§5. The Necessity of Rent. Behind all such detailed applications there lies a more general consideration which deserves attention. The way in which the land of a country is used, the way in which it is apportioned between the countless alternative employments that are possible, is a most important matter, more important perhaps than any questions as to the size of the incomes which particular landowners receive by virtue of their rights of ownership. How is this apportionment effected as things are now? The answer is clear: mainly by the agency of either rent or price. The business which finds it worth while to offer the highest rent or the highest price for any piece of land will, as a rule, be able to command its use. And, with this as the governing principle, an apportionment is secured between shops, offices, factories, agriculture, between the immense variety of different employments covered by each of these broad headings; not a rigid unvarying apportionment, but one which constantly changes as economic circumstances change, and as the margin of transference between different occupations moves hither and thither. This apportionment takes place at present as the result of the independent decisions and bargains of many private individuals, who are thinking mainly of their own interests, and not of those of the community. But this state of affairs might be altered. The land might be nationalized and allocated to its various uses by the co-ordinated labors of a great State department, or some other agency of the collective will. However improbable such a change, it is perfectly conceivable. But what is not conceivable is that any State department should handle the job with a success even approaching that of the present system, unless it continued to use, as its main instrument, the criterion of either rent or price. That a piece of land would yield a higher rent in one occupation than in any other is not conclusive evidence that it is best to devote it to the former purpose, but it is very good evidence, and it should be allowed to prevail unless it is demonstrably outweighed, as it possibly might often be, by considerations of a different kind. That it would not be well for the community to employ land in the city of London for corn-growing purposes, however desirable might be a revival of home agriculture, is so obvious that it may seem to have no bearing on the present issue. But it is only an extreme indication of the absurd and wasteful use of our natural resources, which would grow up slowly but surely, if we dispensed with ideas of rent and price as sordid irrelevancies, and allocated our land on the basis of a balancing of the loftiest arguments of a vague and sentimental character. If you are prepared for the distribution of land to become stereotyped, for each piece to continue indefinitely in its present use, then indeed you might dispense with rent, as primitive societies very largely do. That would mean stagnation and, for an industrial country, decay. But if changes are ever to be contemplated, a simple quantitative measure is the only safeguard against utter chaos. Thus rent, like interest, will be found indispensable as a measure under any efficient system of society, even if it might not always represent the payment of sums of money to private individuals. And that is why the principles governing rent possess, as I indicated at the outset of this chapter, an importance more fundamental than our present system of ownership and tenure.
§6. The Question of Real Costs. But we must not forget the preliminary question that started us upon our analysis of the agents of production. The rent which a manufacturer or farmer has to pay for his land he naturally includes in his cost of production. But does this money cost to the individual correspond to, and measure, any real cost to the community as a whole? Here let us note in the first place that if only we could disregard the variety of uses to which land is put, if we could suppose that all industry was agriculture, and that agriculture was a single industry with a single product, we could argue that rent does not enter into marginal costs at all. For we could regard the marginal producer as the one working on a marginal farm, whereas we have seen there is no pure rent. The rent which other producers have to pay would thus represent merely the destination of the surplus profits which arise wherever actual costs fall short of marginal costs. This way of looking at the matter has proved attractive to some thinkers, not in the least because of a desire to palliate the effects of landlordism, but because it fits in so well with our general sense of rent as a "surplus," and a surplus as something distinct from a necessary price. But it is clearly illegitimate in an economic theory which professes "to describe the facts." The marginal land for many purposes fetches, as we have seen, a considerable rent; and this rent is certainly part of the marginal costs and of the necessary price of the products of the particular industry. The answer to our question is, however, not now very difficult to see. Land, greatly as it differs in many respects from the other agents of production, resembles them in the very important respect that, being used for one purpose, it is not available for other purposes, and that the productive powers of the community in other directions are thereby diminished. This is the real cost to the community, which attaches to the products of any industry, in virtue of the land which it occupies; not any human labors or sacrifices required to produce the land itself, but the curtailment of the natural resources available for productive use elsewhere. This is the real cost of which rent is the money measure, and generally speaking an accurate measure at the margin of transference between one occupation and another. A somewhat fanciful use of the term cost, this may seem perhaps, one not quite in accordance with our instinctive sense of what real costs should be. But possibly the real costs represented by wages and profits may turn out to be not so very different, and we had best leave the matter there, until we have examined the nature of these other costs.
§7. Rent and Selling Price. In this chapter we have spoken mainly of the rent rather than the price of land: the relation between the two things is fairly obvious and well understood, but it will be well not to close the chapter without a brief account of it. The price of any piece of land is affected by all the considerations on which its rent depends, but it is also affected by another factor which has no influence whatever upon rent. This factor is the rate of interest. The higher the rate of interest, the higher the return which a man could obtain by buying gilt-edged securities, the lower will be the price that he will pay for a piece of land which yields a given rent. We can express the relation more precisely by the formula Price = (Rent × 100)/(Rate of Interest), though we must be careful, in applying this formula in practice to allow for the possible deviations between the nominal and the true rent, and similar complications. The price, it must be observed, is derived in this way from the rent, not the rent from the price.[[1]] Rent is thus logically the simpler, price the more complex thing. It is well, therefore, to analyze in the first instance the principles of rent, if we live in a country where the practice of leasing land for annual rent is less common than it is in Great Britain, even if, for whatever reason, it is the price of land with which we are concerned in practice. The problem of price contains two distinct elements which it is not easy to handle when mixed up together. For the rate of interest represents in itself an important branch of economics, which will require a separate chapter to itself.
[1] In this the rent of land differs fundamentally from that of other things, such as houses. For the price of a house is largely influenced by the costs of construction of new houses, and should correspond closely to them in the long run. The same relation between rent, price and rate of interest will hold good; but the rents will be affected by changes in the rate of interest, owing to the reactions of such changes on the supply of houses.
Chapter VII
Risk-Bearing and Enterprise
§1. Profits and Earnings of Management. The profits of a business, as they are ordinarily reckoned, whether for the purposes of income tax or of a balance sheet, comprise several elements which are fundamentally distinct. The relative importance of these various elements varies greatly from one type of business to another. The profits of a private business include, for instance, the remuneration of the work of management, which in the case of a Joint Stock Company is mostly paid for by salaries or directors' fees. It is to their profit that farmers, small shopkeepers, and the partners of a private firm look not merely for a return upon their capital, but for the reward of their own labors. "Earnings of Management," as they are usually termed (though in truth they often cover other and humbler forms of labor) are thus frequently one of the ingredients of profits.
§2. The Payment for Risk-bearing. There is another element of great importance about which our ordinary ideas are apt to be so vague that it will be well to devote a chapter to its examination. This is the element of payment for risk, or rather the reward of risk-bearing. Risk is inherent in all business, as it is inherent in all life. The vagaries of nature and the vagaries of man are alike responsible. The farmer may find his harvest ruined by a drought or by a deluge; the coal or the gold, for the extraction of which you have perhaps set up an extensive mining plant, may come to an end which is unexpectedly abrupt. You may put your money into roller-skating rinks and find that cinemas have become the rage with the fickle public; sometimes "the market" may decline for causes which remain obscure but with consequences which are disagreeably plain. But while risk is always present in some degree, the degree varies enormously from one industry to another. Now, it is obvious enough that in an exceptionally risky industry, where there is a considerable possibility that the capital invested will yield no return at all, the profits of those concerns which succeed are likely to exceed the rate of interest on gilt-edged securities. But what is likely to be the magnitude of this excess? Is risk-taking rewarded if there is any such excess, however small? Or will it suffice that the gains and losses should average out to a fair rate of interest over the whole industry? To enable us to think closely let us suppose for a moment that we can measure accurately what the chances are.
Suppose, then, that there were a precisely equal chance of success on the one hand and failure on the other in any enterprise, failure involving a complete loss of all the capital invested. Suppose, further, 6 per cent to be at the time a fair return on a perfectly secure investment. What would be the return which must be expected from the risky enterprise, in the event of its succeeding, before it will be undertaken? The reader may be tempted to answer, 12 per cent. But 12 per cent would not suffice. An equal chance of 12 per cent or nothing, as compared with a certainty of 6 per cent, does not mean that the risk in the former case is paid for to the tune of 6 per cent. It means that it is not paid for at all. In each case what a mathematician would call the expectation is a return of 6 per cent. The odds are evenly balanced; in the long run, over a large number of cases, if the law of averages works as we assume it does, you would get just as much from the one type of investment as the other. Now, risky enterprises will not, as a rule, be undertaken on terms like these; investors and business men will not take risks with the odds precisely equal; they must have them, or believe that they have them, in their favor.