Risk, uncertainty and profit

Preface

This series of books owes its existence to the generosity of Messrs. Hart, Schaffner & Marx, of Chicago, who have shown a special interest in trying to draw the attention of American youth to the study of economic and commercial subjects. For this purpose they have delegated to the uqdersigned committee the task of selecting or approving of topics, making announcements, and awarding prizes annually for those who wish to compete.

For the year ending June 1, 1917, there were offered:

In Class A, which included any American without restriction, a first prize of $1000, and a second prize of $500.

In Class B, which included any who were at the time undergraduates of an American college, a first prize of $300, and a second prize of $200.

Any essay submitted in Class B, if deemed of sufficient merit, could receive a prize in Class A.

The present volume, submitted in Class A, was awarded second prize in that class.

University of Chicago 3. B. Clabk

New York City

Author's Preface

There is little that is fundamentally new in this book. It represents an attempt to state the essential principles of the conventional economic doctrine more accurately, and to show their implications more clearly, than has previously been done. That is, its object is refinement, not reconstruction; it is a study in "pure theory." The motive back of its presentation is twofold. In the first place, the writer cherishes, in the face of the pragmatic, philistine tendencies of the present age, especially characteristic of the thought of our own country, the hope that careful, rigorous thinking in the field of social problems does after all have some significance for human weal and woe. In the second place, he has a feeling that the "practicalism" of the times is a passing phase, even to some extent a pose; that there is a strong undercurrent of discontent with loose and superficial thinking and a real desire, out of sheer intellectual self-respect, to reach a clearer understanding of the meaning of terms and dogmas which pass current as representing ideas. For the first of these assumptions a few words of elaboration or defense may be in place, in anticipation of the essay itself.

The "practical " justification for the study of general economics is a belief in the possibility of improving the quality of human life through changes in the form of organization of want-satisfying activity. More specifically, most projects of social betterment involve the substitution of some more consciously social or political form of control for private property and individual freedom of contract. The assumption underlying such studies as the present is that changes of this character will offer greater prospect of producing real improvement if they are carried out in the light viii AUTHOR'S PREFACE

of a clear understanding of the nature and tendencies of the system which it is proposed to modify or displace. The essay, therefore, endeavors to isolate and define the essential characteristics of free enterprise as a system or method of securing and directing cooperative effort in a social group. As a necessary condition of success in this endeavor it is assumed that the description and explanation of phenomena must be radically separated from all questions of defense or criticism of the system under examination. By means of first showing what the system is, it is hoped that advance may be made toward discovering what such a system can, and what it cannot, accomplish. A closely related aim is that of formulating the data of the problem of economic organization, the unchangeable materials with which, and conditions under which, any machinery of organization has to work. A sharp and clear conception of these fundamentals is viewed as a necessary foundation for answering the question as to what is reasonably to be expected of a method of organization, and hence of whether the system as such is to be blamed for the failure to achieve ideal results, of where if at all it is at fault, and the sort of change or substitution which offers sufficient chance for improvement to justify experimentation.

The net result of the inquiry is by no means a defense of the existing order. On the contrary, it is probably to emphasize the inherent defects of free enterprise. But it must be admitted that careful analysis also emphasizes the fundamental difficulties of the problem and the fatuousness of over-sanguine expectations from mere changes in social machinery. Only this foundation-laying is within the scope of this study, or included within the province of economic theory. The final verdict on questions of social policy depends upon a similar study of other possible systems of organization and a comparison of these with free enterprise in relation to the tasks to be accomplished. This one "conclusion" may be hazarded, that no one mode of organiza-

AUTHOR'S PREFACE ix

tion is adequate or tolerable for all purposes in all fields. In the ultimate society, no doubt, every conceivable type of organization machinery will find its place, and the problem takes the form of defining the tasks and spheres of social endeavor for which each type is best adapted.

The particular technical contribution to the theory of free enterprise which this essay purports to make is a fuller and more careful examination of the role of the entrepreneur or enterpriser, the recognized "central figure" of the system, and of the forces which fix the remuneration of his special function. The problem of profit was suggested to the writer as a suitable topic for a doctoral dissertation in the spring of 1914 by Dr. Alvin Johnson, then Professor of Economics in Cornell University. The study was chiefly worked out under the direction of Professor AUyn A. Young after Dr. Johnson left Cornell. My debt to these two teachers I can only gratefully acknowledge. Since the acceptance of the essay as a thesis at Cornell in June, 1916, and its submission in the Hart, Schaffner & Marx competition in 1917, it has been entirely rewritten under the editorial supervision of Professor J. M. Clark, of the University of Chicago. I have also profited much by discussions with Professor C. O. Hardy, my colleague at the same institution, and by access to his unpublished "Readings on Risk and Risk-Bearing." Professor Jacob Viner, of the University of Chicago, has kindly read the proof of the entire work. My obligations to various economists through their published work are very inadequately shown by text and footnote references, but are too comprehensive and indefinite to express in detail.

F. H. Knight

Iowa City, Iowa January, 1921

Chapter I. The Place of Profit and Uncertainty IN Economic Theory 3

The nature and necessity of a deductive science of economics — Analogy of physical science — Necessity of emphasizing the abstract character of hypotheses — Thought means analysis and analysis abstraction — The assumption of perfect competition — Profit absent — The conditions of perfect competition include especially perfect knowledge, and profit is to be explained by uncertainty — Plan of the book.

Chapter II. Theories of Profit; Change and Risk IN Relation to Profit 22

J Historical sketch of the treatment of profit in economic literature — Special consideration of the Dynamic and the Risk theories — The former confuses the effects of change with those of the uncertainty connected with change — The latter falls into confusion by failing to distinguish between risk in the sense of a measurable probability and an uncertainty which cannot be measured — Change according to a known law does not give rise to profit, nor does risk if measurable, since it can be eliminated by insurance or some equivalent device.

Chapter III. The Theory of Choice and of Exchange 51

Wants, and the economic order as a mechanism for organizing want-satisfying activity — Conflict of wants — Resoiu-ces, and their use to satisfy a plurality of wants — Utility and Diminishing Utility — Simple choices ; the boy and the berries ; Crusoe and the Crusoe economy ; the production and exchange of goods under simplified social conditions — The problem that of combining alternatives — Pleasxire and pain relative — Cost is a sacrificed alternative — The true significance of resources and resource costs — Formulation of the relations in functions, curves and equilibria.

xii CONTENTS

Chapter IV. Joint Production and Capitalization 94

The use of a plurality of kinds of resource in producing various commodities and the resulting problem of organization — The law of diminishing returns, analogue of the law of diminishing utility — The imputation of product-values to resources or cost-goods and resultant placing of the latter to maximize their yield — Critique of the productivity theory — The values of productive services in terms of demand and supply — No valid classification of productive agencies into "factors" is possible — The role of time in production and the fallacy of time-preference.

Chapter V. Change and Progress with Uncertainty Absent 141

The meaning of static conditions and the forms of progress — Question of classifying productive agencies along conventional tripartite lines — Changes in supply and demand of productive goods and in the distributive shares — Question of progress toward equilibrium levels — All modes of progress represent alternative methods of investing present resources for a future gain — With uncertainty absent the rate of retiu-n would be equal in all these fields — Contrast with present facts — The nature of interest as a peculiar form of income, distinguishable from rent.

Chapter VI. Minor Prerequisites for Perfect Competition 174 (

Brief consideration of conditions requisite for perfect competition other than the absence of uncertainty — Divisibility of elements in the adjustment — Lack of moral connotation of the term "productivity" — Monopoly; various forms; is productive in the economic sense — Tendency of a competitive system toward monopoly and a universal dead-lock.

Chapter VII. The Meaning of Risk and Uncertainty 197

Outlines of a theory of knowledge — The role of consciousness in behavior — Conduct is forward-looking and the problem of knowledge is prediction — Knowledge of the future depends on the fact that experience can be analyzed into the behavior of ob-

CONTENTS xiii

jects which maintain their identity — But there are too many of these for our intelligence to handle, so we depend on inferring one mode of behavior from another; i.e., upon constancy in association of properties — Generally speaking, exhaustive and quantitative analysis is impossible, and we "estimate" — Commonly there is a diversity in the possible modes of behavior to be inferred, and we reason in terms of "probability" of various outcomes — Probability a priori vs. statistical — Errors in judgment usually not susceptible to objective evaluation on any ground, though they are estimated as probabilities — The "risks" which give rise to profit are chiefly of the nature of chances of error in judgment, and hence not measurable, because too unique to form into classes.

Chapter VIII. Structures and Methods for Meeting Uncertainty 233

Attitudes toward uncertainty — Variable factors — Free enterprise — The economic organization deals with imcertainty by reducing it or specializing the function of meeting it — The chief method of reduction is by consolidation, though important structures exist for perfecting information and for the direct control of the future — Insurance the chief device for consolidation — Speculation speciaEzes risk, but is fully as important as a means of consolidation — Large-scale operation, especially the corporation — Promotion.

Chapter IX. Enterprise and Profit 264

Introduction of uncertainty into a perfectly equilibrated static society — Specialization of the function of management and risk-assumption — Contractual income and residual income — Conditions which control the amount of the profit share, chiefly timidity vs. optimism of entrepreneurs, especially in estimating their own powers — Supply and demand of entrepreneur ability.

Chapter X. Enterprise and Profit (continued) The Salaried Manager 291

Indirectness of knowledge and control — We generally judge the capacity of some one else to judge for us and not our problem itself — In the same way we get things done by getting others to do them — The characteristic quality of the executive is judgment of men — The final control is the selection of men to control in business organization, and this is inseparable from responsibility — The distribution of authority and responsibility in the modern business world.

xiv CONTENTS

Chapter XI. Uncertainty and Social Progress 313

Change, the main source of uncertainty, is the source of the problem of control — Uncertainty in the investment of resources gives rise to a separation of the function of investment from that of saving — The theory of interest — The uncertainty element in relation to the various forms of progressive change — Complicated problems arising out of the capitalization of profits — The permanence of profit; friction, and mobility.

Chapter XII. Social Aspects of Uncertainty and Profit 347

All methods of reducing or redistributing uncertainty involve costs — The extent to which they should be carried depends upon how far uncertainty as such is undesirable — Free enterprise concentrates control and responsibility in the hands of property-owners, and a small class of these — Contrast between free enterprise and freedom — From the standpoint of efficiency alone it is fairly clear that men work more interestedly and effectively for an uncertain than for a certain reward — Question of the aggregate amount of the profit share — All evidence indicates that it is negative — Question of abolishing free enterprise in favor of some other system — Largely a problem of getting those in control of economic activity to feel an independent creative spirit — The great difficulty of control beyond one's own life-time; social continuity and the family problem.

Index 377

I

Part I Introductory

KISK, UNCERTAINTY, AND PROFIT

CHAPTEH I

THE PLACE OF PROFIT AND UNCERTAINTY IN ECONOMIC THEORY

Economics, or more properly theoretical economics, is the only one of the social sciences which has aspired to the distinction of an exact science. To the extent that it is an exact science it must accept the limitations as well as share the dignity thereto pertaining, and it thus becomes like physics or mathematics in being necessarily somewhat abstract and unreal. In fact it is different from physics in degree, since, though it cannot well be made so exact, yet for special reasons it secures a moderate degree of exactness only at the cost of much greater unreality. The very conception of an exact science involves abstraction ; its ideal is analytic treatment, and analysis and abstraction are virtually synonyms. We have given us the task of reducing to order a complex mass of interrelated changes, which is to say, of analyzing them into uniformities of sequence or behavior, called laws, and the isolation of the different elementary sequences for separate study.

Sometimes the various elementary constituents of our corciplex phenomenon are met with in nature in isolation complete or partial, and sometimes artificial experiments can be devised to present them either alone or with attendant conditions subject to control. The latter is, of course, the characteristic procedure of physical science. Its application to the study of industrial society is, however, generally impracticable. Here we must commonly search for manifestations of the various factors in our complex, under varying associations, or rely upon intuitive knowledge of general principles and follow through the workings of individual chains of sequence by logical processes.

The application of the analytic method in any class of problems is always very incomplete. It is never possible to deal in this way with a very large proportion, numerically speaking, of the vast complexity of factors entering into a normal real situation such as we must cope with in practical life. The value of the method depends on the fact that in large groups of problem situations certain elements are common and are not merely present in each single case, but in addition are both few in number and important enough largely to dominate the situations. „ The laws of these few elements, therefore, enable us to reach an approximation to the law of the situation as a whole. They give us statements of what "tends" to hold true or "would" hold true under "ideal" conditions, meaning merely in a situation where the numerous and variable but less important "other things" which our laws do not take into accou&t were entirely absent.

Thus, in physics, the model and archetype of an exact science of nature, a relatively small and workable number of laws or principles tell us what would happen if simplified conditions be assumed and all disturbing factors eliminated. The simplified conditions include specifications as to dimensions, mass, shape, smoothness, rigidity, elasticity and properties generally of the objects worked with, specifications usually quite impossible to realize in fact, yet absolutely necessary to make, while the "disturbing factors " are simply anything not included in the specifications, and their actual elimination is probably equally impossible to realize, and, again, equally necessary to assume. Only thus could we ever obtain "laws," descriptions of the separate elements of phenomena and their separate behavior. And while such laws, of course, never accurately hold good in any particular case, because they are incomplete, not including all the elements in the case, yet they enable us to deal with practical problems intelligently because they are approximately true and we know how to discount their incompleteness. Only by such approximations, reached by dealing analytically with the more important and more universal aspects of phenomena, could we ever have attained any intelligent conception of the behavior of masses of matter in motion and secured our present marvelous mastery over the forces of nature.

In a similar way, but for various reasons not so completely and satisfactorily, we have developed a historic body of theoretical economics which deals with "tendencies"; i.e., with what "would" happen under simplified conditions never realized, but always more or less closely approached in practice. But theoretical economics has been much less successful than theoretical physics in making the procedure useful, largely because it has failed to make its nature and limitations explicit and clear. It studies what would happen under "perfect competition," noting betimes respects in which competition is not perfect; but much remains to be done to establish a systematic and coherent view of what is necessary to perfect competition, just how far and in what ways its conditions deviate from those of real life and what "corrections" have accordingly to be made in applying its conclusions to actual situations.^

The vague and unsettled state of ideas on this subject is manifest in the difference of opinion rife among economists as to the meaning and use of theoretical methods. At one extreme we have mathematical economists and pure theorists ^ to whom little if anything outside of a closed

^ Cf . Mackenzie, Introduction to Social Philosophy, p. 58. Also Bagehot, Economic Studies, no. 1: "The Presuppositions of English Political Economy."

* There are three types or schools of mathematical economic theory.

system of deductions from a very small number of premises assumed as universal laws is to be regarded as scientific economics at all. At the other extreme there is certainly a strong and perhaps growing tendency to repudiate abstraction and deduction altogether, and insist upon a purely objective, descriptive science. And in be* tween are all shades of opinion.

In the present writer's view the correct "middle way" between these extreme views, doing justice to both, is not hard to find. An abstract deductive system is only one small division of the great domain of economic science, but there is opportunity and the greatest necessity for cultivating that field. Indeed, in our analogy, theoretical mechanics is a very small section of the science of physical nature; but it is a very fundamental section, in a sense the "first" of all, the foundation and prerequisite of those that follow. And this also may very well hold good of a body of "pure theory" in economics; it may be that a small step, but the first step, toward a practical con^rehension of the social system is to isolate and follow out to their logical conclusion a relatively small number of fundamental tendencies discoverable in it. There is abundant need for the use of both deduction and induction in economics as in other sciences, if indeed the two methods are theoretically separable. As Mill has well argued ^ we must reason deductively as far as possible, always collating our conclusions with observed facts at every stage. Where the data are too complex to handle in this way induction must be applied and empirical laws formulated, to be connected deductively with the general principles of "ethology" (we should now say simply "human behavior"). Emconnected with the names of Cournot, Jevons, and Walras respectively. Dr. Vilfredo Pareto, of the University of Lausanne (successor of Walras), is now the most prominent exponent of the mathematical method. Among "literary" pure theorists, Wicksteed, Schumpeter, and Pantaleoni stand out.

^ Logic, book vi, chaps, ix and x.

phasis being laid on the provisos, in both cases, that in using deduction the conclusions must be constantly checked with facts by observation and premises revised accordingly, while the empirical laws resulting from induction must in turn be shown to follow from the general principles of the science before they can be credited with much significance or dependability, we see that there is little divergence left between the two methods.^

^ The relations between deduction and induction are intimate, and a rigid separation or contrast between the two methods is misleading. A more careful study of the fundamentals of scientific method will be undertaken hereafter (chapter vii). We shall see that there is ultimately no such fact as deduction as commonly understood, that inference is from particulars to particular, and that generalization is always tentative and a mere labor-saving device. The fact is, however, that we can study facts intelligently and fruitfully only in the light of hypotheses, while hypotheses have value more or less in proportion to the amount of antecedent concrete knowledge of fact on which they are based. The actual procedure of science thus consists of making and testing hypotheses. The first hypotheses in any field are usually the impressions of "common sense"; i.e., of that superficial knowledge forced upon intelligence by direct contact with the world. Study, in the light of any hypothesis, corrects or refutes the guiding generalization and suggests new points of view, to be criticized and tested in the same way, and so the organization of the material proceeds. The importance of generalization arises from the fact that as our minds are built, it is nearly fruitless to attempt to observe phenomena unless we approach them with questions to be answered. This is what a hypothesis really is, a question. Superficial observation suggests questions which study answers. If and so long as it answers a question affirmatively and the answer is not contradicted by the test of practical application or casual observation, we have a law of nature, a truth about our environment which enables us to react intelligently to it in our conduct.

There is, then, little if any use for induction in the Baconian sense of an exhaustive collection and collation of facts, though in some cases this may be necessary and fruitful. On the other hand, there is equally little use for deduction taken as doing more than suggesting hypotheses, subject to verification. It is to be noted, however, that our common-sense generalizations have a very high degree of certainty in some fields, giving us, in regard to the external world, for instance, the "axioms" of mathematics. Even more important in the present connection is the role of common sense or intuition in the study of human phenomena. Observation and intuition are, indeed, hardly distinguishable operations in much of the field of human behavior. Our knowledge of ourselves is based on

The method of economics is simply that of any field of inquiry where analysis is in any degree applicable and anything more than mere description possible. It is the scientific method, the method of successive approximations.^ The study will begin with a theoretical branch dealing with only the most general aspects of the subject matter, and proceed downward through a succession of principles applicable to more and more restricted classes of phenomena. How far the process is carried will be a matter of taste and of the practical requirements of any problem. In science generally it does not pay to elaborate laws of a very great degree of accuracy of detail. When the number of factors taken into account in deduction becomes large, the process rapidly becomes unmanageable and errors creep in, while the results lose in generality of application more significance than they gain by the closeness of approximation to fact in a given case. It is better to stop dealing with ele-

introspective observation, but is so direct that it may be called intuitive. Its extension to our fellow human beings is also based upon the mterpretation of the communicative signs of speech, gesture, facial expression, etc., far more than upon direct observation of behavior, and this process of interpretation is highly instinctive and subconscious in character. Many of the fundamental laws of economics are therefore properly "intuitive" to begin with, though of course always subject to correction by induction in the ordinary sense of observation and statistical treatment of data.

These brief statements must not be thought of as dealing with philosophical problems. The writer is, like Mill, an empiricist, holding that all general truths or axioms are ultimately inductions from experience. By induction as a method is meant deliberate, scientific induction, the planned study of instances for the purpose of ascertaining their "law." And deduction means reaching new truth by the application of general laws to particular cases. In the present view both of these processes are regarded as suggestive merely, exhaustive induction and conclusive deduction being alike impossible.

1 The reader will recall Comte's arrangement of the sciences in the order of generality of the principles they establish. Mathematics, the properties of space and of quantity in the abstract, is applicable to all phenomena — and tells us correspondingly little about any of them. The laws of matter, of living matter, etc., are less general and more concretely real. The same principles are applicable within any grand division of knowledge.

ments separately before they get too numerous and deal with the final stages of the approximation by applying corrections empirically determined.

The theoretical method in its pure form consists, then, in the complete and separate study of general principles, with the rigid exclusion of all fluctuations, modifications, and accidents of all sorts due to the influence of factors less general than those under investigation at any particular stage of the inquiry. Our question relates to the advisability of using this method in a tolerably rigid form in economics. The answer to this question depends on whether in the phenomena to be studied general principles can in fact be found of sufficient constancy and importance to justify their careful isolation and separate study. The writer is strongly of the opinion that the question must be answered affirmatively. Economics is the study of a particular form of organization of human want-satisfying activity which has become prevalent in Western nations and spread over the greater part of the field of conduct. It is called free enterprise or the competitive system. It is obviously not at all completely or perfectly competitive, but just as indisputably its general principles are those of free competition. Under these circumstances the study, as a first approximation, of a perfectly competitive system, in which the multitudinous degrees and kinds of divergences are eliminated by abstraction, is clearly indicated. The method is particularly indicated in a practical sense because our most important questions of social policy hinge directly ixpon the question of the character of the "natural" results of competition, and take the form of queries as to whether the tendencies of competition are to be furthered and supplemented or obstructed and replaced.

That such a theoretical first approximation is indicated in a theoretical sense, that it is the natural logical way of going at the problem, conforming to the workings of our thought processes, is sufficiently evidenced by the fact that this is what economists have always in fact done, ever since there has been such a science or such a social system to be studied. They have, to be sure, been criticized for doing it, and severely. But in the present writer's judgment theorists of the past and present are to be justly criticized not for following the theoretical method and studying a simplified and idealized form of competitive organization, but for not following it in a sufficiently seKconscious, critical, and explicit way. In their discussions of methodology the historic economists have, indeed^ been as clear and explicit as could be desired,^ but in the use of the method as much cannot, unfortunately, be said.

It should go without saying that in the use of the scientific method of reasoning from simplified premises, it is im- ^perative that it be clear to the reasoner and be made unmistakable to those who use his work what his procedure is and what presuppositions are involved. Two sjipreme difficulties have underlain controversies regarding method in the past. The first is the strong aversion of the masses of humanity, including even a large proportion of " scholars, " to all thinking in general terms. The second difficulty, on the other side, is the fact referred to above, that the persons employing methods of approximation in economics have not themselves adequately and always recognized, and still less have they made clear to their readers, the approximate character of their conclusions, as descriptions of tendency only, but have frequently hastened to base principles of social and business policy upon very incomplete data. The evil results of the failure to emphasize the theoretical character of economic speculation are apparent

^ Cf. Mill's Essays on Unsettled Questions, no. 5, which really leaves little to be said on the subject. Also Cairnes, on the Character and Logical Method of Political Economy, and the discussions of methodologj' of the English economists generally. The conception of the "economic man" was one way of emphasizing the abstract and simplified character of the premises of the science. Keynes's Scope and Logical Method of Political Economy is an admirably clear and conclusive discussion of this whole subject.

in every field of practical economics. The theorist not having definite assumptions clearly in mind in working out the "principles," it is but natural that he, and still more the practical workers building upon his foundations, should forget that unreal assumptions were made, and should take the principles over bodily, apply them to concrete cases, and draw sweeping and wholly unwarranted conclusions from them. The clearly untenable and often vicious character of such deductions naturally works to discredit theory itself. This, of course, is wrong; we do not allow perpetual motion schemes to discredit theoretical mechanics, which is built upon the assumption of perpetual motion at every stage. But in economics a distrust of general principles, fatal as it is to clear thinking, wUl be inevitable as long as the postulates of theory are so nebulous and shifting. They can hardly be made suflSciently explicit; it is imperative that the contrast between these simplified assumptions and the complex facts of life be made as conspicuous and as familiar as has been done in mechanics.