Profit and wages; a study in the distribution of income

Preface

Though its abstract and intricate character has made it an esoteric discipline, the theory of distribution demands the consideration of every serious student of affairs. No fundamental conception of our most important economic problems is attainable except in relation to the factors governing the distribution of income. Unless resigned to superficial views, we cannot, therefore, maintain a passive attitude toward the unsettled state of economic doctrine. In the face of continued failure, neither discouragement nor scepticism should halt the struggle for a definite and accepted theory of distribution. May the publication of this book contribute something to the will to master the difficulties of the problem.

The author is under obligation for permission to use parts of an article published in the Quarterly Journal of Economics for February, 191 2. He is also under great obligation to his wife for criticism and assistance in revision and proof-reading, and to his friend, Mr. Edward Porritt for helpful counsel.

Chapter I. Introduction

Definitions of distribution and income, i. Concept of psychic income not of service to present inquiry, i. Differences in method of investigation according as the subject is the distribution of wealth or the distribution of income, 2. The method of economic theory, 3. Hypothetical assumptions to be made and limitations of our inquiry, 5. Reasons why our inquiry must be largely critical, 7.

General Outline of Subject — The parties who share in the total product of society, 8. Different concepts of capital, 9. Capital regarded as subsistence advanced to labor the most fruitful concept for the theory of distribution, II. Distinction between differential and marginal income, 13. First stage in our analysis of distributive process the separation of differential gain from marginal income, 15. The second stage the division of marginal income between capitalist and laborer, 16. Three different methods by which it has been attempted to explain this division, 18.

Chapter II. Bohm-Bawerk's Theory of Interest

Reasons for beginning a critical study of the problem with Bohm-Bawerk's theory, 20. Bohm-Bawerk's fundamental concept, 21. Three reasons for preference for present over future goods given by Bohm-Bawerk, 22. The technical superiority of present good no direct ground for preference for present goods but possibly an indirect one, 25. Bohm-Bawerk failed to give a unitary explanation of interest, 28.

Chapter III. The Time-Preference Theory

■ Attempt to base interest theory on first two grounds of preference mentioned by Bohm-Bawerk, 29. Do these play an actual part in saving and investment? 30. Defini-

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tion of time-preference, 33. Transition from earlier idea of abstinence to that of time-preference, 35. No postponement of consumption of capital in actual investment, 36. Is there an exchange of present for future goods? 39. A less objectionable form of time-preference theory, 43. The consumption loan, 45. The purchase of durable goods not explained by time-preference theory, 46. The reductio ad absurdum of the time-preference theory, 47. Sceptical reaction against theories based on subjective valuations, 49. Excessive rationalism of time-preference theory, 51. Time-preference not a direct determinant of the rate of interest, 53.

Chapter IV. The Abstinence Theory

The abstinence theory treats only of supply of capital and does not give a complete explanation of the income of capital, 55. Accumulation of capital without subjective cost, 56. Idea of marginal savings, 57. Ambiguities of a formulation of the theory in terms of demand and supply, 59. The two fundamental propositions of the theory, 61. Criticism of idea that changes in supply of capital regulative of rate of return are brought about by marginal savers, 62. Prime factors determining supply of capital are objective, not subjective, 68. Supply of capital, on the whole, tends to rise with increase in rate of return, 70. Does not decrease as rate of return declines, 71. Factors which prevent extinction of capitalist income, 73. Only extreme changes in rate of interest affect determination to save, 75. Theory of rate of capitalist income must emphasize objective factors, 77. Does abstinence theory explain existence of interest? 79.

Chapter V. The Productivity Theory of Interest

The specific productivity theory, 82. Difficulties of imputing a specific product to capital, 82. Vicious circle in deriving value of capital goods, 85. Productivity theory does not show how interest on sums spent for wages is derived, 87. Difficulties growing out of concept of capital

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and restricted view of productive process, 87. A form of productivity theory suggested by Bohm-Bawerk and Landry, 92. The assumption of a normal lack of capital made by this theory, 94. The theory at bottom almost the same as the specific productivity theory and encounters similar difficulties in determining value of capital invested, 95. Importance of the theory, 97.

Chapter VL The Essentials of a Theory of Profit and

Interest.

Relation of four quantities (gross income, net income, rate, and capital) expressed in two equations, 99. None of theories so far examined has explained, or is justified in assuming as accounted for, more than one quantity, 100. Necessity of accounting for value of capital independently of amount of product or rate of profit, loi. Capital consists of wages, and profit of capital is a residual income, 102. Name to be given to our theory, 105. What prevents fall of prices from extinguishing share going to capital? 108. What keeps labor from getting entire marginal product of industry? 109. How is surplus value growing out of a series of processes controlled by different entrepreneurs distributed at a uniform rate to every part of investment made by each entrepreneur? no. Theory here proposed assumes as given factors transmitted from pre-capitalistic times, 112.

Chapter VII. The Theory of Wages. The Supply of Labor

Relation of theory of wages to theory of income of capitalist, 114. Wage theories which might form basis of a residual claimant theory of profit and interest, 115. Malthusian basis of subsistence theory, 116. Relation between standards of living and wages, 117. Arbitrary character of assumption of a natural wage, 118. Marx's criticism of subsistence theory, 119. Immigration a disturbing factor, 119. Need of a theory of demand for labor felt by classical economists, 120. Rise of standard of living of wage-earners and its bearing on subsistence theory of

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wages, 121. Conditions under which subsistence theoryhas some validity, 122. How supply price of labor is determined, 124. Why geographical differences in wages correspond to differences in productivity, 126.

Chapter VIII. The Theory of Wages. The Demand for Labor. The wages fund doctrine suggests a collective exchange

128. Necessity of laborer and employer coming to terms,

129. Does possibility of substituting machines for labor show that there is no definite wages fund? 130. Under static conditions and when production period of maximum efficiency has been reached, there is a definite wages fund, 133. Bohm-Bawerk's wages fund theory, 135. Is wages fund capable of quick expansion? 137. When viewed as a money fund, 138. When regarded as real income, 139. The bargain theory of wages, 141. Wages fund theory only possible explanation of general level of wages, 142.

Criticism of Productivity Theory of Wages — Erroneous assumption in regard to expansibility of demand for labor, 144. Productivity explains comparative wages only, 146. Can wages be paid out of current product? 149. Productivity determines wages only by its influence on the accumulation of capital, 151. Wages not determined by discounted product of labor because there is no rate of discount established independently of level of wages, 153. Criticism of productivity theory on ground that specific product of labor is not ascertainable, 155.

Conclusion — General level of wages is determined by size of wages fund and the supply price of different quantities of labor, 157.

Chapter IX. Conclusion

The two stages in our analysis of the problem of distribution, 159. Criticism of the concept of capital as including land, 160. Criticism of the "law of three rents," 160. Summary of conclusions reached, 163. The return to the classical school of economists, 164. Unfortunate tendencies of modern economic theorizing: (i) Excessive rationalism, 166. (2) Confusion of problem of distribution with that of value, 167.

Introduction

In the meaning usual to economic literature, distribution is division into parts and the apportionment of the parts to those who share in the division. Now it is the distribution of income rather than of wealth with which we are here concerned. Income is wealth just produced or come into existence. It should be thought of as a stream and measured by its volume per unit of time. Taking the collective view essential to the science of economics the problem becomes that of the division of the total income or produce of human industry. We are to explain how the flow of goods from mine and farm and factory spreads and divides into streams of private income, — into the rent, profit, and interest, for instance, which falls to the well-to-do, or the wages with which the poor must be content.

As the ultimate significance of these streams of goods is in the uses made of them, one might regard income as consisting of the feelings of the consumer of goods rather than of the goods themselves. But such a conception of income would not serve the purposes of the present inquiry. "Psychic income" is too remote from the problems with which a study of distribution must begin. The amount of utihty derived from equal quantities of any commodity varies widely as between different consumers and even between different times and conditions for the same consumer. The final determination of psychic incomes, therefore, lies in the process of consumption. It comes at a later stage than that of distribution.*

Income is measurable only as a rate, as amount per unit of time. The total of wealth, on the other hand, cannot be measured otherwise than by taking the quantity existing at a point of time. As such it would include the income of the moment but also the wealth which has arisen or come in at previous times and which still remains unconsumed and undestroyed. When referring to income, the term distribution evidently denotes a process. When applied to wealth, however, it means the result or outcome of a process of distribution, or of a series of such processes. The method of investigation must differ according as the object of inquiry is the process or the result. To picture the result, the distribution of wealth at any point of time, the only satisfactory method would be the statistical. If complete data were available, the statistician could tell us how many rich men there are and what is their wealth, and how

*A very satisfactory discussion of income thought of as a stream of goods can be found in Lexis, Allgemeine Volkswirtschaftslehre, p. 137 ff.

many poor there are and what is the depth of their poverty. The explanation of how this distribution came about would constitute an historical problem. It is not, however, the object of the present essay to describe and explain the distribution of an existing stock of wealth. Our problem is the complicated process of parcelling out the newly produced wealth or income of society. In the analysis of such a process statistics and history can give little aid. At least in the initial, and most difficult stages, of the inquiry, the method of "theory" alone is of service.

This is the method of mental experiment with different lines of approach to the problem, — the exploitation of different facts and ideas as tentative premises. The forces of our industrial system are so involved that no conception of its operation could be reached by any attempt to describe its details. In fact the more photographic and concrete the picture presented to the mind, the more confusing and difficult the problem becomes. The only feasible procedure, therefore, is to seek for essential facts and to reason from these, while deliberately excluding from view a mass of complicating phenomena. Intellectually portable and manageable results are won by selection only. Complications must be eliminated, or, in other words, hypothetical assumptions must be made. Economic theory differs from other sciences only in the degree of its hypothetical character.

But for use in practical affairs or to satisfy a mental craving for a more concrete picture of the world, our first simplified, hypothetical, general theory may be subjected to a series of qualifications by bringing in one by one the complicating conditions which had been excluded at the beginning. Thus a series of propositions may be reached which, descending into ever greater detail, lead us by successive approximations* to a closer view of things as they are. How closely we desire to approximate the confusing reality of our industrial life, or at. the other extreme, how far we are willing to carry the process of abstraction to gain a general view, depends largely on our mental constitution. It is not altogether flippant to call it a matter of taste. In the end, however, the use we intend to make of our theories may decide to what degree of abstraction from or approximation to the complexities of the actual world we may safely proceed.

*The idea of " successive approximations," a metaphor derived from physics and mathematics, has perhaps received its vogue especially from Pareto (Cours d'economie politique, p. i6 ff.). Graziani {Instituzioni di economia politica, p. 45) attributes the use of the term especially to Pareto and Barone but says that the method itself goes back to the classical writers such as Smith, Ricardo, and the two Mills. It has probably been used more or less deliberately by many writers. The opening paragraph of the third volume of Das Kapital, for instance, shows Marx making conscious use of this method. The mention of Marx suggests the dangers and difficulties of beginning with assumptions too remote from reality. A recent instance of a start too remote from reality, in the present writer's opinion, is that made by Schumpeter ( Theorie der wirtschaftlichen Entwicklung.)

It follows from what has just been said that the general theory of the distribution of income aimed at in the following pages must submit to certain limitations. To state some of these, (i) it must confine itself to what may be called the primary process of distribution, the dividing up of the product of industry among the parties immediately connected with the productive process. In other words, our problem is that of wages, interest, profit, and rent. How secondary incomes are derived from these primary shares through gift, theft, begging or taxation, need not concern us. Profits or other incomes from business operations which are not productive or whose relation to production is remote and uncertain must also be omitted from consideration. Various "pecuniary" employments of capital, as Veblen would call them, — speculative manipulations, for instance, — for all their spectacular interest and disturbing significance, must be excluded. To get a clear view of the fundamental factors, our study must stick closely to the process of production and to those classes which draw their living immediately from that process. (2) Our study must assume the prevalence of competition. At a time of widespread apprehension of the growing power of large aggregations of capital, this assumption may appear to lead to conclusions somewhat too remotely connected with contemporary conditions. However the extent of the monopoly exercised by those to whom popular opinion attributes this power is somewhat in doubt and certainly their power is not absolute. The mixture of competition and monopoly in the industrial life of today cannot be understood unless we have a clear conception of the workings of a competitive system. For the purposes of our theory it will be well, therefore, to set aside monopoly as a disturbing factor acting upon a fundamentally competitive order. In other words we reach a "first approximation" by assuming a competitive system. (3) Another limitation to which our theorizing must submit is in the historical range of its application. It is confined to present conditions, to the "system of industrial liberty," to "capitalism." Starting from facts and conditions of the present it may not asstime universal validity for its conclusions. On the other hand it is under no necessity of accounting for the origin and evolution of economic institutions which our industrial system has inherited from the past. It may take their existence for granted, asking only how they affect the quantity of income going to the different "shares in distribution."

The foregoing limitations are observed throughout this book. Other assimiptions will be made from time to time to save the argument from unnecessary complication. Although these are not always explicitly mentioned, we trust they will be reasonably obvious to the reader and will be such as experience has shown to be necessary to the operations of economic theory. The results reached by the method pursued are necessarily propositions of an abstract character. To the type of mind that hungers for graphic and abundant detail they may appear very unsatisfactory. But our present aim is an analysis of the industrial world, not photography, and so no other course lies open.

To find the starting points for an analysis of the distributive process it will be prudent to examine the results of the mental experimentation of leading thinkers in this field. The stock of facts and ideas with which theory operates is selected from a complex reality largely in the form of general impressions of what may prove significant. A review of the impressions of able theorists as to what elements enter into the determination of the shares in distribution, and of the failures and successes of the different theories set forth, is the only sure precaution against making a false start. Our work then must be largely critical. That to save time the discussion is restricted to theories which still have some standing in scientific controversy will, we trust, commend itself to the approval of those competent in economic studies. But before entering into the necessarily technical, and perhaps confusing, detail of a critical study, it may be well for the sake of perspective to offer the reader a general sketch of the field we are to enter. This is the purpose of the remaining pages of this chapter.

The classical economists represented the national product as divided among landowners, capitalists, and laborers — three rather distinct classes in the social life of the England of their day. A fortunate tradition for the theory of distribution was thus established by an historical accident of time and place. Had the owners of capital and those of land been merged as completely as they were in some countries and as they are in the England of the present time, economic theorists might have failed to isolate the share in distribution that falls to the landowner as such. A part, at least, of what goes under the popular term of rent of land, has important characteristics which distinguish it from the income of capital. As will soon appear it is a differential gain of a rather permanent character. Not to recognize this would seriously distort our picture of the distributive process. In the writer's opinion, it was fortunate also that economists did not at once make and emphasize the distinction between capitalist and entrepreneur, which later came into fashion. The capitalist is lender and investor only of capital, the entrepreneur user of it. To an increasing degree the entrepreneur is coming to be not an individual, but a group of men, a corporation. It will be convenient, however, throughout most of our discussion to think of him as an individual business manager. So conceived, he is the one controlHng and directing the process of the production of wealth. The products are his until he sells them. If they are unsaleable, the loss is his. He may be capitalist and landowner besides being entrepreneur. Indeed, he usually owns some capital. Out of the process of buying, borrowing, and hiring for his business, and the sale of the products, he gets his profit. To the landowner he pays rent, to the capitalist interest, to the laborer wages. The problem for the theory of distribution is, what determines the amount of each of these shares in distribution — rent, interest, wages, and the entrepreneur's profit.

Confusion enters into this controversial matter at the very outset, through the failure to agree upon some distinct concept of capital. What is this thing whose ownership gives the power to get an income without labor, or in other words, to levy on the labor of others? Popular terminology is indefinite and shifting. One meaning suggested by it, that of capital as a sum of money is obviously inadequate for our inquiry. Even if it were permissible either to overlook bank credit or to regard it as a kind of money, this popula-r concept would be too superficial. It is what is bought with the money by the managers of productive enterprises that makes it effective in securing an income and, which, therefore, constitutes the true capital. It will be advantageous at least lo PROFIT AND WAGES

in our first approximate formulation of the theory of distribution, to forget the existence of money and to think of commodities and services as exchanged by barter, though with a celerity and ease not possible to that crude method of exchange.

Passing from popular usage to that of the more scientific literature of economics, we meet a discouraging diversity of opinion. In general, however, there are two tendencies. One is to regard capital as a sum of value, the other as consisting of concrete goods of some kind. To consider capital as value (or as a sum of prices) instead of using value or price merely to measure a quantum of capital, gives a concept useful only to one theory of interest, the time-preference theory, and not acceptable, therefore, unless that theory can be accepted.* Of course the concept is also useful to the bookkeeping or accounting of private and individual economics {Privatwirtschaft). Our aim, however, is not to describe the individual's method of measuring his gains, but to explain the source and amount of income that goes to the owners of capital as a class.

*Professor Clark employs a concept of this kind in connection with a productivity theory. Obviously, however, it is the concrete "capital goods," which he distinguishes from the fund of capital or capital proper, which really aid production and constitute the basis of the capitalist's income, not the abstract fund or collective value of these goods. See remarks by Carver in Quarterly Journal of Economics, May, 1907. See also the trenchant criticism by Bohm-Bawerk ibid., November, 1906, and February, 1907, and by Veblen ibid., February, 1908.

INTRODUCTION ii

Of definitions of capital as concrete goods there is a considerable variety but two may be taken as dividing between them a large part of the usage of economic literature — one, that of capital as consisting of "intermediate goods" or goods produced to be used in further production; the other, as subsistence maintaining labor in the long process of production, and advanced to the laborers out of past product by the capitalist class. Which of these is to be preferred can be decided only when we inquire what each leads to when used as a basis for a theory of interest. Some reasons will be given at this point for choosing the view of capital as subsistence advanced to the laborers. The chief purpose of these remarks, however, is not to dispose definitively of the question of the proper definition of capital, but to give the reader the background of a general picture of the production and distribution of wealth.

If capitalists as a class enjoy a peculiar income, that income must in some way be traced to the peculiar contribution made to the productive process by capitalists as a class. To this contribution it would seem appropriate to give the name capital if that trouble-breeding term is to be used at all.* Now what capitalists

*Something might be said in favor of dropping the term altogether from economic theory because of the confusion it has always caused. The dreary debate about its proper meaning has had the advantage of estabhshing in our terminology a number of convenient names for proposed claimants for the title of capital, e. g., intermediate goods, producers' goods, as a class contribute is the subsistence of the laborer or wages (that is real wages). This appears when we consider the entire process of the production of any consumable commodity, viewing it as beginning with the first labor employed to make any instrument or material used in the course of the long process. Production is then seen to be simply the use of labor power on the physical world. The process of making any commodity may be, and usually is, divided into different stages, controlled by different entrepreneurs. The latter contribute the labor of scheming and directing, but the capitalists, or the entrepreneurs in so far as they are capitalists, contribute nothing but the wages paid to the laborers.* This is the one investment of capitalists as a class with reference to productive enterprise. The "capital goods" such as machines, raw material, etc., which appear in the productive process, are bought by one capitalist or entrepreneur from another. The purchase and sale of these products or intermediate goods, however, is a purely intra-class affair. Such purchases and sales are a

consumers' goods, durable goods. The use of these terms in place of the ambiguous word capital would clarify many economic discussions.

*Our reason for not mentioning the rent of land among the payments made by the capitalist will soon appear (page 15S.). Taxes may also be disregarded. We may think of them as paid out of income and, in any case, as having no necessary direct relation to the process of producing and distributing wealth.

means of dividing up between different capitalists the capital investment necessary in the long process of producing any consumable commodity. The buyer of a machine for instance, pays the seller the wages the latter had paid in having the machine made. As the price of the machine, however, also includes interest and profit to the seller, the purchase and sale of such "intermediate goods" also appears as means of dividing up the profits and gains of capital of the entire productive process. But these transactions within the class of capital owners constitute no part of the necessary contribution of the capitalist class to the process of production. The necessary contribution of this class, the investment from which it derives its income, the mysterious thing called capital, consists of the subsistence or "real wages" given the laborer. For the theory of distribution at least, this seems the most fruitful conception of capital.

And now we return to the question asked a few pages back as to what determines the amount of each share in distribution — of rent, interest, profit, and wages. In the attempt to give a preliminary sketch of the questions at issue, we may start with an idea which has come very near to having gained universal acceptance among economists, and make it the background for a formulation of the principal contending theories. This idea is that of a distinction between differential and marginal income. The productive result of the investments made by capitalists and entrepreneurs varies widely. Any return in excess of the lowest or marginal rate of productivity is a differential gain, and may take the form either of rent of land, or of differential profit. The most permanent differences in productivity are inherent in the quality and location of the land which is used. Less stable differences may be traced to the differing abilities and luck of the entrepreneurs. As the capital of the world increases, entrepreneurs proceed to less and less productive investments — assuming that they first took advantage of the best opportunities. The course of investment is from more to less productive lands and locations, stopping at successive "extensive margins," and also from more to less productive investments on the same land, according to the "law of diminishing returns," making successive stops at "intensive margins."* On the assumption of perfect mobility of capital, a given total of capital will be so distributed in its investment as to establish a uniformly productive margin along

*The law of diminishing returns from land will hold, that is there will be an increase of total product but a diminished product per unit of investment, if the additional "capital" invested takes the form of, or results in, an increased application of either labor or capital goods to the land. As will appear later, it is possible that an increased supply of capital may bring about nothing but an increase in the rate of wages. In that case, of course, there is no increase of either total or marginal product. The relative shares received by capital and labor will be changed, but there will be no change in the differential gains.

both the extensive and intensive frontier. Additions to the supply of capital can then be invested at the margin only, and get only the marginal rate of return — unless they can displace capital at other points. The competition of this new capital with the older supplies which it is capable of displacing, tends to make the marginal rate the rate of return for all capital, by giving the landowner the power to demand all in excess of this (except the "ability rent" of the superior entrepreneur) as a rent.* At the outset, of course, the entrepreneur receives the entire product, but the destination of all the differential gain, the surplus over the marginal rate of return, is apparent.

We may thus view the problem of distribution as being, at the first stage, a question between

*The rate of "productivity" of capital at the margin would vary according to the ability of the entrepreneurs managing it. A marginal rate, therefore, if it is to be something definite, implies a marginal managerial ability. The amount of capital (and consequent size of business) controlled by different entrepreneurs tends to vary according to their ability and energy, the least competent of the entrepreneurs able to maintain themselves against competition, the marginal entrepreneurs, controlling the smallest business units. This on the assumption, very far indeed from being fully justified by the reality, that the control of capital is distributed according to ability and not by accident and favor. Because of the advantages of large scale production, those able to manage large amounts of capital will get a higher rate of return than the marginal entrepreneur, a differential profit, even for their marginal investments. The marginal rate pays only interest and "wages of management" to capitalist and entrepreneur, but the abler entrepreneurs get more than this rate. Even under static conditions, therefore, there is a differential profit graded roughly according to the ability of the entrepreneur. Under dynamic conditions, there are also the temporary gains that come to the alert, progressive, and lucky ones.