Principles of Economics
BOOK VI, CHAPTER VII
PROFITS OF CAPITAL AND BUSINESS POWER.
§ 1. In the concluding chapters of Book IV. we made some study of the various forms of business management, and the faculties required for them; and we saw how the supply of business power in command of capital may be regarded as consisting of three elements, the supply of capital, the supply of the business power to manage it, and the supply of the organization by which the two are brought together and made effective for production. In the last chapter we were concerned mainly with interest, the earnings of the first of these elements. In the earlier part of this chapter we shall be occupied with the earnings of the second and third taken together, which we have called gross earnings of management; and afterwards we shall pass to the relation in which this stands to the earnings of the second taken by itself which we have called net earnings of management*70. We have to inquire more closely into the nature of the services which are rendered to society by those who undertake and manage business enterprises, and the rewards of their work; and we shall find that the causes by which these are governed are less arbitrary, and present closer analogies to those which govern other kinds of earnings, than is commonly supposed.
We must however make a distinction at starting. We must call to mind*71 the fact that the struggle for survival tends to make those methods of organization prevail, which are best fitted to thrive in their environment; but not necessarily those best fitted to benefit their environment, unless it happens that they are duly rewarded for all the benefits which they confer, whether direct or indirect. And in fact this is not so. For as a general rule the law of substitution—which is nothing more than a special and limited application of the law of survival of the fittest—tends to make one method of industrial organization supplant another when it offers a direct and immediate service at a lower price. The indirect and ultimate services which either will render have, as a general rule, little or no weight in the balance; and as a result many businesses languish and die, which might in the long run have done good work for society if only they could have obtained a fair start. This is especially true of some forms of co-operative associations.
In this connection we may divide employers and other undertakers into two classes, those who open out new and improved methods of business, and those who follow beaten tracks. The services which the latter perform for society are chiefly direct and seldom miss their full reward: but it is otherwise with the former class.
For instance, economies have lately been introduced into some branches of iron manufacture by diminishing the number of times which the metal is heated in passing from iron ore to its final form; and some of these new inventions have been of such a nature that they could neither be patented nor kept secret. Let us suppose then that a manufacturer with a capital of £50,000 is getting in normal times a net profit of £4,000 a year, £1,500 of which we may regard as his earnings of management, leaving £2,500 for the other two elements of profits. We assume that he has been working so far in the same way as his neighbours, and showing an amount of ability which, though great, is no more than the normal or average ability of the people who fill such exceptionally difficult posts; that is, we assume that £1,500 a year is the normal earnings for the kind of work he has been doing. But as time goes on, he thinks out a way of dispensing with one of the heatings that have hitherto been customary; and in consequence, without increasing his expenses, he is able to increase his annual output by things which can be sold for £2,000 net. So long, therefore, as he can sell his wares at the old price, his earnings of management will be £2,000 a year above the average; and he will earn the full reward of his services to society. His neighbours however will copy his plan, and probably make more than average profits for a time. But soon competition will increase the supply, and lower the price of their wares, until their profits fall to about their old level; for no one could get extra high wages for making eggs stand on their ends after Columbus's plan had become public property.
Many business men whose inventions have in the long run been of almost priceless value to the world, have earned even less by their discoveries than Milton by his Paradise Lost or Millet by his Angelus; and while many men have amassed great wealth by good fortune, rather than by exceptional ability in the performance of public services of high importance, it is probable that those business men who have pioneered new paths have often conferred on society benefits out of all proportion to their own gains, even though they have died millionaires. Although then we shall find that the rewards of every business undertaker tend to be proportionate to the direct services he renders to the community, this will by itself go but a small way towards proving that the existing industrial organization of society is the best conceivable, or even the best attainable; and it must not be forgotten that the scope of our present inquiry is limited to a study of the action of causes that determine the earnings of business undertaking and management under existing social institutions.
We will begin by tracing the adjustment of the rewards of the services rendered to society by ordinary workmen, by foremen, and by employers of different grades: we shall find the principle of substitution everywhere at work.
§ 2. We have already noticed that a great part of the work done by the head of a small business himself, is relegated in a large business to salaried heads of departments, managers, foremen and others. And this thread will guide us to much that is useful for our present inquiry. The simplest case is that of the earnings of the ordinary foreman; with which we may begin.
Let us suppose, for instance, that a railway contractor or a dockyard manager finds that it answers best to have one foreman to every twenty labourers, the wages of a foreman being twice those of a labourer. This means that, if he found himself with 500 labourers and 24 foremen, he would expect to get just a little more work done at the same expense by adding one more foreman, than by adding two more ordinary labourers: while if he had had 490 labourers and 25 foremen, he would have found it better to add two more labourers. If he could have got his foreman for one and a half times the wages of a labourer, perhaps he would have employed one foreman to every fifteen labourers. But, as it is, the number of foremen employed is determined at one-twentieth of that of the labourers, and their demand price at twice the labourers' wages*72.
In exceptional cases the foremen may earn their wages by overdriving those whose work they superintend. But we may now suppose them to contribute to the success of the undertaking in a legitimate way, by securing a better organization of its details; so that fewer things are done amiss and need to be undone; so that everyone finds the help that he wants in moving heavy weights, etc., ready for him just when he wants it; so that all machinery and implements are kept in good working order, and no one has to waste his time and strength by working with inadequate appliances, and so on. The wages of foremen who do work of this kind may be taken as typical of a great part of the earnings of management: society, acting through the individual employer, offers an effective demand for their services until that margin is reached at which the aggregate efficiency of industry would be increased by adding workers of some other trade more than by adding the foremen whose wages would add an equal amount to the expenses of production.
So far the employer has been regarded as the agent through whom competition acts in contriving and arranging the factors of production so that the maximum of direct services (estimated by their money measure) should be performed at a minimum money cost. But now we have to look at the work of the employers themselves being contrived and arranged for them, though of course in a more haphazard fashion, by the immediate action of their own competition.
§ 3. Let us then look next at the way in which the work of foremen and salaried managers is constantly being weighed against that of the heads of businesses. It will be interesting to watch the course of a small business as it gradually expands. A house carpenter, for instance, steadily increases his stock of tools, till he can hire a small workshop, and undertake odd jobs for private persons, who have to agree with him as to what is to be done. The work of management and of undertaking what little risks there are, is shared between them and him; and, as this gives them a great deal of trouble, they are not willing to pay him at a high rate for what work of management he does*73.
So his next step is to undertake all the different sides of small repairs. He has now entered on the career of a master-builder; and if his business grows, he gradually withdraws himself from manual labour, and to some extent even from the superintendence of its details. Substituting for his own work that of hired men, he has now to deduct their wages from his receipts, before he can begin to reckon his profits: and unless he proves himself to have a business ability up to the normal level of that grade of industry which he has now entered, he will probably soon lose all the little capital which he has gained, and after a short struggle return to that humbler rank of life in which he has prospered. Should his ability be just about that level, he will, with average good fortune, retain his position and perhaps gain a little ground: and the excess of his receipts over his outgoings will be representative of the normal earnings of management in his grade.
If his ability be greater than that which is normal in his grade, he will be able to obtain as good a result with a given outlay for wages and other expenses, as most of his rivals can with a larger outlay: he will have substituted his extra ability in organization for some of their outlay; and his earnings of management will include the value of that outlay with which he has dispensed. He will thus increase his capital and his credit: and be able to borrow more, and at a lower rate of interest. He will obtain a wider business acquaintanceship and connection; and he will get an increased knowledge of materials and processes, and opportunities for bold but wise and profitable adventure; until at last he has delegated to others nearly all those duties which occupied his whole time even after he had ceased to do manual work himself*74.
§ 4. Having watched the adjustment of the earnings of foremen and of ordinary workmen, and again of employers and foremen, we may now look at the earnings of employers on a small and a large scale.
Our carpenter having become a master-builder on a very large scale, his undertakings will be so many and so great as to have occupied the time and energies of some scores of employers who superintended all the details of their several businesses. Throughout this struggle between large businesses and small, we see the principle of substitution constantly in operation; the large employer substitution a little of his own work and a good deal of that of salaried managers and foremen for that of a small employer. When, for instance, tenders are invited for erecting a building, a builder with a large capital often finds it worth his while to enter the lists, even though he lives at a distance. The local builders secure great economies in having workshops and men whom they can trust already near the spot; while he gains something through buying his materials on a large scale, through his command of machinery, especially for woodwork, and perhaps through being able to borrow what capital he wants on easier terms. These two sets of advantages frequently about balance one another; and the contest for the field of employment often turns on the relative efficiencies of the undivided energies of the small builder, and of that slight supervision which is all that the abler but busier large builder can afford to give himself, though he supplements it by the work of his local manager and of the clerks in his central office*75.
§ 5. So far we have been considering the gross earnings of management of a man who applies his own capital in business, and therefore can himself reap the equivalent of the costs direct and indirect, which are entailed when command over capital has to be collected from owners, who do not care to apply it to business uses themselves, and to be transferred to those whose own capital is insufficient for their enterprises.
We are next to consider the struggle for survival in pushing forward in some trades business men working chiefly with their own capital and in others those who work chiefly with borrowed capital. The personal risks, against which the lender of capital to be used in business requires to be indemnified, vary to some extent with the nature of that business, as well as with the circumstances of the individual borrower. They are very high in some cases, as for instance when a man is starting in a new branch of the electrical trades, in which there is very little past experience to go by, and the lender cannot easily form any independent judgment as to the progress which is being made by the borrower; and in all such cases the man working with borrowed capital is at a great disadvantage; the rate of profit is determined chiefly by the competition of those who apply their own capital. It may happen that not many such men have access to the trade; and in that case the competition may not be keen, and the rate of profit may be high; that is, it may exceed considerably net interest on the capital together with earnings of management on a scale commensurate with the difficulty of the business done, though that difficulty will probably be above the average.
And again, the new man with but little capital of his own is at a disadvantage in trades which move slowly and in which it is necessary to sow a long time before one reaps.
But in all those industries in which bold and tireless enterprise can reap a quick harvest; and in particular wherever high profits are to be made for a time by cheaper reproductions of costly wares, there the new man is in his element: it is he who by his quick resolutions and dexterous contrivances, and perhaps also a little by his natural recklessness, "forces the pace."
And he often holds his own with great tenacity even under considerable disadvantages; for the freedom and dignity of his position are very attractive to him. Thus the peasant proprietor whose little plot is heavily mortgaged, the small so-called "sweater" or "garret master" who takes out a sub-contract at a low price, will often work harder than the ordinary workman, and for a lower net income. And the manufacturer who is doing a large business with comparatively little capital of his own will reckon his labour and anxiety almost as nothing, for he knows that he must anyhow work for his living, and he is unwilling to go into service to another: he will therefore work feverishly for a gain that would not count much in the balance with a wealthier rival, who, being able to retire and live in comfort on the interest of his capital, may be doubting whether it is worth while to endure any longer the wear-and-tear of business life.
The inflation of prices which culminated in 1873, enriched borrowers in general, and in particular business undertakers, at the expense of other members of society. New men therefore found their way into business made very smooth; and those who had already made or inherited business fortunes, found their way made smooth for retiring from active work. Thus Bagehot, writing about that time*76, argued that the growth of new men was making English business increasingly democratic: and, though admitting that "the propensity to variation in the social as in the animal kingdom is the principle of progress," he pointed out regretfully how much the country might have gained by the long duration of families of merchant princes. But in recent years there has been some reaction, due partly to social causes, and partly to the influence of a continued fall in prices. The sons of business men are rather more inclined than they were a generation ago to take pride in their fathers' callings; and they find it harder to satisfy the demands of an ever-increasing luxury on the income which would be theirs if they withdrew from business.
§ 6. But the weighing in the balance of the services and therefore the earnings of employees against the earnings of management of business men is in some ways best illustrated by reference to Joint-stock companies. For in them most of the work of management is divided between salaried directors (who indeed hold a few shares themselves) and salaried managers and other subordinate officials, most of whom have little or no capital of any kind; and their earnings, being almost the pure earnings of labour, are governed in the long run by those general causes which rule the earnings of labour of equal difficulty and disagreeableness in ordinary occupations.
As has already been observed*77, joint-stock companies are hampered by internal frictions, and conflicts of interest between shareholders and debenture holders, between ordinary and preferred shareholders, and between all these and the directors; and by the need for an elaborate system of checks and counterchecks. They seldom have the enterprise, the energy, the unity of purpose and the quickness of action of a private business. But these disadvantages are of relatively small importance in some trades. That publicity, which is one of the chief drawbacks of public companies in many branches of manufacture and of speculative commerce, is a positive advantage in ordinary banking and insurance and kindred businesses; while in these, as well as in most of the transport industries (railways, tramways, canals, and the supply of gas, water, and electricity), their unbounded command over capital gives them almost undisputed sway.
When powerful joint-stock companies are working in harmony, and are not directly or indirectly involved in speculative ventures on the stock exchange, or in campaigns for the crushing or for the compulsory fusion of rivals, they generally look forward to a distant future, and pursue a far-seeing if a sluggish policy. They are seldom willing to sacrifice their reputation for the sake of a temporary gain; they are not inclined to drive such extremely hard bargains with their employees as will make their service unpopular.
§ 7. Thus then each of the many modern methods of business has its own advantages and disadvantages: and its application is extended in every direction until that limit or margin is reached, at which its special advantages for that use no longer exceed its disadvantages. Or, to put the same thing in another way, the margin of profitableness of different methods of business organization for any particular purpose, is to be regarded not as a point on any one line, but a boundary line of irregular shape cutting one after another every possible line of business organization; and these modern methods, partly on account of their great variety, but partly also on account of the scope which many of them offer to men of business ability who have no capital, render possible a much closer correspondence between the earnings of undertaking and management and the services by which those earnings are got than could be generally attained under the primitive system in which capital was scarcely ever applied to production by any save its owners. For then it could only be by a fortunate accident that those who had the capital and the opportunity for carrying on any trade or performing any service, of which the public was in need, had the aptitudes and the abilities required for the task. But, as it is, that share of the normal expenses of production of any commodity which is commonly classed as profits, is so controlled on every side by the action of the principle of substitution, that it cannot long diverge from the normal supply price of the capital needed, added to the normal supply price of the ability and energy required for managing the business, and lastly the normal supply price of that organization by which the appropriate business ability and the requisite capital are brought together.
The supply of business power is large and elastic, since the area from which it is drawn is wide. Everyone has the business of his own life to conduct; and in this he can gain some training for business management, if he has the natural aptitudes for it. There is therefore no other kind of useful rare and therefore highly-paid ability which depends so little on labour and expense applied specially to obtaining it, and so much on "natural qualities." And, further, business power is highly non-specialized; because in the large majority of trades, technical knowledge and skill become every day less important relatively to the broad and non-specialized faculties of judgment, promptness, resource, carefulness and steadfastness of purpose*78.
It is true that in small businesses, in which the master is little more than the head workman, specialized skill is very important. And it is true that "each sort of trade has a tradition of its own, which is never written, probably could not be written, which can only be learnt in fragments, and which is best taken in early life, before the mind is shaped and the ideas fixed. But each trade in modern commerce is surrounded by subsidiary and kindred trades, which familiarize the imagination with it, and make its state known*79." Moreover those general faculties, which are characteristic of the modern business man, increase in importance as the scale of business increases. It is they which mark him out as a leader of men; and which enable him to go straight to the kernel of the practical problems with which he has to deal, to see almost instinctively the relative proportions of things, to conceive wise and far-reaching policies, and to carry them out calmly and resolutely*80.
It must be admitted indeed that the adjustment of supply to demand in the case of business ability is somewhat hindered by the difficulty of ascertaining exactly what is the price that is being paid for it in any trade. It is comparatively easy to find out the wages of bricklayers or puddlers by striking an average between the wages that are earned by men of various degrees of efficiency, and allowing for the inconstancy of their employment. But the gross earnings of management which a man is getting can only be found after making up a careful account of the true profits of his business, and deducting interest on his capital. The exact state of his affairs is often not known by himself; and it can seldom be guessed at all accurately even by those who are in the same trade with himself. It is not true even in a little village at the present day that everyone knows all his neighbour's affairs. As Cliffe Leslie said, "The village inn-keeper, publican or shopkeeper, who is making a small fortune does not invite competition by telling his neighbours of his profits, and the man who is not doing well does not alarm his creditors by exposing the state of his affairs*81."
But though it may be difficult to read the lessons of an individual trader's experience, those of a whole trade can never be completely hidden, and cannot be hidden at all for long. Although one cannot tell whether the tide is rising or falling by merely watching half-a-dozen waves breaking on the seashore, yet a very little patience settles the question; and there is a general agreement among business men that the average rate of profits in a trade cannot rise or fall much without general attention being attracted to the change before long. And though it may sometimes be a more difficult task for a business man than for a skilled labourer, to find out whether he could improve his prospects by changing his trade, yet the business man has great opportunities for discovering whatever can be found out about the present and future of other trades; and if he should wish to change his trade, he will generally be able to do so more easily than the skilled workman could.
On the whole then we may conclude that the rarity of the natural abilities and the expensiveness of the special training required for the work affect normal earnings of management in much the same way as they do the normal wages of skilled labour. In either case, a rise in the income to be earned sets in operation forces tending to increase the supply of those capable of earning it; and in either case, the extent to which the supply will be increased by a given rise of income, depends upon the social and economic condition of those from whom the supply is drawn. For though it is true that an able business man who starts in life with a great deal of capital and a good business connection is likely to obtain higher earnings of management than an equally able man who starts without these advantages; yet there are similar, though smaller, inequalities between the earnings of professional men of equal abilities who start with unequal social advantages; and the wages even of a working man depend on the start he has had in life almost as much as on the expense which his father has been able to afford for his education*82.
Notes for this chapter
See p. 313.
See IV. VIII.
With this argument may be compared that of VI. I. 7.
Comp. IV. XII. 3.
The employer of a large number of workmen has to economize his energies on the same plan that is followed by the leading officers of a modern army. For as Mr Wilkinson says (The Brain of an Army, pp. 42-6):—"Organization implies that every man's work is defined, that he knows exactly what he must answer for, and that his authority is coextensive with his responsibility ... [In the German army] every commander above the rank of captain deals with a body composed of units, with the interior affairs of none of which he meddles, except in the case of failure on the part of the officer directly responsible.... The general commanding an army corps has to deal directly with only a few subordinates.... He inspects and tests the condition of all the various units, but ... he is as far as possible unhampered by the worry of detail. He can make up his mind coolly." Bagehot in characteristic fashion had remarked (Lombard Street, ch. VIII.) that if the head of a large business "is very busy, it is a sign of something wrong"; and had compared (Essay on the Transferability of Capital) the primitive employer with a Hector or Achilles mingling in the fray, and the typical modern employer with "a man at the far end of a telegraph wire—a Count Moltke with his head over some papers—who sees that the proper persons are slain, and who secures the victory."
Comp. IV. XI. 4.
Lombard Street, Introductory chapter.
See IV. XII. 9, 10.
IV. XII. 12. When the forms of productions cease to be few and simple, it becomes "no longer true that a man becomes an employer because he is a capitalist. Men command capital because they have the qualifications to profitably employ labour. To these captains of industry ... capital and labour resort for opportunity to perform their several functions." (Walker, Wages Question, ch. XIV.)
Bagehot, Postulates, p. 75.
Bagehot (l. c. pp. 94-5) says that the great modern commerce has "certain general principles which are common to all kinds of it, and a person can be of considerable use in more than one kind if he understands these principles and has the proper sort of mind. But the appearance of this common element is in commerce, as in politics, a sign of magnitude, and primitive commerce is all petty. In early tribes there is nothing but the special man—the clothier, the mason, the weapon-maker. Each craft tried to be, and very much was, a mystery except to those who carried it on. The knowledge required for each was possessed by few, kept secret by these few, and nothing else was of use but this monopolised and often inherited acquirement; there was no 'general' business knowledge. The idea of a general art of money making is very modern; almost everything ancient about it is individual and particular."
Fortnightly Review, June 1879, reprinted in his Essays.
See VI. IV. 3. On the general functions of those who undertake the chief responsibilities of business, see Brentano, Der Unternehmer, 1907.
End of Notes
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