CHAPTER XXXVII

PROFITS

What are profits? Profits may be broadly defined as the income of the independent business man who receives neither stipulated wages, rent, nor interest. In a somewhat narrower sense they include whatever he has left over after he has allowed himself interest on his own capital, rent for his own land, and wages for his own labor. This would seem to narrow the meaning of profits down to the reward for taking risk, though risk must be defined rather broadly. The enterpriser, as the independent business man may with fair accuracy be called, is essentially the man who undertakes something and relieves others of a part at least of the risk which they would otherwise have to take.

It would be quite possible, for example, for a group of laboring men to borrow capital, build their own factory, and run it. But if they did so, they would always be in danger of losing not only what they themselves had invested, but even their wages for a time; that is to say, if there should come a bad season, when the demand for products fell off, they might have to work for very low wages or for none at all. If some individual or group of individuals will undertake to run the business for them and guarantee them a certain fixed rate of wages, they are relieved of a part of that risk.

Profits as payment for insurance. Again, the men who furnish the capital may jointly assume all the risks of the enterprise. They may, however, be in part relieved by having one individual or group of individuals undertake the business and guarantee them interest on their capital. In such a case, however, the enterprisers usually have to invest some of their

own capital. In such cases they, the enterprisers, put their own capital in the most hazardous position. This is virtually the distinction between common stock and preferred stock in a corporation. Those who own the common stock take the greater risk. So long as the enterprise is running at all, the owners of the preferred stock must get their interest, whether the owners of the common stock get anything or not; but if the enterprise is very successful, the owners of the common stock get larger returns than the owners of the preferred stock. These larger returns over and above the rate of interest will be called profits.

The lure of an enterprise. In a smaller business, run, let us say, by an individual rather than by a corporation, the individual may borrow a part of his capital, and in this case, so long as he is in business at all, he must pay interest on what he borrows, whether he has anything left for himself or not. In case the business succeeds very well, he gets a surplus which may be called profit. The lender of borrowed capital gets no more than the stipulated rate of interest. It is the function of the independent business man or the enterpriser to insure the other participants in the industry against at least a part of their risk. Any income which the insurer gets over and above the normal rate of interest on the capital which he himself puts in may be called profit. This is the lure which induces men to undertake risks of this kind.

This suggests a functional theory of profits which fits in with the functional theories of value, wages, and interest already described in the previous chapters. The function of high profits is to induce a larger number of men to undertake independent enterprises. Where a larger number of such enterprises are needed, there are only two ways of getting them started. One is for the community as a whole to take a part of the social income and by authority invest it in new enterprises; the other is to offer a special inducement to private individuals to undertake the new enterprises voluntarily.

This is usually done by the offer, on the open market, of high prices for the products of the enterprise.

Necessity of taking risk. Risk-taking is no more meritorious in itself than is waiting or working. It is meritorious only when it results in increased production and well-being. Still, the well-being of society or the increased production of the goods which society needs makes it absolutely necessary that some risks should be taken. Risk is therefore something which cannot be avoided. These risks are of many kinds and degrees. The tastes of the people may change so that the product which is to be produced may be no longer desired. Some new invention may render obsolete the processes used and the machinery which has been installed. Strikes, insurrections, wars, and unforeseen physical calamities, such as fires, storms, and earthquakes, must also be taken into account. It would be very difficult to imagine any productive undertaking that did not involve risk. In the case of the farmer, bad weather, insect pests, and diseases of all kinds threaten to decrease or destroy his income. Risk-taking is therefore as necessary as working or waiting in order to get effective production under way.

Irksomeness of risk. Unless, however, risk-taking were in some way irksome or disagreeable, it would not deter men from entering business, and there would be nothing here that would have to be paid for. That is to say, if people liked to take risks, there would be no hesitancy in entering a risky occupation. It would therefore not be necessary to offer a reward to induce men to enter it. But since risk-taking is irksome or disagreeable, since men would rather not hazard their accumulations and their present income, they must be paid something as a lure, or attraction, to overcome this disinclination. The reason here is precisely the same as the reason for paying wages or interest, or for paying the price of any commodity. The function of price, in a free country, is to overcome the disinclination to work, wait, or to take risks.

NOT ALL RISK IS IRKSOME

It is not to be inferred, however, that all risk is burdensome. The gambling instinct is so strong in some people that they will eagerly hazard their wealth on chances which they know to be against them purely for the excitement of the hazard. Different individuals differ greatly in this particular, but in general it will be found that small sums will be risked on the chance of winning large ones more readily than large ones will be risked on the chance of winning small ones, even when the chances in the latter cases are more than proportionally superior. So great is the preference for the former class of hazards that a great many men one might almost say the majority of men — will risk $1 on the chance of winning $1000, even when it is well known that there are 2000 chances to one against their winning. That is why lotteries flourish where they are not suppressed by law. But very few will risk $1000 on the chance of winning $1, even if they know that there are 2000 chances to one in favor of their winning. If a company should offer to sell 2000 tickets at $1000 each, only one of which was a blank, all the rest drawing prizes of $1001 each, it would be making a better offer than any lottery ever has made or ever could make; but it would probably not be able to induce 2000 individuals to buy tickets. And yet such a company would be offering a good risk, as risks go, and anyone who kept on buying them would gain in the long run, though he might lose all his money on the first venture.

DIFFERENCE BETWEEN GAMBLING AND LEGITIMATE

RISK-TAKING

Things are happening all around us every day which cannot be foreseen. We can therefore very easily discover or invent ways of taking risk that have no connection whatever with production or any kind of useful work. Men may bet upon the weather, the speed of horses, the outcome of an election, the way a flipped coin will fall, or which way a cat will jump, but in none of these cases is there anything accomplished as a result of the wager, except the transfer of money from one person to another. These are pure gambling risks and have no connection with any economic function. The farmer takes risk when he plants seed. He does not know what the weather will be, how late the frosts will come in the spring or how early in the fall, what insect pests may destroy his crop, what thieves may steal it, nor what other circumstances, fair or unfair, may occur. Nevertheless, if no one were willing to take such risks, we should never have any food. This kind of risk-taking cannot properly be called gambling. The manufacturer likewise, when he erects his building, fills it with expensive

machinery, and hires his help, does not know how soon a change of fashion may upset his calculations, how soon a strike may occur to stop his production, when financial panic or industrial depression may cause his prospective customers to stop buying, or when a change of government policy or some other fortuitous circumstance may send him into bankruptcy. If no one were willing to take such hazards, consumers would have no manufactured products, and labor would have no employment. Such risk-taking, again, could not be called gambling. It is absolutely necessary to the normal work of production. In short, a hazard of money or anything else of value, on a chance which is not necessary to production, is gambling; a hazard on work which is necessary is not gambling but legitimate risk-taking.

ORDINARY INDUSTRIAL RISKS ARE IRKSOME

Outside of mining and a few extrahazardous enterprises, industrial and commercial risks belong in the class where relatively large sums must be hazarded on the chance of small gains. Such risks do not appeal to the gambling instinct, and consequently they do not attract men except where the chances are good in the long run that is, where the gains, on the whole, considerably exceed the losses. Those who embark on such enterprises will, in the long run, receive profits; but in such extrahazardous enterprises as appeal to the gambling instinct, by the chance of large gains from small investments, men are so overanxious to invest that the losses, on the whole, exceed the gains, and there are no profits for such men as a class, though of course a few win large prizes. It is in the former class of enterprises that the "irksomeness of risk" deters men from embarking, reduces competition, and improves the chances of those who have the foresight or the hardihood to enter.1

Relation of risk to abstinence. There is a close parallelism between the part played by risk in the determination of profits, by abstinence in the determination of interest, and by cost production in the determination of the price of a reproducible commodity. It was pointed out in Chapter XXXVI, on The Cost of Capital and its Price, that the necessity of waiting, combined with the fact that waiting beyond a certain point is disagreeable, tended to reduce the present price of a piece of capital to something less than the sum of its future earnings.

1 T. N. Carver, The Distribution of Wealth, pp. 282-283. The Macmillan Company, New York.