory; when control is accurately defined and located, the functions of making decisions and assuming the responsibility for their correctness will be found to be one and indivisible.

III.X.6

The phenomena can be best elucidated by beginning at the very "bottom" of the scale, with the "routine" duties of the common, unskilled laborer. It will be evident on reflection that even the coarsest and most mechanical labor involves in some sense meeting uncertainty, dealing with contingencies which cannot be exactly foreseen. It seems to be the function of all conscious life to deal with "new situations." Consciousness would never have developed if the environment of living organisms were perfectly uniform and monotonous, conformable to mechanical laws. In such a world organisms would be automata. There is a manifest tendency to economize consciousness, to make all possible adaptations by unconscious reflex response. In human life we see complex adaptations such as performing on a musical instrument drop below the threshold when learned. If the requisite movements were constant from generation to generation there is little doubt that they would become fixed in the germ plasm by the slow process of natural selection if we eliminate the more direct method by inheritance of acquired characters.

III.X.7

Moreover, in industrial life, purely routine operations are inevitably taken over by machinery. The duties of the machine tender may seem mechanical and uniform, but they are really not so throughout the operation. His function is to complete the carrying-out of the process to the point where it becomes entirely uniform so that the machine can take hold of it, or else to begin with the uniform output of the machine and start it on the way of diversification. Some part of the task will practically always be found to require conscious judgment, which is to say the meeting of uncertainty, the exercise of responsibility, in the ordinary sense of these terms.

III.X.8

But from the standpoint of organization the work of the common laborer does not involve uncertainty or responsibility in the effective sense, on account of the principle of indirect knowledge and transfer of responsibility discussed above. Even when it is impossible to reduce the work itself to routine sufficiently for a machine to handle it—due usually to lack of uniformity (i.e., uncertainty) in the material worked with—it is possible to judge with a high degree of accuracy the capacity of a human individual to deal with the sort of irregularities to be met with in the occupation. It is the function of the operative in industry to deal with uncertainty as a matter of routine! The exact movements he shall have to perform cannot be foretold, but his ability to perform them can be, and so the uncertainty is eliminated as an element in the calculations; ignorance of the environmental situation gives place to knowledge of human judgment.

III.X.9

The contrast again, even in case of the humblest operative, is not absolute. Most such persons occasionally meet with contingencies in regard to which they are expected to appeal to judgment and ability superior to their own. Nor can the operative's ability to handle his job be known with complete accuracy to his superior. The operative must exercise judgment over his own capacities in knowing when to go ahead independently and when to appeal for guidance. And the official who assigns the operative to his job and fixes his remuneration for performing it must exercise a rather higher quality of judgment in estimating the powers of the operative. The net effect is that uncertainty and responsibility are not quite eliminated, but are partially transferred to the superior in the scale of organization. The true uncertainty in the case relates to this official's judgment of his man in relation, of course, to the position he is to fill. As far as the lowest man in the scale is concerned, he is freed from all responsibility beyond the ("routine") duty of using his best judgment as occasion requires. His superior is responsible for him, and he accordingly receives a fixed wage.*33

III.X.10

It will already be clear that this process of transferring responsibility does not end with the first step at the bottom of the scale, and the goal to which the argument will lead is in fairly plain view. The foreman (let us say) who passes judgment on the abilities of operatives and takes the responsibility for their performing in accordance with his expectations finds himself in turn in a similar relation to his own ranking superior in the organization. His capacity to judge operatives is passed upon and reduced to a routine function in the same way that he passes upon their capacities to do their work, and likewise his capacity to deal with those more exceptional contingencies in which operatives are likely to appeal to him; and his responsibility is in turn transferred to the higher official (superintendent or what-not) who selects him, assigns him to his work, and hears appeals in those still rarer questions which he refers higher up for decision. The knowledge on which the higher control is based is again, and still more, knowledge of a man's capacity to deal with a problem, not concrete knowledge of the problem itself. The higher official may in fact be very competent to deal with the problem directly, but he does not do so. And it is noteworthy that he may not be competent in this sense. Some superintendents would doubtless make better foremen than their foremen, and only serve in the higher capacity because of the still greater rarity and value of the ability to judge and handle foremen. But it is unquestionable that a great many men make very good superintendents who would not make good foremen at all, and perhaps this is the more common case.

III.X.11

On up the scale the same relations hold good until we come to the supreme head of the business. For simplicity we may suppose that this individual combines all the managerial functions in his single person, that he is president, general manager, and so forth, that his directors exercise no control over him whatever beyond giving him his place and salary and a perfectly free hand. Even such an individual is in a position similar in essential respects, as far as the problem of organization is concerned, to that of the lowly machine tender. His capacities to deal with the kind of situations he has to deal with are subject to evaluation, are evaluated. His work is also a "routine" task of exercising his best judgment—and leaving the consequences to others. The real responsibility is again shifted back, as the effective uncertainty is in the judgment which placed him in his position. The responsible decision is not the concrete ordering of policy, but ordering an orderer as a "laborer" to order it. And this final responsibility necessarily takes the consequences of its decisions. The apparent separation between control and risk taken turns out, as predicted, to be illusory. The paradox of the hired manager, which has caused endless confusion in the analysis of profit, arises from the failure to recognize the fundamental fact that in organized activity the crucial decision is the selection of men to make decisions, that any other sort of decision-making or exercise of judgment is automatically reduced to a routine function. All of which follows from the very nature of large-scale control, based on the replacement of knowledge of things by knowledge of men, as our analysis has shown.

III.X.12

We must refuse to be misled by the superficial similarity between the daily work of the hired manager and that of the man in business on his own account. The difference is far more fundamental. The former has had his task cut out for him by others and been set to perform it; the latter has cut out his own task to fit his own measure of himself, and set himself at it. Here is the really responsible decision, made for the hired manager, by the independent enterpriser. Whenever we find an apparent separation between control and uncertainty-bearing, examination will show that we are confusing essentially routine activities with real control.*34

III.X.13

Like a large proportion of the practical problems of business life, as of all life, this one of selecting human capacities for dealing with unforeseeable situations involves paradox and apparent theoretical impossibility of solution. But like a host of impossible things in life, it is constantly being done. Though we cannot anticipate a concrete situation accurately enough to meet it without the intervention of conscious judgment at that moment, it can be foreseen that under certain circumstances the kind of things that will turn up will be of a character to be dealt with by a kind of capacity which can be selected and evaluated. That large-scale organizations are formed and operate successfully demonstrates that this principle is sound, that for these impossible problems solutions more right than wrong are actually found. Partly through operation of the principle of reduction of uncertainty by consolidation, partly for reasons embodied in our faculties of interpreting personality and which seem to be inscrutable, knowledge of men's capacities to know turns out to be more accurate than direct knowledge of things.

III.X.14

Another phase of entrepreneurship based on the same fundamental facts of transfer of responsibility, and which still further complicates its analysis, is the incompleteness of specialization. We may introduce the problem as a continuation of the above argument by inquiring into the question, To whom is the responsibility ultimately transferred when the entire conduct and policy of a business are in the hands of a hired manager? The answer is obvious: to the owners of the productive services used in the business; i.e., to the very shoulders from which the same responsibility is taken in the case of the specialization of function involved in contracting with an independent entrepreneur. In the latter case the entrepreneur, who selects himself, takes over all the uncertainty of the business along with control over it. But in view of the difficulty of any single individual giving adequate security for the performance of his contracts in the case of a large undertaking, such a form of organization has a very limited opportunity for growth. For it is clear that only the possessor of transferable wealth already produced (consumers' or producers' goods) or of future productive capacity in some form can make guarantees or really bear uncertainty or take risks for other persons. And it is nearly inevitable that the man who "undertakes" any line of business as entrepreneur will commit a part of his own wealth or productive powers to that business. What naturally happens, then, in any case is that the control of enterprise falls into the hands of the owner (or owners) of a part of the productive services used in the enterprise, which resources are placed in an exposed position with regard to losses in the business and so guarantee the owners of the remaining "land, labor, and capital" against failure to receive their full contractual remuneration.

III.X.15

It is impossible for entrepreneurship to be completely specialized or exist in a pure form, except in the rare and improbable case of a man who owns nothing in a particular business and contributes nothing to it but responsibility. Even a man who conducted a business entirely with borrowed funds and hired labor, but managing it himself, would not exemplify pure entrepreneurship, for a large part of the work of management is as we have seen reducible to routine and can be paid for with a fixed wage. The nearest approach to an entrepreneur only would be a man who borrowed all the resources for operating a business and then hired a manager and gave him an absolutely free hand. And such a man would have to be more than an entrepreneur in relation to some other business, or he would not be a true entrepreneur, making responsible decisions, in the business in question.

III.X.16

The natural result is a complicated division or diffusion of entrepreneurship, distributed in the typical modern business organization by a hierarchy of security issues carrying every conceivable gradation and combination of rights to control and to freedom from uncertainty as to income and vested capital. The feature of the system apt to be overlooked is a large element of real control disguised under a nominal contract for a fixed return. It is seldom true that the guarantees given can be regarded as absolute. If they are not, the owner of resources is taking a certain share of responsibility or risk, obviously. That he is also exercising control becomes apparent if we consider that his decision to allow the use of his labor or property under the conditions affects the scale of operations of the business. Control is completely absent from the function of furnishing productive services to a business only in case an accurately determined competitive value of the services is effectively guaranteed, so that everything but the money remuneration is made completely indifferent to their owner.

III.X.17

As a matter of fact we know that it is common for those who furnish resources to an enterprise to retain a large amount of direct consultative authority in regard to the conduct of the business. The voting trust is a device for securing this end and owes its importance to the necessity of providing for security owners an assurance of competent control when adequate protection of their interests cannot otherwise be achieved, especially when the value of the property depends largely on its intelligent employment in the particular use to which it has been committed. With the increasing specialization of industry such conditions become more and more common, effective guarantees become harder and harder to make, and investors find it necessary to insist more and more on sharing in the control of business. The distinction between stocks and bonds tends to fade out.*35 It is hard to find an illustration of an unconditional transfer of productive resources to a business for its use for a pecuniary consideration alone without an outright transfer of ownership. The owners of limited issues of first-mortgage bonds have an ultimate recourse to the courts to compel honest management of the concern if their interests are jeopardized. Only in such a case as the lease of pure site value which is indestructible and not changed in any way by use can we find an example of an income entirely freed from the element of responsible control.

III.X.18

The case of labor is somewhat peculiar, owing to the disposition of laboring people to gamble recklessly with life and limb as well as income. Under free competition there is little doubt that a considerable proportion of the losses of enterprise would fall upon labor, since laborers show themselves ready to engage in hazardous enterprises at their own risk for an increase in wages which is a fraction of an adequate compensation for the chances they take. But the social interest in the man who cannot afford the loss comes to the rescue with prior claim laws, mechanics' liens, and the like, so that the wages of labor are in fact generally a fair approximation to a guaranteed contractual return. The element of control which would be involved in a dependence of business upon laborers' choice of the ventures they would engage in, is correspondingly absent, as the effective contracting-out of the risk places different lines of employment on a plane of indifference at the wages fixed.*36

III.X.19

The relations between profit and the contractual shares call for a few further remarks. As observed in our historical introduction (chapter II) the older English economists used the term "profit" to designate the income of the owner of a business, who was regarded as essentially an investor. Hence, as the classical economics was essentially a long-time theoretical treatment, little distinction was drawn between profit and interest. A wage element was recognized in the income, and also a risk factor. Little was made of the latter as constituting a distinction between profit and interest, as ordinary contract interest so obviously contains an element of payment for risk also. And in view of our argument above that the assumption of risk in this connection involves the exercise of effective control to the same extent, the relegation of this factor into the background is still further justified.

III.X.20

American economic discussion developed under the influence of the marginal utility theory, which is essentially a short time view of the valuation problem. There is some connection between this fact and the greater emphasis given in this country to "wages of management" and the separation of this element from the entrepreneur's income, leaving "profit" or "pure profit" in a narrower sense than that given the term by the older writers. For management is more conspicuous in American industry, due to the more "dynamic" conditions of this country. In a long-time view or "static state" it would be relatively much less important. The greater emphasis given the risk factor in American (as in German) discussions is explained in the same way, a more dynamic background and greater interest in short-period changes.

III.X.21

With the recent development of accounting theory, the question whether interest on investment should be counted in profit has become acute from another point of view and has tended to constitute an issue between accountants and economic theorists. This is of course entirely uncalled-for, as the difference in position is a matter of obvious difference in standpoint. Economic theory is interested in the forces which determine the prices of goods, and in costs of production as a condition of supply. It goes without saying that, in the long run again, a return on capital equal to the competitive rate of interest is a condition of production, and so from this point of view a cost. (That things may be different from a short-time viewpoint serves to increase the confusion.) The accountant is interested in proprietorship, the relations between a business and its owners, and in cost as a deduction from the owner's income. Moreover, scientific accounting is an outgrowth of corporation problems, and in the corporation the responsible owner is thought of as an investor, his interest as a capital interest, whether he has put any money in the business or not and whether or not it has any value above its debts. And profit, being a return on investment, is naturally thought of as a rate of return.

III.X.22

In most cases it would not be fruitful to attempt an accurate separation of profit from interest.*37 For on the other side of the relation, pure interest is almost as rare a phenomenon and as elusive a concept as pure profit. The specialization of the entrepreneur function is a fundamental fact in business organization, but for reasons which should already be clear, it cannot be carried to theoretical completeness. The entrepreneur must almost of necessity own some property and the owner of property used in a business can hardly be freed from all risk and responsibility. It is useful, however, to distinguish between the return actually realized by an entrepreneur and the "competitive" rate of interest on high-class "gilt-edge" securities where the risk and responsibility factor is negligible. The difference would be profit, or "pure profit" in the sense in which economic theory uses the term.

III.X.23

Even at last some reservation must be made in calling interest on the entrepreneur's investment a cost of producing the commodity. It is generally admitted that if this rate of return is not realized on the average and in the long run the investment will not be held in the business in question. But the truth accurately stated evidently is that the owner must expect in the future to receive a return equal to that which he can be sure of elsewhere, on the investment which he is free to transfer to other uses. And of course allowance must be made for the connection between different elements of investment as well as technological fluidity. If half the investment in an enterprise represents machinery, working-capital, land, or what-not which can be transferred to other lines, and the other half represents permanent commitment, worthless outside the particular business, the cost of producing the output of that business (after the commitment has been made) is only the (anticipation of the) competitive return on the removable half of the capital alone. Of course this half could not be removed without rendering the remainder worthless.

III.X.24

The association of profit with income on property is valid, within the limits discussed, for the greater part of business enterprises, but there are important exceptions. The independent entrepreneur is not yet by any means an extinct species. Such a person typically furnishes both property and labor services to a business, meaning by labor services personal activities which might be hired and paid for with a fixed wage. The entrepreneur income in a case of this sort contains an element of wages as well as an element of interest. The contention of some accountants that a salary should be allowed for the owner's work and the residue considered as a return on his investment does not seem to be well founded. It is based on a bias derived from the habitual (and proper) procedure in corporations, where the responsible owner furnishes property services only. It would be just as logical to deduct from the owner's income a competitive rate of interest and call the residue wages or wages of management. The only significant distinction is that between the total income and a "pure profit" secured by deducting both competitive wages for the work and competitive interest on the investment furnished by the owner. The determination of the proper wage rate will be fraught with the same sort of difficulties that have been referred to in the case of pure interest, but in a much more aggravated form; it is far more difficult to appraise labor and find similar services in the competitive field as a basis of comparison than in the case of property.*38

III.X.25

In some instances, though perhaps a relatively small proportion of real enterprises and those probably of small average size, the independent entrepreneur may have no property investment in his business, furnishing labor services only. It is in reference to such a situation that the conventional (American) treatment of profit and wages of management has most significance. It must be very unusual, for reasons already pointed out, for a man to hire the use of the labor and property of others without putting up some property as well as labor of his own. It would be possible, within limits, for such a man to give adequate security for payment of the fixed remuneration of outside agencies, if his own earning capacity were high.*39

III.X.26

But in reality this probably does not happen on any considerable scale, or with enterprises of large magnitude. However, allowance must be made for the ownership of property used in other enterprises, and also for the "moral backing" of wealthy relatives or friends. And such "moral backing" may or may not constitute a division of the entrepreneur's responsibility. The only ultimate security may still be the potential earning power of the entrepreneur himself, which, however, might not be marketable on account of a moral hazard without being underwritten by property-owning connections.

III.X.27

On the whole we must say that the discussion of profit in relation to wages of management has been greatly overworked. The connection with property income is enormously more common, direct, and close. The residual share of income falls of necessity to the person in responsible control of a business; hence, in most cases to a person who also receives a property income. He may or may not also receive a labor income as well. The important distinction for the purposes of theoretical analysis is that between pure residual income or pure profit and property income. The relation to labor income is incidental in importance comparatively, and being of the same character, at any rate, does not call for much space in a discussion of profit. If a distinction is made between land and capital, it must be recognized that the profit receiver may be also a recipient of rent, in addition to interest or wages or both. And in exceptional cases he may receive rent only, as, for instance, a farmer who owns his land, but borrows all his working capital and hires all his work done. In such a case the practical problem would be to distinguish pure profit from rent. But such a situation is somewhat artificial, and the distinction between land and other property is from this point of view even more so.

III.X.28

The importance of property-ownership in connection with profit will be even greater and more apparent if "good-will," business connection, and established reputation, etc., be regarded as property. If these categories are capitalized and included in investment the cases are rare indeed where an employer of others' labor and capital has no investment of his own in the undertaking. As to the proper procedure in dealing with these items, whether they should or should not be regarded as property, the answer depends on whether they are salable. If good-will is separable from the other elements in a business, the test of which is that it can be sold away from them without affecting their value, then it is property on its own account, and the competitive rate of return on its sale value must be deducted from the owner's income before a pure profit is arrived at. If good-will is inseparable from some other property element, such as a site, it is a factor in the value of that piece of property, and income on the total value must similarly be considered a property income, not a pure profit. If the good-will inheres in the person of the owner, however, it is not property, but an element in the personal service of the owner, and its proper income is a wage; again not a profit. In so far as its value (in the capital or revenue sense) can be appraised, it must be considered as entitled to a contractual return and does not give rise to profit in the narrow sense.

III.X.29

Our discussion of the meaning of profit may now be summed up in a few brief statements. Organization involves the concentration of responsibility, placing resources belonging to a large number of individuals under centralized control. Examination shows that the human functions in production involve making decisions, exercising control, but that this control is not final unless combined with assumption of the results of the decisions. The responsible decision relates to men rather than things; the ultimate manager is he who plans the organization, lays out functions, selects men for functions and appraises their value to the organization as a whole, in competition with all other bidders in the market. For this ultimate management there is but one possible remuneration, the residuum of product remaining after payment is made at rates established in competition with all comers for all services of men or things for which competition exists.*40 This residuum is profit; it is the remainder out of the value realized from the sale of product after deduction of the values of all factors in production which can be valued, or after all the product has been imputed to productive elements which can be imputed by the competitive mechanism. Profit is unimputable income, as distinguished from the total income of the owner of the business. Normally there are other elements in this total income, which, since they are not paid out by the business, may be said not to be imputed, or they may be described as "residually imputed."

III.X.30

Pure profit is theoretically unimputable, in the sense in which the competitive system of industrial organization imputes product value to agencies concerned in production. In this competitive process, all the product value which can be associated with any agency will accrue to that agency. The essence of the process is the bidding of entrepreneurs or would-be entrepreneurs for the use of productive services in the future, the rates of remuneration being determined by a present general competitive estimate of the values of the services in the market, while the return finally received from their use may diverge from this estimate in view of the fact of uncertainty or liability to error in all human prognostications. As far and as fast as any portion of income can be known in advance to be connected with the exercise of superior judgment, it will be imputed to the person possessing the unusual powers, and will become a wage (of management), no longer a profit. Wages of management are not different in principle from wages for routine work; management is routine work when the term is properly understood in the present connection. The true uncertainty in organized life is the uncertainty in an estimate of human capacity, which is always a capacity to meet uncertainty.

III.X.31

In general practice the ownership of property is necessary to the assumption of genuine responsibility, and in the typical modern business organization the responsible owner furnishes no labor services to the business, but property services only. In such a case profit in our sense of the term appears as a difference between the rate of return on the owner's investment and a competitive rate of return on investment generally. The scientific use of the term "profit" must therefore be distinguished from the various loose uses of the term in business, and particularly from the net revenue of the owner; it is well to use a special expression, such as "pure profit," to distinguish the share which is accurately residual, theoretically different from the returns from routine functions, imputed by competition to the agents which earn them. We must bear in mind, however, that the imputed or competitive element in the owner's income does not bear quite the same relation to the price of the product as outlays actually incurred. The expectation of such a return at the general competitive rate is a condition of the production of that business's contribution to the total supply of a commodity, but its realization cannot be said to be necessary.

III.X.32

If it is necessary to distinguish between profit and wages, it is just as vital to contrast profit with payment for risk-taking in any ordinary use of the terms. An insurer, in so far as his business is reduced to a science, takes no risk; the risk in the individual case of the insured is obliterated on being thrown in with the multitude of cases of the insurer. And it is immaterial whether the "cases" are a homogeneous group of similars or whether each is objectively in a class by itself, if the true probability can be ascertained. The "risk" which gives rise to profit is an uncertainty which cannot be evaluated, connected with a situation such that there is no possibility of grouping on any objective basis whatever. For while it is true that decisions made by an individual tend to approximate an objective value when considered as a group, decisions of this character reduce to routine and do not involve ultimate responsibility; in so far as the powers of the entrepreneur become evaluated, a definite return is imputed to his activity, and this return is no longer a profit, but a wage.*41

III.X.33

The only "risk" which leads to a profit is a unique uncertainty resulting from an exercise of ultimate responsibility which in its very nature cannot be insured nor capitalized nor salaried. Profit arises out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless. The receipt of profit in a particular case may be argued to be the result of superior judgment. But it is judgment of judgment, especially one's own judgment, and in an individual case there is no way of telling good judgment from good luck, and a succession of cases sufficient to evaluate the judgment or determine its probable value transforms the profit into a wage.

III.X.34

The fundamental fact of organized activity is the tendency to transform the uncertainties of human opinion and action into measurable probabilities by forming an approximate evaluation of the judgment and capacity of the man. The ability to judge men in relation to the problems they are to deal with, and the power to "inspire" them to efficiency in judging other men and things, are the essential characteristics of the executive.

III.X.35

If these capacities are known, the compensation for exercising them can be competitively imputed and is a wage; only, in so far as they are unknown or known only to the possessor himself, do they give rise to a profit. The powers and attributes of leadership form the most mysterious as well as the most vital endowment which fits the human species for civilized or organized life, transcending even that power of perceiving and associating qualities and relations which is the true nature of what we call reasoning. It is the margin of error in this most ultimate faculty of judging faculties whose exercise is the essence of responsible control, which constitutes the only true uncertainty in the workings of the competitive organization (as of any other organization). And it is uncertainty in this sense which explains profit in the proper use of the term, the sense toward which economic usage has been groping, that of a pure residual income, unimputable by the mechanism of competition to any agent concerned in its creation.

III.X.36

It remains to follow out this line of reasoning in detail, to show how a large part of the phenomena of current economic life, on the organization side, are the natural results of the fact of uncertainty and this fundamental method of meeting it. But it seems best to postpone this further discussion until we have examined the bearings of progressive change on the amount and kind of uncertainty involved in economic life. These two chapters have dealt only with the more fundamental features of free enterprise which would be met with even in a society as nearly static as material possibility admits, and in which a minimum degree of uncertainty would be present. We have abstracted from many important features of entrepreneurship which are connected with the fact of progress or the presence of the conditions of progress, for progress involves uncertainty in a high degree and in very special forms. We turn now to consider the bearings upon economic organization of the various dynamic factors or elements of progress*42 and the uncertainty connected with them.


Notes for this chapter


32.
That is, the most important characteristic from the standpoint of organization. Of perhaps equal importance is the legal nature of the corporation as an entity separate from its member owners. The term "limited liability" is not descriptive. The members of a corporation have, strictly speaking, no responsibility at all; only the property of the corporation, which property does not directly belong to the owners, is liable for the corporation's obligations.
33.
It need hardly be pointed out that the principle of consolidation of risks is operative here to a certain extent. The employer of men passes judgment on their "average" competency to do the things that they are expected to do, an average in the case of each individual and an average involving a further canceling-out of errors if he selects a number of employees. A still higher order of responsible judgment is involved in laying-out and subdividing the work of the establishment so that the task of each single employee is adapted to a certain fairly uniform grade of ability.
34.
Cf. Hawley's contention (Quarterly Journal of Economics, vol. XV, p. 88) that the hired manager makes decisions, but the enterpriser takes the consequences of decisions, and that the former is therefore not an enterpriser.
35.
Of course, the machinery by which control is exercised becomes more indirect and the control itself more remote. Stocks approximate to the real position of bonds as well as bonds to that of stocks. One form of the change is a tendency to cover a larger proportion of investment by stock issues (as compared with bonds) than formerly. The increased recourse to borrowing from banks shows the same tendency, for banks in particular keep in touch with the management of businesses in which they invest.
36.
The case of the ultimate entrepreneur, dealing with and knowing men rather than things, suggests again the analogous political problem. The progress of democracy toward intelligent efficiency seems to depend on a tendency for the ultimate sovereign, the electorate, to center its attention on the selection of competent agents, leaving to them the actual formulation of policies and conduct of affairs. Commission government, and still more the manager plan of municipal government, is a case in point. In the political sphere there is a real problem of ultimate ends, which must, of course, be dealt with by the electorate if the system remains democratic. And perhaps more than in the case of business the voter's judgment of the candidate must be connected with passing an opinion upon the issues, partly because major issues to some extent involve a question of ultimate social ideals. Professor Cooley (Social Organization, p. 129 and chap. XIII) bases an optimistic view of democracy on a belief in the capacity of the populace, admittedly ignorant in regard to political issues and the technique of government, to select men wisely on the basis of a sort of intuitive recognition of personal superiority.
37.
By "interest" is here meant property income merely. The relation between interest and rent is essentially a "dynamic" problem, and will be taken up for discussion in the following chapter. It is questionable whether interest would be met with at all in an unprogressive society, and certain that the distinction between interest and rent would be of small importance. Cf. also above, chapter V.
38.
We must again refer to the use of the term "interest" as meaning property income merely, though superficially this is not quite consistent with treatment of it as a "rate." Pure interest is much more easily defined than a pure competitive return on actual property, but even the latter offers less difficulty than an appraisal of the competitive value of the services of an independent entrepreneur.
39.
To the extent that he does not give adequate security the owners of the productive services exposed to loss are the true entrepreneurs.
40.
Including, of course, monopoly elements in the situation. Cf. above, chapter VI.
41.
The hiring of men to meet uncertainty can be illustrated by many examples from different fields. Corporations employ at set, fixed wages inventors, experimenters, prospectors for minerals, weather and crop forecasters, market predictors, speculators, etc. Gambling-houses pay men weekly salaries to play poker with their clients. It is clear that such employees, like the hired manager, make decisions as a matter of routine, without taking responsibility. The responsible decision is made by the employer, who selects them for their tasks, and the operation of the principle of consolidation of uncertainties is also apparent. The latter point is not so clear in other cases; the doctor makes decisions, but his patients take the responsibility for their correctness!
42.
See chapter V.

Part III, Chapter XI.

End of Notes


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