THE LAW OF INTEREST

The product of the final unit of labor - an amount which in practice is measured without any tracing of the previous growth of the working force - sets the standard of the rate of wages. We have now to see that the rate of interest has a similar basis; and yet it is worth while to build up, wholly in imagination, a fund of capital, just as we have made up the force of laborers, increment by increment. This will have the incidental effect of illustrating another way in which wages may be determined.

Interest as a Residual Amount. - The area BCD in our former figure represents the difference between the total product of an industry and the wages paid to laborers. If there is no net profit accruing to the entrepreneur, this area must represent interest. It is what is left for the capitalist on the supposition that he and the laborer together get all that there is. If the goods sell for what they cost, this must be the fact, and the amount represented by BCD has thus to go to capital, since, by a rule of exclusion, it cannot go to the entrepreneur nor to the laborer. The mill and its contents earn for their operator nothing but simple interest on the money they have cost. Paying the laborers discharges the first claim on the product, and there then remains only enough of the product to pay the remaining claim, that of capital.

The question still remains to be answered, how the capitalist, if he is a different person from the entrepreneur, or operator of the mill, can make this functionary pay over to him all that he has in his hands after paying the wages of labor.

The Importance of the Residuum. - The above reasoning does not satisfactorily show what influence the capitalist can use to make the entrepreneur pay over to him the entire amount of the residuum. It shows that after paying wages the entrepreneur will have a certain amount left, but it is not thus far clear how the capitalist can get it from him. The fact that the laborers get only the amount represented by ABDE and that the whole amount is ACDE does, however, at least show that the entrepreneur has the amount BCD left in his hands, and that he is able to pay this amount to the capitalist if by any appeal to competition the capitalist is able to make him do it.

Interest not determined Residually. - The fact is that the interest on capital is fixed exactly as are the wages of labor.

We will let another figure represent the entire product of the same amount of labor and the same amount of capital that were represented in the former case. We will assume that there is at the outset a complete force of laborers, and that no men are added to it or taken from it; but we will gradually introduce units of capital instead of units of labor as in the former case. The amount of capital is now represented by the line A’E’ and the product of the first unit of it by the line A’C’. The product of the successive units declines along the curve C’D’. The final unit of capital then brings into existence the amount of wealth represented by E’D’. As every other unit now produces the same amount, the capital as a whole creates the quantity represented by A’B’D’E’ and every unit of it makes its own separate contribution to that amount. In this we have simply applied to capital and its earnings the principle we formerly applied to labor and its earnings.

General Form of the Law of Final Productivity. - This principle is the law of final productivity, one of those universal principles which govern economic life in all its stages of evolution. Either one of the two agents of industry, used in increasing quantities in connection with a fixed amount of the other agent, is subject to a law of diminishing returns. The final unit of the increasing agent produces less than did the earlier units in the series. This does not mean that at any one time one unit produces less than another, for at any one time all are equally productive. It means that the tenth unit produces less than the ninth did when there were only nine in use, and that the ninth unit formerly produced less than the eighth did in that still earlier stage of the process in which there were only eight in use, etc. If the productive wealth of the United States were only five hundred dollars per capita instead of more than twice that amount, interest would be higher than it is, because the productive power of every dollar’s worth of capital would be more than the productive power of each dollar’s worth is now; and, on the other hand, if we continue to pile up fortunes, great and small, till there are in the country two thousand dollars for every man, woman, and child of the population, interest will fall, because the productive power of a dollar’s worth will become less than it now is.

How Competition fixes Interest. - We can now see how it is that the capitalist can make the entrepreneur pay over to him the amount left in his hands after paying wages. Every unit of capital that any one offers for hire has a productive power. It can call into existence a certain amount of goods. The offer of it to any entrepreneur is virtually an offer of a fresh supply of the kinds of goods which he is making for sale. Loaning ten thousand dollars to a woolen manufacturer is really selling him the amount of cloth that ten thousand dollars put into his equipment will bring into existence. Loaning a hundred thousand dollars to the manufacturer of steel, so as to enable him in some way to perfect his equipment, is virtually selling him the number of additional tons of steel, ingots, or rails that he can make by virtue of this accession to his plant.

The Significance of Free Competition. - Now, the tender of capital may be made to any entrepreneur in a particular industry, and the existence of free competition between these entrepreneurs implies that a lender of capital can get from one or another of them the whole value of the product that this capital is able to create. A unit of capital in the steel business can produce n tons of steel in a year, and if one employer will not pay the price of n tons for the loan of it, another will. This, indeed, implies an absolutely free competition; but that is the condition of the problem we have first to solve. When we know what ideally active competition will do, we can measure the effects of the obstructions that, in practice, competition actually encounters.

Competition for Capital among Different Industries. - The capitalist can invoke the aid of competition outside of the limits of one particular business. He may offer his loan to steel makers, to woolen manufacturers, cotton spinners, silk weavers, shoemakers, etc. Within each one of these industries perfect competition between the different employers will give him the value of the product which, in that business, his capital is able to create. If, however, what in this way he offers to men in one occupation is worth more than what he offers to men in another line, - if capital is worth more to steel makers than it is to cotton spinners, - he will find a market for his capital in the former industry; and this process of seeking out the employment in which capital is the more productive and there bestowing the loans of capital, will go on until every such local excess of productive power is removed and capital can produce as much wealth in one business as it can in another. Everywhere capital will then be both producing and receiving the same amount, and general interest will everywhere be determined by the final productivity principle acting all through the business world.

When Interest as Directly Determined equals Interest as Residually Measured. - The area BCD of the first figure measures what the entrepreneur has left after paying wages. This amount and no more he can pay as interest, and he will pay it if he has to. The area A’B’D’E’ of the second figure represents what he must pay as interest; and we can now see that, if competition is perfectly free, this amount equals the amount BCD of the first figure. If, after paying wages, there is any more left in the entrepreneur’s hands than competition compels him to pay out as interest, he is realizing a net profit; he is selling his goods for more than they cost him, and this, as we saw at the outset, is a condition that under perfect competition cannot continue. The natural price of goods is the cost price. If the market price of anything is in excess of cost, entrepreneurs receive a profit, and in order to do more business and make a larger aggregate of such profit they bring new labor and capital into their industry. The increased output lowers prices, and the excess of gain is thus taken from the entrepreneur. If BCD is smaller than A’B’D’E’, the entrepreneur incurs a loss and will curtail his business and let some labor and capital go where they can produce more.

Taking this remainder of income from the entrepreneur by means of an addition to the output of goods and a reduction of the price of them does not annihilate the income, but bestows it on other recipients; for the reduction in price which destroys an employer’s profit can come only in a way that benefits consumers. It means that enlarged production of which we have just spoken, which scatters more goods throughout the community and insures an addition to the real incomes of both laborers and permanent investors.

Effect of Perfect Mobility of Labor and Capital. - Perfect mobility of labor and capital insures that the residuum in the entrepreneur’s hands after wages are paid shall all be made over to the capitalist. We encounter here again the static law that, with competition working without let or hindrance, the entrepreneur as such can keep nothing for himself; though if he is also a worker he will get wages, and if he is also a capitalist he will get interest. His business will pay wages on all kinds of labor, including that of management, and interest on all capital, including his own. A net gain above all this it will not afford, and whatever the entrepreneur has left after paying wages he will have to use in paying interest, and vice versa. Laborers and owners of capital have, as it were, to take each others’ leavings. Such is the situation in an ideally static condition, though we shall see how it is changed in actual and progressive society.

The area BCD of the first figure is, under static conditions, exactly equal to the area A’B’D’E’ of the second figure, because ACDE represents the whole product, BCD in the first figure represents all that is left of it after wages, measured by ABDE, are paid; and we know by evidence both theoretical and practical that the capitalist, whose share is directly expressed by A’B’D’E’ of the second figure, can claim and get the whole of this amount.

Wages as a Residuum. - It is clear that the same reasoning applies to wages. In the second figure they are represented as a residuum. The area B’C’D’ represents what the entrepreneur has left after paying interest, and nobody can get this amount but the wage earner. The reason, however, why the wage earner can get it is that free competition will give him the amount ABDE of the first figure, and this, under perfectly static conditions, must equal B’C’D’ of the second. Under perfect competition the entrepreneur cannot have any of the amount B’C’D’ left in his hands after meeting the claims that the wage earner makes on him. On the other hand, he must have enough left to pay interest, since otherwise he would be incurring a loss, and that could not fail to force him and others who are in the same situation to contract their operations or go out of business. If the output of goods is reduced, either by the retirement of some employers or the curtailment of product by all, the price of what continues to be sold will be raised to the point at which wages and interest can be paid.

Wages and Interest both adjusted at Social Margins of Production. - It is to be noted that wages and interest are fixed at the social margin of production, which means that they equal what labor and capital respectively can produce by adding themselves to the forces already at work in the general field of employment. In making the supposition that, owing to some disturbing fact, a particular entrepreneur has not enough after paying wages to pay interest, we assume that the rate of interest is fixed, in this way, in the general field and not merely in his establishment.

If B’C’D’ were larger than ABDE, the entrepreneur would be selling goods for more than cost and realizing a net profit, which he cannot do in a static state; but a pure profit is not only possible but actual in a dynamic state.

In actual business total returns represented by ACDE amount to more than the sum represented by ABDE (wages) plus A’B’D’E’ (interest). There are conditions that in practical life are continually bringing this to pass in different lines of business, though not in all of them at once. The real world is dynamic and therefore the true net profit, or the share of the entrepreneur in the strict sense of the term, is a positive quantity. This income is always determined residually. It is a remainder and nothing else. It is what is left when wages and interest are paid out of the general product. To the entrepreneur comes the price of the products that an industry creates. Out of this he pays wages and interest, and very often he has something remaining. There is no way of determining this profit except as a remainder. The return from the sale of the product is a positive amount fixed by the final utility principle. Wages and interest are positive amounts, and each of them is fixed by the final productivity principle. The difference between the first amount and the sum of the two others is profit, and it is never determined in any other way than by subtracting outgoes from a gross income. It is the only share in distribution that is so determined. Entrepreneur’s profits and residual income are synonymous terms. In the static state no such residual income exists, but from a dynamic society it is never absent. Every entrepreneur makes some profits or losses, and in society as a whole the profits greatly predominate.

Summary of Facts concerning a Static Adjustment of Wages. - We know then that in any industry wages and interest absorb the whole product, because any deviation from that rule in a particular group is corrected in the way above mentioned. Moreover, general wages and interest, as determined by the law of final productivity, must equal those incomes when they are determined residually. The area of the rectangular portion of one of the foregoing figures must equal the area of the three-sided part of the other. The question arises why all entrepreneurs might not get a uniform profit at once. This would not lure any labor or capital from one group or subgroup to another. If, after paying wages and interest at market rates, the entrepreneurs in each industry have anything left, the entire labor and capital are producing more than they get and there is an inducement to managers and capitalists to withdraw from their present employers and become entrepreneurs on their own account. Such an entrepreneur entering the field, drawing marginal labor and capital away from the entrepreneurs who are already there and combining them in a new establishment, can make them produce more than he will have to pay them and pocket the difference. If such a condition were realized, there would be a gain in starting new enterprises, since luring away marginal agents and combining them in new establishments would always be profitable. When we introduce into the problem dynamic elements we shall see that centralization, which makes shops larger instead of smaller, makes industries more productive, and that what happens when net profits appear is more often the enlarging of one establishment than the creation of new ones. Entrepreneurs in the large establishments can afford to resist the effort made by others to lure away any of the labor or capital which they are employing, and they will do this for the sake of retaining their profits. They can do it by bidding against each other, in case any of them are making additions to their mills or shops, and also by bidding against any new employers who may appear. Perfect competition requires that this bidding for labor and capital shall continue up to the profit-annihilating point. Here, as elsewhere in the purely static part of the discussion, we have to make assumptions that are rigorously theoretical and put out of view in a remorseless way disturbing elements which appear in real life. The static state requires that all entrepreneurs who survive the sharp tests of competition should have equally productive establishments, which means that they should all be able to get the same amount of product from a given amount of labor and capital. The actual fact is that differences of productive power still survive. There are some small establishments which, within the little spheres in which they act, are as productive as large ones; but there are also some which are struggling hopelessly against large rivals in the general market and are destined erelong to give up the contest. In other words, the centralizing and leveling effects of competition are approximated but never completely realized in actual life.

A fact that it is well to note is that the test of final productivity is inaccurately made when unduly large amounts of labor and capital are made the basis of the measurement. Take away, for instance, a quarter of the working force, estimate the reduction of the product which this withdrawal occasions, and attribute this loss entirely to the labor which has been taken away, and you estimate it too highly. With so large a section of the labor withdrawn the capital would work at a disadvantage, and a part of the reduction of the product would be due to this fact. If we should take away all the labor, the capital would be completely paralyzed, and the product would become nil. It would obviously be inaccurate to say that the whole product is attributable to the labor, on the ground that withdrawing the labor annihilates it all. With any large part of the labor treated as a single unit, the loss of product occasioned by a withdrawal of such a unit is more than can be accurately imputed to it as its specific product. The smaller the increments or units are made, the less important is this element of inaccuracy, and it becomes a wholly negligible quantity when they become very small. A study of the forms of the productivity curves will show that if we take as the increment of labor used in making the test only a tenth of the whole force, we exaggerate the product imputable to it by a very minute fraction, say by less than a one-hundredth part; and if we take a hundredth of the labor as a final unit, we exaggerate the product that is solely attributable to it by an amount so minute that it is of no consequence in practice or in any theory that tries to be applicable to practice.

A question may be raised as to whether we are correct in saying that the entrepreneur’s profit is residual, in view of the fact that the entire product of a business is at the mercy of the management, so that a bad manager may reduce it or a good one may increase it. It may be further claimed that that part of the management of a business which consists in making the most far-reaching decisions cannot safely be intrusted to a salaried superintendent or other paid official and must get its returns, if at all, in the form of profits. Even in this case the gains are secured by making the gross return, which is the minuend in the case, large, leaving the two subtrahends, wages and interest, unchanged, and thus creating a remainder or residuum. We shall later see to what extent entrepreneurs do in fact create the profits that come to them.

The complete static conception of society requires that no entrepreneur should be left in the field who cannot continue indefinitely to hold his own against the competition of his rivals, and this requires essential equality of productive power on the part of all of them. It is not necessary, however, that all should operate upon an equal scale of magnitude, for an interesting feature of modern life is the need of many small productive establishments that cater to local demands and to wants which, without being local, call for only a few articles of a kind. Repairs, small orders, and peculiar orders are executed more cheaply in small establishments, and they survive under the very rule of essential equality of productive power which static conditions require. For catering to the general market and producing staple goods the large establishment has a decisive advantage, and this insures the centralization which is the marked feature of recent industrial life.