THE LAW OF PROFITS
§ I. MEANING OF TERMS
Broadest use of the term profit
1. The term profit is popularly used as any gain or advantage secured by any means in business. The terms used in economics, being taken from popular language, vary in meaning according to the context. It is necessary to clear thinking to reject some words entirely and when using others to define them more strictly. The broad usage of the term profits just noted includes every kind of return to industry: such as interest on capital, and wages or services of the man owning the industry. Precise thinking requires its use in a much narrower sense.
Used of gross gains on sales
2. A common meaning of profits in retail business is the gross gain on a given sale. Buying an article for one dollar and selling it for two dollars, is said by the merchant to be selling at one hundred per cent. profit, jocularly called, "The Dutchman's one per cent." The cost price is considered to be that paid to the manufacturer or wholesaler. In different lines of goods there is added regularly to this cost twenty, thirty, or fifty per cent., as the case may be, as the merchant's profit on the sale. This is of course a gross profit, and not net, or true profit. It leaves out of account rent, interest on capital, clerk hire, freight, and many other minor items that enter into the cost of running a store. It often happens that the Dutchman's way of reckoning is nearer the truth, and that the gross profit of one hundred per cent. proves at the end of the year to be only a net profit of one per cent. This evidently is a loose meaning, impossible in the discussion of theoretical questions. This meaning is sometimes developed, making profits the sum of all the gross profits on separate sales within a year, or the difference between the wholesale and retail prices of goods sold within the year.
Another meaning given to the term is gross profit (as above) compared with the capital invested. The "profit" in this case varies partly with the rate of the turnover. To illustrate: if the amount invested in a printing-office is $100,000, and the annual business done is $300,000, the capital is said to be turned over three times; if the gross profits on sales averaged twenty per cent., they would be sixty per cent. on the investment; but, if the capital had been turned over four times, the gross profit would have been eighty per cent. on the investment.
Of net gains as a percentage of invested capital
3. Another meaning of profits is the annual net gain of the business, as compared with the average investment of capital. This is a long step toward greater definiteness. If at the end of a year it were found that after paying all outside expenses there were $10,000 to set aside, this would be accounted a profit of ten per cent. on $100,000 invested. But confusion still reigns because of wide variation in the methods of estimating costs before fixing net profits. In one case the enterpriser rents lands and buildings, in another he owns them; in one case he has borrowed money and counts interest as a cost, in another he is free from debt; in one case he counts as a part of cost an estimated fair salary for himself and his partners, in another (usually in a small business) no such allowance is made Such a variation in business usage is most perplexing. In all these cases one must have the exact conditions in mind before it is possible to make any comparisons and draw any conclusions as to the relative profits of different industries.
Profits in economic theory
4. In the narrower and exacter sense profits are the net gain of the enterpriser after counting the rent of material agents and contract wages of employees at the prevailing rates. Into the practical problem of cost and profit many factors enter, and the theoretical problem is to determine just how much ought to be attributed to each. In a large business usually the practical bookkeeping problem is not unlike that of economic analysis. A stock company counts as cost, as a part of fixed charges, interest on capital borrowed either from banks or bondholders. Its managers are paid salaries, counted as a part of cost. The net balance, after deducting these and all other expenses, is counted profits and paid in dividends to stockholders. The economic student is not attempting to get a theory of profits that is in contrast with practice. Rather, he is trying to analyze profits generally, just as they are analyzed in the few cases where the books are properly kept. In economic theory, therefore, profits are the part of the gain of any business that is logically attributable to fortunate investment and good management; profits are the income attributable to the enterpriser's services.
Profits a species of wages
5. Typical economic profits are thus a species of wages but are marked by peculiar features. In some of the older treatises on political economy, profits are treated merely as a combination of "wages of management," and of interest on capital invested. A man hired at a fixed sum to manage a business is receiving simply contract wages. Economic profits are not contract wages, not being paid by agreement, but being yielded impersonally by the industry. Profits are, however, economic wages or the earnings of services. As business has developed, it has been seen that the enterpriser's work has its peculiar character and deserves special attention. The old English word "enterpriser," used of the "adventurer" who embarked in foreign trade, may fittingly apply to the organizer and director of business to-day. Foreign trade then, more often than now, was most uncertain, and there were many chances that the ship would be lost, or the venture prove a losing one. In the simplest business to-day there is this element of enterprise, or undertaking, combined with ordinary capital and labor. As industry develops, this special service stands out more clearly. In the corner-grocer and in the manager of the little news-stand, the elements of enterprise and labor are not apart. In the large wholesale house, the enterpriser is seen to be not merely an abstractly thinkable function, but a separate and concrete person. The typical enterpriser is the man who gives his time and energies to the launching and guiding of business.
§ II. THE TYPICAL ENTERPRISER'S SERVICES REVIEWED
The enterpriser's skilful use of capital
1. The enterpriser guarantees to the capitalist-lender a fixed return. Agents will yield the highest economic rent of which they are capable only in the hands of those who can use them with exceptional skill. Owners of capital who for any reason, such as youth, inexperience, ill health, incapacity, or conflicting duties, are not able to make agents yield the average rent, seek out, or are sought out by, those who in general can make the agents yield more than the average. The interest contract between them is one of mutual advantage, in that the enterpriser pays a definite sum to the investor unable himself to apply his productive agents. Immense sums of capital are now put into the hands of small enterprisers, such as Western farmers improving their lands, builders of city homes and business blocks, and small manufacturers. But stocks and bonds of corporations give a wide variety of investments which shade off from the safer or capitalistic type, to the more uncertain, or enterpriser's type. First-mortgage bonds, being a first claim on the income and property, have the highest security and yield generally the lowest interest. Even national bonds are not absolutely safe, and for that reason as well as because of their fluctuation in price, even their purchase has something of the nature of an enterprise. Stocks are the enterpriser's type of investment, the dividends being more uncertain, but giving the chance of a higher return than the average. It is because some stand ready to assume the risk of making goods yield average returns or more, that others can sit and enjoy a fixed income with little effort and in comparative security.
The enterpriser's insurance of the lender's capital
2. The enterpriser gives up the certain income to be got by lending his own capital, and, becoming a borrower, offers his capital as insurance to the lender. Every business has an element of uncertainty in it, and some one must meet the risk. A man with marked ability as an organizer of industry is rarely found long without capital of his own. But even a penniless man who can gain the confidence of investors is able to get backing and to secure the necessary funds to engage in business. The lenders in such a case, however, run a greater risk than when the enterpriser is a man of some means, and they therefore ask a higher rate of interest than if they were loaning to a wealthy man or to a wealthy company. They are in part the enterprisers. When, as usually, the enterpriser invests some of his own capital, it is a guarantee of his good faith, a sort of insurance reserve to protect the lender from loss. The first loss falls on the enterpriser, and the chance of loss to the lender is in large part, though not entirely, eliminated. It is characteristic of modern loans that the borrower may be rich, not poor,—often richer than the lender. The mortgage on real estate and the creditor's claim on a merchant's property usually give security of far greater value than the loan.
The enterpriser's insurance of the laborer's production
3. The enterpriser gives to other workers a definite amount for services applied to distant ends. In discussing the wage system it was pointed out that most labor at the present time is put upon future goods. It is not known what they will be worth a month or a year later when they mature as consumption goods; their present worth can merely be estimated. If they prove to be worth little, the profits may be nothing or less than nothing. The enterpriser, however, buys the services for ready money, embodies them in goods, and assumes the risk; the goods may sell for more or less than the wages. It is sometimes said with a certain irony that if the enterpriser assumes the risk he is very careful to pay so little for labor that he does not lose. In this naive view the enterpriser is so independent of the market that he can pay much or little as he pleases. In fact in many cases he gains little, and in many he loses and loses largely.
The risk of the enterpriser's services
4. The enterpriser risks his own services and accepts an indefinite chance instead of a definite amount for them. Assuming the risk for the right conduct of industry, he backs himself, expresses his faith in himself as a manager who can make labor earn more than the prevailing wages and make capital yield more than the prevailing rate of interest. If it were otherwise, he would loan what capital he has instead of borrowing more; instead of employing others, he would himself seek employment in some other industry. Men are constantly shifting from the class of hired workers to that of enterprisers. It is a rude and often tragic process of adjustment and selection that enables men having ability as enterprisers to continue in that work, and forces others into the class of employees.
The enterpriser the intermediary in industry
5. The enterpriser is the economic buffer; economic forces are transmitted through him. In a more primitive industry each man is wage-earner, capitalist, and enterpriser combined in one. As industry develops, some of the factors of cost become distinguishable, and relatively stable and calculable. A low rate of interest, ranging from three to four per cent., can be secured with practical certainty by putting one's money into good corporation securities, into the savings-bank, or into national bonds. Contract wages in each class of labor also are fixed by competition at a point where they are a medium or average of gains and losses. The enterpriser is the most movable element. As the specialized risk-taker, he is the spring or buffer, which takes up and distributes the strain of industry. He feels first the influence of changing conditions. If the prices of his products fall, the first loss comes upon him, and he avoids further loss as best he can by paying less for materials and labor. At such times the wage-earners look upon him as their evil genius, and usually blame him for lowering their wages, not the public for refusing to buy the product at the former high prices. Again, if prices rise, he gains from the increased value of the stock in his hand that has been produced at low cost. If the employer often appears to be a hard man, his disposition is the result of "natural selection." He is placed between the powerful, selfish forces of competition, and his economic survival is conditioned on vigilance, strength, and self-assertion. Weak generosity cannot endure.
Fluctuation of profits
6. Profits therefore fluctuate more from industry to industry and from man to man than do other incomes. As a somewhat exceptional case, small employers in industries such as baking and tailoring, may for long periods get less for their work than their employees get in wages. The pride in being an employer and occasional chances of greater gains perhaps explain the fact. The fluctuations of the market may sweep away from the enterpriser not only all his "profits," but all his accumulated wealth. As a consequence, profits may be at other times very high, for men will not take the risk of great losses unless there is a chance of large gains. While the income of the salaried man is occasionally advanced, and then for long periods remains unchanged, the profits of enterprise come in waves. In seasons of prosperity the income of the employer swells with a dramatic swiftness while rents and wages move tardily upward. But for years again the employer earns a return hardly exceeding a low interest on the capital invested in the enterprise, or runs the business for a time at a loss. Profits of this kind should not be spoken of as a percentage. Greater or less, they are the net result attributable to the enterpriser's skill, and bear no fixed or calculable relation to any capital investment.
§ III. STATEMENT OF THE LAW OF PROFITS
Antisocial or pseudo-profits
1. Some apparent profits are due to antisocial or criminal acts. Cheating, lying, breaking of contracts, bribery of public officials, and many similar acts may greatly increase individual incomes. These are not profits, as the term is here understood, but they are hard to distinguish from profits in practical life. One man gains a temporary success by acts that are later punished as crimes; another, guilty of like deeds, escapes conviction for lack of evidence or on technicalities, and enjoys ill-gotten wealth. More fortunes, however, are due to actions on the border-line of ethics, which society is not yet honest enough to condemn or wise enough to prevent. No code of laws can be framed that will make possible the punishment of all antisocial acts. Any law that would catch all the guilty would injure many of the innocent. Economic analysis may exclude from the concept of profits the gains made by such means, but only omniscience could distinguish them in every actual case from "swag and boodle."
Chance profits
2. Some profits are the result of pure chance or luck. What is luck? A result that is not calculable, coming to pass in conditions where a rational choice is not possible, is called luck, for lack of another name. Now pure luck often brings temporary profit to the individual, but chance does not in the least account for the average and abiding profits. There is bad luck as well as good luck. According to the law of chance, in the tossing of a coin for "heads and tails," one side is as likely to come up as the other, and in the long run the number of heads and tails will be equal. Where cases are numerous, losses and gains distribute themselves about a general average, and may be eliminated by insurance, as that against fire, flood, lightning, against sickness of the employer, which would cripple the business, or against his death, which would check it. But many factors evade all attempts to reduce them to rule, and chance remains a considerable factor in the success of many individuals. It still sometimes appears better to be born lucky than rich.
Profits due to a union of chance and choice
3. Some profits are temporary gains from happy but not entirely accidental choice of the best course. Many cases of profit said to be due to chance are found on closer knowledge to be due to superior judgment. A slight advantage in choice will give now and then apparently chance gains. The adventurer who, on the discovery of gold, goes at once to California or to Alaska, may stumble upon a gold-mine. It is luck; but if he stays at home it is more likely, according to the theory of chances, that he will stumble over an ash-heap. In places where gold-mines are comparatively plentiful, one takes chances between a load of lead and a bag of money. Throughout life there is constant opportunity, but it must be sought. One who has the good judgment to be ever at the right time at the place where he has the best chance of stumbling upon a good thing, usually gets the advantage, and men call it luck. The more the causes of success in general are studied, the larger is found the element of choice, the smaller that of luck. Some writers make these temporary gains the essence of profits. Considering that profits are always due to the introduction of new and better methods, and not to the continued use of better ones, they argue that as the knowledge of these becomes common property profits will disappear. But this in our view is a partial truth.
Skill the essential condition of continuing profits
4. Continuing profits arise from the continued exercise of superior judgment. After all the chance elements are taken into account, there remain differences in the abilities of men, and a continued and ever-renewed need of organizing power. Profits, being recognized as due to these differences in the abilities just as rent is due to differences in the fertility and efficiency of goods, have therefore been called differential gains. There would be no objection to the term were it not intended to emphasize a supposed difference between profits and rents on the one hand and interest wages on the other.
Risk of loss reduced by skill
Some writers have so magnified the thought that the enterpriser's function is to assume risk, as to make it a denial of the view that profits are the earnings of ability. The risks of business are not those of the throwing of dice in which (if it is fair) skill plays no part, and gains in the long run offset losses. Business risks are rather those of the rope-walker in crossing Niagara; the task is easily undertaken by the skilful Blondin, it is fatally dangerous to the man of unsteady nerve and limb. Profits are due not to risks, but to superior skill in taking risks. They are not subtracted from the gains of labor but are earned, in the same sense in which the wages of skilled labor are earned. So long as some men have better organizing ability than others, have better judgment, are better able to take the risks, there is reason to believe that profits will continue.
Profits are the share, or income, of the enterpriser for his skill in directing industry and in assuming the risks. Despite the complex influences, they are determined by his contribution to industry essentially as is the value of any skilled service.